In re Canada, CASE NO. 15-33757-BJH
| Decision Date | 07 June 2016 |
| Docket Number | CASE NO. 15-33757-BJH |
| Parties | IN RE: WILLIAM R. CANADA, JR., DEBTOR. |
| Court | United States Bankruptcy Courts. Fifth Circuit. U.S. Bankruptcy Court — Northern District of Texas |
Related to ECF Nos. 40, 82
Before the Court are Debtor's Objection to Claim of United States Department of Thr [sic] Treasury/Internal Revenue Service [ECF No. 40] (the "Original Claim Objection") and Debtor's Supplemental Objections to Claim of United States Department of The Treasury/Internal Revenue Service [ECF No. 82] () filed by the debtor, William Ralph Canada, Jr. ("Canada" or the "Debtor"). The Claim Objections relate to a proof of claim (the "Original Proof of Claim")1 and an amended proof of claim (the "Amended Proof of Claim")2 filed by the United States Department of the Treasury/Internal Revenue Service (the "IRS"). Pursuant to the Scheduling and Case Management Order Regarding Debtor's Objection to Claim of the United States Department of The Treasury/Internal Revenue Service (the "Scheduling Order") entered on February 1, 2016 [ECF No. 67], an evidentiary hearing on the Claim Objections commenced on May 12, 2016 and concluded on May 13, 2016.3 At the Court's direction, the IRS filed a post-trial brief on May 19, 2016,4 and Canada filed a reply brief on May 23, 2016.5 The Claim Objections are now ripe for ruling.
After carefully considering the arguments of the parties (as advanced orally and in writing both pre and post-trial), the evidence admitted at trial, and its own research of the legal issues raised, this Memorandum Opinion contains the Court's findings of fact and conclusions of law pursuant to Federal Rules of Bankruptcy Procedure 7052 and 9014.6
The district court of the Northern District of Texas has subject matter jurisdiction over the Debtor's bankruptcy case pursuant to 28 U.S.C. § 1334. This Court has the authority to determine the allowance or disallowance of the Amended Proof of Claim, which seeks tax penalties under 26 U.S.C. § 6707, pursuant to 28 U.S.C. § 157(a), (b)(1), (b)(2)(B), 11 U.S.C. §505(a), and the Order of Reference of Bankruptcy Cases and Proceedings Nunc Pro Tunc adopted in the Northern District of Texas on August 3, 1984. Venue is proper in this district pursuant to 28 U.S.C. § 1408.
The issue raised by the Claim Objections is whether Canada is liable for the $40,346,167.87 in penalties that the IRS asserts in the Amended Proof of Claim.7 According to the IRS, Canada is liable for these penalties because under 26 U.S.C. § 6111—as effective during 1998-2002, the time period at issue here (the "Relevant Time Period")—Canada was a "tax shelter organizer" who was required to register certain "tax shelters" that he helped to market and sell (the "Heritage Transactions") while he was working at the Heritage Organization, LLC ("Heritage") during the Relevant Time Period.8 Failure to register a "tax shelter" under 26 U.S.C. § 6111 leads to penalties under 26 U.S.C. § 6707 which are equal to "1 percent of the aggregate amount invested in such tax shelter."9
Canada argues that he is not liable for penalties under 26 U.S.C. § 6707 on various grounds, but for the purposes of this Memorandum Opinion two of those grounds are controlling. First, Canada argues that the Heritage Transactions were not "tax shelters" as that term is defined in 26 U.S.C. § 6111(c) because tax shelters under § 6111(c) must be an "investment" and theHeritage Transactions are an idea or strategy rather than an investment.10 Second, Canada argues that even if 26 U.S.C. § 6111 required him to register the Heritage Transactions as a tax shelter, he should not be liable for penalties under 26 U.S.C. § 6707 because he has established reasonable cause for his failure to register them.11 The Court will provide a factual and procedural history of this case, and will then proceed to evaluate these two arguments, as they are dispositive of the issues here.12
After graduating from Harvard law school in 1979 and prior to his employment at Heritage, Canada worked at a variety of law firms primarily as a commercial litigator.13 Canada testified that he had "very little" tax experience prior to coming to work at Heritage in 1995.14 Canada was initially exposed to Heritage through its main principal, Gary Kornman ("Kornman"), for whom Canada periodically handled what were primarily employment litigation matters.15 In 1994, unhappy practicing law, Canada concluded that he should "trysomething different because [he] wasn't enjoying what he was doing day-to-day."16 Around this time, Kornman offered Canada a job at Heritage.17 At first, Canada was hired by Heritage as a "contractor," which in Heritage's parlance was someone who would initially meet with prospective clients in order to interest them in Heritage's services, including the Heritage Transactions.18 By 1998, Canada was a key player at Heritage who was heavily involved in the marketing and sale of the Heritage Transactions to clients.19 Beyond his responsibility for marketing and selling the Heritage Transactions, at some point Canada became Heritage's President and/or Chief Operating Officer, although he contends that Kornman was always the person who was truly in control of Heritage.20 Regardless of how much authority Canada hadover the operations of Heritage itself, one thing is clear—during the Relevant Time Period, Canada was heavily involved in the organization, implementation, and marketing of the Heritage Transactions.21
The Heritage Transactions were first marketed in 1998, and they were designed to ameliorate capital gains taxes for Heritage's clients.22 The Heritage Transactions were initially conceived of by an attorney named Edward Ahrens ("Ahrens") of Ahrens and DeAngeli, who brought the concept to Heritage's attention and who also did legal work for Heritage's clients related to the Heritage Transactions after the concept was more fully developed.23 The particular Heritage Transactions for which the IRS seeks to impose penalties on Canada occurred between 1998 and 2001.24 Canada described the Heritage Transactions in his trial testimony as follows:
at its simplest, I guess, the client would form an entity, an LLC, or some other type of pass through entity like an S-Corporation, would open a brokerageaccount with a major brokerage firm, would sell Treasury securities short, would then reinvest those into what are called reverse repurchase agreements, that brokerage account would then be contributed to a partnership, and at that point in time the lawyers opined that the client created basis in the partnership equal to the amount of the proceeds of the Treasury short.25
The Treasury securities that Canada described were not purchased outright by Heritage clients, but were instead borrowed pursuant to an obligation to return or replace those Treasury securities in the future. When a Heritage client's brokerage account was contributed to a partnership in the scenario Canada described, as an economic matter the obligation to replace the Treasury securities would also be contributed to the partnership.26 The key to the "tax magic" of the Heritage Transactions was in how this obligation to replace the Treasury securities was treated as a tax matter. During the Relevant Time Period, certain lawyers were willing to opine that under the Internal Revenue Code, Heritage clients contributing their brokerage accounts to the partnerships involved in the Heritage Transactions could, as a tax matter, disregard their obligation to eventually replace the Treasury securities, because this obligation was a contingent liability.27 Disregarding this obligation created a variety of opportunities to manufacture capitallosses or to artificially offset capital gains.28
When Canada marketed the Heritage Transactions, he was not attempting to sell shares of a particular partnership entity or the services of a particular brokerage company or law firm. Instead, the product that Canada sold was an idea—i.e., a strategy for producing incredible tax savings that Heritage would reveal to its clients for a (very high) price. This is what the evidence shows that the Heritage Transactions were—an idea or a strategy. For example, Heritage's contracts with its clients provided that "[Heritage], after receiving the necessary data and objectives regarding the financial situation and potential tax liabilities of the Principals and after meeting with the Principals to discuss their objectives, may communicate to the Principals one or more Strategies which, singularly or in combination, may produce the following results (herein referred to as the "Results")..."29 These "Results" mostly involved the reduction of tax liabilities.30 "Strategies" was a defined term in Heritage's contracts, and the contracts stated that the term "Strategies"
shall be broadly construed and shall mean the securities, contracts, Persons identified, facts, data, knowledge, documentation, opinions, combinations of concepts, ideas, techniques, methods, transactions, combinations, sequences of events, timing, financial models, diagrams, illustrations, and procedures divulged, described, communicated, detailed, arranged or identified by [Heritage] and all variations, modifications, sequences, rearrangements and recombinations thereof.31
The Heritage contracts acknowledge that although "the Strategies are not necessarily composed of information which is proprietary, trade secrets or exclusively known to [Heritage]" that nevertheless "the usefulness and value of the Strategies may be attributable to the timing, sequencing and combinations of the various non-proprietary components of the Strategies and/or to the fact that the Strategies may not be known to the Principals even though they may be known to others."32
That the value of the Heritage Transactions consisted...
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