In re Wyly

• Citation: 552 B.R. 338
• Decision Date: 10 May 2016
• Docket Number: CASE NO. 14–35043–BJH JOINTLY ADMINISTERED
• Parties: In re: Samuel Evans Wyly, et al., Debtors.
• Court: United States Bankruptcy Courts. Fifth Circuit. U.S. Bankruptcy Court — Northern District of Texas

552 B.R. 338

In re: Samuel Evans Wyly, et al., Debtors.

CASE NO. 14–35043–BJH JOINTLY ADMINISTERED

United States Bankruptcy Court, N.D. Texas, Dallas Division.

Signed May 10, 2016

Josiah M. Daniel, III, Paul E. Heath, James Jay Lee, Rebecca Lynn Petereit, Vinson & Elkins L.L.P., Donald P. Lan, Jr., Lan Smith Sosolik, PLLC, Lesley C. Ardemagni, Law Offices of Judith W. Ross, Judith W. Ross, Eric A. Soderlund, Judith Ross, PC, Dallas, TX, David L. Kornblau, New York, NY, for Debtors.

Related to ECF Nos. 4, 75, 516, 923, & 938

MEMORANDUM OPINION

BARBARA J. HOUSER, United States Bankruptcy Judge

I. JURISDICTION, AUTHORITY, AND VENUE... 355

II. PRELIMINARY MATTERS... 356

A. Factual and Computation Stipulations of the Parties... 356

B. Facts Found Due to this Court's Application of Collateral Estoppel... 356

C. United States' Motion to Exclude the Expert Report, Opinions, and Testimony of Joshua S. Rubenstein... 358

D. Dee's Motion for Partial Summary Judgment... 366

III. FACTUAL AND PROCEDURAL HISTORY... 366

IV. LEGAL ANALYSIS... 374

A. Burden of Proof... 374

1. Bankruptcy Law Burden of Proof—In General... 374

a) Prima Facie Validity under Bankruptcy Rule 3001(f)... 375

b) Have the Debtors Raised Evidence of a Probative Force Equal to that of the Proofs of Claim?... 378

2. Tax Law Burden of Proof—In General... 380

a) Gift Tax Deficiencies and the Presumption of Correctness... 380 (1) Is the IRS' Determination “Arbitrary and Erroneous?”... 381

(2) Burden Shifting under 26 U.S.C. § 7491... 383

b) Fraud Penalties for Income Tax and Gift Tax Underpayments... 386

c) International Failure to File Penalties... 387

3. The Debtors' Defenses... 388

a) Reasonable Cause Defenses... 388

b) Dee's Innocent Spouse Defense... 389

B. Was the Debtors' Underpayment of Income Taxes Due to Fraudulent Intent?... 389

1. Relevant Statutes and Badges of Fraud... 392

a) The Complexity of the Offshore System... 394

b) The Wylys' Willingness to Commit Securities Fraud to Preserve the Secret Offshore System and to Maintain its Tax Advantages... 408

c) The Failure to Take Action to Resolve the Conflicting Advice Sam and Charles Received Regarding the 1992 IOM Trusts... 413

d) The Creation of False Documents to Support the Settling of IOM Trusts in 1994 and 1995 to Attempt to Obtain Favorable Tax Benefits for the Wylys... 415

e) The Treatment of the Offshore System as the Wyly Family Piggy Bank....... 423

f) The Planned Insolvency of Various IOM Corporations that Owed Annuity Obligations... 431

g) Understatement of Income... 441

h) Concealment of Income or Assets... 446

i) Offering False or Incredible Testimony... 447

j) Offering Implausible or Inconsistent Explanations of Behavior... 449

k) Filing False Documents... 452

l) Failure to Cooperate with Taxing Authorities... 460

C. Was Dee Willfully Blind?... 461

D. Is Dee Entitled to the Benefits of the Innocent Spouse Defense?... 464

E. Did Sam Establish his Reasonable Cause Defense to the Imposition of Fraud Penalties for His Income Tax Underpayments?... 475

1. The Defense in General... 475

2. The 1992 Private Annuity Transactions... 482

3. The Settlement of the Bessie IOM Trust and the La Fourche IOM Trust and their Proper Characterization... 494

4. The 1996 Private Annuity Transactions... 498

5. Alleged Reliance on French... 503

F. Were Gifts Made to the Wylys' Children?... 512

1. The Relevant Standards... 513

a) Defining a Gift... 513

b) Determining the Underlying Substance of the Transaction... 514

(1) The Economic Substance Doctrine... 514

(2) The Substance Over Form Doctrine... 515

(3) The Step Transaction Doctrine... 515

2. Understanding the Transactions Alleged to be Gifts by Sam to His Children... 516

a) Formation and Funding of the Cayman LLCs... 516

b) The Real Estate Holdings... 519 c) Liquidation of the Cayman LLCs... 524

3. Analysis of Alleged Gifts Made by Sam... 524

a) Cash Used to Purchase, Improve, and Maintain the Cottonwood Ventures I and II Properties... 525

b) Cash and Other Assets that were Transferred Into the Cayman LLCs... 532

(1) The Interests in IOM Real Estate Companies... 532

(2) Cash and Other Financial Assets Transferred to the Cayman LLCs... 535

4. Understanding the Transactions Alleged to be Gifts by Dee to Her Children... 536

c) Stargate Horse Farm... 537

d) Little Woody (LL Ranch)... 538

5. Analysis of the Alleged Gifts Made by Dee... 539

a) Cash Used for the Purchase, Maintenance, Improvement, and Upkeep of the Stargate Horse Farm and Little Woody (LL Ranch) Real Estate Properties... 539

b) The Promissory Note Due to Dee from the Caroline D. Wyly Irrevocable Trust... 543

(1) Overview of the Transaction... 543

(2) Analysis of the Alleged Gift Made by Dee... 546

(3) Is Dee Liable for Fraud Penalties on her Gift?... 549

G. Are Penalties Owing for the Failure to File Forms 3520, 3520–A, and 5471?... 551

1. Introduction... 551

2. Statutory Overview... 551

a) § 6038 and Failures to File Form 5471... 553

b) § 6048(b) and Failures to File Form 3520–A... 556

c) § 6048(c) and Failures to File Form 3520... 557

(1) In General... 557

(2) Annuity Payments... 558

(3) Real Estate Transactions... 569

(4) Security Capital Loans... 570

(5) Sales of Options to IOM Corporations... 575

H. Did the Debtors Establish Their Reasonable Cause Defenses to the Imposition of International Penalties?... 576

1. Introduction... 576

a) Review of Provisions of § 6038... 576

b) Review of Provisions of §§ 6048(b) and 6677... 576

2. Reasonable Cause and Lack of Willful Neglect... 577

a) In General... 577

b) Reliance on the Advice of Professionals... 579

c) Honest Difference of Opinion... 580

d) Application to Both Debtors... 583

(1) As to Sam... 585

(2) As to Dee... 593

I. Does the Imposition of the International Penalties Violate the Eighth Amendment?... 602

1. Applicable Supreme Court Precedent... 602

a) The Supreme Court Decisions... 603

b) Lower Courts' Interpretations of Supreme Court Precedent...608

2. Are the International Penalties “Fines”?... 609

3. Alternatively, Are the International Penalties “Excessive?”... 614

a) As to Sam... 616 b) As to Dee... 621

J. Do the Equitable Doctrines of Laches or Estoppel Apply Here, or Does the Court have Discretion Regarding the Assessment of Taxes or Penalties Against the Debtors?... 624

1. Does Laches Apply Here?... 624

2. Does Estoppel Apply Here?... 627

3. Does the Court have Discretion to Alter the Penalty Amounts?... 634

K. Suspension of Interest Under 26 U.S.C. § 6404(g)... 635

1. This Court has Jurisdiction to Determine the Amount of Interest Payable by the Debtors, Including Whether the Debtors Are Entitled to Mandatory Interest Suspension under 26 U.S.C. § 6404(g)... 636

2. Mandatory Suspension of Interest Does Not Apply in Any Case Involving Fraud, Precluding Suspension for Sam in the Relevant Years...638

3. Interest Suspension is Moot as to Dee Because She Did Not Commit Tax Fraud and She is Entitled to Innocent Spouse Relief from the Income Tax Underpayments to Which § 6404(g) Interest Suspension Would Apply... 639

V. CONCLUSION... 639

Before the Court are the Motion Pursuant to Bankruptcy Code § 505 to Determine Tax Liability, If Any [ECF No. 4] and the Amended Motion Under Bankruptcy Code Section 505 to Determine Tax Liability, If Any [ECF No. 516] (together, the “Motions ”) filed by Samuel Evans Wyly (“Sam ”) and Carolyn Dee Wyly (“Dee, ” and together with Sam, the “Debtors ”), respectively, in which the Debtors seek to have this Court determine the allowed claim of the Internal Revenue Service (“IRS ”) against them. The Debtors have also objected to the proofs of claim¹ filed by the IRS against them (together, the “Claim Objections ”).² By agreement of the parties, the Motions and the Claim Objections were heard concurrently, as each seeks to have the Court determine the IRS' allowed claims against the Debtors' respective estates. Pursuant to a Scheduling Order agreed to by the parties and entered by the Court [ECF No. 564], trial commenced on January 6, 2016 and concluded on January 21, 2016. Closing arguments were heard on January 27 and 28, 2016. At the Court's direction, the Debtors and the IRS filed post-trial briefs on certain issues on February 5, 2016 and reply briefs to each other's post-trial brief on February 10, 2016. The Motions and 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 9014.³

I. JURISDICTION, AUTHORITY, AND VENUE

The district court of the Northern District of Texas has subject matter jurisdiction over the Debtors' bankruptcy cases (the “Cases ”) pursuant to 28 U.S.C. § 1334, and this Court has authority to determine the amount or legality of tax and the allowance or disallowance of claims against the bankruptcy estates pursuant to 28 U.S.C. § 157(a), (b)(1), (b)(2)(B), and (b)(2)(O ), 11 U.S.C. § 505(a),⁴ and the Order of Reference of Bankruptcy Cases and Proceedings Nunc Pro Tunc adopted in the Northern District of Texas on August 3, 1984. As explained by the Fifth Circuit, § 505(a)(1) is a “broad grant of jurisdiction” authorizing the bankruptcy court to determine certain tax issues, subject to statutory exceptions that are not applicable to the Cases.⁵ Venue is proper in this district pursuant to 28 U.S.C. § 1408.

II. PRELIMINARY MATTERS

A. Factual and Computation Stipulations of the Parties

At the Court's urging, the parties stipulated to a large number of undisputed facts, which are contained in the Joint Stipulations of Fact [ECF No. 1040] (the “Joint Stipulations ”) filed December 30, 2015. While the Court will not repeat those factual stipulations verbatim in this Memorandum Opinion, it adopts them as if they were set forth herein.

In addition, the parties were able to stipulate to the facts that will be necessary for them to compute the amount of tax, interest, and penalties that may...