United States v. Canada (In re Canada)
| Decision Date | 08 May 2017 |
| Docket Number | CIVIL ACTION NO. 3:16–CV–2000–B |
| Citation | 574 B.R. 620 |
| Parties | IN RE: William R. CANADA, Jr., Debtor, United States of America (IRS), Appellant, v. William R. Canada, Jr., Appellee. |
| Court | U.S. District Court — Northern District of Texas |
Thomas M. Herrin, US Department of Justice, Dallas, TX, for Appellant.
John P. Lewis, Law Office of John P. Lewis Jr., Dallas, TX, for Appellee.
Appellant United States of America (IRS) appeals a final order of the bankruptcy court sustaining Debtor/Appellee William R. Canada, Jr.'s objection to the IRS's claim for civil penalties. In this case, the IRS attempts to impose a $40,346,167.87 civil penalty on Canada's bankruptcy estate for his failure to register as tax shelters certain financial arrangements he marketed and sold from 1998 to 2001 as an employee of the Heritage Organization, LLC. The bankruptcy court held that the arrangements were not "tax shelters" under the applicable statute, and thus Canada could not be penalized for failing to register them. Alternatively, the bankruptcy court found that even if the arrangements were "tax shelters," Canada fell within a statutory safe harbor provision because he had "reasonable cause" for the failure to register. For the reasons explained below, the ruling of the bankruptcy court is AFFIRMED.
After graduating from Harvard law school in 1979, Appellee William R. Canada, Jr. worked for a variety of law firms, primarily as a commercial litigator. Bankr. Op. 4.2 Dissatisfied with the practice of law, Canada went to work for the Heritage Organization in 1995 to "try something different." Id. at 4–5. Canada admits he had "very little" tax experience before going to work for the Heritage Organization. Id. at 4. The Heritage Organization specialized in insurance-based estate planning strategies for high net worth individuals. R. 175. According to Canada, employees called "initiators" would "work the phones" to locate high net worth individuals, after which "contractors"—such as Canada—would schedule face-to-face meetings with prospective clients to interest them in Heritage's estate planning services. R. 174. Finally, principals of the Heritage Organization would make targeted presentations to specific individuals who showed interest in Heritage's services. Id.
Canada was employed at Heritage from 1995 to 2002. Doc. 8, Canada Resp. Br. 6. Despite holding the position of President from approximately 1995 to 2002 and Chief Operating Officer from approximately 1995 to 2000, Canada contends that Heritage's main principal, Gary Kornman, was always truly in control of the organization and that Canada had none of the duties traditionally associated with the title of President or Chief Operating Officer. Bankr. Op. 5–6; Doc. 8, Canada Resp. Br. 8. According to Canada, he was hired simply to "learn the business of Heritage and ultimately be able to make presentations to clients." R. 174. He describes his position in the organization as a "pure salesman." Id.
In 1998, an attorney named Ed Ahrens brought a new strategy to the attention of the Heritage Organization. R. 175–76. The new strategy (the Heritage Transactions) was designed to reduce capital gains taxes for Heritage's clients by short-selling Treasury securities. Bankr. Op. 7–8. As described in its simplest form by Canada, the client would form a pass-through entity, such as an LLC or an S–Corporation. R. 176. Next, the client would open an individual brokerage account with a major brokerage firm, short-sell Treasury securities through the brokerage account, and reinvest the short-sale proceeds in reverse repurchase agreements. Id. Then the client would contribute the brokerage account, including the obligation to repurchase the Treasury securities arising from the reverse repurchase agreements, to the pass-through entity. Id. The client, by ignoring the obligation to repurchase the Treasury securities—which lawyers were willing to opine was legal at the time based on the tax laws—was able to create "basis" in the pass-through entity equal to the amount of the proceeds of the Treasury short. R. 176–77. Though the actual implementation varied from client to client, the essence of the strategy was that a complicated series of financial transactions involving Treasury short-sales could be used to manipulate an asset's "basis" and manufacture artificial losses on paper, which could then be applied against large capital gains to reduce capital gains taxes in a given year. It is undisputed that neither Heritage nor Canada ever bought or sold any of the assets or securities to, from, or for the Heritage clients to effectuate the Heritage Transactions; what Heritage and Canada sold was the strategy itself. This distinction is very important to the Court's analysis below.
From 1998 to 2002, Heritage successfully marketed the Heritage Transactions to several clients.3 The Heritage Transactions were marketed in a similar manner to that described above: "initiators" would make phone calls and try to set up initial meetings, "contractors" would follow up with face-to-face meetings, and at some point individualized presentations and materials would be created for interested clients. R. 199–202. Before Heritage would reveal the specifics of the strategy, however, the client had to sign an engagement contract. See, e.g. , R. 1026–33. Although the contracts varied slightly for each client, they generally provided that, after receiving the necessary information regarding the client's financial affairs, Heritage "may communicate to [the client] one or more Strategies which, singularly or in combination, may produce one or more of the following results," which usually amounted to "reducing capital gains tax liabilities." R. 1026. The contracts defined "strategies" as follows:
The term "Strategies" shall be broadly construed and shall mean the contracts, Persons identified, facts, data, knowledge, documentation, opinions, 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.
R. 1030. The contracts also acknowledged that "the Strategies are not necessarily composed of information which is proprietary, trade secrets or exclusively known to [Heritage] and that 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 [clients] even though they may be known to others." R. 1027.
In the event that a client implemented "in whole or in part, any one or more of the Strategies" in the ten years following disclosure of the strategy by Heritage to the client, the client would pay Heritage 25% of the taxes avoided by implementing the strategy. R. 1026. If a client signed the engagement agreement but did not implement any of the strategies, the client would not owe Heritage any fees other than a $22,500 up front fee for Heritage's employees' "travel expenses" in presenting the strategy. R. 1026.
The contracts also imposed a stiff penalty for unauthorized disclosures of the strategy by a Heritage client. After signing the engagement contract, if a client did not "maintain the absolute secrecy and confidentiality of the Strategies," the client would be assessed a "fee" of "Two Million Dollars ($2,000,000) for each Person to whom the Strategies are Revealed." R. 1027. Additionally, if a person to whom the unauthorized disclosure was made implemented any of the strategies, the client would be assessed an additional "fee" of "six percent (6%) of the Value of all Property used to Implement any of the Strategies." Id.
According to the IRS, the total fees collected by Heritage for Heritage Transactions in which Canada participated between 1998 and 2001 was $62,914,237. Doc. 7, IRS Br. 10 (citing R. 659). It appears Canada may have been involved in as many as 12 different Heritage Transactions for different clients. See R. 659 (). In the bankruptcy court, Canada indicated that "Heritage never did more than a few deals a year of any type." R. 199. It is undisputed that the Heritage Transactions were never registered with the IRS as tax shelters by Canada or anyone else.
Following a dispute over his compensation, Canada left the Heritage Organization in 2002. Bankr. Op. 10. In April 2004, Canada won an arbitration award for more than $6 million against Heritage. Id. A month later, in May 2004, Heritage filed for Chapter 11 bankruptcy, in which Canada participated as a creditor. Id. The bankruptcy court confirmed Heritage's Chapter 11 reorganization plan in September 2007. Id. Sometime in late 2006, however, the IRS apparently began investigating Canada for his involvement with the Heritage Transactions. R. 891–904. Canada was first contacted by the IRS in February 2007 regarding the Heritage Transactions. R. 923. A second letter, dated April 3, 2007, notified him that he was being investigated for tax shelter promoter penalties under 26 U.S.C. § 6707. R. 924. Though it is unclear from the record what progress was made on the investigation or whether the IRS communicated with Canada at all during the interim, in a letter dated April 9, 2015—almost a decade after the investigation began—the IRS notified Canada of its intention to impose $49,108,452 in civil penalties for his "failure to register a tax shelter as required by IRC § 6111 and the associated regulations." R. 646.
As a result of the IRS's notice of its intention to impose this...
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