Tax Update Blog: Permalink

« Previous · Tax Update Blog Home · Next »

WE THINK YOU LIED. YOU BACKDATED DOCUMENTS. BUT IT'S OK, YOU RELIED ON YOUR LAWYER.

February 16, 2006

The Tax Court came to a puzzling conclusion yesterday. The Court reviewed a case where the sellers of a scrap metal business tried to have their cake and eat it too. Immediately before the sale (or maybe later) the sellers, Zajman and Moshe Melnik, transferred their business shares to an offshore corporation in exchange for a private annuity. The idea was to defer the gain over the annuity period.

Unfortunately for the Melniks, they were - well, careless. They had effective control over the company that bought their annuity, and they used it as a piggy bank:

The record demonstrates that Clend functioned primarily as a conduit and that neither the Melniks, Clend, nor Bermuda Trust acted with the kind of restraint that one would expect to see from participants in a legitimate annuity transaction. Although Clend had a substantial annuity obligation to fund, Clend and Bermuda Trust used substantial portions of Clend's assets to make unsecured loans and high-risk real estate investments in the United States at the Melniks' request. In reality, the Melniks treated Clend's assets as a personal bank account and line of credit. Such transactions support a conclusion that the Melniks had access to, and indirect control over, Clend's assets in a manner that is inconsistent with the Melniks' paper status as creditors/annuitants.

The court had little trouble dismissing the transaction as lacking substance:

The resulting record reeks of self-interest and is riddled with imprecision and inconsistencies that petitioners do not explain. The record fails to establish the dates when certain relevant events took place, is lacking in credible evidence that the annuity transactions had economic substance independent of tax considerations, and is woefully inadequate to demonstrate that respondent's determination was wrong.

The inadequacies permeate every aspect of the record. We shall review in detail some of the problems with the record presented by petitioners and our reasons for concluding that petitioners' evidence is not worthy of belief and is not sufficient to demonstrate that respondent's determination was in error.

The opinion goes on to detail the problems in sections with titles like "Backdateing and 'Effective As of' Dating of Documents," "Missing Documents," "Lack of Arm's Length Dealings" and "Suspicious Timing."

BUT IT'S OK, NO PENALTIES: YOU HAD A LAWYER

If you just read this far into the opinion, you would think that at the very least the taxpayers would face negligence penalties, if not penalties for civil fraud, with backdated documents and whatnot. But like garlic warding off a vampire, the presence of a lawyer warded off penalties for the Melniks:

The uncontroverted record establishes that petitioners relied on [taxpayer attorney] Mr. Pennoni, who was the driving force behind the planning of the annuity transactions and who assured petitioners that there was a reasonable basis for the income tax reporting of the private annuity transactions and the HouTex stock sale.

We conclude that, under the circumstances, petitioners' reliance on Mr. Pennoni was reasonable, that petitioners had reasonable cause for the underpayment, and that petitioners acted in good faith with respect to the underpayment within the meaning of section 6664(c)(1). Consequently, we hold that petitioners are not liable for the section 6662 accuracy-related penalty.

WHEN THE WORST CASE IS NO WORSE AT ALL

Unwittingly, the Tax Court here tells taxpayers that they have nothing to lose by careless, and even outrageous, tax planning. From the opinion, the transactions look flaky from the get-go. The documents were bad, backdated, and perhaps even cooked up afterwards. Yet the taxpayers are no worse off for engaging in these shenanigans than they would have been had they properly reported the income in the first place. If the cost of cheating and losing is no worse than the cost of properly reporting a transaction in the first place, why not cheat? And why wouldn't an honest taxpayer feel like a sap for not cheating?

Link: Zalman Melnik and Moshe Melnik

      Bookmark: del.icio.us • Digg • reddit