Blum v. Commissioner , 737 F.3d 1303 ( 2013 )

  FILED
United States Court of Appeals
PUBLISH Tenth Circuit
UNITED STATES COURT OF APPEALS December 18, 2013
Elisabeth A. Shumaker
FOR THE TENTH CIRCUIT Clerk of Court
__________________________________
SCOTT A. BLUM; AUDREY R. BLUM,
Petitioners - Appellants,
v. No. 12-9005
COMMISSIONER OF INTERNAL
REVENUE,
Respondent - Appellee.
__________________________________
APPEAL FROM THE UNITED STATES TAX COURT
(NO. 2679-06)
__________________________________
Christopher Reimer of Long Reimer Winegar Beppler, LLP, Jackson, Wyoming, for
Appellants.
Judith Hagley of the U.S. Department of Justice, Tax Division, Appellate Section,
(Kathryn Keneally, Assistant Attorney General; Tamara W. Ashford, Deputy Assistant
Attorney General; Gilbert S. Rothenberg, Attorney; Richard Farber, Attorney,
Department of Justice, with her on the brief) Washington, DC, for Appellee.
__________________________________
Before HARTZ and TYMKOVICH, Circuit Judges, and JACKSON, District Judge.
__________________________________
JACKSON, District Judge.
__________________________________

The Honorable R. Brooke Jackson, United States District Judge for the District of
Colorado, sitting by designation.
I. Introduction
This case comes to us on appeal from a decision of the Tax Court upholding the
actions of the Commissioner of the Internal Revenue Service (IRS) invalidating a
financial transaction as lacking economic substance and imposing two accuracy-related
penalties for underpayment of taxes. We have jurisdiction to hear this appeal under
I.R.C. § 7482(a)(1). The intricacies of this offshore financial transaction and the fog of
plausible deniability surrounding it cannot make up for the clarity of the big picture: this
was a transaction designed to produce nothing more than tax advantages, and the Tax
Court was right to uphold the Commissioner’s actions.
II. Facts
The taxpayer in question, Mr. Blum, is a successful businessman who founded
Buy.com. In response to Mr. Blum’s 1998 and 1999 federal income tax returns, the
Commissioner of the IRS issued a notice of deficiency and penalties against Mr. Blum.1
Mr. Blum challenged that notice in the Tax Court. He lost and subsequently appealed the
ruling to this Court.
Mr. Blum’s briefs describe a “hard-working and self-made business owner.”
Indeed, Mr. Blum’s accomplishments are numerous and impressive. Mr. Blum founded
Buy.com which in 1998 set records as the fastest growing company in U.S. history. This
achievement undoubtedly springs from Mr. Blum’s drive and business acumen. Mr.
Blum’s success, it should be noted, was not necessarily the result of formal education or
1
Mr. and Mrs. Blum jointly filed the tax returns at issue in this appeal, and therefore Mrs.
Blum is also a party to this lawsuit. For simplicity’s sake, this opinion refers only to Mr.
Blum.
2
expertise. As he points out in his brief, he never graduated from college, nor does he
have special expertise in the areas of federal income tax law, accounting, or stock market
investment. Rather he is a business development expert, and he generally relies on others
to counsel him on matters like tax and investment.
In 1996, Mr. Blum retained KPMG for accounting services. Mr. Blum’s father
vouched for the firm’s reputation, and Mr. Blum has relied on them for years. He has
also hired former KPMG employees. It was, by all accounts, a good and fruitful
relationship.
In August 1998, Mr. Blum made two sales of Buy.com stock resulting in $45
million in capital gains. A KPMG accountant who previously worked on Mr. Blum’s tax
returns was aware of Mr. Blum’s possible capital gains and referred him to Carl Hasting
of KPMG’s Capital-Transaction Group. Mr. Hasting met with Mr. Blum twice. At these
meetings, Mr. Hasting pitched a transaction called OPIS (Offshore Portfolio Investment
Strategy) to Mr. Blum. The transaction, it is now widely acknowledged, is a tax shelter.
However, KPMG recommended the transaction to Mr. Blum before IRS and
Congressional investigations revealed this information to the public. Mr. Blum claims he
saw an investment opportunity; the Commissioner claims Mr. Blum saw a tax evasion
opportunity.
At this point, a brief overview of the OPIS transaction will be helpful. The OPIS
shelter is designed to create large, artificial losses for taxpayers by allowing them to
claim a large basis in certain assets. These artificial losses offset actual capital gains,
reducing the tax liability of the participating taxpayer. A basis is, to oversimplify, the
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capital cost of an asset. IRS Topic 703 – Basis of Assets, available at
www.irs.gov/taxtopics/tc703.html (last visited Oct. 16, 2013). There are technical rules
that allow certain related parties in a financial transaction to claim a basis that, in reality,
does not reflect the amount that the party paid for the asset. In fact, the party might not
have actually purchased the asset at all. OPIS took advantage of this technical rule to
allow clients to pay a relatively small amount of money in order to claim a
disproportionately large basis and to use that basis to shelter their own otherwise taxable
income. See generally Staff of S. Comm. on Gov’t Affairs, Permanent Subcomm. on
Investigations, 108th Cong., Rep. on U.S. Tax Shelter Industry 5-10, 28 (Comm. Print
2003) [hereinafter Senate Report].
Individual components of this transaction presented the possibility of profit. No
one, however, argues that profits were likely. Indeed, while the parties dispute the
method used to calculate the likelihood of profit, both agree profits were unlikely.
Rather, according to Mr. Blum, the small chance of huge profits justified the risk of such
an investment.
According to Mr. Blum, he never discussed the tax effects of the transaction with
Mr. Hasting. Tr. 65-66.2 He also cannot remember discussing OPIS with any of his
other advisors. Nevertheless, after a second meeting with Mr. Hasting, Mr. Blum signed
an Engagement Letter with KPMG that indicated KPMG would receive a fee of $687,500
2
We use the abbreviations used by the parties to refer to materials in the record: Tr. (to
refer to the tax court transcript); Op. (to refer to the tax court opinion); and Ex. (to refer
to exhibits in the trial court).
4
in exchange for serving as a tax advisor to Mr. Blum on the OPIS transaction. Ex. 12-J.
Mr. Blum does not recall reading this engagement letter.
It appears that Mr. Blum left the management of his OPIS investments to KPMG.
As a result, he claimed $45 million in losses on his 1998 income tax returns. Mr. Blum
filed those returns on April 15, 1999. The next month, KPMG provided Mr. Blum with
an opinion letter that explained the legal justification for these financial transactions and
concluded that the IRS would “more likely than not” view the transactions as legitimate.
Ex. 98-P.
These sorts of basis-shifting transactions caught the IRS’s attention in 2001.
According to the GAO, abusive tax shelters may have deprived the U.S. Treasury of
between $11 and $15 billion per year during the 1990s. Sen. Rep. at 20. Extensive
investigation by the IRS and U.S. Senate revealed a widespread practice of using basis-
shifting to create paper losses for clients, thereby reducing their tax bills. The
investigation revealed that even within KPMG there was concern about the potential
illegality of these transactions. One memorandum went so far as to call the economic
substance of these deals “smoke and mirrors.” Id. at 41. The Senate Report concluded
that KPMG might have bullied or misled clients into signing off on certain factual
representations underlying the transactions. For example, the Senate Report observes
that in certain cases “KPMG alone, apparently without any client input, wrote the client’s
representations and then demanded that each client attest to them by returning a signed
letter to the accounting firm.” Id. at 68.
5
The IRS formally disallowed OPIS and similar transactions in 2001. I.R.S. Notice
2001-45, 2001-2 C.B. 129. Rather than individually prosecute each OPIS scheme, the
IRS settled with over 90 percent of OPIS purchasers in 2003. Johnson, Tales from the
KPMG Skunk Works: The Basis-Shift or Defective-Redemption Shelter, Tax Notes 431,
433-34 (July 25, 2005). Mr. Blum did not accept the settlement offer.
These revelations occurred after Mr. Blum participated in OPIS. Nonetheless, in
2005, the IRS sent a deficiency notice to Mr. Blum regarding his 1998 and 1999 federal
income tax returns. This notice disallowed the losses Mr. Blum claimed in connection
with OPIS, and it imposed penalties for a gross valuation misstatement (I.R.C. § 6662(h))
and negligent underpayment (I.R.C. § 6662(b)). Mr. Blum challenged this notice in the
Tax Court in February 2006. The Tax Court rejected his challenge, concluding that the
Commissioner was correct to disallow the claimed losses under the economic substance
doctrine, and that both the gross undervaluation and negligence penalties were
appropriate.
Mr. Blum also filed a civil case against KPMG for fraudulent misrepresentation in
the Central District of California in 2011. After the Tax Court approved the negligent
underpayment penalty, the District Court ruled that such a finding collaterally estopped
Mr. Blum from arguing that he relied on KPMG’s advice that OPIS was a legitimate
investment strategy. Blum v. KPMG, LLP, No. SACV 11-01885-CJC (C.D. Cal. July 17,
2012) (Order).
In his appeal to this Court, Mr. Blum makes three arguments: (1) that the Tax
Court erred when it disallowed the OPIS losses under the economic substance rule; (2)
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that the Tax Court erred by imposing a penalty for a gross valuation misstatement after it
concluded the underlying transaction lacked economic substance; and (3) that the Tax
Court erred by imposing penalties for negligent underpayment, because Blum relied in
good faith on KPMG’s representations. The Commissioner continues to maintain that the
transaction lacked economic substance, and that the gross valuation misstatement and
negligence penalties are warranted.
We affirm the opinion of the Tax Court and note that the question of whether Mr.
Blum is collaterally estopped from arguing that he reasonably relied on KPMG’s advice
in good faith is not before this Court.
III. Discussion
A. Disallowance of OPIS Losses
Quixotically, Blum maintains that the OPIS transaction presented a reasonable
probability of generating a profit. It follows, he argues, that the Commissioner was
wrong to disallow the losses he claimed as a result of the transaction, and the Tax Court
was wrong to validate the Commissioner’s action. In a nutshell, Mr. Blum argues that the
Tax Court applied the wrong test to determine whether the transaction lacked economic
substance, that it improperly ignored the testimony of one of two dueling expert
witnesses, and that it committed clear error by finding that Mr. Blum lacked the
subjective motivation to generate a profit from OPIS.
We are unconvinced and find ourselves arriving at the same conclusion arrived at
by the IRS, the U.S. Senate Committee on Governmental Affairs, and the Tax Court. The
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OPIS transaction in this case was a sham designed to reduce Mr. Blum’s tax liability, and
it lacked any reasonable probability of generating a profit.
We review de novo the tax court’s “general characterization of a transaction for
tax purposes.” Frank Lyon Co. v. United States, 435 U.S. 561, 581 n.16 (1978). The
facts underlying that characterization, however, are subject to clear error review. Id.
i. Law to Apply
In the Tenth Circuit, the economic substance doctrine dictates whether the
Commissioner may rightfully disregard a transaction as lacking economic substance.
Sala v. United States, 613 F.3d 1249 (10th Cir. 2010); Keeler v. Comm’r, 243 F.3d 1212
(10th Cir. 2001); Jackson v. Comm’r, 966 F.2d 598 (10th Cir. 1992); James v. Comm’r,
899 F.2d 905 (10th Cir. 1990); see also Casebeer v. Comm’r, 909 F.2d 1360, 1365 (9th
Cir. 1990) (holding that courts must disregard transactions that are designed to comply
with the literal terms of the tax code but are unlikely to produce non-tax economic
benefits). The doctrinal framework is fairly straightforward. Courts must ask two
questions: (1) what was the taxpayer’s “subjective business motivation,” and (2) did the
transaction have objective economic substance? Jackson, 966 F.2d at 601.
Things get a little muddled when courts attempt to flesh out the answers to these
two questions. Just how much weight should each prong get? How, exactly, should a
court determine whether a transaction possessed objective economic substance?
Mr. Blum argues that the answers to these questions are different today than they
were before 1998. He contends that pre-1998 cases such as Jackson and James used a
“unitary test” for economic substance. He further contends that this unitary test is
8
narrower than the post-1998 cases. As best we can tell, his core theory here is that a so-
called unitary test would put more weight on the possibility of profit in any given
transaction and less weight on the subjective motivation for entering the transaction.
Later cases like Sala and Keeler, by contrast, “minimiz[e] the relevance of [a
transaction’s] objective profit potential and requir[e] that tax advantages be linked to
actual losses.” Appellant Br. 24. Therefore, he concludes, it would be unfair to rely on
these later cases when he and other taxpayers in 1998 were operating under the unitary
test—in Mr. Blum’s eyes a more lenient standard because it does not concern itself as
much with evidence of a subjective motivation to avoid taxes so long as the transaction
presents some possibility of profit.
We find no such division between pre- and post-1998 cases. Indeed, the “unitary
test” relied on by Mr. Blum is not a codified doctrine in its own right, but rather a
divergence from Fourth Circuit precedent in James and a recognition of the common
sense approach adopted by this circuit. The Fourth Circuit utilizes a two-prong approach
requiring a court to find “[1] that the taxpayer was motivated by no business purposes
other than obtaining tax benefits . . . and [2] that the transaction has no economic
substance because no reasonable possibility of profit exists.” James, 899 F.2d at 908-09
(citing Rice’s Toyota World, Inc. v. Comm’r, 81 T.C. 184, 202-03 & n.17, 209 (1983),
aff’d in part, rev’d in part on other grounds, 752 F.2d 89 (4th Cir. 1985). Our approach
holds that these two factors, rather than being independent prerequisites to finding an
absence of economic substance, are simply “more precise factors to consider” in that
9
analysis. James, 899 F.2d at 908-09 (citing Sochin v. Comm’r, 843 F.2d 351, 354 (9th
Cir.), cert. denied, 488 U.S. 824 (1988).
The unitary test from James is hardly different from the analysis applied in Sala.
To be sure, something did change between those two cases. The Keeler court held that
tax advantages must be linked to actual losses. And, it is true that a taxpayer in 1998
could have scoured the legal tomes without finding an explicit enunciation of this idea.
However, such an idea is not novel. In fact it is a rather obvious extension of the
underlying doctrine. For many decades, cases have identified the artificiality of a
transaction as one of the most important factors to consider when evaluating economic
substance. See Shoenberg v. Comm’r, 77 F.2d 446, 449 (8th Cir. 1935). A transaction
that produced enormous tax savings without concomitant losses would have triggered red
flags under pre-Keeler case law. It would have smacked of a too-good-to-be-true
transaction, and it would have been a “transaction[] lacking an appreciable effect, other
than tax reduction.” James, 899 F.2d at 908. In other words, the applicable case law has
changed—if at all—only in minor, predictable ways, none of which would have changed
the outcome of Mr. Blum’s case.
Mr. Blum does not dispute, apparently, that an economic substance analysis
requires the Tax Court to look at subjective motivation and objective profit potential. He
simply believes it is reversible error for the Tax Court to explain its reasoning under
those two broad factors. We find this argument counter-intuitive at best.
The Tax Court engaged in precisely the detailed factual analysis required under
Jackson, Keeler, and Sala. It was appropriate for the court to consider such things as the
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artificiality of the loss, the close connection between the loss and the purportedly
sheltered capital gains, Mr. Blum’s apparent failure to investigate the economics of the
transaction, the pre-planned design of the transaction, and the disparity between the
transaction’s profit potential and tax benefits. The Tax Court, to put it another way,
showed its work. We cannot find error in its decision to enumerate the facts that support
its conclusion.
We do not need to address Mr. Blum’s arguments about retroactivity because, as
we have just explained, there is no appreciable difference between the economic
substance doctrine as it existed in 1998 and the doctrine applied by the Tax Court in this
case.
In a field as intricate and ingenious as the tax shelter industry, it makes good sense
to let courts weigh relevant factors to determine the underlying character of a challenged
transaction. To do otherwise would unnecessarily tie the hands of the IRS and the Tax
Courts in their ongoing adaptation to new schemes. The Tax Court identified the correct
test for economic substance, Mr. Blum’s arguments about changing precedent
notwithstanding. We therefore turn our attention to whether the Tax Court correctly
applied this test to Mr. Blum’s participation in OPIS and the resulting losses he claimed
on his federal income tax returns.
ii. Objective Economic Substance
Mr. Blum argues that the evidence before the Tax Court established that his OPIS
investment offered a reasonable possibility of generating a profit. In the face of
substantial evidence indicating that the transaction was a sham, Mr. Blum is essentially
11
arguing that the Tax Court should have believed his expert instead of the government’s
expert, and that his expert’s testimony leads to the inexorable conclusion that the OPIS
transaction presented a substantial likelihood of generating a profit. We disagree.
To reach the conclusion that the OPIS transaction lacked objective economic
substance, the Tax Court made four relevant factual findings. First, it noted that the $45
million loss associated with the transaction was grossly disproportionate to the $6 million
Mr. Blum invested in OPIS. Moreover, Mr. Blum did not lose $45 million. The loss was
fictional and did not have any real world effect on Mr. Blum’s pocketbook. Mr. Blum
does not dispute this.
Second, the Tax Court noted that the OPIS transaction was planned and executed
in a way that was designed to generate the loss. Evidence that a transaction was designed
to “produce a massive tax loss” indicates the transaction lacks economic substance. Sala,
613 F.3d at 1255. UBS, the bank involved in the OPIS transaction, understood that the
“essence of the [OPIS] trade” was to create a tax loss. This explains, in part, why the
transaction’s stock purchase matched the desired amount of capital loss. It also explains
why the deal included an options collar. By limiting the potential for huge gains and
losses, KPMG was able to retain absolute control over the transaction and ensure that
UBS “retained almost all of the economic benefit.” Appellee Br. 43; see Dow Chem. Co.
v. United States, 435 F.3d 594, 603-604 (6th Cir. 2006) (finding that a transaction lacked
economic substance where a practical possibility for gain also “contained features
designed to neutralize the taxpayer’s ability to realize [those] gains”). The desire to
generate a loss also explains the timing of the various elements of the transaction. As the
12
government points out, both the sale of the UBS stock and the expiration of the options
were discretionary actions by KPMG that occurred just before the end of the 1998 tax
year. All of this would make economic sense if there were some evidence in the record
that Blum or KPMG thought this timing was economically advantageous to Mr. Blum.
However, the record contains no such evidence.
Third, the Tax Court found that OPIS did not provide a reasonable expectation of
profit. One rule of thumb is that a transaction has economic substance if it is “likely to
produce economic benefits aside from a tax deduction.” Casebeer, 909 F.2d at 1365
(citation omitted). The probability of earning a profit must be reasonable, not a mere
possibility. See Stobie Creek Invs., LLC v. United States, 608 F.3d 1366, 1376 (Fed. Cir.
2010) (requiring a showing that “a prudent investor would have had a reasonable
expectation of earning a profit from the transaction) (citing Coltec Indus., Inc. v. United
States, 454 F.3d 1340, 1357 (Fed. Cir. 2010)). Here, the parties offered dueling expert
opinions. Mr. Blum’s expert, Dr. Hodder, admitted that OPIS was unlikely to produce a
profit, but concluded that the small possibility of a very large profit made the investment
reasonable. Ex. 119; Tr. 200-01, 228-29, 361-62 (noting that Mr. Blum had a “76.3
percent chance of losing money” in OPIS). The government’s expert, Dr. Kolbe, agreed
that OPIS was unlikely to produce a profit. This fact, coupled with other elements of the
transaction—such as overpriced options—led Dr. Kolbe to conclude that the net present
value of and expected rate of return on OPIS were both negative. No prudent investor, in
other words, would enter into such a transaction based on its non-tax characteristics. The
Tax Court weighed the testimony and reasonably decided that Dr. Kolbe’s conclusions
13
were more helpful in determining whether the transaction presented a reasonable chance
of profitability.
Fourth and finally, the Tax Court, relying on the testimony of both experts,
concluded that what profit potential OPIS presented was “de minimis” when compared to
the tax benefits of declaring capital losses of $45 million. This disparity indicated a lack
of economic substance. See Sala, 613 F.3d at 1254.
Contrary to Mr. Blum’s assertions, the economic substance issue cannot be boiled
down to “one overriding consideration [of] whether Blum’s OPIS investment had
substantial economic effects in the form of a probability of generating a pre-tax profit.”
Appellant’s Reply 6 (citing James, 899 F.2d at 908-09). The Eighth Circuit recently
reached the same conclusion we do today. WFC Holdings Corp. v. United States, 728
F.3d 736, 746 (8th Cir. 2013) (rejecting an effort to justify a similar basis-inflating
scheme by “isolat[ing] a kernel of prospective profitability to justify a large, multi-step,
multi-property transaction”).
Supposing we give Mr. Blum the benefit of the doubt, however, and delve more
deeply into the profit potential prong, we still cannot find that the Tax Court erred in
reaching the conclusion that OPIS did not present a reasonable probability of pre-tax
profit. Mr. Blum makes four arguments within the profit potential prong. Specifically,
he asks us to reverse the Tax Court because (1) his expert, Dr. Hodder, testified that each
component of the OPIS deal might have generated a profit, (2) that the remote possibility
of very large profits justified the deal’s high risk, (3) that the government’s expert, Dr.
Kolbe, used the wrong method to reach his conclusions, and (4) that the Tax Court let
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evidence about KPMG’s subjective motivation for OPIS serve as a substitute for
evidence of objective unprofitability.3
Mr. Blum’s first two arguments are similarly flawed. They ask us to look not at
the forest but at the trees. Simply because Dr. Hodder testified that each step of OPIS
had economic substance, and that there was an “enormous possible upside” to OPIS, does
not mean the overall transaction presented a reasonable chance of turning a profit.
Evidence that each step was profitable or that there was a tiny chance of an extremely
large profit could theoretically establish a reasonable probability of profitability.
However, as the Tax Court observed, “profit potential does not necessarily compel the
conclusion the transaction has economic substance. Sala, 613 F.3d at 1251-54. Here, the
overarching context included the facts that the options were overpriced, and that the UBS
stocks would have been more profitable if they had been purchased independently of the
OPIS transaction.
Likewise, Mr. Blum’s attacks on Dr. Kolbe’s methods don’t land a punch. It was
appropriate for the Tax Court to rely on Dr. Kolbe’s testimony about expected rates of
return. There is no case law suggesting that “simulations are the only effective way” for
the Tax Court to evaluate the profit potential of a given transaction. Appellant Br. 27-28.
On the contrary, profit potential can be evaluated in various ways including “examin[ing]
3
At times, Mr. Blum appears to suggest that because he was unaware of the aspects of
OPIS that made the transaction unlikely to produce a profit, this Court should conclude
that the transaction presented a reasonable likelihood of producing a profit. Mr. Blum’s
knowledge, however, is irrelevant for purposes of the objective prong. See, e.g.,
Appellant Reply 9 (arguing that Mr. Blum could not have been aware of alleged
overpricing associated with options in the OPIS transaction and suggesting that this lack
of awareness indicated an objective profit potential).
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the probability of each outcome, the expected rate of return, and the price of the options,
which are all factors a prudent investor might consider when deciding whether to invest.”
Stobie Creek Invs., 608 F.3d at 1376. Even Dr. Hodder agreed that the expected rate of
return was a “common method of evaluating an investment.” Ex. 108 at 61-84, 107. And
as the Commissioner points out, Dr. Kolbe in fact used simulations to determine an
estimated rate of return. That appears to leave Mr. Blum with an argument that the Tax
Court should not have believed Dr. Kolbe because he failed to use the Black-Scholes
method and did not perform as many simulations as Dr. Hodder. To describe that
argument is to reject it. There is simply nothing in the case law or in common sense that
compels us to reverse the Tax Court on this narrow evidentiary issue.
Finally, we turn to the issue of subjective motivation and intent as it relates to
objective profit potential. Of all the arguments Mr. Blum raises about the proper
application of the objective economic substance analysis, this one gives us the most
pause. It probably would be inappropriate for the Tax Court to let the subjective
motivations of some of the players overwhelm contrary evidence about profit potential.
Fortunately, the Tax Court did not let that happen. Mr. Blum points to a handful of the
Tax Court’s observations that, in his mind, indicate that the Tax Court neutered the
objective prong by interpreting Dr. Hodder’s testimony in light of KPMG’s and UBS’s
subjective purposes behind OPIS. See, e.g., Op. 37 (“calculations assume a transaction
that was not pre-ordained to create a loss intended specifically to offset a particular gain”)
(emphasis added). This type of reasoning is permissible, however, and does not neuter
the objective prong. Indeed, the subjective motivations of parties to a transaction can
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help put objective evidence into context, especially in a transaction like this one that is
embedded with various discretionary tools. That is to say, one party’s purportedly
objective evidence that a deal could result in profit may be less persuasive if another
party offers evidence that the actors could influence the outcome and had a motive to do
so. Importantly, the Tax Court did not reference Mr. Blum’s subjective motivation in this
part of its analysis; it merely looked to the subjective motivation of the parties that
structured and executed the transaction to understand better the objective profit potential.
Therefore the Tax Court did not err when it reconciled conflicting expert testimony in
this way.
iii. Subjective Motivation
Mr. Blum argues that the Commissioner relied on inappropriate evidence under
the subjective business motivation prong of the economic substance analysis. He
maintains that he participated in OPIS to make a profit, not to reduce his tax liability, and
therefore the Tax Court erred in finding that the transaction lacked economic substance.
The Tax Court didn’t buy it, and neither do we. Mr. Blum’s “actions during and
after the OPIS transaction” indicate that his sole motive was tax avoidance. Op. 33. In
particular, we note that the timing of the transaction relative to the sale of his stock, his
purpose in retaining KPMG, his failure to investigate the deal’s economic prospects, and
his subsequent description of the transaction in his civil suit against KPMG speak
volumes about his intent.
Regarding the timing of the transaction, Mr. Blum claims that he had “already
fully committed himself to OPIS” before he sold the Buy.com stock. Appellant Br. 38.
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The Commissioner counters that Mr. Blum signed the agreement to purchase OPIS on the
same day he sold the stock. The back and forth about dates is confusing, to be sure, but it
appears that the Commissioner offers a better chronology. The first sale of Buy.com
stock occurred before Mr. Blum committed to OPIS. He claims he sold the first $5
million of Buy.com stock on August 18, 1998. Tr. 50, 56, 72-75. Then he began
negotiating the second sale of $40 million in late September of 1998. Tr. 61-62. He
executed the purchase agreement with his buyer on September 30, 1998. Tr. 76. This
was, however, the same day he signed the OPIS agreement. Ex. 13. Therefore, the Tax
Court could infer that Mr. Blum entered OPIS with his capital gains tax liability in mind
and could disregard as self-serving Mr. Blum’s insistence that he was attracted to OPIS
for its profit potential and nothing more. That Mr. Blum retained KPMG as a tax advisor
rather than an investment advisor further undermines his explanation of events.
Moreover, Mr. Blum did not investigate the deal after hearing Mr. Hasting’s
promotional pitch. A court may conclude that a transaction lacked a business purpose
where the taxpayer demonstrates a disregard for the economic consequences of a
transaction. See Casebeer, 909 F.2d at 1365 (noting that “failure to consult an attorney
and [the taxpayer’s] lack of understanding of the transaction, indicated that [he] had no
business purpose . . . other than tax avoidance”).
In his defense, Mr. Blum insists that he did not understand the details of the
transaction and relied on the statements made by KPMG. He believes the Commissioner
is punishing him for his lack of understanding and supplanting his motives with KPMG’s
more nefarious motives. But neither the Commissioner nor the Tax Court faulted Mr.
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Blum for mere lack of understanding. Rather they took his lack of understanding coupled
with demonstrated indifference to remedy that lack of understanding as evidence of his
real motive: to shelter his capital gains. As the government notes, Mr. Blum
admitted that he (i) knew nothing about Alfaside or Benzinger, his counter-parties
in the OPIS transaction; (ii) knew nothing about the swap agreement, which
purportedly was critical to the investment strategy (Ex. 96) and involved most of
the money invested in the transaction (i.e., $2.9 million (Op. 12)); (iii) did not
analyze the transaction’s economics; (iv) did not ask his financial advisors to
analyze the transaction’s economics or otherwise evaluate the transaction; (v)
decided to participate in the transaction based on two one-hour discussions with
his tax advisor; and (vi) did not monitor the transaction.
Appellee Br. 37 (citation omitted). KPMG’s engagement letter explicitly warned Mr.
Blum that he needed a “reasonable expectation” of profit if OPIS was to withstand IRS
scrutiny, and that he ought to “seek independent advice concerning the investment
aspects of the proposed transactions.” Ex. 12; cf. Sacks v. Comm’r, 82 F.3d 918, 920 (9th
Cir. 1996) (holding that where promotional materials provided warnings that would have
“warranted further investigation by a prudent investor” failure to do so was
unreasonable). Mr. Blum did not seek independent advice, and he even neglected to ask
his own investment advisors to evaluate the deal.
Mr. Blum counters that “[u]ncontroverted trial testimony indicated that Blum’s
discussion with KPMG employees focused solely on the OPIS investment’s profit
potential.” Appellant Br. 40. It would be more accurate to say that Mr. Blum offered
testimony at trial that he discussed the profit potential but not the tax advantages of OPIS
with Mr. Hasting. The Commissioner, however, offered substantial evidence that Mr.
Blum entered OPIS with the subjective intent to shelter his taxes. To reiterate some of
19
that evidence, Mr. Blum retained KPMG for tax services, demonstrated disregard for the
economic terms of the deal, and decided to participate at approximately the same time
that he generated large capital gains by selling his Buy.com stock. While the
Commissioner apparently did not contest the trial testimony, this other evidence severely
undermines that testimony’s worth. The Tax Court was well within its discretion to
disregard as self-serving Mr. Blum’s testimony regarding his subjective intent.
Finally, the Tax Court relied on statements Mr. Blum has made in his civil case
against KPMG to understand his subjective intent. Mr. Blum sued the firm over its “Tax
Strategies,” claiming that his reliance on KPMG led him to not adopt “other available
strategies which would have deferred or minimized tax liability.” Ex. 10 at 4. Taken as a
whole, the Tax Court had sufficient evidence before it to conclude that Mr. Blum entered
the OPIS transaction with no legitimate business purpose and to void the associated
losses he claimed on his taxes.
B. Gross Valuation Misstatement Penalty
The Commissioner also assessed penalties against Mr. Blum for his underpayment
of taxes associated with OPIS in 1998. One of these penalties was a gross-valuation
misstatement penalty authorized by I.R.C. § 6662. The Tax Court upheld the imposition
of the gross-valuation misstatement penalty. Mr. Blum maintains that in doing so, the
Tax Court committed reversible error. In particular, he argues that such a penalty is
inapplicable where the underlying transaction has been invalidated by the economic
substance doctrine. Recognizing that the applicability of gross-valuation misstatement
penalties in this situation is an open question in the Tenth Circuit, Mr. Blum urges us to
20
find that the text, legislative history, and underlying public policy of I.R.C. § 6662
prohibit the imposition of the penalty here. The Supreme Court recently answered this
open question in a way that forecloses Mr. Blum’s argument. United States v. Woods,
No. 12-562 (U.S. Dec. 3, 2013). Accordingly we affirm the Tax Court’s decision.
Before we proceed to Mr. Blum’s arguments, we offer a quick overview of the
gross-valuation misstatement penalty. The penalty is, in a nutshell, a fine to be paid
when a taxpayer makes a relatively large error on his tax return and ends up paying less
than she actually owes. I.R.C. § 6662(b) & (e). Valuation misstatements include
misstatements of basis. Id. Typically the penalty for a gross valuation misstatement is 20
percent, but if the taxpayer misstates her basis by 400 percent or more the penalty
increases to 40 percent. I.R.C. § 6662(h).
Here, after the Commissioner disallowed the OPIS basis-shifting scheme, that left
Mr. Blum’s $45 million capital gain from his sale of Buy.com stock unprotected. As a
result, he owed taxes on that money—taxes he didn’t pay. The Commissioner identified
this as an underpayment. Mr. Blum originally claimed a basis in UBS stock and options
totaling $48.3 million. Once that amount was invalidated under the economic substance
doctrine, Blum’s actual basis in the transaction was no more than what he actually paid
for the stock and options—that is, $2.25 million for the stock and $675,000 for the
options. The misstatement between the two amounted to over 1,200 percent. Because
21
the size of Mr. Blum’s misstatement exceeded 400 percent, the Commissioner imposed
the larger 40 percent penalty.4
Whether the gross-valuation misstatement penalty applies to misstatements of
basis associated with transactions voided under the economic substance rule is a pure
question of law, and we review the Tax Court’s conclusion de novo. Koch Indus., Inc. v.
United States, 603 F.3d 816, 821 (10th Cir. 2010).
The majority of circuits allowed the penalty to apply when the economic substance
doctrine invalidates the underlying transaction. See Gustashaw v. Comm’r, 696 F.3d
1124, 1136-38 (11th Cir. 2012); Fidelity Int’l v. United States, 661 F.3d 667, 671-75 (1st
Cir. 2011); Massengill v. Comm’r, 876 F.2d 616, 619-20 (8th Cir. 1989); Zfass v.
Comm’r, 118 F.3d 184, 190-91 (4th Cir. 1997); Merino v. Comm’r, 196 F.3d 147, 155,
157-59 (3d Cir. 1999); Illes v. Comm’r, 982 F.2d 163, 167 (6th Cir. 1992); Gilman v.
Comm’r, 933 F.2d 143, 151 (2d Cir. 1991).5 But see Heasley v. Comm’r, 902 F.2d 380,
383 (5th Cir. 1990); Keller v. Comm’r, 556 F.3d 1056, 1061 (9th Cir. 2009). The Tax
Court and Court of Federal Claims also adopted the majority approach. See New Phoenix
4
The tax court applied the gross valuation misstatement penalty because the
underpayment “stem[med] from deductions or credits” that were disallowed because they
lacked economic substance. Op. at 40. The tax court did not clearly state whether Mr.
Blum's basis was the $2.25 million cost basis for the stock he purchased or zero. Under
either scenario, however, Mr. Blum misstated his basis by over 400 percent and therefore
the gross valuation misstatement penalty should apply. See Crispin v. Comm’r, 708 F.3d
507, 517-18 (3d Cir. 2013).
5
After the parties filed their briefs with this Court, the Seventh Circuit adopted the
majority position regarding Section 6662. Superior Trading, LLC v. Comm’r, 728 F.3d
676, 682 (7th Cir. 2013) (“taxpayer who overstates basis and participates in sham
transactions, as in this case, should be punished at least as severely as one who does only
the former”).
22
Sunrise Corp. v. Comm’r, 132 T.C. 161, 187-89 (2009), aff’d, 408 Fed. App'x 908 (6th
Cir. 2010); Clearmeadow Invs., LLC v. United States, 87 Fed. Cl. 509, 530-36 (2009).
The Supreme Court has now resolved the split in favor of the majority approach.
Invalidation of a transaction under the economic substance doctrine does not prohibit the
imposition of the gross valuation misstatement penalty. The Tax Court’s decision
allowing the penalty in Mr. Blum’s case is upheld.
C. The Negligent Underpayment Penalty
The Tax Code also establishes penalties for negligent underpayment of taxes,
separate from the gross valuation misstatement penalties discussed above. The
Commissioner imposed a 20 percent penalty upon Mr. Blum for negligent underpayment
of taxes on his 1999 return. The Tax Court affirmed that penalty, and Mr. Blum appeals.
We affirm the Tax Court’s opinion, but in so doing we recognize that KPMG instigated
this tax evasion scheme, even going so far as to prepare Mr. Blum’s client representation
letter and telling him, in effect, “sign here.” Nevertheless, Mr. Blum was properly
penalized because (1) he knew that KPMG was not rendering independent tax advice; (2)
he signed the representation letter containing a material misrepresentation, albeit one that
was drafted by KPMG; and (3) he filed his return claiming the improper deduction before
he received KPMG's formal tax opinion. Any one of these grounds would be sufficient
in itself to justify the imposition of the penalty.
Section 6662(b)(1) of the Tax Code allows the IRS to impose a 20% penalty if the
taxpayer’s underpayment resulted from negligence. Negligence is “strongly indicated” if
a “taxpayer fails to make a reasonable attempt to ascertain the correctness of a deduction,
23
credit or exclusion on a return which would seem to a reasonable and prudent person to
be ‘too good to be true’ under the circumstances.” 26 C.F.R. § 1.6662-3(b)(1) &
(b)(1)(ii). This accuracy-based penalty for negligence is not available if the taxpayer
reasonably and in good faith relied upon professional tax advice. I.R.C. § 6664(c)(1);
United States v. Boyle, 469 U.S. 241, 251 (1985). This is, however, a “narrow defense.”
Stobie Creek Invs., 608 F.3d at 1381. In determining whether reasonable cause and good
faith exist, the most important factor is “the extent of the taxpayer’s effort to assess the
taxpayer’s proper tax liability” judged in light of his experience, knowledge, and
education. 26 C.F.R. § 1.6664-4(b). A common issue within the reasonable cause
analysis is the taxpayer’s reliance on the advice of a professional tax advisor. Such
reliance, however, “does not necessarily demonstrate reasonable cause.” 26 C.F.R.
§ 1.6664-4(b).
Professional advice providing the basis of a reasonable cause defense typically
exhibits certain characteristics, of which three are particularly applicable in this case.
First, the advice must be independent. Van Scoten v. Comm’r, 439 F.3d 1243, 1253 (10th
Cir. 2006). Second, the advice must be based on all relevant facts and no inaccurate
factual representations. 26 C.F.R. §1.6664-4(c). And third, reasonable cause requires
that the taxpayer actually receive the advice and rely upon it before claiming the tax
benefit. Conway v. United States, 326 F.3d 1268, 1279 (Fed. Cir. 2003). The advice that
Mr. Blum received from KPMG exhibited none of these qualities, and therefore he
cannot claim the defense of reasonable cause and good faith for his negligent
underpayments resulting from the OPIS scheme.
24
Mr. Blum recites a litany of reasons why his reliance on KPMG’s advice should
excuse him from paying this penalty. He asked his trusted advisors about KPMG’s
reputation; he did not read KPMG’s opinion letter, and perhaps he was unaware of any
factual misrepresentations contained within it; and he promises that he relied on KPMG’s
advice in deciding to participate in OPIS. We do not minimize KPMG’s important role
in creating the tax shelter and leading Mr. Blum down the path. There is enough fault to
go around. However, even if we accept Mr. Blum’s claims at face value, they do not
establish reasonable cause, because they miss the point. Mr. Blum still relied on a
company that was not independent, he signed an opinion letter that he knew or should
have known contained a material misrepresentation, and he claims to have relied on
advice that he didn’t receive until after he filed his taxes.
Mr. Blum knew or should have known that KPMG was not an independent advisor
in this context. KPMG’s role as a promoter—i.e. someone who stood to make a profit off
the transaction—made reliance unreasonable. Mr. Blum learned about the deal from
KPMG and knew that the company was promoting it to other clients. Just because Mr.
Blum had “earlier bona fide dealings” with KPMG does not mean he was justified in
overlooking their promotion of the OPIS scheme in this case. See 106 Ltd. v. Comm’r,
684 F.3d 84, 92 (D.C. Cir. 2012) (citing Stobie Creek Invs., 608 F.3d at 1383). Mr.
Blum’s citation to Mauerman v. Comm’r, 22 F.3d 1001, 1006 (10th Cir. 1994) is
inapposite. In Mauerman, we did indeed hold that a taxpayer may rely on the
professional advice of someone who had previously prepared the taxpayer’s taxes.
25
However, we noted that the tax preparers in that case were “independent.” Id. That is
not the case here.
The KPMG opinion letter that Mr. Blum signed contained statements that Mr.
Blum knew or should have known were false. The advice stated that it depended on the
representation that Mr. Blum had reviewed the economics of the deal and expected to
earn a profit. Ex. 98 at 1, 8. He knew that he had not reviewed the economics of the deal
himself, nor had he asked his advisors (other than KPMG) to do so. Mr. Blum neglected
to do this despite KPMG’s explicitly stating that its opinion letter was premised on an
independent evaluation of the transaction. Ex. 12. Because a reasonable cause defense
depends on the presence of advice not based on “inaccurate representation or assumption
as to the taxpayer’s purposes for entering into a transaction” that generated the disputed
benefits, this misrepresentation means that Mr. Blum cannot claim the defense in this
case. 26 C.F.R. § 1.6664-4(c). See 106 Ltd., 684 F.3d at 92-93; Fidelity Int’l Currency
Advisor A Fund, LLC v. United States, 747 F. Supp. 2d 49, 242-44 (D. Mass. 2010).
Mr. Blum claims that the Commissioner is arguing that Mr. Blum “hoodwinked” a
Big Four accounting firm. Appellant Reply 28. That is not how we interpret the
Commissioner’s argument. KPMG knew what it was doing. The facts we know today
indicate that KPMG was the mastermind behind the tax sheltering schemes. However,
just because KPMG misbehaved does not mean Mr. Blum is without fault. In particular,
the reasonable cause exception requires that he prove he did not provide inaccurate
information to KPMG. But, in fact, he did. KPMG may have acted nefariously, but that
does not excuse Mr. Blum’s negligence.
26
Finally, Mr. Blum cannot claim good faith reasonable reliance on KPMG’s
professional tax advice in this case because he filed the taxes at issue before receiving
any advice from KPMG. The Tax Court observed that “[t]he record does not show when
the opinion [letter] was finalized, but we know that it was finalized after petitioners filed
the tax return for 1998.” Op. 44-45. Mr. Blum’s argument that the face of the letter
indicates it was sent earlier and that it is not in draft form does not provide convincing
evidence that he received it before he filed his tax returns. Moreover, the opinion letter is
not the same as the April 19, 1999 representations letter. The latter did not purport to
provide advice, and it cannot be the basis for a reasonable cause defense.
In his reply brief, Mr. Blum raises an argument that KPMG did not base its tax
advice on the alleged misrepresentations in the opinion letter. The gist of his argument is
that the IRS regulations state that it is reasonable to rely on professional advice unless
that advice is “based upon” bad information. Because, according to Mr. Blum, KPMG
took advantage of him, KPMG knew from the beginning that it would issue the opinion
letter regardless of whether the facts therein were true or false. He notes that “KPMG’s
opinion was thus not ‘based upon’ Blum’s alleged misrepresentations. Appellant Reply
29 (citing 26 C.F.R. § 1.6664-4(c)(1)(i) & (ii)).
This argument is clever, but again it misses the point. The advice contained in the
opinion letter was premised on the fact—attested to by Mr. Blum—that he had a
reasonable, non-tax economic reason for entering into the transaction. The fact that
KPMG also probably knew it to be false is irrelevant for purposes of this penalty. Even
if the statements that Mr. Blum had independently reviewed the economics of the
27
transaction and found them to be profitable were boilerplate, several other courts have
found similar misrepresentations and omissions relevant in determining that reliance on a
tax adviser was not reasonable. See, e.g., Crispin, 708 F.3d at 519 (finding no reasonable
reliance because Mr. Crispin represented to a law firm that provided him with a tax
opinion (1) that he had a valid business purpose when he knew or should have known that
representation was false; and (2) that no party had provided him any tax related
promotional material to him prior to his entering into the transaction even though he had
received such materials). See also Kerman v. Commissioner, 713 F.3d 849 (6th Cir.
2013) (finding no reasonable reliance where taxpayer affirmed he reviewed economic
substance of transactions when he had not).
D. Preclusive Effect of Affirming the Negligence Penalty
Before concluding, we turn to Mr. Blum’s concern that the Tax Court’s opinion, if
allowed to stand, will bar him from pursuing his civil claims against KPMG. The District
Court overseeing Mr. Blum’s civil case concluded that collateral estoppel prohibits Mr.
Blum from arguing KPMG was negligent in preparing his taxes. See Blum v. KPMG,
LLP, No. SACV 11-01885-CJC (C.D. Cal. July 17, 2012) (Order).
Ultimately it is not our place to decide whether the Tax Court’s decision and our
affirmance or reversal should collaterally estop Mr. Blum’s claims in other courts.
Furthermore, we agree with the Commissioner, in his supplemental briefing on this issue,
that even if we were to affirm on more limited grounds, we could not guarantee that such
a ruling would have any impact on the District Court’s collateral estoppel analysis. It is
worth noting, however, that the District Court did not “expressly predicat[e]” its ruling on
28
the Tax Court’s finding that OPIS lacked economic substance. Contra Appellee Supp.
Br. 10. Rather the District Court pointed to both the lack of economic substance and the
reasonableness of Mr. Blum’s reliance on KPMG and appeared to treat these as separate
issues, both of which were collaterally estopped. See, e.g., Blum, No. SACV 11-01885-
CJC at *6 (“Mr. Blum is now collaterally estopped from litigating the issues of whether
he believed OPIS was a legitimate investment strategy and whether he relied on KPMG’s
advice to that effect.”).
In any event, we find that the Tax Court reached correct conclusions regarding
each of the independent reasons why Mr. Blum could not prove reasonable cause to rely
on KPMG for purposes of avoiding a negligent underpayment penalty. We simply note
that the Tax Court’s opinion on reasonable reliance and good faith appears narrowly
tailored to this penalty provision. Op. 44 (“[W]e do not find that petitioners actually
relied on KPMG in good faith for purposes of the reasonable cause and good faith
defense to accuracy-related penalties.”). In fact, the Tax Court concluded that Mr. Blum
“certainly relied on KPMG, and KPMG’s failures toward its client during and after the
years at issue are well-documented.” Id. We cannot provide an opinion about the
relationship these conclusions have to the applicable law in Mr. Blum’s civil case.
Perhaps these issues are sufficiently similar to satisfy the prerequisites for collateral
estoppel. Perhaps they are not. But that is an issue for the Central District of California
or the Ninth Circuit Court of Appeals to decide. The question is not properly before this
Court.
29
IV. Conclusion
The judgment of the Tax Court is affirmed.
30