DocketNumber： Docket No. 12697-05.
Judges： HOLMES
Filed Date： 8/26/2010
Status： Non-Precedential
Modified Date： 11/20/2020
Decision will be entered under
HOLMES,
In this case, we consider whether Shao, unlike Calloway, can avoid the penalty that the Commissioner has asserted against her.
The facts in this case are largely uncontested. Cecilia Shao moved to California from Taiwan as a child and did well in school, earning a degree in cultural anthropology 2010 Tax Ct. Memo LEXIS 225">*226 from the University of California, Santa Barbara in 1993. After college, she put her degree to work in a museum, but quickly began looking for better (or at least better paying) jobs—first at a finance company, and in 1996 as an administrative assistant for Veritas Software Corporation. This was the start of the dot-com boom, and Veritas offered each new employee an initial stock grant and then more stock after each merit review. Shao didn't have any experience with stocks, and so she did what was "like a default" for Veritas employees—she opened an account with E*trade because it administered Veritas's merit grants and employee stock option program. Now that she was working in the high-tech industry and had stock options, Shao decided she needed to hire someone to prepare her tax returns, so she turned to a firm named Wade Financial.
Shao rose at Veritas, ultimately becoming a contracts administrator in the legal department. Over the next few years, she accumulated more than 6,000 shares of Veritas stock in her E*trade account and saw it as a source of income for retirement—her nest egg. But at some point she needed money to buy a car and began looking for ways to unlock her stock's 2010 Tax Ct. Memo LEXIS 225">*227 value without selling. Shao turned to a certified financial planner named Jovita Honor for advice. Honor worked at Wade Financial and also prepared Shao's taxes. Honor suggested using a margin loan, so Shao signed up for one with E*trade.
Margin-loan brokers offer stockholders a loan worth some of their stocks' value, but usually require that the remaining value not fall below a certain limit, or margin. If the stock value falls too low to cover the margin, the stockholder has to deliver more collateral or pay back part of the loan to keep the broker secured. This makes a margin loan risky.
Shao's stock increased in value from less than $60,000 to upwards of $360,000 by July 2001. But Shao was still riding the dot-com bubble when it began to leak—Veritas stock began to sink in early 2001. Shao, like many who didn't know the bubble was a bubble, mistook the decline for a temporary correction, and didn't want to sell her nest egg. But at this point Shao also wanted to buy a home and needed cash for a downpayment, so she asked Honor about options with lower risk.
Honor thought she had found something better for her clients like Shao—she discovered a South Carolina company called Derivium 2010 Tax Ct. Memo LEXIS 225">*228 Capital, LLC. Derivium offered what it called loans worth 90 percent of a stock's value, with interest usually set at 9.5 or 10.5 percent, and a term of two to five years. The loans were nonrecourse, meaning that if a borrower didn't repay, Derivium would not have to return the stock or its equivalent to the borrower, but couldn't sue for any unpaid balance. And unlike E*trade's loans, the Derivium loans had no margin requirements. Derivium boasted to its potential clients that it could make these loans because it had a sophisticated hedging strategy.
Honor recommended a Derivium loan to meet Shao's objectives, and Shao agreed. The loan was for three years at 10.5 percent interest. It was nonrecourse, and at the end of the term, left her with three choices. She could retrieve her stock by repaying the loan plus interest, surrender the stock, or put off a final decision by renewing the loan. But renewing the loan wasn't cheap—she would have to pay a fee of 4.5 percent of the original value of her stock if its price had fallen. 2010 Tax Ct. Memo LEXIS 225">*230 During the period covered by the loan, Derivium reserved the right to "assign, transfer, pledge, repledge, hypothecate, rehypothecate, lend, encumber, short 2010 Tax Ct. Memo LEXIS 225">*229 sell, and/or sell outright some or all of the securities," without notice to Shao. Shao waived her rights to receive many of the benefits of the stock during the term of the loan, and she could not prepay. She did keep the right to receive any dividends, which Derivium promised to credit against the interest she owed—but since her stock didn't pay dividends, she never paid interest under this provision. At the end of the loan term Shao could repay the loan and get back "the same number of shares of the same securities received as collateral," which would "reflect any and all stock splits, conversions, exchanges, mergers, or other distributions, except dividends credited toward interest due." Shao believed that the only difference between Derivium's deal and her E*trade margin account was that she wasn't subject to margin calls with Derivium.
Shao and Derivium's president, Charles Cathcart, signed the Master Agreement on June 27, 2001. That same day, Shao asked E*trade to transfer her Veritas shares and the associated margin debt to Derivium's account at First Union Securities. On July 5, Derivium confirmed the amount of the E*trade margin debt it would accept when the shares were transferred. Derivium got Shao's shares on July 6. On July 9, Derivium sold the Veritas stock—without Shao's knowledge—in several sales ranging between $57.20 and $57.99 a share. That same day, Derivium sent Shao a "Valuation Confirmation," letting her know that the precise "hedged value" of her stock was $361,980.60, and that after accounting for the existing debt from her E*trade margin loan, she would receive $138,081.43 cash via wire transfer. Shao got the loan proceeds on July 11. Derivium got the money from the Veritas stock sale on July 12.
Consistent with Shao's understanding of the transaction, Honor prepared Shao's 2001 tax return without reporting a sale of the Veritas stock. Shao never received a Form 1099-B, Proceeds from Broker and Barter Exchange Transactions, for the sale of the securities, nor 2010 Tax Ct. Memo LEXIS 225">*231 a Form 1099-C, Cancellation of Debt, and didn't withhold any information from Honor.
During the loan's term, Derivium sent Shao quarterly account statements reflecting the interest accrued, the balance of the loan, and the value of the shares. In June 2003, these quarterly statements began coming from Bancroft Loan Processing, not Derivium. The change was apparent only in the very fine print at the bottom of the statements—Bancroft's statements otherwise looked identical to Derivium's. The 2003 year-end statement and all Shao's later statements came from "Bancroft U.S. Processing." And when the three-year term was up, it was "Bancroft Ventures Limited" that wrote Shao to remind her that she could renew the loan. None of the statements from the various Bancroft entities during the term of the first loan showed a business location other than the United States; they even listed a South Carolina phone number.
Despite the halving of her stock's value over the three-year term of the loan, Shao nonetheless paid the renewal fee of more than $16,000 to Bancroft Ventures in July 2004 to keep the loan alive. But time and interest made this deal look doubtful to someone without Shao's optimism. 2010 Tax Ct. Memo LEXIS 225">*232 If she had repaid the loan instead of renewing it, she would have needed to send Bancroft over $400,000 for stock worth only about $165,000. Shao, though, still had hope and credibly testified that she renewed the loan thinking the market would rebound and she could redeem her stock at the end of a second three-year term.
The new Master Loan Financing and Security Agreement which Shao signed came from Bancroft Ventures, Ltd., and prominently mentioned that BVL was a company based on the Isle of Man. The provisions of this agreement were different from those of the first one. For instance, Article 12 prohibited Shao from granting any security interest in the collateral (which, remember, had already been sold) superior to Bancroft's interest and required Bancroft to give Shao notice if it did certain things with her stock. The Loan Schedule, however, preserved Derivium's original rights to "assign, transfer, pledge, repledge, hypothecate, rehypothecate, lend, encumber, short sell, sell, sell outright and/or otherwise dispose of some or all of the Collateral." The Loan Agreement Rider made it explicit that "Borrower is the lawful owner of the Collateral." It also promised Shao that "All 2010 Tax Ct. Memo LEXIS 225">*233 Collateral pledged for all Previous Loans made to Borrower under Derivium Documents has been in the custody of Derivium, as agent for BVL, or in the custody of BVL, and is in the custody of BVL as at the date hereof * * *."
About a week after renewing her loan, Shao was laid off from Veritas. She got a letter from the California Franchise Tax Board in July 2004 telling her the state was challenging her tax treatment of the 2001 loan proceeds. 2010 Tax Ct. Memo LEXIS 225">*234 In early 2005, she learned of problems other Derivium clients were having, and Bancroft sent her a letter about some issues it was experiencing. By this point, Honor had "dumped" Shao as a client, and Shao turned to a man named Mr. Nagy for additional tax advice. Derivium To understand the Commissioner's position, however, requires some understanding of Derivium's history. For a while, the system seemed to work. Derivium made approximately 1,700 loans totaling about $1 billion with commissions of $22 million. In 2001, before Derivium ran out of money altogether, the California Corporations Commissioner sued to enjoin the firm from marketing the 90-percent loan, alleging that either Derivium was an unlicensed broker dealing in securities or that Derivium was an unlicensed lender making 2010 Tax Ct. Memo LEXIS 225">*237 consumer or commercial loans. The court granted summary judgment partially in Derivium's favor, finding that Derivium had engaged in marketing Not to be outdone, in 2004 the IRS began to investigate whether Derivium and its related entities had promoted an abusive tax shelter in violation of You don't have to sell your shares and trigger a tax liability (because loans are not taxable events). In fact, depending on your individual tax situation, the 90% Stock Loan may even enable you to generate more cash than selling the position outright, net of capital gains tax liabilities. The government alleged the total tax loss associated with Derivium's scheme to be almost $235 million, Complaint, Even before this last litigation loss Derivium was beginning to crater, and it had filed for bankruptcy in September 2005. Derivium said at the time that it would move under As the bankruptcy went forward, the trustee uncovered what he deemed a "Ponzi scheme." In an action for a permanent injunction and equitable relief against the Cathcarts, Debevc, Nagy, and Derivium, the Northern District of California granted summary judgment for the government, finding that the loan transactions were "sales of securities for purposes of tax code treatment, as opposed to bona fide loans." We recently decided in another Derivium case that the transfer of stock from a customer to Derivium's control was a sale under the Code. See The Commissioner claims that Shao's understatement was "substantial"—i.e., that it was more than $5,000 and ten percent of the tax required to be shown on her return—and therefore she should pay a twenty-percent penalty. See Among the facts and circumstances that we must consider is whether 2010 Tax Ct. Memo LEXIS 225">*243 there was "an honest misunderstanding of fact or law that is reasonable in light of all of the facts and circumstances, including the experience, knowledge, and education of the taxpayer." The relevant regulation 2010 Tax Ct. Memo LEXIS 225">*244 also tells us that to find good faith and reasonable cause "the most important factor is the extent of the taxpayer's effort to assess the taxpayer's proper tax liability." We have also found it inappropriate to penalize taxpayers where a mistake of law was in a complicated subject area without clear guidance. In In Shao's case we don't find the circumstances that led the Court to penalize Calloway—there is no evidence of a wink-wink-nudge-nudge-say-no-more arrangement with 2010 Tax Ct. Memo LEXIS 225">*247 Derivium. See Monty Python's Flying Circus: How To Recognise Different Types of Trees From Quite a Long Way Away (BBC1 television broadcast Oct. 19, 1969). Shao had legitimate, nontax motivations for wanting to structure her deal as a loan instead of a sale—she wanted to reduce risk and use some of the stocks' value without selling her nest egg. Her naivete, but not (we expressly find) her negligence, is especially prominent in her renewal of the loan at a steep price after three years. Unlike Calloway, Shao treated her transaction like a loan throughout its existence, proving her good faith. We therefore find that Shao acted in good faith upon an honest misunderstanding of the law that was reasonable in her circumstances. She has proven her defense to the accuracy-related penalty.
1. The renewal fee in
2. The parties did not enter this letter into the record, so we make no finding of fact regarding its contents beyond Shao's admissions at trial. However, we believe her testimony that the letter was sent July 13, 2004. Shao renewed her loan by writing a check to Bancroft Ventures dated June 30, 2004, and a 2004 letter from Bancroft dates Shao's new loan to July 11, 2004. We therefore find as a matter of fact that Shao received the Franchise Tax Board letter after she renewed her loan.
3. Although Shao didn't specify Mr. Nagy's first name, one Robert Nagy was a defendant in an action to enjoin the promotion of tax-fraud schemes allegedly carried out by Derivium and related entities.
4. This section is provided for background only—we make no findings of fact as to Derivium's history outside the (already presented) facts specific to Shao's case, although this section summarizes other published decisions.↩
5. Derivium's asserted hedging activity apparently masked the fact that their long-term strategy, reminiscent of South Park's Underpants Gnomes, relied on a business plan of "Step 1: Make 90% loans. Step 2: ? Step 3: Profit." See Comaford-Lynch, "Make Your Financing Pitch Sizzle," Business Week Online (Feb. 20, 2007),
6. Shao got statements from Derivium until 2003, suggesting that Derivium did not entirely stop doing business despite running out of money.↩
7. A few examples of opinions issued in the nearly 70 civil cases brought as a result of the Derivium scheme—
8. Unless otherwise noted, all section references are to the Internal Revenue Code, and the single Rule reference is to the Tax Court Rules of Practice and Procedure.