Grounded by the IRS

After the 9th U.S. Circuit Court of Appeals ruled in January that two Internal Revenue Service attorneys committed a fraud upon the U.S. Tax Court, IRS Chief Counsel B. John Williams took to the bully pulpit. He promised in two gatherings of the tax bar that he would apologize to the court, remind his underlings of their ethical duties and prevent a relapse. The 9th Circuit found that the two IRS attorneys cut secret deals to undermine the fair resolution of a test case affecting 1,300 taxpayers. Williams’ apologies ring a little hollow to Jerry Dixon, a retired Continental Airlines pilot who lives with his wife, Patricia, in El Paso, Texas. Like the other taxpayers, many of them airline pilots and their families, the Dixons put money into tax shelters operated by Honolulu businessman Henry Kersting in the late 1970s and early 1980s. As early as 1982, the IRS decided that the shelters were invalid and sent out deficiency notices. Closure has been a long time coming. Part of the delay stems from the taxpayers’ appeal of the deficiency notices in the U.S. Tax Court. But years of delay can be chalked up to two IRS attorneys, Kenneth W. McWade and William A. Sims, whose machinations put a cloud over the agency’s actions and drew the wrath of the 9th Circuit. Following the 9th Circuit’s Jan. 17 decision in Dixon v. Commissioner of Internal Revenue, No. 00-70858, Sen. Charles E. Grassley, R-Iowa, the Senate Finance Committee chairman, demanded to know how the IRS will clean up its act. Lawyers for the taxpayers estimate that if the 9th Circuit hadn’t saved the day, their clients would collectively have had to pay hundreds of millions of dollars in back taxes, penalties and, most of all, long-accumulating interest. NO APOLOGY Dixon alone was worried that he would have to pay more than $1 million. “There’s never been an apology to the people the IRS has been harassing for 27 years,” he says, adding that “People shouldn’t have to spend most of their adult lives worrying about what some court will decide.” Tax practitioners are a little more forgiving than Dixon: the word they use most often to describe this case is “aberrational.” According to Henry Binder, who represented Dixon and several other taxpayers and argued the case before the 9th Circuit, Kersting gave his clients stock in one of his companies in exchange for notes on which the clients were required to pay interest. Usually, the client would not have to pay the entire interest amount, since Kersting would issue second-level interest-bearing notes to cover the first-level interest. Through a series of such transactions, a taxpayer could turn an annual outlay of a few thousand in interest payments into tax writeoffs much larger, taking advantage of a deduction for personal interest that was later eliminated by Congress in 1986. In remanding the case to the Tax Court for a final determination of what is owed, the 9th Circuit has given some room for further wrangling between the taxpayers and the IRS, although Williams has promised to move expeditiously. But this much is clear: Dixon and hundreds of other taxpayers will end up owing a fraction of what they feared. The 9th Circuit panel, composed of judges Michael Daly Hawkins, Dorothy W. Nelson and Kim McLane Wardlaw, found that McWade and Sims entered into a scheme “plainly designed to corrupt the legitimacy of the truth-seeking process” at a 1992 Tax Court “test case” trial that was supposed to decide once and for all what was owed by the 1,300 taxpayers. According to the panel, McWade and Sims cut deals with two taxpayers, John R. Thompson and John R. Cravens, to ensure that they would give testimony detrimental to the group of taxpayers as a whole. The 9th Circuit ruled that the only fitting remedy for this fraud on the court is to give all 1,300 taxpayers the same deal offered to Thompson, whom McWade and Sims gave better terms than Cravens. The tax court had ruled in 1999 that the 1992 trial judgment in favor of the IRS should stand because the outcome would have been the same even if McWade and Sims had acted properly. Michael L. Minns, a Houston solo practitioner who says he represents more than 100 of the Kersting taxpayers and who also argued the case before the 9th Circuit, estimates that his clients will end up having to pay at most 11 cents on the dollar. Minns’ clients owed on average about $2 million, he says (by comparison, their average estate is about $1.2 million). Multiply that figure by 1,300 and it’s easy to see how hundreds of millions, if not billions, were at stake, he says. The 9th Circuit stated that so momentous a remedy is necessary because, contrary to the tax court’s 1999 ruling, fraud upon a court can never be merely “harmless error.” Beyond that, though, the panel seemed intent on sending a message to the IRS. “The IRS has done little to punish the misconduct and even less to dissuade future abuse,” Hawkins wrote. To hear Binder and Minns tell it, the righteous anger of the three panel members took on almost Old Testament proportions at oral argument. “It moved me profoundly,” says Binder of Houston’s Porter & Hedges. Minns says that he was chastised by Judge Hawkins for failing to report McWade and Sims to their respective bars, a task he is in the process of carrying out. The three judges are not the only ones outraged. On Jan. 29, Sen. Grassley wrote to IRS Chief Counsel Williams wanting to know when McWade and Sims had left the IRS and with what benefits, whether the IRS could recover $1,000 bonuses reportedly paid to McWade and Sims before their misconduct was discovered and what action the IRS would take to prevent a recurrence. Grassley gave a Feb. 19 deadline for a reply, which has not yet been proffered, according to a Grassley spokesperson. Williams would not agree to an interview. McWade retired in 1993 rather than accept discipline, according to a 1999 tax court decision. Sims was put on two weeks’ unpaid leave, transferred from Honolulu to San Francisco and stripped of supervisory powers. An IRS spokesman would not comment on his subsequent history, except to say that he is now retired. Sims could not be reached. In an interview, McWade said that he was under pressure to bring the Kersting cases to trial and that he and Sims settled with Thompson and Cravens only after they showed reluctance to go forward as test cases. He said he thought Sims cleared the deals with higher-ups. BAR REACTION Tax practitioners, even some involved in this case, have generally not lost their confidence in the integrity of IRS lawyers. To be sure, Minns has much the same reaction as Dixon: “I’m glad Williams is apologizing to the New York State Bar. But the people who were injured should be the first to get an apology.” Binder, on the other hand, is gratified that Williams has publicly acknowledged the IRS’ fault in comments before the New York State Bar Association tax section on Jan. 21 and before a San Antonio meeting of the ABA tax section on Jan. 23. Among other attorneys, Richard A. Shaw is typical in saying that “B. John Williams and other senior people in the chief counsel’s office have excellent integrity and work very hard to have the system work fairly.” Shaw is a partner in San Diego’s Higgs, Fletcher & Mack and will assume the chair of the ABA’s tax section in October. Shaw notes that on Feb. 3, at Williams’ direction, Associate Chief Counsel Deborah A. Butler circulated a memorandum to all IRS attorneys. Butler directed them to read the Dixon opinion and reminded them that IRS attorneys “are expected to adhere to the highest standards of conduct, not simply conform to minimum professional obligations.” Finally, she warned that conduct such as lying to or misleading a court would bring “appropriate disciplinary action, including possible termination of employment.” If Shaw has any criticism, it is that lower-level attorneys sometimes get out of line. He points to a case from October of last year, Rauenhorst v. Commissioner of Internal Revenue, 119 T.C. 157, in which the tax court chided the IRS because one of its attorneys tried to argue that the taxpayer on trial should be held to a different standard than what the head office advised taxpayers in general. Williams circulated a warning note to his attorneys over that as well. Even so, Shaw sees the Dixon case as an “isolated incident.” The 1992 Dixon trial took the form of a test case, a procedure now rarely used. The IRS and defense attorneys chose eight taxpayers, including Dixon, Thompson and Cravens, as test cases. The outcome of those cases was to determine the fate of the 1,300 or so taxpayers who agreed to “piggyback,” thus reducing litigation costs for both sides. Kenneth W. Gideon, former IRS chief counsel and now partner in the D.C. office of New York’s Skadden, Arps, Slate, Meagher & Flom, says that the test case lost most of its reason for being when Congress passed reform legislation in 1986 putting most mass-market individual tax shelters out of business. The test-case format gave McWade and Sims added leverage. Binder says that it was in their interest to cut a deal with Thompson because a related dispute Thompson had with Kersting gave him an incentive to say that he knew from the start that certain Kersting transactions were shams. Cravens had a fairly favorable case going into trial, because he had paid capital gains taxes on certain Kersting transactions, indicating that he thought them legitimate investments. By making a deal with Cravens and persuading him that he didn’t need an attorney, McWade and Sims “eviscerated” his case, Binder says. He describes McWade’s and Sims’ dealings with Cravens and Thompson as “taking out the taxpayers’ star quarterback and then putting a ringer in.” As both the tax court and the 9th Circuit noted, once Sims and McWade cut the deals they acted — or stood by when they should have acted — to keep the deals hidden from the tax court, the other taxpayers and their attorneys. The scheme began to unravel shortly after the trial, when Cravens and Thompson insisted that they were not bound by the tax court’s adverse rulings. To the IRS’ credit, it was McWade’s and Sims’ supervisors who brought their misconduct to the attention of the tax court. Kersting was never indicted, but in 1989 he was assessed nearly $4 million for operating an abusive tax shelter. Kersting tied up that assessment in appeals for many years, arguing, among other things, that McWade’s and Sims’ misconduct tainted his case as well. The 9th Circuit affirmed the assessment in 2000. Kersting died that same year. Minns foresees another year of litigation to determine how the terms of the Thompson settlement will be applied to the other taxpayers. The 9th Circuit found that McWade and Sims had allowed Thompson to take bogus deductions so that he could pay his attorney fees, which amounted to more than $60,000. “Does that mean that all the taxpayers get their attorney fees paid?” Minns wonders.