If it’s too good to be true, then it’s not! On the advice of their attorneys and accountants, taxpayers invested in tax-planning strategies that generated huge tax losses to offset sizable taxable gains without any significant economic risk. The nation’s leading law firms, accounting firms, and banks endorsed these transactions and propped them up with legal opinions, thereby creating an air of legitimacy around them. Comforted by the trappings of lawfulness, taxpayers jumped at the opportunity to reduce their taxes, paying considerable fees in the process.
As the IRS learned of these techniques, it categorized them as “listed transactions” (https://www.irs.gov/businesses/corporations/listed-transactions) and disallowed punitive losses associated with their use. A listed transaction is defined in Regs. Sec. 1.6011-4(b)(2) as a transaction that is the same or similar to one that the IRS has determined to be a tax-avoidance transaction and identified in a notice, regulation, or other publication. Many professionals scoffed at these IRS notices and their supposed application to the tax shelters in question. In some instances, these professionals did not immediately inform taxpayer clients of the IRS’s position. In other instances, they made disclosure but insisted that the nature of the purchased tax shelter was distinguishable from those shelters described in the IRS notices.
Once the taxpayer client receives a notice from the IRS informing him that the tax benefits claimed are not allowable for federal tax purposes, he faces a choice: he can either concede the invalidity of the transaction for which he had paid sizable fees—and pay taxes owed, interest, and penalties—or fight the IRS challenge, which would involve expensive, protracted litigation with an uncertain outcome and the prospect of higher penalties. The majority of investor taxpayers opt to cut their losses, forgo the reported tax savings, and remit back taxes and interest. These concessions, however, do not prevent investor taxpayers from suing the professionals who peddled the invalidated tax-planning strategies. One such lawsuit is Logan v. Morgan, Lewis & Bockius LLP, 2022 Fla. App. LEXIS 7178 (Fla. 2nd DCA 2022).
In Logan, BDO, an accounting firm with a dedicated tax advisory group, and AIGI marketed an “investment strategy” directed toward high-income individuals. That strategy involved offsetting long and short options in the foreign currency markets. The only problem was that the executives in charge of BDO’s “Tax Solutions” group (“tax executives”) knew that their strategy was likely illegal. But they believed that if they could obtain an opinion from a major law firm giving BDO a “clean bill of health” and downplaying the risk of illegality, they could quash the growing concern among others within BDO about potential criminal exposure. BDO could then also continue to market the strategy to new clients and encourage existing clients to claim the strategy’s purported tax benefits. BDO’s tax executives had considerable incentive to keep the scheme going for as long as possible because they received thirty percent of the Tax Solutions group’s significant profits.
To obtain that legal cover, the tax executives turned in part to Morgan Lewis. From the outset, the attorneys that they consulted at that firm recognized that the strategy was an illegal tax shelter. Morgan Lewis noted that the “tax solutions” were “too good to be true,” “dubious,” and did not pass the “‘smell’ test of experts.” One Morgan Lewis attorney promptly recognized several “uglies,” including “enormous losses and no apparent profit motive.” Morgan Lewis commented in an early meeting with the tax executives that “someone wanting to make a [criminal] case could.”
As if to remove all doubt, the IRS issued a warning that tax shelters involving “transactions calling for the simultaneous purchase and sale of offsetting options which were then transferred to a partnership” could give rise to criminal liability. Confirming its awareness of the illegality of BDO’s tax shelter, Morgan Lewis internally concluded that the shelter was identical or substantially identical to the type identified in the IRS notice. A senior Morgan Lewis criminal tax expert presciently commented that “BDO’s conduct reminds me of an old fashion[ed] Klein conspiracy”—a criminal tax conspiracy designed to obstruct the IRS’s auditing of tax returns and collection of taxes.
But as notes of a conference between the tax executives and a principal Morgan Lewis tax attorney demonstrate, the tax executives wanted a whitewashed opinion with a preordained conclusion that was dismissive of any illegality or potential criminal liability: “List of all cr. statutes possible to apply + indication of no guilt.” And according to Logan’s complaint, Morgan Lewis, despite its knowledge to the contrary, gave the tax executives exactly what they wanted.
Now able to tell their other BDO partners and BDO’s board that a major law firm had concluded that BDO had nothing to worry about, the tax executives not only successfully encouraged BDO to continue marketing and implementing the investment strategy, but they also had the cover they needed to continue to assure clients such as Logan that that strategy was perfectly legal and that they would ultimately be successful in any litigation with the IRS.
BDO’s client, Logan, through a pass-through entity, engaged in a series of these “investments.” When filing his tax return relating to the sale of his business, Logan, relying on BDO’s assurances, filed his return claiming the supposed benefits of those investments, offsetting the purported losses against the substantial taxable gains from the sale of his business.
The IRS, however, eventually figured out what BDO was doing and commenced litigation against BDO in federal court. Ultimately, several of the tax executives pled guilty to criminal tax fraud in connection with the scheme.
The IRS also audited Logan. Relying on BDO’s assurances that its investment strategy and his resulting tax benefits had been perfectly legitimate, Logan fought the IRS for several years. However, the IRS eventually obtained a $11 million tax judgment against Logan’s partnership thereby disallowing the use of any purported losses from the “investments” against Logan’s capital gains.
Logan brought suit against BDO, Morgan Lewis, and AIGI. In the complaint, Logan alleged, in part, that BDO breached its fiduciary duty to Logan by falsely advising and continuing to assure Logan that “claiming capital and ordinary losses” from the subject investments “was an appropriate tax treatment” despite knowing that its “investment strategy” was actually an illegal tax shelter. Logan further alleged that by providing the opinion, Morgan Lewis did not simply enable the underlying torts to occur but was instrumental to their success and directly contributed to Logan’s ultimate damages. Without Morgan Lewis’s “blessing,” the concerns of other BDO executives and BDO’s board would have killed the tax executives’ program, and BDO never would have been able to continue to falsely assure Logan of the program’s legitimacy and encourage Logan in his ongoing dispute with the IRS.
Morgan Lewis was sued for aiding and abetting fraud, aiding and abetting breach of fiduciary duty, and civil conspiracy. Morgan Lewis moved to dismiss the complaint, in part, for failure to state a cause of action arguing that it could not be liable to Logan because it had had no duty to him whatsoever and that it could not conspire as a matter of law with BDO, its own client, simply by providing legal services.
The trial court granted Morgan Lewis’s motion to dismiss and the appellate court reversed. The court found that the trial court erred by dismissing Logan’s claim for aiding and abetting fraud and breach of fiduciary duty because the complaint alleged that Morgan Lewis did not merely remain silent or fail to act; instead, it provided the tax executives with affirmative assistance in the form of a knowingly false and misleading opinion. In addition, the trial court erred by dismissing Logan’s claim for civil conspiracy because the complaint alleged that Morgan Lewis agreed to assist BDO in committing criminal tax fraud – conduct that plainly fell outside the scope of legitimate legal representation.
Practice Pointer: Your correspondence can come back to bite you! If your client voluntarily produces your correspondence, if you are sued for malpractice, or if the court finds that the crime/fraud exception applies [§90.502(4)(a)], then your correspondence with your client is discoverable. In addition, the identities of clients utilizing certain tax avoidance techniques are potentially not privileged. See United States v. Jenkens & Gilchrist, P.C., 2004 U.S. Dist. LEXIS 6919 (N.D. Ill. Apr. 21, 2004), United States v. Sidley Austin Brown & Wood LLP, 2004 U.S. Dist. LEXIS 6452 (N.D. Ill. Apr. 20, 2004), and Doe v. KPMG, L.L.P., 2004 U.S. Dist. LEXIS 6191 (N.D. Tex. Apr. 4, 2004),