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Lessons Learned From U.S. Tax Fraud Case

Court issues $1.1 billion judgment

In May 2016, a U.S. bankruptcy court judge in Texas ruled that billionaire Texas business mogul Samuel Wyly committed tax fraud in using offshore non-grantor trusts to hide income from the Internal Revenue Service.1 The ruling, which resulted in a $1.1 billion judgment against Wyly, highlights a number of issues that your clients should be aware of when engaging in offshore planning when the resulting positions are uncertain.

The IRS has also filed a lawsuit against the estate of Charles Wyly to collect $249 million in penalties for failure to file certain forms to report the offshore trusts.2

The court also found that Dee Wyly, the widow of Charles Wyly (who was Samuel Wyly’s brother and business partner), hadn’t committed tax fraud, even though she was a joint signer on Charles’ returns. However, she must pay taxes, penalties and interest for a gift to her children. In addition, the court addressed the Wylys’ failure to file certain forms reporting the offshore accounts and gift tax issues. 

Background Facts

Samuel and Charles Wyly were brothers and business associates for the majority of their adult lives. Over the course of their careers, the brothers enjoyed considerable success in founding or acquiring numerous companies. By the early 1990s, the brothers had amassed a significant fortune and sought advice with respect to U.S. income and estate tax planning.

The Wylys and their advisors ultimately implemented an aggressive strategy devised by a lawyer and trust promoter involving the use of offshore trusts and companies. The strategy called for the Wylys to establish trusts in the Isle of Man and transfer their stock options in companies they owned to the trusts in exchange for private annuities issued by companies owned by the trusts. The Wylys took the position that the trusts were “nongrantor trusts” for U.S. income tax purposes. Any income earned by the assets in the trusts would be taxed at the trust level and not automatically to the Wylys. Had the Wylys taken an alternative position that the trusts were “grantor trusts,” all income from the trusts would have been taxed to them regardless if a distribution was made. The Wylys took the non-grantor position even though an outside attorney reviewed the structure and advised that the IRS would likely treat the trusts as grantor trusts from a U.S. income tax perspective. Thus, the Wylys didn’t report any income earned by the trusts.

In 2003, certain advisors to the Wylys re-evaluated the positions taken with respect to the Isle of Man trusts. The advisors concluded that there was a significant risk that Isle of Man trusts dating back to 1992 would be treated as grantor trusts for U.S. income tax purposes. The advisors recommended an anonymous meeting with the IRS to see if a global settlement could be reached surrounding the offshore system. The meeting occurred, but the IRS and the advisors didn’t reach an agreement.

The advisors also recommended that the Wylys formally disclose their tax positions by filing Forms 8275. Form 8275 can be filed with the IRS when a position on a tax return has only reasonable basis of being sustained and is filed to avoid accuracy-related penalties. Beginning in 2002, Samuel filed Form 8275 disclosing the sale of the stock options to the trusts in exchange for private annuities and their position that the trusts were non-grantor trusts; Charles and his wife Dee filed similar Forms 8275 with beginning with their 2003 joint tax return. On audit, the IRS asserted income and gift taxes, failure to file penalties for gift taxes and foreign reporting requirements and fraud penalties. In addition, the IRS asserted “willful neglect penalties with respect for failing to file certain forms disclosing the foreign trusts.” Charles passed away while the case was pending, leaving Dee and his probate estate to face the fallout.

Income Tax Fraud

The IRS carries the burden of establishing tax fraud by clear and convincing evidence separately for each tax year at issue upon review of all the facts and circumstances. For fraud to exist, the taxpayer’s underpayment of tax must have been intentional with the purpose of avoiding the tax.

The courts have developed a nonexclusive list of indications of fraudulent intent. Such indications include: (1) understatement of income, (2) inadequate maintenance of records, (3) failure to file tax returns or make estimated tax payments, (4) offering implausible or inconsistent explanations of behavior, (5) concealment of income or assets, (6) failure to cooperate with tax authorities, (7) engaging in illegal activities, (8) dealing in cash, (9) offering false or incredible testimony, and (10) filing false documents. No single indicator may necessarily be sufficient to establish fraud; however, the existence of several indicia may be persuasive evidence of fraud.

The court pointed to a number of facts in this case indicating that Samuel and Charles Wyly acted with fraudulent intent by failing to report the income earned by the offshore trusts. For example, the structure the Wylys established was unnecessarily complex. The Wylys settled multiple foreign trusts, which in turn owned numerous foreign corporations that in turn owned U.S. corporations. The court mentioned specifically 54 offshore trusts or corporations and at least 10 U.S. corporations. The trusts weren’t adequately capitalized and had charities or family members as beneficiaries. The court found the complexity was much greater than actually needed. It even pointed out many multinational corporations weren’t structured so complexly.

The court found other indicia of fraud by Samuel and Charles. For example, the Wylys used the structures to commit securities fraud, failed to resolve conflicting legal advice as to the legitimacy of the transactions, established trusts and companies to muddy the nature of the structure, and falsified documents and filings. Of particular note, on multiple occasions the Wylys directly exercised their control over the trust assets by causing the trusts to take certain actions, including spending money for the benefit of family members or make certain investments. Indeed, the court stated the Wylys treated the trusts as the “Wyly Family Piggy Bank.” Despite all of these indications that the Wylys directly controlled the assets in the Isle of Man trusts, the Wylys didn’t report the income earned by the trusts as their own.

Therefore, with respect to the income tax fraud issues, the court found the IRS had met its burden in proving fraud. Under similar reasoning, the court also concluded the Wylys acted with willful neglect for failing to file Forms 3520-A and 5471 to report the existence of the offshore accounts, companies and trusts.

Reasonable Cause Defense

Samuel asserted a reasonable cause defense against the fraud penalties. This defense allows a taxpayer to assert s/he relied on the advice of legal counsel and therefore should be exempt from the fraud penalties. Samuel pointed to the fact that he received a legal opinion from the original promoter of the structure and that he relied on the advice of his in-house counsel in implementing the structure. The court found these arguments unpersuasive for a few major reasons.

First, the IRS prohibits taxpayers from relying on the written opinion of a promoter of a tax shelter. Here, the advice obtained by the Wylys when setting up the structure came from the firm employing the promoter of the overall planning. Furthermore, Samuel received conflicting advice from another advisor around the time of inception informing him the IRS would likely treat the trusts as grantor trusts. This failure to resolve the conflicting legal advice was a sticking point for the court.

The court also found Samuel’s argument that he relied on the advice of his in-house counsel unpersuasive, as the in-house counsel wasn’t a tax expert, and Samuel apparently knew this. Also of note, the in-house counsel never offered tax advice but served as a middleman between the outside lawyers and Samuel. Thus, the court rejected Samuel’s reasonable cause defense.

Dee’s Innocent Spouse Defense

Charles filed joint tax returns with his wife, Dee. As Dee was still alive during the trial but Charles wasn’t, the fallout from the investigation and trial fell on her. During the trial, Dee asserted an innocent spouse defense. This defense provides an exception to the general rule that spouses who file joint returns are jointly liable for the tax, penalties and interest due. During the trial, Dee showed that she had no knowledge or involvement in the establishment of the trusts. She also proved that a reasonable person in her situation wouldn’t have known about the tax fraud. Of particular importance, the court noted Dee’s lack of education or sophistication in business and tax matters. Dee was primarily the homemaker in the relationship and rarely, if ever, involved herself in her husband’s business affairs. As a result, the court determined Dee established that she was an innocent spouse with respect to the tax, interest and penalties due and thus not liable even though she signed the tax returns at issue. 

Gift Tax Issues

The court examined certain alleged gifts made by Samuel to his children and Dee to her children. The transactions were quite complex. The court found that Samuel never made a completed gift because he didn’t relinquish dominion and control of the gifted assets. For Dee’s alleged gifts, the court did find one completed gift resulting in Dee being liable for the gift tax due. However, the court didn’t find that Dee was liable for a fraud penalty on the failure to report the gifts and pay the tax because persuasive evidence didn’t exist that Dee understood the transactions. Rather, she entered into them with full reliance on Charles’ direction. 

Planning Considerations

The Wyly cases provide a number of important points to be aware of when engaging in offshore planning from a U.S. tax perspective. First, foreign taxpayers should always receive an opinion from an independent, qualified and competent U.S. tax advisor. Even if the planning is disallowed later on, obtaining the opinion provides the taxpayer with an additional argument against the implementation of the fraud penalty.

Second, taxpayers taking uncertain planning positions may benefit from disclosing the position to the IRS and providing the IRS with all pertinent information. This puts the IRS on notice and prevents the argument that the taxpayer acted fraudulently by withholding information.

Finally, advisors to spouses of individuals charged with tax fraud should keep in mind the innocent spouse rule. If successful, this would allow a spouse who didn’t have any involvement with the scheme to avoid joint liability for the wrongdoing of their spouse.

Endnotes

  1. In Re: Samuel E. Wyly, et al. (Bankr. N.D. Tex. 2016).
  2. United States v. Miller, D. Tex., No. 3:16-cv-02643 (complaint Sept. 15, 2016).

 

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