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In re Canada

United States District Court, N.D. Texas, Dallas Division

May 8, 2017

IN RE WILLIAM R. CANADA, JR., Debtor,
v.
WILLIAM R. CANADA, JR., Appellee. UNITED STATES OF AMERICA IRS, Appellant,

          MEMORANDUM OPINION AND ORDER

          JANE J. BOYLE UNITED STATES DISTRICT JUDGE.

         Appellant United States of America (IRS) appeals a final order of the bankruptcy court sustaining Debtor/Appellee William R. Canada, Jr.'s objection to the IRS's claim for civil penalties. In this case, the IRS attempts to impose a $40, 346, 167.87 civil penalty on Canada's bankruptcy estate for his failure to register as tax shelters certain financial arrangements he marketed and sold from 1998 to 2001 as an employee of the Heritage Organization, LLC. The bankruptcy court held that the arrangements were not “tax shelters” under the applicable statute, and thus Canada could not be penalized for failing to register them. Alternatively, the bankruptcy court found that even if the arrangements were “tax shelters, ” Canada fell within a statutory safe harbor provision because he had “reasonable cause” for the failure to register. For the reasons explained below, the ruling of the bankruptcy court is AFFIRMED.

         I. BACKGROUND

         A. Factual History[1]

         After graduating from Harvard law school in 1979, Appellee William R. Canada, Jr. worked for a variety of law firms, primarily as a commercial litigator. Bankr. Op. 4.[2] Dissatisfied with the practice of law, Canada went to work for the Heritage Organization in 1995 to “try something different.” Id. at 4-5. Canada admits he had “very little” tax experience before going to work for the Heritage Organization. Id. at 4. The Heritage Organization specialized in insurance-based estate planning strategies for high net worth individuals. R. 175. According to Canada, employees called “initiators” would “work the phones” to locate high net worth individuals, after which “contractors”-such as Canada-would schedule face-to-face meetings with prospective clients to interest them in Heritage's estate planning services. R. 174. Finally, principals of the Heritage Organization would make targeted presentations to specific individuals who showed interest in Heritage's services. Id.

         Canada was employed at Heritage from 1995 to 2002. Doc. 8, Canada Resp. Br. 6. Despite holding the position of President from approximately 1995 to 2002 and Chief Operating Officer from approximately 1995 to 2000, Canada contends that Heritage's main principal, Gary Kornman, was always truly in control of the organization and that Canada had none of the duties traditionally associated with the title of President or Chief Operating Officer. Bankr. Op. 5-6; Doc. 8, Canada Resp. Br. 8. According to Canada, he was hired simply to “learn the business of Heritage and ultimately be able to make presentations to clients.” R. 174. He describes his position in the organization as a “pure salesman.” Id.

         In 1998, an attorney named Ed Ahrens brought a new strategy to the attention of the Heritage Organization. R. 175-76. The new strategy (the Heritage Transactions) was designed to reduce capital gains taxes for Heritage's clients by short-selling Treasury securities. Bankr. Op. 7-8. As described in its simplest form by Canada, the client would form a pass-through entity, such as an LLC or an S-Corporation. R. 176. Next, the client would open an individual brokerage account with a major brokerage firm, short-sell Treasury securities through the brokerage account, and reinvest the short-sale proceeds in reverse repurchase agreements. Id. Then the client would contribute the brokerage account, including the obligation to repurchase the Treasury securities arising from the reverse repurchase agreements, to the pass-through entity. Id. The client, by ignoring the obligation to repurchase the Treasury securities-which lawyers were willing to opine was legal at the time based on the tax laws-was able to create “basis” in the pass-through entity equal to the amount of the proceeds of the Treasury short. R. 176-77. Though the actual implementation varied from client to client, the essence of the strategy was that a complicated series of financial transactions involving Treasury short-sales could be used to manipulate an asset's “basis” and manufacture artificial losses on paper, which could then be applied against large capital gains to reduce capital gains taxes in a given year. It is undisputed that neither Heritage nor Canada ever bought or sold any of the assets or securities to, from, or for the Heritage clients to effectuate the Heritage Transactions; what Heritage and Canada sold was the strategy itself. This distinction is very important to the Court's analysis below.

         From 1998 to 2002, Heritage successfully marketed the Heritage Transactions to several clients.[3] The Heritage Transactions were marketed in a similar manner to that described above: “initiators” would make phone calls and try to set up initial meetings, “contractors” would follow up with face-to-face meetings, and at some point individualized presentations and materials would be created for interested clients. R. 199-202. Before Heritage would reveal the specifics of the strategy, however, the client had to sign an engagement contract. See, e.g., R. 1026-33. Although the contracts varied slightly for each client, they generally provided that, after receiving the necessary information regarding the client's financial affairs, Heritage “may communicate to [the client] one or more Strategies which, singularly or in combination, may produce one or more of the following results, ” which usually amounted to “reducing capital gains tax liabilities.” R. 1026. The contracts defined “strategies” as follows:

The term “Strategies” shall be broadly construed and shall mean the contracts, Persons identified, facts, data, knowledge, documentation, opinions, concepts, ideas, techniques, methods, transactions, combinations, sequences of events, timing, financial models, diagrams, illustrations, and procedures divulged, described, communicated, detailed, arranged or identified by [Heritage], and all variations, modifications, sequences, rearrangements and recombinations thereof.

         R. 1030. The contracts also acknowledged that “the Strategies are not necessarily composed of information which is proprietary, trade secrets or exclusively known to [Heritage] and that the usefulness and value of the Strategies may be attributable to the timing, sequencing and combinations of the various non-proprietary components of the Strategies and/or to the fact that the Strategies may not be known to the [clients] even though they may be known to others.” R. 1027.

         In the event that a client implemented “in whole or in part, any one or more of the Strategies” in the ten years following disclosure of the strategy by Heritage to the client, the client would pay Heritage 25% of the taxes avoided by implementing the strategy. R. 1026. If a client signed the engagement agreement but did not implement any of the strategies, the client would not owe Heritage any fees other than a $22, 500 up front fee for Heritage's employees' “travel expenses” in presenting the strategy. R. 1026.

         The contracts also imposed a stiff penalty for unauthorized disclosures of the strategy by a Heritage client. After signing the engagement contract, if a client did not “maintain the absolute secrecy and confidentiality of the Strategies, ” the client would be assessed a “fee” of “Two Million Dollars ($2, 000, 000) for each Person to whom the Strategies are Revealed.” R. 1027. Additionally, if a person to whom the unauthorized disclosure was made implemented any of the strategies, the client would be assessed an additional “fee” of “six percent (6%) of the Value of all Property used to Implement any of the Strategies.” Id.

         According to the IRS, the total fees collected by Heritage for Heritage Transactions in which Canada participated between 1998 and 2001 was $62, 914, 237. Doc. 7, IRS Br. 10 (citing R. 659). It appears Canada may have been involved in as many as 12 different Heritage Transactions for different clients. See R. 659 (listing 12 Heritage Transactions on the document from which it appears the IRS calculates total fees to Heritage of $62, 914, 237 during the period). In the bankruptcy court, Canada indicated that “Heritage never did more than a few deals a year of any type.” R. 199. It is undisputed that the Heritage Transactions were never registered with the IRS as tax shelters by Canada or anyone else.

         Following a dispute over his compensation, Canada left the Heritage Organization in 2002. Bankr. Op. 10. In April 2004, Canada won an arbitration award for more than $6 million against Heritage. Id. A month later, in May 2004, Heritage filed for Chapter 11 bankruptcy, in which Canada participated as a creditor. Id. The bankruptcy court confirmed Heritage's Chapter 11 reorganization plan in September 2007. Id. Sometime in late 2006, however, the IRS apparently began investigating Canada for his involvement with the Heritage Transactions. R. 891-904. Canada was first contacted by the IRS in February 2007 regarding the Heritage Transactions. R. 923. A second letter, dated April 3, 2007, notified him that he was being investigated for tax shelter promoter penalties under 26 U.S.C. § 6707. R. 924. Though it is unclear from the record what progress was made on the investigation or whether the IRS communicated with Canada at all during the interim, in a letter dated April 9, 2015-almost a decade after the investigation began-the IRS notified Canada of its intention to impose $49, 108, 452 in civil penalties for his “failure to register a tax shelter as required by IRC § 6111 and the associated regulations.” R. 646.

         B. Procedural History

         As a result of the IRS's notice of its intention to impose this penalty, Canada filed for Chapter 11 bankruptcy on September 15, 2015. Bankr. Op. 10-11. In the bankruptcy court, the IRS submitted its original proof of claim on October 14, 2015, for $40, 286, 499 (R. 131-33), to which Canada objected on various grounds (R. 121-30). The IRS filed an amended proof of claim on January 12, 2016, for $40, 346, 167.87 (R. 456-59), to which Canada again objected on multiple grounds (R. 141-48). In the bankruptcy court, Canada moved for summary judgment on his objection to the IRS's proof claim on two grounds: (1) statute of limitations, and (2) preclusion. R. 1732-63. After full summary judgment briefing and a hearing, the bankruptcy court orally denied Canada's motion for summary judgment. R. 47.

         Ultimately, after pre-trial briefing, a two-day trial, and another round of post-trial briefing, the bankruptcy court sustained Canada's objection and disallowed the IRS's claim for civil penalties. R. 7-43. Although Canada had raised multiple grounds in his objection, the bankruptcy court found dispositive the argument that the Heritage Transactions did not fit within the applicable statutory definition of a “tax shelter” because they were not “investments.” Bankr. Op. 4. The court went a step further and held, alternatively, that even if the Heritage Transactions were “tax shelters, ” then Canada had established “reasonable cause” for not registering them. Id. Therefore, the bankruptcy court did not reach any of the additional grounds advanced by Canada in his objection to the IRS's claim. Id. at 4 n.12. A final order consistent with the bankruptcy court's decision was entered on June 17, 2016. R. 4-6.

         The IRS timely filed its Notice of Appeal of the bankruptcy court's decision on July 8, 2016. Doc. 1; R. 1. “As a precautionary matter to preserve and protect all of his objections, ” Canada later filed a provisional cross-appeal based on the bankruptcy court's denial of his motion for summary judgment, “as well as the multiple grounds not reached or decided by the [bankruptcy] Court in its” final order disallowing the IRS's claim. R. 44-46.[4] Canada makes clear that his cross-appeal is “to be considered only in the event that the reviewing court determines that the [bankruptcy court's decision sustaining his objection] should be vacated or reversed in whole or in part for any reason or cannot be affirmed based on the grounds and reasoning relied upon [sic] the Court below.” R. 44.

         The IRS filed its appeal brief in this Court on September 23, 2016. Doc. 7, IRS Br. Canada filed a combined response and cross-appeal brief on October 24, 2016. Doc. 8, Canada Resp.[5] The IRS then filed its reply/cross-appeal response brief on November 22, 2016 (Doc. 10, IRS Reply), and Canada filed a combined sur-reply/cross-appeal reply brief on December 6, 2016 (Doc. 12, Canada Sur-Reply). On the same day, Canada filed a motion to strike a portion of the IRS's reply brief. Doc. 11, Mot. to Strike. The IRS responded (Doc. 13, IRS Resp. to Mot. to Strike), and Canada replied (Doc. 15, Canada Reply to IRS Resp. to Mot. to Strike). Both the IRS's appeal and Canada's Motion to Strike are ripe for review.

         II. LEGAL STANDARDS

         A. District Court Review of Bankruptcy Court Order

Final judgments, orders, and decrees of a bankruptcy court may be appealed to a federal district court. 28 U.S.C. § 158(a). Because the district court functions as an appellate court in this scenario, it applies the same standards of review that federal appellate courts use when reviewing district court decisions. Webb v. Reserve Life Ins. Co., 954 F.2d 1102, 1103-04 (5th Cir. 1992). Thus, a district court reviews the bankruptcy court's findings of fact for clear error and its conclusions of law or mixed questions of law and fact de novo. McLain v. Newhouse, 516 F.3d 301, 307 (5th Cir. 2008); Wooley v. Faulkner, 542 F.3d 131, 135 (5th Cir. 2008). A factual finding is clearly erroneous when, “although there is evidence to support it, the reviewing court on the entire evidence is left with a definite and firm conviction that a mistake has been committed.” Memphis-Shelby Cty. Airport Auth. v. Braniff Airways, Inc., 783 F.2d 1283, 1287 (5th Cir. 1986) (quoting Anderson v. City of Bessemer City, 470 U.S. 564, 573 (1985)). It is insufficient that the reviewing court, upon examining the evidence, would merely have decided differently if sitting as the trier of fact. Id. (quoting Anderson, 470 U.S. at 573). In conducting a “clear error” review, the court must give due regard to the opportunity of the bankruptcy judge to determine the credibility of the witnesses. In re Dennis, 330 F.3d 696, 701 (5th Cir. 2003). De novo review of the bankruptcy court's conclusions of law, on the other hand, “requires this court to make a judgment independent of the bankruptcy court's, without deference to that court's analysis or conclusions.” In re Lawler, 106 B.R. 943, 952 (N.D. Tex. 1989) (citing Moody v. Amoco Oil Co., 734 F.2d 1200, 1210 (7th Cir. 1984)).

         B. Proof of Claim in Bankruptcy

         The Bankruptcy Code establishes a burden-shifting framework for proving the amount and validity of a claim. In re Margaux City Lights Partners, Ltd., No. 12-35828-BJH, 2014 WL 6668982, at *3 (Bankr. N.D. Tex. Nov. 20, 2014). A proof of claim executed and filed in accordance with the Federal Rules of Bankruptcy Procedure “shall constitute prima facie evidence of the validity and amount of the claim.” Fed.R.Bankr.P. 3001(f). “[T]he burden of going forward with the evidence then shifts to the objecting party to produce evidence at least equal in probative force to that offered by the proof of claim and which, if believed, would refute at least one of the allegations that is essential to the claim's legal sufficiency.” Id. (quoting In re Rally Partners, L.P., 306 B.R. 165, 168-69 (Bankr. E.D. Tex. 2003)).

         An objecting party may meet this burden by producing specific and detailed allegations that place the claim into dispute, by presenting legal arguments based on the contents of the claim and its supporting documents, or by presenting pretrial pleadings, such as a motion for summary judgment, in which evidence is presented to bring the validity of the claim into question. Id. (quoting In re Rally Partners, 306 B.R. at 168-69). If the objecting party comes forth with such evidence rebutting the claim, then the claimant must produce additional evidence to prove the validity of the claim by a preponderance of the evidence. In re Fidelity Holding Co., Ltd., 837 F.2d 696, 698 (5th Cir. 1988); see also 26 U.S.C. 7491(c) (“Notwithstanding any other provision of this title, the Secretary shall have the burden of production in any court proceeding with respect to the liability of any individual for any penalty, addition to tax, or additional amount imposed by this title.”).

         In this case, the IRS, therefore, has the ultimate burden to establish by a preponderance of the evidence Canada's liability for civil penalties under 26 U.S.C. § 6707. Canada, on the other hand, bears the burden of proving his reasonable cause defense, which he must also establish by a preponderance of the evidence. Brinkley v. Comm'r of Internal Revenue, 808 F.3d 657, 668-69 (5th Cir. 2015).

         III. ANALYSIS

         This bankruptcy appeal essentially turns on two questions which the IRS avers the bankruptcy court answered incorrectly: (1) whether the Heritage Transactions were “investments” constituting “tax shelters” within the meaning of 26 U.S.C. § 6111, for which registration would have been required; and (2) if so, whether Canada established “reasonable cause” under 26 U.S.C. § 6707 for failing to register them. Doc. 7, IRS Br. 2-3.[6] Regarding the first issue, the bankruptcy court, noting an almost total lack of authority interpreting the applicable versions of 26 U.S.C. §§ 6111 and 6707, applied various canons of statutory construction, as well as a plain meaning analysis, to find that the Heritage Transactions were not “tax shelters” because they were not “investments” within the meaning of 26 U.S.C. § 6111. Bankr. Op. 13-26. Going a step further, the bankruptcy court found that even if the Heritage Transactions were “investments” under § 6111, Canada had “reasonable cause” for failing to register them, which is a defense to liability under § 6707. Id. at 28-37. In reaching this conclusion, the bankruptcy court considered caselaw interpreting a similar “reasonable cause” provision in the tax code, the authority interpreting § 6111 available at the time, the lack of an obvious way to fit the Heritage Transactions into the statutory framework, and Canada's testimony that he had analyzed the statute and implementing regulation himself and determined that they did not apply-testimony which the bankruptcy court found “to be both plausible and credible.” Id. at 35. The Court begins with the question of whether the Heritage Transactions were “investments” constituting “tax shelters” for which registration was required.

         A. Whether the Heritage Transactions Were “Investments” Under 26 U.S.C. § 6111

         As the parties acknowledge, the underlying facts in this bankruptcy appeal are largely undisputed. See Doc. 7, IRS Br. 4 (“The facts material to [this appeal] are not in dispute as Canada offered the only testimony on the Heritage transactions, he entered into a stipulation regarding his ‘reasonable cause' defense, and the exhibits were admitted without objection.”); Doc. 8, Canada Resp. 13 (“The Court must construe and apply the two relevant tax statutes to virtually undisputed facts.”). The parties generally agree on the details of the Heritage Transactions, how they worked, and Canada's involvement with them. The threshold issue is whether the Heritage Transactions fell within the statutory definition of a tax shelter under the version of 26 U.S.C. § 6111 in effect at the time. As both sides acknowledge, this is a matter of statutory interpretation, which this Court reviews de novo. Doc. 7, IRS Br. 2-3; Doc. 8, Canada Resp. 1; In re Bodenheimer, Jones, Szwak, & Winchell L.L.P., 592 F.3d 664, 668 (5th Cir. 2009).

         At the start, there is no question that the Heritage Transactions were “tax shelters” in a colloquial sense, in that the whole point was to shield income from capital gains taxes. Canada admits as much. Doc. 8, Canada Resp. 9, 13 n.8. There is also no dispute that the tax benefits from these and similar types of transactions have since been disallowed by the IRS. Id. at 9; Bankr. Op. 36. Indeed, the IRS has apparently collected all of the taxes avoided by the Heritage Transactions from the individual Heritage clients themselves. Bankr. Op. 36. The precise issue before the Court, however, is not whether the Heritage Transactions fit some general concept of a tax shelter or even whether they were “legal” or “illegal.” Rather, the issue the Court must decide is whether they were correctly classified as “tax shelters” within the language of a specific statute and thus required to be “registered” as such, for which such failure to register would subject Canada to civil penalties.

         To begin, the IRS's claim for civil penalties is actually a function of two different tax provisions: 26 U.S.C. §§ 6707 and 6111. Before delving into the statutory language, however, the Court notes that both provisions were amended in October 2004, two years after Canada left Heritage.[7] As the conduct for which the IRS now seeks to impose civil penalties occurred between 1998 and 2001 (Doc. 7, IRS Br. 8), the parties agree that the applicable versions of the statutes are those in effect from August 5, 1997, through October 22, 2004. Doc. 7, IRS Br. 2; Doc. 8, Canada Resp. 14 n.10. Therefore, unless otherwise indicated, any references in this opinion to either statute are to those versions.

         Section 6111, titled “Registration of tax shelters, ” encompasses the actual registration requirement. 26 U.S.C. § 6111. It requires “[a]ny tax shelter organizer [to] register the tax shelter with the Secretary (in such form and in such manner as the Secretary may prescribe) not later than the day on which the first offering for sale of interests in such tax shelter occurs.” Id. § 6111(a)(1). This naturally begs the questions: (1) What is a tax shelter? and (2) Who is a tax shelter organizer?[8] It stands to reason that the answer to the latter necessarily depends on the answer to the former-that is, to be a “tax shelter organizer” one must first be dealing with a “tax shelter.”[9]

         The general definition of a tax shelter is found in § 6111(c), which provides as follows:

(c) Tax shelter.--For purposes of this section--
(1) In general.--The term “tax shelter” means any investment--
(A) with respect to which any person could reasonably infer from the representations made, or to be made, in connection with the offering for sale of interests in the investment that the tax shelter ratio for any investor as of the close of any of the first 5 years ending after the date on which ...

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