I will in this post highlight some interesting parts of last week’s Exelon v Comm’r. The case involves Exelon’s seeking to shelter billions in gains on sales of fossil fuel plants by attempting to shoehorn a sale and leasing transaction into a like-kind exchange. In Exelon, the accuracy-related penalties alone were over $87 million, and the Tax Court found that despite a sophisticated law firm’s legal opinion Exelon was liable for the accuracy-related penalty. In discussing Exelon, I will also flag two other recent opinions involving the same issue.
One of the issues in Exelon was the IRS’s assertion of accuracy-related penalties despite Exelon’s receiving a detailed legal opinion blessing the transaction’s tax consequences. A common issue courts consider is whether reliance on a tax advisor will insulate a taxpayer from civil penalties. As with many issues, the black letter law is relatively straightforward. Derived in part from dicta in the Supreme Court Boyle case, the Tax Court relies on a three-part test case that essentially asks the following questions:
- Was the advisor a competent professional who had sufficient expertise to justify reliance;
- Did the taxpayer provide necessary and accurate information to the advisor;
- Did the taxpayer actually rely in good faith on the advisor’s judgment.
Neonatology Assoc. v Comm’r 115 T.C. 43, 99 (2000), aff’d, 299 F.3d 221 (3d Cir. 2002). The cases applying the standard are notoriously fact-specific and difficult to easily synthesize.
Exelon is a case that has generated a great deal of attention, in part because of the sheer amount of the deficiency, which is over $500 million for the two years at issue. The transactions included complicated sale in lease out (SILO) transaction that Exelon entered into so it could identify a replacement property for 1031 purposes to shelter billions in gain on sales of fossil fuel plants. The opinion has over 150 pages detailing and analyzing the complexities of the transactions and how they should be treated for tax purposes. What is key for purposes of this write up however is after the court found in favor of the IRS on the underlying issue (essentially that Exelon did not acquire the beneficial ownership of the properties it leased back to tax-indifferent public entities and thus could not shelter its gain through 1031), was its conclusion that despite an opinion letter from Winston & Strawn it still found the taxpayer liable for the penalty. Some things to highlight:
- IRS argued that Winston & Strawn’s involvement in assisting with structuring the transaction was a per se disqualification for considering the advice reasonable. Some cases have held that the advisor is essentially tainted with a scarlet C for conflict of interest. The opinion cites one of those cases, Kerman v. Commissioner, T.C. Memo. 2011- 54, aff’d, 713 F.3d 849 (6th Cir. 2013). This was not one of those cases; even though Winston & Strawn was paid handsomely for its advice it did not bill based upon the transaction closing but rather its fees were based on normal hourly rates. Because W&S billed on an hourly basis and did not tie its fees to the transaction the Tax Court concluded that the advice was not per se disqualified from protecting the taxpayer under the Neonatology test.
- Despite not finding a per se disqualification of the advice based on a conflict of interest, the Tax Court did find that W&S’s actions with the appraisers (Deloitte) prior to issuing its legal opinion tainted its advice because these actions rendered the facts and assumptions it relied on as unreasonable. The Tax Court’s opinion focused on W&S’s discussing with Deloitte what values it expected in the appraisals:
We found that Winston & Strawn interfered with the integrity and the independence of the appraisal process by providing Deloitte with a list of conclusions it expected to see in the appraisals to be able to issue tax opinions at the “will” and “should” level. Such interference improperly tainted the Deloitte appraisal, rendering it useless. Further, because Winston & Strawn directed the conclusions that Deloitte had to arrive at, we are highly suspicious that the tax opinions are similarly tainted.
In other words, factor 2 in the Neonatology test for reliance can be a problem if the advisor is seen as influencing the facts and assumptions that are crucial determinants of the substantive tax advice. As I understand, it is not uncommon for advisors to work with appraisers and other agents of the taxpayers. From what I read in the opinion I do not see evidence that the appraiser acted improperly. W&S’s discussion as to what it needed to issue a will or should opinion alone appears to be sufficient to taint or color the facts that it relied on in issuing its opinion. What the Tax Court does in this opinion is suggest that the allure of fees associated with the appraiser’s understanding as to what the advisor needed is enough to conclude that the advisor has not received accurate information from the taxpayer (here, the taxpayer’s agent, Deloitte). That outcome should give pause to legal advisors who may as a matter of course discuss what they need from appraisers to reach comfort to give tax advice.
- The Exelon Tax Court opinion, as many before it, looks to the sophistication of the taxpayer to test whether in fact the taxpayer really relied in good faith on the advice that it received. As the opinion discusses, in Boyle the Supreme Court discusses that it is not incumbent on taxpayers to seek a second or third opinion. Yet, as here, when the taxpayer is sophisticated the court will be more skeptical that there was in fact good faith reliance. What is interesting about the Exelon opinion is that sometimes the sophistication goes beyond tax expertise, especially if the transaction’s form depends on outcomes and decisions that are inconsistent with general business practices. Here there was an expectation that the purported sellers of the replacement properties would in fact purchase the properties back from Exelon, a fact that contributed to the Tax Court’s finding against the taxpayer on the merits and on the penalties:
Sophistication and expertise of a taxpayer are important when it comes to determining whether a taxpayer relied on a tax professional in good faith, or simply attempted to purchase an expensive insurance policy for potential future litigation. Petitioner had been involved in the power industry since 1913 and described itself as “an electric utility company with experience in all phases of that industry; from generation, transmission, and distribution to wholesale and retail sales of power.” Although petitioner did not have experience with section 1031 transactions, it certainly had experience in operating power plants and must have understood the concept of obsolescence…
Our analysis of the test transactions shows that petitioner knew or should have known that CPS and MEAG were reasonably likely to exercise their respective cancellation/purchase options because they would not be able to return the Spruce, Scherer, and Wansley power plants to petitioner without incurring significant expenses to meet the return requirements.
At the end of the day, the Tax Court found incredulous that a taxpayer with Exelon’s sophistication would believe the tax opinion it received because the judge did not believe that Exelon bought into the opinion’s assumptions about the transactions’ counterparties. Rather than seek advice, the Exelon opinion suggests that the taxpayer was purchasing penalty insurance through engaging its legal and tax advisors. In language that is direct and deeply critical of what Exelon and its advisors did, the opinion sums up what it thought of the taxpayer and its advisors’ conduct:
We cannot condone the procuring of a tax opinion as an insurance policy against penalties where the taxpayer knew or should have known that the opinion was flawed. A wink-and-a-smile is no replacement for independence when it comes to professional tax opinions.
Exelon also sought to justify its reliance by noting that its auditor did not flag the transaction but the opinion minimizes that fact (see page 172 note 35):
Unlike petitioner, Arthur Andersen did not have the benefit of vast experience in operating power plants and may have overlooked the issue of return conditions. The record is also silent as to what documents related to the transactions were actually reviewed by Arthur Andersen and to what extent. We are thus not persuaded by petitioner’s argument.
The Tax Court found that the above led it to conclude that Exelon “could not have relied on the Winston & Strawn tax opinions in good faith because petitioner, with its expertise and sophistication, knew or should have known that the conclusions in the tax opinions were inconsistent with the terms of the deal. Second, in the light of the previous conclusion, petitioner’s alleged reliance on Winston & Strawn’s tax advice fails the Neonatology test.” At the end of the day, Exelon did not have good faith and reasonable cause under Section 6664(c) and that it was liable for the penalty due to a “disregard of rules and regulations within the meaning of section 6662 with respect to ascertaining the tax consequences of the test transactions.”
Some Parting Thoughts and A Comparison to Some Other Cases Finding in Favor of the Taxpayer
The case is worth a deep read of the facts, including its discussion of how Exelon’s registering the transaction as corporate shelter did not help and that many of the Exelon higher ups did not read the W&S opinion. It also cryptically notes that IRS conceded the substantial understatement leg of the accuracy-related penalty (page 162), but does not state why.
While I will not discuss extensively here, it is worth contrasting the outcome in Exelon with two other recent opinions. One is Boree v Commissioner, which involves the characterization of an individual’s gain on the sale of subdivided property. In Boree, the Eleventh Circuit affirmed the Tax Court’s finding that the sale generated ordinary income but reversed it on the substantial understatement penalties in large part because the individual was able to show that he relied on his longtime tax preparer in treating the gain as capital gain. The other is Collodi v Commissioner, a summary Tax Court opinion where the Tax Court found that a constantly-travelling gas well worker had no tax home and thus could not deduct his costs on the road. Despite denying the deductions, in Collodi the Tax Court found for the taxpayer’s reliance on his tax return preparer was a defense to the accuracy-related penalties for the deficiency attributable to the denied travelling expenses.
In both Boree and Collodi the taxpayers had no tax or accounting experience. Boree was a former logger who went on to develop land. Collodi worked on gas wells. While both were engaged in their business and had expertise in the businesses, the expertise had no bearing on the tax consequences of the positions on the returns. In both cases the taxpayers relied on their longtime preparers who had tax expertise. Boree is perhaps more interesting in that it is an appellate opinion and it reversed the Tax Court; moreover, in Boree there were some inconsistencies in the return itself that might have generated a question as to whether the taxpayer relied in good faith on the advice (namely that the return reflected some trade or business expenses with the development activity which are inconsistent with the capital gain treatment).
What these cases suggest is that courts will be rightfully skeptical of taxpayers like Exelon where the facts suggest that rather than purchasing tax advice they are purchasing penalty insurance in the form of tax advice. For most individuals who come to the table with little financial or tax sophistication and who have a long history of tax compliance and stable tax advisors, courts tend to respect the relationship between advisor and taxpayer and not second guess the advice for penalty purposes.