Once Again, the “Tax Plan” Fails

On February 2, 2022, the Tax Court issued a memorandum opinion in the case of John M. Larson (“Larson”).[1] This case involves a dispute going back more than 20 years. Mr. Larson was an attorney and CPA. He and two other men, Robert A. Plaff and David Amir Makov, promoted a fraudulent tax shelter transaction known as Bond Linked Issue Premium Structure (“BLIPS”).

Facts

Larson, together with Plaff and Makov, created an S corporation, Morley, Inc. (“Morley”). Morley also created an employee stock option plan (“ESOP”). Larson, Plaff, and Makov, together with a Ms. Bratton, a CPA who partnered in 1997 with Larson, Plaff, and Makov, acted as trustees of the ESOP plan. Morley entered into a three-year employment agreement and restricted stock agreement with the trustee-officers. For the 1999 and 2000 tax years, the ESOP owned one hundred percent of Morley. Through his ownership via the ESOP, Larson deferred recognition of his share of the S corporation’s income because, under the restricted stock agreement, the stock was not substantially vested.[2] The Tax Court disagreed.

The tax years at issue were 1999, 2000, and 2001. Larson, together with Plaff and Makov, promoted the BLIPS transaction through an entity named Presidio Growth, LLC (“Presidio”), a single member subsidiary of Morley. The BLIPS transaction involves the formation of a strategic investment fund (“SIF”), of which investors owned about ninety percent and Presidio owned approximately ten percent. The SIF would obtain a premium loan consisting of a principal amount and a substantial additional premium with an above-market interest rate. The premium amount of the loan was set to the desired tax loss of the investor. Presidio used the SIF’s loan proceeds to place a short position speculating that particular foreign currencies would lose value. In calculating the investor’s outside basis, the investor would treat the obligation to repay the premium portion of the loan as contingent and not as a liability. The BLIPS investments were structured to close within sixty to ninety days. The intended effect of this arrangement was for the investor to claim inflated basis in the distributed assets which in turn would generate losses upon the subsequent sale of the distributed assets. The arrangement had been found to previously lack economic substance.[3] Larson, Plaff, and Makov, sold the BLIPS structure to more than one hundred investors.

In August 1999, Morley created the ESOP and a trust. The trust, under the ESOP, was funded with 150 shares of Morley. Larson, Plaff, and Makov, together with a Ms. Bratton, acted as trustees of the ESOP. The ESOP received its determination letter in May 2000 in which the IRS acknowledged its recognition of the ESOP as a qualified plan under IRC §401(a) and 4975(e)(7). As of December 31, 1999 and 2000, Larson, Pfaff, and Makov were vested in the ESOP. Another six employees were vested, but were employed by Presidio.

The IRS released Notice 2000-44, identifying the transaction at issue as a “listed transaction,” on September 5, 2000, advising taxpayers that purported losses from tax shelters such as BLIPS were not bona fide and lacked economic substance.[4] Further, the IRS indicated that penalties may be imposed on promoters of such transactions. Following release of the Notice, Larson, Pfaff, and Makov began terminating Presidio’s employees, ceased new BLIPS transactions, and wound down existing structures. On January 2, 2001, the three released the forfeiture restrictions on their shares of Morley stock. However, they did not release the restrictions as trustees of the Morley ESOP or resign as trustees before terminating their stock restrictions. The Tax Court noted that neither the ESOP nor anyone on behalf of the ESOP provided written consent for such termination of the forfeiture provisions. The Presidio employees were not made aware and did not vote to release the restrictions. The Tax Court seemed to find it persuasive that the trustees also did not hire outside counsel to advise the ESOP. These employees received funds from the ESOP via transfers to rollover individual retirement accounts. At trial, Larson, the CPA/attorney, stated he was unaware that he had fiduciary obligations and should not self-deal.[5] The IRS and the Tax Court seemed convinced that the whole structure was just a tax play lacking any real economic substance.

With respect to subchapter S, “stock that is issued in connection with the performance of services… and that is substantially nonvested … is not treated as outstanding stock of the corporation, and the holder of that stock is not treated as a shareholder solely by reason of holding the stock.”[6] Mr. Larson did not claim any of the Morley passthrough income on his personal returns on this basis during the years at issue. He did report such income on his 2001 return.

In 2008, Larson and Pfaff were convicted of twelve counts of tax evasion. Larson was sentenced to imprisonment for 121 months, three years of supervised release, and a fine. Next, and relevant to this case, Larson received a notice of deficiency for $6.8 million, $2.4 million, and $1.2 million, for each of the respective tax years.

Analysis

The major issue in this case came down to whether the Morley stock was subject to a substantial risk of forfeiture. If the stock was subject to a substantial risk of forfeiture, then deferral of the income could be possible. If not, the income, as assessed, would be treated as earned in the years at issue. When restricted property is transferred to an employee “who owns a significant amount of the total combined voting power or value of all classes of stock of the employer corporation,” several factors should be considered.[7] One needs to look beyond just the ownership percentages, but instead look to de facto control.

Here, the officer-trustees illustrated that their actions were collective and made together. Their actions were also in conflict with what a fiduciary would normally do, specifically acting in their own interests. In other words, the ESOP served merely as a tax vehicle only, and the officer-employees continued to operate the business in their own interests, ignoring their obligations with respect to the ESOP, for their own financial interests. These factors played heavily against the Tax Court respecting Larson’s claim of the stock being subject to a substantial risk of forfeiture. Illustrative of these actions were their acting in their own self-interest, not notifying employees of actions to be taken on behalf of the ESOP (which were in the interest of the trustees), and even taking such actions without hiring outside counsel to advise them of fiduciary duties as trustees. The other employee-participants would have a strong economic incentive to enforce the restrictions on the stock. Further, the ESOP could veto the termination of the restrictions. Accordingly, the Tax Court determined that restrictions were not subject to substantial risk of forfeiture and therefore were not subject to deferral. The Tax Court found Larson’s casual treatment of his fiduciary duties “particularly telling” as he acted in a “grotesque conflict of interest.”

Conclusion

Once again, we see that a “tax plan” can lead to troubles. Larson, a promoter himself, had marketed the structure to others and in utilizing the plan for himself, things did not go as he seemed to have intended. His own tax plan failed. While tax planning structures can be advantageous, usually the ones that arise by statute or regulation will generally be respected (ex. ESOP, DISC, GRAT, CRT). Others not found in statute or regulation may be problematic, especially if promoted primarily as a tax savings vehicle. While this can be a difficult needle to thread, a telling sign can usually be who and how such structure or plan is being promoted. Generally, when marketed as a “tax plan,” the best option is to get an independent second opinion. Here though, it was the promoter himself that caught himself in an expensive bind following his own criminal case.

[1] Larson v. Comm’r, T.C. Memo. 2022-3

[2] See IRC § 83.

[3] See Shasta Strategic Inv. Fund, LLC v. U.S., 114 AFTR 2d 2014-5517 (N.D. Cal. July 31, 2014).

[4] The ability of the IRS to identify certain transactions outside of the notice and comment requirements under the Admin. Procedure Act is currently in dispute. See CIC Services, et. al. v. Comm’r, Case No. 3:17-cv-110 (E.D. Tenn. Sept. 21, 2021), Doc # 82.

[5] The Tax Court did not find this credible.

[6] See Treas. Reg. § 1.1361-1(b)(3).

[7] See Treas. Reg. § 1.83-3(c)(3).