Kentucky: Thoroughbreds, Bourbon, and Taxpayer-Friendly Courts

The IRS hasn’t been faring well in the Bluegrass State. In the past six months it has lost three cases in the state involving tax shelters or what the agency suspects to be tax shelters. Two of those losses were to the same dermatologists.  

The loss that may have really left the government smarting wasn’t to the doctors, though: It was to the Ervin family—three brothers who worked on the family farm and in coal mines while in school and went to college on wrestling scholarships.   

Gary, Timothy, and Robert Ervin spent 20 years climbing poles and hanging telecommunications cable to build a successful business. They sold their business for a large sum in 1999 at the height of the telecom boom—a time when certain accounting and law firms were eager to help people like the Ervins invest their windfall with substantial tax savings.  

These investment products--tax shelters--involved imaginative interpretations of the federal partnership tax provisions and were marketed with catchy acronyms—like Son-of-BOSS, which is what BDO Seidman, the predecessor of BDO USA LLP, sold the Ervins.  

The Ervin brothers may know a lot about hanging cable and the fastest way to take an opponent to the mat, but, like most normal humans, they don’t know a lot about the proper treatment of contingent liabilities or the difference between inside and outside basis.

Like many other tax shelter participants, they learned the promised tax savings were illusory. They paid the tax bill and the interest and penalties, but fought for a refund of the penalties.

A jury of the Ervins’ western Kentucky peers found that the brothers had reasonable cause and relied in good faith on the advice of BDO and the law firm Curtis Mallet (now known as Curtis, Mallet-Prevost, Colt & Mosle LLP) when they claimed the deductions from the tax shelter, and were thus entitled to a refund of the penalties with interest.

Adding salt to the IRS’s wound, the Ervins settled a lawsuit against BDO and Curtis Mallet prior to the refund trial. The IRS failed in May to convince Chief Judge Joseph H. McKinley Jr. of the U.S. District Court for the Western District of Kentucky that a refund on top of the settlement would amount to double recovery.

Despite McKinley’s rejection of the government’s first argument to avoid the refund and the judge’s May 2 order to pay it, the government tried again by pointing to the lack of economic substance in Son-of-BOSS. McKinley said in an Aug. 23 ruling that the transaction’s lack of economic substance had been “conclusively established” and wasn’t the issue. The issue was the Ervin’s reliance on the advice.

The Ervins ultimately weren’t happy with their advisers and may not have had any qualms about turning over their correspondence with BDO and Curtis Mallet. The dermatologists, in contrast, seem to remain on good terms with their advisers, because those attorneys—Moore Ingram Johnson & Steele LLP—were representing them as of Sept. 1, when McKinley handed the government another loss by refusing to order the doctors—Michael J. Crowe and Artis P. Truett—to turn over emails between the doctors’ agents and attorneys at Moore Ingram.

McKinley ruled that the doctors didn’t waive their attorney-client privilege by saying in a court document that they relied on the advice of counsel in claiming deductions for their micro-captive insurance arrangements. The IRS is highly suspicious of micro-captives and has listed them in its annual “Dirty Dozen” of tax avoidance schemes.

The doctors aren’t yet close to arguing that they’re entitled to the reasonable cause exception to penalties, as McKinley pointed out. The doctors and their entities have pending Tax Court cases, and the IRS must follow Tax Court rules to get those documents—if and when the doctors lose on the substance of their deductions.

Crowe and Truett won their first attorney-client privilege battle against the IRS when Judge Joseph M. Hood of the U.S. District Court for the Eastern District of Kentucky ruled, as did McKinley, that the IRS must go through the Tax Court discovery procedures.

In both of the doctors’ cases, the government relied on a U.S. Tax Court decision, AD Investments 2000 Fund v. Commissioner, which said that if the taxpayer continued to pursue a defense that it had reasonable cause to rely on the advice of its tax advisers, it would waive the attorney-client privilege protecting the documents containing that advice.

AD Investments dropped the reasonable cause defense. It may have faced a more difficult battle than the Ervins. The company was a vehicle used by James Haber, the architect of Son-of-BOSS, to carry out tax shelter transactions.