Appeals court reverses $2.6 million penalty against tax shelter promoter


The Fourth Circuit Court of Appeals reversed and remanded a district court decision because the lower court permitted the jury to hear evidence of a taxpayer’s failure to file his personal income tax returns and to pay his taxes as evidence of his bad acts in determining whether he should be subject to the Sec. 6700 penalty for promoting an abusive tax shelter ( Nagy, No. 10-2072 (4th Cir. 3/29/13)). The jury had assessed a $2.636 million penalty against the taxpayer; the liability verdict and the penalty have been vacated by the appeals court and remanded to the lower court for a new trial.

The taxpayer, Robert Nagy, a CPA, had issued an opinion on the Derivium 90% loan program, in which investors purportedly transferred securities as “collateral” in return for a loan from Derivium of 90% of the securities. His opinion stated that the transactions were bona-fide loans and not sales of the securities. Derivium claimed it would use the securities it received in hedging transactions and return them when the investors repaid their loans, but the entire program was in fact a Ponzi scheme in which Derivium immediately sold the securities it received to continue perpetrating the scheme. Upon investigation, the IRS determined that the 90% loans were actually sales of the securities for tax purposes.

As a result of Nagy’s involvement in the scheme, the IRS assessed penalties against him under Sec. 6700 for promoting a tax shelter. He paid part of the penalty and sued for refund in district court. At trial, the district court allowed the IRS to introduce as evidence regarding his Sec. 6700 liability Nagy’s failure to file his personal income tax returns and to pay his taxes.

According to the appeals court, the rules of evidence prohibit evidence of a crime, wrong, or other act to prove a person’s character to show that on a particular occasion the person acted in accordance with that character. It agreed with Nagy, who argued that this evidence was not relevant to his liability under Sec. 6700 for an unrelated transaction and only served to cast him in a bad light.

The IRS claimed that evidence of his behavior in failing to file his taxes at the same time he was issuing an opinion about the tax shelter was relevant to show an absence of mistake in his tax advice. The appeals court found that there was no relationship between the two transactions (his returns and the tax shelter) and that the evidence was so prejudicial (and was not harmless error) that it must be excluded on remand.  It held that the district court had abused its discretion in admitting the evidence and therefore vacated the liability and penalty verdicts.

As for the other five issues on appeal, Nagy was not as successful. The appeals court upheld the district court’s granting summary judgment on the issue whether the 90% loans were sales and not loans for tax purposes, and it upheld the lower court’s decision to exclude certain testimony Nagy wanted to submit. It found that he had failed to timely object to the lower court’s jury instruction stating that the 90% loans were sales and not loans was “a false or fraudulent statement as a matter of law” under Sec. 6700.

On the final issue, whether the lower court gave erroneous instructions for calculating the penalty (if it is determined to apply on remand), the appeals court gave specific jury instructions for how the penalty should be calculated.   

Sally P. Schreiber ( ) is a JofA senior editor.


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