T.C. Memo. 1999-101
UNITED STATES TAX COURT
JERRY AND PATRICIA A. DIXON, ET AL.,1 Petitioners
v. COMMISSIONER OF INTERNAL REVENUE, Respondent*
Docket Nos. 9382-83, 17646-83, Filed March 30, 1999.
4201-84, 7323-84,
15907-84, 20119-84,
40159-84, 22783-85,
30010-85, 30979-85,
29643-86, 35608-86,
19464-92, 621-94,
7205-94, 9532-94,
17992-95, 17993-95.
1
Cases of the following petitioners are consolidated
herewith: Ronald L. Alverson and Mattie L. Alverson, docket No.
17646-83; Hoyt W. and Barbara D. Young, docket Nos. 4201-84,
22783-85, 30010-85; Anthony E. and Carol A. Eggers, docket No.
7323-84; Robert L. and Carolyn S. DuFresne, docket Nos. 15907-84,
30979-85; John L. and Terry E. Huber, docket No. 20119-84;
Terry D. and Gloria K. Owens, docket No. 40159-84; Richard and
Fidella Hongsermeier, docket No. 29643-86; Norman W. and
Barbara L. Adair, docket No. 35608-86; Willis F. McComas, II and
Marie D. McComas, docket No. 19464-92; Wesley Armand and Sherry
Lynn Cacia Baughman, docket No. 621-94; Joe A. and JoAnne
Rinaldi, docket No. 7205-94; Norman A. and Irene Cerasoli, docket
No. 9532-94; Stanley C. and Sharon A. Titcomb, docket No. 17992-
95; Richard B. and Donna G. Rogers, docket No. 17993-95.
*
This opinion supplements our previously filed Memorandum
Findings of Fact and Opinion in Dixon v. Commissioner, T.C. Memo.
1991-614, vacated and remanded per curiam sub nom. DuFresne v.
Commissioner, 26 F.3d 105 (9th Cir. 1994).
- 2 -
In Dixon v. Commissioner, T.C. Memo. 1991-614,
vacated and remanded per curiam sub nom. DuFresne v.
Commissioner, 26 F.3d 105 (9th Cir. 1994), following a
trial of 14 docketed test cases of eight Ps, the Court
sustained R's disallowance of interest deductions
claimed by Ps in various tax shelter programs promoted
by K. After the Court entered decisions against the
test case Ps in accordance with its opinion, R moved to
vacate the decisions entered in three test cases (T, C,
and X). R alleged that, before the trial of the test
cases, R's trial attorney and District Counsel had
entered into contingent settlement agreements with T
and C that had not been disclosed to the Court or to
the other test case Ps or their counsel. R asked the
Court to conduct an evidentiary hearing to determine
whether the undisclosed agreements with T and C had
affected the trial of the test cases or the opinion of
the Court.
The Court granted R's motions to vacate the
decisions entered in the T and C cases, entered revised
decisions in the T and C cases consistent with R's
prior agreements with T and C, denied R's motion to
vacate the decision in the X case, and denied R's
request for an evidentiary hearing on the ground that
the testimony, stipulated facts, and exhibits relating
to the T and C cases had no material effect on the
Court's opinion as it related to the remaining test
case Ps.
On appeal, the Court of Appeals for the Ninth
Circuit vacated the decisions in the remaining test
cases and remanded them to this Court with directions
"to conduct an evidentiary hearing to determine the
full extent of the admitted wrong done by the
government trial lawyers." DuFresne v. Commissioner,
supra at 107. The Court of Appeals, citing Arizona v.
Fulminante, 499 U.S. 279, 309 (1991), directed the
Court to consider "whether the extent of misconduct
rises to the level of a structural defect voiding the
judgment as fundamentally unfair, or whether, despite
the government's misconduct, the judgment can be upheld
as harmless error." Id. Further, the Court of Appeals
directed this Court to consider on the merits all
motions of intervention filed by affected parties. See
id. This Court ordered that the cases of 10 nontest
case Ps, the majority of whom had previously signed
piggyback agreements, be consolidated with the
remaining test cases for purposes of the evidentiary
hearing. Three groups of Ps participated in all
subsequent phases of the evidentiary hearing.
- 3 -
Ps argue (under various theories) that the Court's
decisions in the remaining test cases should not be
reinstated, or, in the alternative, that the piggyback
agreements are not enforceable. R counters that the
decisions in the remaining test cases should be
reinstated on the ground that Ps were not prejudiced by
the Government misconduct in the trial of the test
cases and that the piggyback agreements remain in
force.
Held: The Government misconduct in the trial of
the test cases did not result in a structural defect in
the trial. Held further: The Government misconduct in
the trial of the test cases resulted in harmless error.
Held further: The Government misconduct in the trial
of the test cases does not provide any other basis for
invalidating the Court's decisions in the remaining
test cases or for setting aside the piggyback
agreements. Held further: As a sanction against R,
program participants who have not been the subject of a
final determination are not liable for time-sensitive
additions to tax for negligence under secs. 6653(a)(2)
and 6653(a)(1)(B), I.R.C., or increased interest under
sec. 6621(c), I.R.C.
Joe Alfred Izen, Jr., counsel for petitioners in docket Nos.
9382-83, 4201-84, 15907-84, 40159-84, 22783-85, 30010-85, 30979-
85, 29643-86, and 35608-86.
Robert Alan Jones, counsel for petitioners in docket Nos.
17646-83, 19464-92, 621-94, and 9532-94.
Robert Patrick Sticht, counsel for petitioners in docket
Nos. 7323-84, 20119-84, 7205-94, 17992-95, and 17993-95.
Mary Elizabeth Wynne, Steven A. Wilson, Andrew J. Gottlieb,
Milton J. Carter, Jr., Robert E. Casey, and Richard S. Goldstein,
for respondent.
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CONTENTS
Page
Introduction....................................................9
FINDINGS OF FACT...............................................15
I. Kersting Tax Shelter Programs and Related Matters........15
A. The Pike Case............................................15
B. Kersting Criminal Investigation..........................16
C. Assessments of Kersting Promoter Penalties...............18
D. Kersting Notice of Deficiency............................19
II. Notices of Deficiency Issued to Kersting Program
Participants ............................................20
A. Form of Notices of Deficiency............................20
B. Thompson Notices of Deficiency...........................21
C. Cravens Notices of Deficiency............................23
D. Alexander Notices of Deficiency..........................24
1. 1974 and 1975.........................................25
2. 1976 and 1977.........................................26
E. Validity of Notices of Deficiency........................27
F. Errors in Notices of Deficiency..........................27
III. Commencement of Kersting Project ........................28
A. Tax Shelter Projects and Test Case Procedures............28
1. Overview..............................................28
2. National Office Tax Shelter Branch Functions..........30
B. Petitions for Redetermination............................31
C. Brian J. Seery...........................................32
D. Respondent's Counsel.....................................33
1. Kenneth W. McWade.....................................33
2. William A. Sims.......................................34
E. Adoption of Test Case Procedures in Kersting Project.....34
1. The Honolulu Session (June 1985)......................34
2. Test Case Procedure...................................35
3. Test Case Array.......................................38
IV. The Maui Session (February 1987).........................42
A. Trial Notices............................................42
B. Piggyback Agreements.....................................44
C. Mr. Seery's Withdrawals as Counsel.......................48
1. The Thompsons.........................................49
2. The Test Cases........................................50
D. Entries of Appearance by Chicoine and Hallett............51
E. Evidentiary Issues.......................................54
1. The Maui Session......................................54
2. Dixon I Opinion.......................................55
V. Kersting Disputes With Program Participants..............55
A. The Thompsons............................................56
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1. The Bauspar Program...................................56
2. Deterioration of Thompson/Kersting Relationship.......57
B. The Alexander Dispute....................................67
C. Collection Actions.......................................72
1. Steve Hane............................................72
2. Carl Mott, George Vermef, and Robert Peterson.........73
VI. Settlements..............................................74
A. Internal Revenue Service Policy..........................74
1. National Office Position..............................74
2. Regional Counsel......................................76
B. Official Kersting Project Settlement Offer (7-Percent
Reduction of Deficiency or Out-of-Pocket Expenses).......77
C. Deviations From Official Project Settlement Offer........78
1. Modified 7-Percent Settlement Offer...................78
2. 20-Percent Settlement Offer...........................80
3. Negotiations for 50-Percent Settlement Offer..........82
4. Revival of 20-Percent Settlement Offer................84
D. The Thompson Settlement..................................92
1. Initial Thompson Settlement Agreement.................92
2. First Revision of Thompson Settlement.................94
3. Second Revision of Thompson Settlement................98
E. The Cravens Settlement..................................100
F. The Alexander Understanding.............................106
G. The Kozak Decision......................................115
VII. Pretrial Developments...................................116
A. The Kersting Deposition--Postponed (January 1987).......116
B. John Doe Summons/Assessments of Promoter Penalties......118
C. Chicoine and Hallett's Withdrawal as Counsel............120
D. Mr. Izen's Entry of Appearance..........................120
E. The Kersting Deposition (October 1988)..................121
VIII. Trial of Test Cases (January 1989)......................123
A. Mr. Cravens.............................................124
B. Mr. Thompson............................................126
C. Mr. Kersting............................................129
D. Mr. Alexander...........................................130
E. Mr. DeCastro............................................133
F. Comfort Letters.........................................133
G. Mr. Izen's Introduction of Evidence of Collection
Litigation..............................................135
IX. Posttrial Developments..................................137
A. First Thompson Refund...................................137
B. Mr. Izen's Motion To Reopen Record......................141
C. Dixon II Opinion........................................142
D. Disclosure of Thompson Settlement.......................143
E. Disclosure of Cravens Settlement........................152
F. Respondent's Motions To Vacate..........................155
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G. Attempted Discovery by Counsel for Nontest Case
Petitioners.............................................156
H. Closing of Thompson Cases/Further Refunds...............156
I. Closing of Cravens Cases................................160
PROCEDURAL HISTORY OF EVIDENTIARY HEARING.....................162
I. Developments Before Evidentiary Hearing.................162
A. Referral of Thompson and Cravens Settlements to Office
of Inspector General....................................162
B. Revival of 7-Percent Settlement Offer...................165
C. Disciplinary Actions....................................165
D. Indictment of Mr. Izen..................................166
E. Pretrial Conference (July 1995).........................167
F. Pretrial Conference (January 1996)......................168
G. Denial of Respondent's Motion To Disqualify Mr. Izen....168
H. Mr. DeCastro's Withdrawal...............................170
I. Discovery of Alexander Decisions and Referral to
Office of Inspector General.............................170
J. Mr. Izen's Motion To Compel Production of Documents
and Issuance of Protective Orders.......................171
K. Burden of Proof and Rule 145 Order......................173
II. The Evidentiary Hearing.................................175
A. Testimony...............................................176
1. Mr. Cravens......................................... 176
2. Mr. Thompson.........................................178
3. Mr. Alexander........................................179
4. Mr. McWade...........................................180
5. Mr. Sims.............................................182
6. Mr. DeCastro.........................................183
7. Mr. Izen.............................................184
B. Mr. Sticht's Allegations of Potential Witness
Intimidation............................................186
C. Mr. Bradt's June 12, 1996, Letter to Mr. Kersting.......187
D. Denial of Mr. Izen's Motion To Refer Thompson and
Cravens Settlements and Alexander Agreement to
Department of Justice (Public Integrity Section)........189
III. Developments Following Initial Evidentiary Hearing......189
A. Denial of Respondent's Motion for Further Hearing
Regarding Potential Witness Intimidation................189
B. Supplemental Evidentiary Hearing (August 18, 1997)......192
C. Denial of Mr. Izen's Motion To Compel Production of
Documents...............................................194
D. Denial of Mr. Sticht's Motion To Reopen Record..........195
E. Denial of Mr. Izen's Motion To Take Judicial Notice.....196
F. Denial of Mr. Sticht's Motions for Release From
Piggyback Agreements....................................198
G. Reports Regarding the Court's Protective Orders.........199
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ULTIMATE FINDINGS OF FACT.....................................200
OPINION.......................................................202
I. Burden of Proof.........................................203
II. Structural Defect.......................................211
A. Case Law................................................211
B. Arguments...............................................215
C. Summary of Government Misconduct........................218
D. Discussion..............................................225
III. Harmless Error Analysis.................................233
A. Review of Dixon II......................................236
1. Mr. Kersting's Lack of Credibility...................237
2. Sham Analysis........................................238
3. Lack of Genuine Debt/Waltz of Funds..................240
i. Subscription Interest...........................241
ii. Primary Loans...................................242
iii. Leverage Loans..................................244
4. Collection Litigation................................244
5. CAT-FIT Plan.........................................245
6. Additions to Tax.....................................247
i. Negligence......................................247
ii. Late Filing.....................................247
iii. Substantial Understatement......................247
iv. Increased Interest..............................248
B. Discussion..............................................249
1. Mr. Cravens.........................................249
i. Sham Analysis...................................251
ii. Lack of Genuine Debt/Waltz of Funds.............254
2. Mr. Thompson.........................................255
i. Sham Analysis...................................257
ii. Lack of Genuine Debt/Waltz of Funds.............258
iii. Additions to Tax................................262
3. Mr. Alexander........................................264
4. Summary..............................................266
IV. Fraud, Misrepresentation, and Misconduct................267
V. Fraud on the Court......................................271
A. Case Law Survey.........................................271
B. Discussion..............................................281
VI. Mr. Izen's Allegations That Mr. DeCastro Was a "Mole"...283
VII. Enforceability of Piggyback Agreements..................284
A. Principles of Contract Law..............................285
B. Discussion..............................................290
1. Benefit of the Bargain...............................290
2. Mr. Seery's Purported Conflict of Interest...........294
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3. Rejection of Mr. Izen's Argument for Entry of
Decision On the Basis of Thompson Decisions..........296
VIII. Mary Carter Agreements..................................296
IX. Mr. Sticht's Motion To Sever Case and for Entry of
Decision or Alternatively To Sever Case and Set for
Trial ..................................................300
X. Protective Orders.......................................302
XI. Sanctions...............................................305
Conclusion....................................................307
SUPPLEMENTAL MEMORANDUM FINDINGS OF FACT AND OPINION
BEGHE, Judge: Eight of these consolidated cases--with five
petitioners represented by Joe Alfred Izen, Jr. (Mr. Izen),--are
test cases before the Court on remand from the Court of Appeals
for the Ninth Circuit in DuFresne v. Commissioner, 26 F.3d 105
(9th Cir. 1994), vacating and remanding per curiam Dixon v.
Commissioner, T.C. Memo. 1991-614.
The other 10 consolidated cases--with petitioners in one
case represented by Mr. Izen and the other petitioners
represented by Robert Alan Jones (Mr. Jones) and Robert Patrick
Sticht (Mr. Sticht)--are nontest cases that have been added to
the consolidated group in order to effectuate the direction of
the Court of Appeals "to consider on the merits all motions of
intervention filed by parties affected by this case." Id. at
107.
Unless otherwise indicated, section references are to the
Internal Revenue Code, as amended, and Rule references are to the
Tax Court Rules of Practice and Procedure.
- 9 -
Introduction
These consolidated cases are part of a group of more than
1,300 remaining cases--more than 500 cases have settled--arising
from respondent's disallowance of interest deductions claimed by
participants in various tax shelter programs promoted by Henry
F.K. Kersting (Mr. Kersting). The Kersting group of cases
(hereinafter the Kersting project) was assigned to Judge
William A. Goffe (Judge Goffe) for disposition. By agreement of
the parties and the Court, the merits of the Kersting programs
were to be litigated in a consolidated trial of 14 docketed cases
of eight petitioners that had been designated as "test cases".
The vast majority of the remaining Kersting project petitioners
signed stipulations to be bound (sometimes referred to herein as
piggyback agreements) in which they agreed with respondent that
their cases would be resolved in accordance with the Court's
opinion in the test cases.
Before the trial of the test cases, some test case
petitioners argued that a 1981 search of Mr. Kersting's office
had been illegal, that materials seized during the search should
be suppressed in the test case proceedings, and that the burden
of proof and burden of going forward with evidence should be
shifted to respondent. In Dixon v. Commissioner, 90 T.C. 237
(1988) (Dixon I), the Court held, in an opinion by Judge Goffe,
that the petitioners had failed to establish standing to contest
the Kersting search and seizure.
- 10 -
Judge Goffe held the trial of the test cases in Honolulu,
Hawaii, during January 1989. The majority of the test case
petitioners were represented at trial by Mr. Izen. However, test
case petitioners John R. and Maydee L. Thompson (docket Nos.
19321-83, 31236-84, and 30965-85) were represented at trial by
Luis C. DeCastro (Mr. DeCastro), and test case petitioners John
R. and E. Maria Cravens (docket Nos. 16900-83 and 15135-84)
appeared pro sese.
Following the trial of the test cases, the Court issued its
memorandum opinion in Dixon v. Commissioner, T.C. Memo. 1991-614,
62 T.C.M. (CCH) 1440, 1991 T.C.M. (RIA) par. 91,614 (Dixon II),
sustaining virtually all of respondent's determinations in each
of the test cases, and entered decisions against the test case
petitioners in accordance with its opinion.
On March 13, 1992, the Court entered the following decisions
in the Thompson and Cravens cases:
John R. and Maydee L. Thompson
Additions to Tax
Sec. Sec. Sec. Sec.
Year Deficiency 6651(a) 6653(a) 6653(a)(1) 6653(a)(2)
1979 $18,161.00 --- $908 --- ---
1980 24,838.00 --- --- --- ---
1981 36,294.52 $4,934.32 --- $1,958.28 50 percent of
the interest
due on the
deficiency
John R. and E. Maria Cravens
Additions to Tax
Year Deficiency Sec. 6653(a)
1979 $4,508.00 $225.40
1980 5,893.45 294.67
- 11 -
On June 9, 1992, respondent filed motions for leave to file
motions to vacate the decisions entered against the Thompsons,
the Cravenses, and another test case petitioner, Ralph J. Rina
(Mr. Rina), docket No. 17640-83. Respondent's motions to vacate
alleged that, before the trial of the test cases, respondent's
trial attorney, Kenneth W. McWade (Mr. McWade), and his
supervisor, Honolulu District Counsel William A. Sims (Mr. Sims),
had entered into contingent settlement agreements with the
Thompsons and the Cravenses that had not been disclosed to the
Court or to the other test case petitioners or their counsel.
Respondent asked the Court to conduct an evidentiary hearing to
determine whether the undisclosed agreements with the Thompsons
and the Cravenses had affected the trial of the test cases or the
opinion of the Court.
On June 22, 1992, Judge Goffe granted respondent's motions
to vacate filed in the Thompson and Cravens cases, vacated the
decisions entered in those cases, ordered the parties to file
agreed decisions with the Court, or otherwise move as
appropriate, and denied respondent's request for an evidentiary
hearing. By order dated June 22, 1992, Judge Goffe also denied
respondent's motion to vacate the decision entered against
Mr. Rina, on the ground that the testimony, stipulated facts, and
exhibits relating to the Thompson and Cravens cases had no
material effect on the Court's Dixon II opinion as it related to
Mr. Rina.
- 12 -
On July 22, 1992, the test case petitioners represented by
Mr. Izen filed a motion for reconsideration of the Court's order
denying respondent's motion to vacate the decision in the Rina
case. By order dated August 4, 1992, Judge Goffe denied
petitioners' motion for reconsideration.
In August 1992, the Court entered revised decisions in the
Thompson and Cravens cases consistent with Mr. McWade's prior
agreements with the taxpayers in those cases. Specifically, the
Court entered the following decisions in the Thompson and Cravens
cases:
John R. and Maydee L. Thompson
Year Deficiency Additions to Tax
1979 --- ---
1980 $15,000 ---
1981 15,000 ---
John R. and E. Maria Cravens
Year Deficiency Additions to Tax
1979 $3,606.40 ---
1980 6,175.76 ---
The decisions entered in the Thompson and Cravens cases are now
final.2
2
Mr. Izen and Mr. Sticht filed separate motions with the
Court to intervene in the Thompson and Cravens cases. The Court
denied these motions to intervene. Although Mr. Izen and
Mr. Sticht filed separate appeals in the Thompson and Cravens
cases with various courts, including the Courts of Appeals for
the Second, Ninth, and Tenth Circuits, all appeals in the
Thompson and Cravens cases eventually were dismissed. In an
unpublished opinion filed June 15, 1994, the Court of Appeals
for the Ninth Circuit stated:
(continued...)
- 13 -
Because of Judge Goffe's termination, on September 30, 1992,
of his recall status as a Senior Judge of the Court, all cases in
the Kersting project group were reassigned to Judge Renato Beghe.
The other test case petitioners, including Mr. Rina,
appealed the decisions entered in their cases to the Court of
Appeals for the Ninth Circuit. On appeal, those petitioners
argued that the trial of the test cases had been tainted by the
Thompson and Cravens settlement agreements. The response of the
Court of Appeals was to vacate the decisions in the remaining
test cases and remand them to this Court with directions "to
conduct an evidentiary hearing to determine the full extent of
the admitted wrong done by the government trial lawyers."
DuFresne v. Commissioner, 26 F.3d at 107. The Court of Appeals,
citing Arizona v. Fulminante, 499 U.S. 279, 309 (1991), directed
the Court to consider "whether the extent of misconduct rises to
the level of a structural defect voiding the judgment as
fundamentally unfair, or whether, despite the government's
misconduct, the judgment can be upheld as harmless error."
DuFresne v. Commissioner, supra at 107. Further, the Court of
2
(...continued)
The Tax Court's August 25 and 26, 1992 decisions
entering settlement in the Cravens and Thompson cases,
respectively, are final. 26 U.S.C. § 7481(a)(1); Fed.
R. App. P. 13. The Tax Court lacks jurisdiction to
vacate those decisions. Billingsley v. CIR, 868 F.2d
1081, 1084 (9th Cir. 1989). Because there is no case
remaining in which the taxpayers can intervene, this
appeal is moot. [Adair v. Commissioner, No. 92-70812,
26 F.3d 129 (9th Cir. 1994).]
- 14 -
Appeals directed this Court to consider on the merits all motions
of intervention filed by parties affected by Dixon II. See id.3
On February 2, 1995, respondent filed a Motion for an
Evidentiary Hearing. On September 14, 1995, the Court granted
respondent's motion. To effectuate the direction of the Court of
Appeals regarding intervention, the Court ordered that the cases
of 10 nontest case petitioners, the majority of whom had
previously signed piggyback agreements, be consolidated with the
remaining test cases for purposes of the evidentiary hearing.4
As a result, three groups of petitioners have participated in all
subsequent phases of the evidentiary hearing: Test case and
nontest case petitioners represented by Mr. Izen; nontest case
petitioners represented by Mr. Jones; and nontest case
petitioners represented by Mr. Sticht.5 The positions taken by
3
The appellate panel in DuFresne v. Commissioner, 26 F.3d
105, 107 (9th Cir. 1994), vacating and remanding per curiam Dixon
v. Commissioner, T.C. Memo. 1991-614, 62 T.C.M. (CCH) 1440, 1991
T.C.M. (RIA) par. 91,614 (Dixon II), issued an order stating that
the panel would retain jurisdiction over any subsequent appeal.
4
On June 13, 1995, test case petitioner Mr. Rina conceded
his case in full, resulting in entry of a stipulated decision in
docket No. 17640-83 that was identical with the decision
originally entered in that case on the basis of the Court's
opinion in Dixon II.
5
The group of cases that were consolidated for purposes of
the evidentiary hearing initially included the case of William D.
and Karen S. Booth, docket No. 28950-88, in which Declan J.
O'Donnell (Mr. O'Donnell) had entered his appearance. However,
at the start of the evidentiary hearing, the Court granted
Mr. O'Donnell's motion to sever the Booth case from the cases
consolidated for the evidentiary hearing. Mr. O'Donnell argued
that, in light of the theory underlying a Motion for Summary
Judgment that he had filed on behalf of the Booths, they had no
(continued...)
- 15 -
the various groups of petitioners during these proceedings have
not been consistent in all respects and in some respects the
positions of counsel--primarily Messrs. Izen and Sticht--have
become adversarial.6
Following pretrial conferences on the record in Los Angeles
on July 17, 1995, and January 16, 1996, the evidentiary hearing
was held at special trial sessions of the Court conducted in Los
Angeles on May 13 to 30 and June 10 to 26, 1996, and August 18,
1997.
In the interest of chronology and as an aid to understanding
this opinion, the procedural history of the evidentiary hearing
comes after the Court's detailed findings of fact and before the
ultimate findings of fact.
FINDINGS OF FACT
I. Kersting Tax Shelter Programs and Related Matters
A. The Pike Case
Mr. Kersting began promoting tax shelter programs in Hawaii
in the early 1970's. Mr. Kersting's early tax shelter programs
included an "Auto-Leasing Plan" and an "Acceptance Corporation
Plan." Those plans generally required participants to purchase
5
(...continued)
need to participate in the evidentiary hearing. In Gridley v.
Commissioner, T.C. Memo. 1997-210, the Court rejected the
argument, raised in the Booths' Motion for Summary Judgment,
that Kersting petitioners who signed stipulations to be bound
to Dixon II were entitled to entry of decisions in their cases
consistent with the decision entered by the Court in the Thompson
case at docket No. 19321-83.
6
See infra pp. 168-169, 171-172, and 187-188.
- 16 -
stock in a subchapter S leasing corporation or an acceptance
corporation and/or enter into a subscription agreement to
purchase stock, all in connection with loans to the participants
by various entities created by Mr. Kersting. The plans were
primarily designed to generate income tax deductions for interest
that the participants purportedly paid to the Kersting entities
on the loans.
The Commissioner determined that participants in
Mr. Kersting's auto-leasing and acceptance corporation plans were
not entitled to deduct: (1) "Interest" that participants claimed
to have paid on either the Auto-Leasing stock purchase or
leverage loans; (2) the participants' pro rata shares of losses
or investment credits from the auto leasing companies; and
(3) "interest" that participants claimed to have paid either on
the acceptance corporation stock purchase or stock subscription
loans.
In Pike v. Commissioner, 78 T.C. 822 (1982), affd. without
published opinion 732 F.2d 164 (9th Cir. 1984), this Court
sustained the Commissioner's disallowances of all deductions for
interest, losses, and credits claimed by participants in
Mr. Kersting's early programs.
B. Kersting Criminal Investigation
While the Pike litigation was underway, Mr. Kersting
continued to promote additional tax shelter programs, which came
to be known as the stock purchase plan, the stock subscription
plan, the leasing company plan, and the CAT-FIT plan. The
- 17 -
Court's opinion in Dixon II describes the mechanics of these
programs in detail.7
On January 22, 1981, following an undercover criminal
investigation, the Internal Revenue Service searched
Mr. Kersting's offices in Hawaii pursuant to a search warrant
issued by the U.S. District Court for the District of Hawaii.
Seventy-seven boxes and two filing cabinets of records were
seized from Mr. Kersting's office, including lists identifying,
by name and address, approximately 1,800 participants in
Mr. Kersting's programs, and schedules of the interest
purportedly paid by each participant to one or more Kersting
companies during the taxable years 1977, 1978, and 1979.
On January 24, 1981, Mr. Kersting wrote a form letter to the
participants of his programs, one of his many "Dear Friend"
letters, stating that he had been entrapped by an undercover
Internal Revenue Service special agent into creating a backdated
"tax deduction" of $21,600.8 By letter dated February 15, 1981,
Mr. Kersting provided participants in his programs with "tax
reporting notices", presumably for the 1980 tax year, and
encouraged them to "take full advantage of the deductions
7
The Kersting programs involved a number of corporations
(hereinafter Kersting corporations). Mr. Kersting served as both
a director and president of most of these corporations and also
sometimes owned stock. For those corporations in which he served
as president during the years in issue, he had exclusive
management authority.
8
The record in these cases contains no fewer than 38 "Dear
Friend" letters.
- 18 -
reported to you." Mr. Kersting further informed participants
that the Internal Revenue Service had "accomplished only a
temporary disruption of our operations" and that his office was
"back to almost normal workings". All records seized in the
January 22, 1981, search were returned to Mr. Kersting by 1987.
In January 1983, Mr. Kersting filed suit in the U.S.
District Court for the District of Hawaii (docket No. CV-83-0018-
MP) against the United States, the Internal Revenue Service, and
certain Internal Revenue Service agents alleging, inter alia,
that the January 1981 search was illegal and that the defendants
had abused the grand jury process by shopping for a favorable
grand jury, by violating grand jury secrecy, and by using the
grand jury as a civil investigation tool. Through a number of
unpublished orders, the District Court and the Court of Appeals
for the Ninth Circuit rejected Mr. Kersting's claims. See
Kersting v. United States, 865 F. Supp. 669, 674-675 (D. Haw.
1994).
C. Assessments of Kersting Promoter Penalties
Mr. Kersting's tax shelter activities did not lead to an
indictment. However, in October 1989, the Commissioner assessed
promoter penalties of $1,545,201 and $2,330,000 against
Mr. Kersting, pursuant to sections 6700 and 6701, respectively,
for the years 1982 through 1988.9 The District Court for the
9
Sec. 6700 provides for imposition of a penalty of a
percentage of the gross income derived from promoting an abusive
tax shelter, and sec. 6701 provides for imposition of a penalty
(continued...)
- 19 -
District of Hawaii sustained the Commissioner's assessments. See
Kersting v. United States, Civil Nos. 90-00304, 91-00747, 92-
00593 (D. Haw., Sept. 30, 1994). Mr. Kersting's appeal of that
decision to the Court of Appeals for the Ninth Circuit, docket
No. 94-16942, was argued and submitted on May 8, 1996, but
subsequently withdrawn from submission (with an opportunity for
supplemental briefing) until after this Court issues its opinion
in these consolidated cases.
D. Kersting Notice of Deficiency
The Commissioner sent Mr. Kersting a notice of deficiency
determining deficiencies in and additions to his Federal income
taxes for the taxable years 1982 through 1988. The deficiencies
were based upon the Commissioner's determination that cash
payments of so-called leverage loan interest received by Kersting
corporations, which were characterized by the District Court in
the promoter penalty cases as "alter egos" of Mr. Kersting, and
which the Court's Dixon II opinion characterized as fees paid to
Mr. Kersting by program participants in exchange for tax
deductions, were includable in Mr. Kersting's gross income.
Mr. Kersting filed a timely petition for redetermination with
this Court (assigned docket No. 7448-96), and the case was tried
at a Honolulu special trial session that commenced January 27,
1999.
9
(...continued)
of $1,000 (per incident) upon a person who knowingly aids or
assists another in understating his tax liability.
- 20 -
II. Notices of Deficiency Issued to Kersting Program
Participants
In 1982, respondent began to issue notices of deficiency to
Kersting program participants, disallowing interest deductions
claimed with respect to the stock purchase plan, the stock
subscription plan, the leasing company plan, and the CAT-FIT plan
for a number of taxable years.
A. Form of Notices of Deficiency
The notices of deficiency issued by respondent to many
Kersting program participants used a common format, stating in
pertinent part as follows:
EXPLANATION OF ADJUSTMENTS
1. It is determined that the following amounts claimed
on your income tax return as interest deductions
are not allowable:
Amount Purported Payee[10]
$--------- Any entity owned, associated
with, or controlled, either
directly or indirectly, by
Henry Kersting
This disallowance is based on the determination that
the transactions giving rise to the claimed interest
deduction are shams. This disallowance is further
based upon your failure to establish that the above
amounts were paid or properly accrued, or that the
transactions purportedly generating the claimed amounts
resulted either in any bona fide indebtedness or in any
enforceable and bona fide obligation to pay
compensation for use or forbearance of money on
indebtedness within the meaning of I.R.C. Section 163.
Furthermore, if it is established that any portion
of the above disallowed "interest" is a properly
10
In some instances, respondent's notices of deficiency
listed specific Kersting corporations under "Purported Payee".
- 21 -
allowable deduction, it is further determined that such
interest constitutes interest in investment
indebtedness and deduction of such amounts is limited
under the provisions of I.R.C. 163(d).
Further, and in support of a portion of the
determined deficiency, if you establish that you are
entitled to the above-mentioned interest deduction, it
is determined that you improperly failed to report the
income resulting from the same transaction.
2. It is determined that part of the underpayment of
tax for the taxable year ____ is due to your negligent
of [sic] intentional disregard of the rules and
regulations. Consequently, the 5 percent addition to
the tax is charged for ____ as provided by Section
6653(a) of the Internal Revenue Code.
B. Thompson Notices of Deficiency
John R. Thompson (Mr. Thompson) was a pilot with Continental
Airlines from 1946 until his retirement in October 1982.
Mr. Thompson became aware of Mr. Kersting's programs through a
conversation with another pilot, Michael Provan (Mr. Provan), who
had solicited other pilots to participate in Mr. Kersting's
programs.11 The Thompsons began participating in Mr. Kersting's
programs in 1977.12 In addition to their participation in
11
Mr. Provan, who was at one time the president of one of
the Kersting companies, eventually became an adversary of
Mr. Kersting. See infra p. 66.
12
Although the Thompsons participated in one of
Mr. Kersting's programs during 1977, the Thompsons did not
claim any Kersting-related interest deductions on their 1977
return because their accountant-return preparer refused to
include them on the return.
The record suggests that the Thompsons' 1978 tax return
was prepared by Phil Scheff (an accountant recommended by
Mr. Kersting) and that the Thompsons claimed Kersting program
interest deductions on their return for that year. The Thompsons
experienced audit problems with their 1978 tax return that were
(continued...)
- 22 -
certain programs that were the subject of this Court's opinion in
Dixon II, the Thompsons, along with some 40 other investors,
including Mr. Provan, participated in a transaction arranged by
Mr. Kersting in early 1978 to acquire First Savings and Loan
Association of Hawaii (First Savings).
The Thompsons filed joint Federal income tax returns for
1979, 1980, and 1981 in which they claimed interest deductions
attributable to their participation in certain Kersting programs.
On May 5, 1983, June 13, 1984, and May 31, 1985, respondent
mailed notices of deficiency to the Thompsons determining
deficiencies in and additions to their Federal income taxes for
the taxable years 1979, 1980, and 1981, as follows:
Additions to Tax
Sec. Sec. Sec. Sec.
Year Deficiency 6651(a) 6653(a) 6653(a)(1) 6653(a)(2)
1979 $18,161.00 --- $908 --- ---
1980 24,838.00 --- --- --- ---
1981 36,294.52 $4,934.32 --- $1,958.28 50 percent of
the interest due
on the deficiency
Respondent further determined that the Thompsons were liable for
increased interest for 1981 pursuant to section 6621(d).13 The
12
(...continued)
due, in part, to their failure to attach to the return a Form W-2
showing the amount of tax that Continental Airlines had withheld
from Mr. Thompson's wages. In early to mid-1986, the Thompsons'
counsel, Samuel M. Huestis, negotiated a settlement of their tax
liability for 1978. The record does not disclose the terms of
the settlement.
13
Sec. 6621(d) was redesignated sec. 6621(c) by sec.
1511(c)(1)(A)-(C) of the Tax Reform Act of 1986 (TRA), Pub. L.
99-514, 100 Stat. 2744. We will hereinafter refer to the
(continued...)
- 23 -
Thompsons filed timely joint petitions for redetermination of the
above-described deficiencies.
C. Cravens Notices of Deficiency
John R. Cravens was a pilot with American Airlines during
1979 and 1980. Mr. Cravens became aware of Mr. Kersting's
programs through conversations with other pilots.
The Cravenses filed joint Federal income tax returns for
1979 and 1980 in which they claimed interest deductions
attributable to their participation in certain Kersting programs.
On April 15, 1983, and March 20, 1984, respondent mailed notices
of deficiency to the Cravenses determining deficiencies in and
additions to their Federal income taxes for the taxable years
1979 and 1980, as follows:
Additions to Tax
Year Deficiency Sec. 6653(a)
1979 $4,508.00 $225.40
1980 19,251.70 962.59
The notice of deficiency issued to the Cravenses for 1979, while
disallowing interest deductions of $9,810, included a credit for
personal exemptions of $4,000, resulting in a net adjustment of
$5,810. The notice of deficiency issued to the Cravenses for
1980 included disallowed interest deductions of $19,620 and, as
an alternative to the disallowance of such interest, the
inclusion of $18,000 in unreported dividend income from a
Kersting controlled entity known as Candace Acceptance Corp.
13
(...continued)
provision as sec. 6621(c).
- 24 -
(Candace). The notice of deficiency issued to the Cravenses for
1980 also included the disallowance of two personal exemptions
claimed for the Cravenses' children. The Cravenses filed timely
joint petitions for redetermination contesting the above-
described notices of deficiency.
The Cravenses' reporting position was unique among the test
case petitioners insofar as the Cravenses had adjusted (reduced)
their tax basis in their Candace stock by the amount of a "non-
taxable distribution" from Candace in 1980. Having reduced the
basis of their Candace stock, the Cravenses reported a capital
gain of $7,200 on their 1980 tax return after surrendering the
stock to Mr. Kersting in exchange for cancellation and return of
the note evidencing their primary loan.14
D. Alexander Notices of Deficiency
Denis Alexander (Mr. Alexander) is a broker and investor
who first met Mr. Kersting in Los Angeles in the early 1960's.
Mr. Alexander lent money to Mr. Kersting's subchapter S leasing
corporations in the 1970's, participated in the acquisition of
First Savings, and participated in some of the Kersting programs
at issue in Dixon II.
14
Although the Cravenses' reporting position was unique
insofar as they had reported a capital gain in a taxable year in
dispute before the Court, we note that test case petitioners
Robert L. and Carolyn S. DuFresne had also reported a capital
gain (albeit in a year subsequent to the years in dispute)
upon the surrender of stock in Charter Financial Corp. to
Mr. Kersting. Like the Cravenses', the DuFresnes' capital gain
was attributable to their reduction of the tax basis of their
stock as opposed to an increase in its value.
- 25 -
1. 1974 and 1975
Mr. Alexander and his wife, Freida, filed joint Federal
income tax returns for the taxable years 1974, 1975, 1976, and
1977. Following an examination of their returns for 1974 and
1975, the Alexanders conceded certain adjustments proposed by
respondent, resulting in agreed assessments of $2,133 and $811
for 1974 and 1975, respectively.15 However, because the
Alexanders declined to agree to other proposed adjustments,
respondent, on November 29, 1979, issued a notice of deficiency
determining deficiencies of $4,891.83 and $40,760.38,
respectively, in their Federal income taxes for 1974 and 1975.
Respondent's deficiency determinations against the
Alexanders for 1974 and 1975 were based, in part, on disallowance
of interest deductions of $2,917 and $46,500, respectively,
attributable to their participation in Kersting programs for
those taxable years. Additional adjustments included
disallowance of an $18,500 capital loss claimed by the Alexanders
for 1974 on a sale of stock in Mendocino Financial Corp. and
respondent's determination that they had failed to report a
$59,080 capital gain for 1975 from a sale of real estate to the
Cadillac Drive Apartments partnership.
15
The Alexanders were represented during the audit
by their accountant, Gilbert Matsumoto (Mr. Matsumoto). Mr.
Matsumoto had served as the accountant for some of Mr. Kersting's
subchapter S leasing corporations, and Mr. Kersting had
recommended that program participants use Mr. Matsumoto, among
others, to prepare their tax returns.
- 26 -
On February 28, 1980, the Alexanders filed a timely petition
with the Court, assigned docket No. 2758-80, contesting the
notice of deficiency for 1974 and 1975.
2. 1976 and 1977
Respondent also examined the Alexanders' joint income tax
returns for 1976 and 1977. On April 17, 1986, respondent issued
the Alexanders a notice of deficiency determining deficiencies in
and additions to their 1976 and 1977 Federal income taxes, as
follows:
Additions to Tax
Year Deficiency Sec. 6653(a)
1976 $3,596 $180
1977 876 44
Respondent also determined that the Alexanders were liable for
increased interest for 1976 pursuant to section 6621(c).
The deficiencies that respondent determined against the
Alexanders for 1976 and 1977 resulted, in part, from respondent's
disallowance of interest deductions of $8,665 and $12,993,
respectively, attributable to their participation in Kersting
programs for those years. Respondent also disallowed a $5,149
partnership loss claimed by the Alexanders for 1976 on their
investment in the Avista Epsilon and Sarbonne partnership.
On July 21, 1986, the Alexanders filed a petition through
Mr. Kersting's office, assigned docket No. 30413-86, contesting
the notice of deficiency for 1976 and 1977.
- 27 -
E. Validity of Notices of Deficiency
In Dixon II, the Court considered and rejected arguments by
the test case petitioners represented by Mr. Izen that the
notices of deficiency issued to them were invalid under Scar v.
Commissioner, 814 F.2d 1363 (9th Cir. 1987), revg. 81 T.C. 855
(1983). After the evidentiary hearing in these proceedings, the
Court rejected the Scar argument advanced by Mr. Jones on behalf
of a Kersting participant who had settled his case before the
trial of the test cases in Dixon II. See Richards v.
Commissioner, T.C. Memo. 1997-149, supplemented by T.C. Memo.
1997-299, affd. without published opinion 165 F.3d 917 (9th Cir.
1998).16
F. Errors in Notices of Deficiency
Although this Court rejected the argument that notices of
deficiency issued to Kersting program participants were invalid,
it is evident that some notices of deficiency issued to Kersting
program participants did contain errors. For instance, in
Richards v. Commissioner, supra, it appears that respondent
overstated the deficiency using an excessive tax rate of 70
percent. In addition, the petition filed in the Richards case
included an allegation that respondent disallowed interest
16
Although Luis C. DeCastro had negotiated the settlement
on behalf of Mr. and Mrs. Richards, he did not participate in the
filing or prosecution of Mr. Jones' motion to vacate the decision
entered in their case.
- 28 -
deductions in excess of Kersting interest deductions that the
Richardses actually claimed.17
Similarly, as observed in the Court's Dixon II opinion,
respondent's alternative determinations in the notice of
deficiency issued to the Cravenses overstated their deficiency
for 1980. The Court ordered that the Cravenses' deficiency for
1980 be reduced to account for: (1) The elimination of
respondent's alternative determination that the Cravenses failed
to report $18,000 in dividends paid by Candace; and (2)
respondent's failure to eliminate the capital gain of $7,200
reported by the Cravenses for 1980 on the disposition of their
Candace stock.
III. Commencement of Kersting Project
A. Tax Shelter Projects and Test Case Procedures
1. Overview
The large volume of cases generated by the Commissioner's
disallowances of deductions claimed by taxpayers participating in
large tax shelter programs during the late 1970's and early
1980's created the largest inventory of cases ever docketed in
the Tax Court. Among the responses of the Internal Revenue
Service and the Tax Court were the development of procedures that
17
Test case petitioners Terry D. and Gloria K. Owens
alleged in their petition that respondent disallowed legitimate
interest deductions in their notice of deficiency. However, it
appears that the allegation was not pursued by or on behalf of
the Owenses, inasmuch as the decision entered by the Court in
their case, following the issuance of the Court's opinion in
Dixon II, was consistent with the deficiency determined by
respondent.
- 29 -
were intended to streamline the litigation process, economize on
the use of administrative and judicial resources, and reduce the
costs incurred by taxpayers in resolving disputes over tax
shelter adjustments. The Internal Revenue Service, Office of
Chief Counsel, created the Tax Shelter Branch in the National
Office to oversee tax shelter litigation across the country and
to organize individual tax shelter projects. Concurrently, the
Tax Court began working with the Internal Revenue Service and
private parties in tax shelter cases to create what became known
as the test case procedure; i.e., the selection of representative
or test cases from a particular tax shelter project for a single
trial on the merits. See, e.g., Drobny v. Commissioner, T.C.
Memo. 1995-209 (citing H. Conf. Rept. 98-861, at 985-986 (1984),
1984-3 C.B. (Vol. 2) 1, 239-240), affd. 113 F.3d 670 (7th Cir.
1997).
The test case procedure is intended to streamline the
litigation process. To this end, taxpayers who are not selected
as test cases are encouraged to execute a piggyback agreement;
i.e., a stipulation to be bound by the outcome of the test cases.
As a practical matter, the effectiveness of the test case
procedure depends in large part upon the agreement of the
taxpayers not selected as test cases to be bound by the outcome
of the test cases. Normally, taxpayers in a tax shelter project
who decline or otherwise fail to sign a piggyback agreement will
either have their cases set for trial with the test cases or,
after the trial of the test cases, will be ordered to show cause
- 30 -
why their case should not be decided the same way as the test
cases. See, e.g., Krause v. Commissioner, 99 T.C. 132 (1992),
affd. sub nom. Hildebrand v. Commissioner, 28 F.3d 1024 (10th
Cir. 1994); Acierno v. Commissioner, T.C. Memo. 1997-441;
Karlsson v. Commissioner, T.C. Memo. 1997-432. Using the order
to show cause procedure to dispose of nontest cases in a tax
shelter project is more cumbersome and consumes more time and
judicial, administrative, and private party resources than using
piggyback agreements. As discussed in greater detail below, the
Court used the test case procedure in the Kersting project; the
vast majority of the Kersting project participants signed
piggyback agreements. See infra pp. 34-41.
2. National Office Tax Shelter Branch Functions
The Tax Shelter Branch, established by the Office of Chief
Counsel in the National Office, was given the responsibilities of
coordinating the examination, appeals, and litigation functions
and of overseeing tax shelter projects from the National Office
perspective. The Tax Shelter Branch provided advice and prepared
material for use by the field in tax shelter cases, reviewed
legal briefs, monitored the status of tax shelter case inventory,
and prepared reports for Internal Revenue Service executives.
The Tax Shelter Branch monitored tax shelter projects by
reviewing and extracting information from quarterly tax shelter
reports that were required to be submitted by the project
attorney; i.e., the District Counsel trial attorney with primary
responsibility for the project. Each project attorney was
- 31 -
required to submit a quarterly tax shelter report providing an
update on the status of the project, including a summary of the
current project settlement offer and any recent court action
affecting the project.
One of the goals of the tax shelter program was consistent
treatment of similarly situated taxpayers. The Tax Shelter
Branch monitored settlement offers in similar tax shelter
projects for disparities and tried to determine whether the
project settlement offers should be similar. However, actual
supervisory responsibility in a tax shelter project was left
primarily in the Regional Counsel and District Counsel offices
to which the project was assigned.
B. Petitions for Redetermination
In or around June 1982, Mr. Kersting facilitated the filing
of petitions with the Tax Court by Kersting program participants.
In letters issued in June and July 1982, Mr. Kersting informed
Kersting program participants that a joint petition was being
prepared on behalf of a large group of taxpayers. On July 12,
1982, Lu N. Nevels, Jr., filed a consolidated Tax Court petition,
assigned docket No. 17445-82, on behalf of 60 Kersting program
participants.18
18
Lu N. Nevels, Jr., had represented the test case
taxpayers in Pike v. Commissioner, 78 T.C. 822 (1982), affd.
without published opinion 732 F.2d 164 (9th Cir. 1984). For an
example of the problems created by using one petition on behalf
of so many different petitioners, see Aaronson v. Commissioner,
T.C. Memo. 1985-131, involving the Hongsermeier petitioners in
what is now docket No. 29643-86. See infra p. 38.
- 32 -
C. Brian J. Seery
In early 1982, Brian J. Seery (Mr. Seery) began assisting
Kersting program participants with issues arising from the audit
of their income tax returns. On April 14, 1982, Mr. Kersting
issued a letter to Kersting program participants informing them
that they soon would receive a letter from the Commissioner
proposing to disallow their Kersting program interest deductions.
Mr. Kersting advised program participants that they should not
remit any amount to the Internal Revenue Service until their
liability was determined in court. On February 15, 1983, Mr.
Kersting issued a letter to Kersting program participants stating
in pertinent part: "I trust that you have placed the tax
retrievals which we have accomplished for you over the years into
profitable investments and that you are receiving a reasonable
rate of return. You will not lose any ground if your funds earn
at least a return equal to the interest charges imposed by the
IRS from time to time."
On March 1, 1985, Mr. Kersting issued a letter to Kersting
program participants stating that he had retained Mr. Seery to
represent them in the Tax Court at no charge to the individual
petitioners.19 The letter requested that each Kersting program
participant provide written authorization for Mr. Seery's
19
Initially, Mr. Kersting or the entities that he
controlled paid the legal fees associated with the Tax Court
litigation. Later, however, some Kersting program participants
began paying $100 per month to a legal defense fund managed by
Mr. Kersting.
- 33 -
representation. In a letter to program participants dated August
11, 1986, Mr. Kersting recommended that program participants not
attempt to resolve their cases on their own and instead rely on
counsel that he had hired.
Mr. Seery subsequently entered his appearance in the Tax
Court on behalf of several hundred Kersting petitioners,
including the Thompsons and the Cravenses. Mr. Seery's
compensation for legal services rendered to Kersting program
participants was always paid by one of the corporations
controlled by Mr. Kersting.
D. Respondent's Counsel
1. Kenneth W. McWade
In 1970, Mr. McWade began his career as a trial attorney
with the Office of Chief Counsel. Mr. McWade's duties with the
Office of Chief Counsel included litigating tax cases.
In January 1982, Mr. McWade transferred from respondent's
District Counsel office in Seattle, Washington, to respondent's
District Counsel office in Honolulu, Hawaii. Mr. McWade
initially assisted with the Pike group of cases. On or about
July 1, 1984, the Kersting project was officially established in
the Honolulu Appeals Office, and Mr. McWade was appointed to
serve as the project attorney. Wally Kobayashi was appointed to
serve as the key Appeals officer for the Kersting project.
By late 1986, Mr. McWade had litigated 40 to 50 Tax Court
cases. However, Mr. McWade had never litigated any cases that
were part of a tax shelter project.
- 34 -
2. William A. Sims
In 1972, Mr. Sims began his career with the Office of Chief
Counsel, General Litigation Division, National Office. Except
for a 6-month assignment doing Tax Court work, Mr. Sims handled
general litigation matters concerning collection, bankruptcy, and
tax liens. Mr. Sims eventually became Assistant Director of the
General Litigation Division in the National Office.
In February 1986, Mr. Sims was appointed District Counsel
for Honolulu, Hawaii. Before his appointment as District
Counsel, Mr. Sims had never worked on a tax shelter project in
any capacity.
E. Adoption of Test Case Procedures in Kersting Project
1. The Honolulu Session (June 1985)
The Court set for trial the cases of approximately 375
Kersting program participants at a Tax Court session scheduled to
commence on June 10, 1985, in Honolulu, Hawaii (the June 1985
session).
Before the June 1985 session, Mr. McWade and Mr. Seery
agreed to use the test case procedure in the Kersting project.
During the June 1985 session, Mr. McWade and Mr. Seery discussed
the use of the test case procedure with Judge Goffe during a
chambers conference. During the conference, Mr. Seery informed
Judge Goffe that, although he was representing petitioners who
were Kersting program participants, he was being paid by Mr.
Kersting. Judge Goffe indicated that he saw no conflict of
interest as long as Mr. Seery had not participated in the
- 35 -
planning or promotion of the Kersting programs. See Rule
24(f).20
Consistent with counsels' agreement to use the test case
procedure in the Kersting project, Judge Goffe granted the
parties' joint motions to continue the cases called at the June
1985 session. At the same time, the parties began filing
piggyback agreements (discussed in greater detail below), which
they did in the vast majority of the Kersting project cases.
Mr. Seery reported the results of the June 1985 proceedings
to Mr. Kersting and kept him abreast of developments. Mr. Seery
relied upon Mr. Kersting to distribute correspondence from
Mr. Seery to petitioners in the Kersting project.
2. Test Case Procedure
Mr. McWade and Mr. Seery agreed to select test cases that
would be representative of all the Kersting programs for all
years in dispute, including the taxable years 1975 through 1983.
At the time that Mr. Seery selected his test cases, he assumed
that the test case petitioners would bear the burden of proof at
trial.
In selecting test cases, Mr. Seery was not concerned with
whether a case involved other tax issues. Mr. Seery was simply
looking for cases "where someone did everything right."
20
Rule 24(f), which became effective on July 1, 1990, see
93 T.C. 857, addresses conflicts of interest in Tax Court
litigation. Rule 24(f) was redesignated Rule 24(g) effective
Aug. 1, 1998. See 109 T.C. 542.
- 36 -
Mr. Seery selected two or three test cases, including the
Cravenses and the Hongsermeiers.
In an effort to find the best cases for trial from
petitioners' point of view, Mr. Seery selected test cases by
reference to the manner in which the taxpayers had reported the
transactions. Mr. Seery selected test cases that he thought he
could win, but, as he testified at the evidentiary hearing, he
had difficulty identifying such cases in addition to the
Cravenses and the Hongsermeiers.21
Mr. Kersting and Mr. Cravens discussed having Mr. Cravens'
case serve as a test case. Mr. Kersting told Mr. Cravens that
Mr. Seery wanted to use him as a test case because, unlike other
Kersting program participants, the Cravenses had reported a
capital gain when they surrendered their stock in the Kersting
holding company in conjunction with the annual termination of the
Kersting program. The Cravenses' reporting position was
consistent with Mr. Kersting's advice to program participants
that distributions by Kersting holding companies used by program
participants to pay the principal amount of leverage loans were
tax-free returns of capital rather than taxable dividends.
Mr. Seery viewed the Cravens cases as "unique" in this respect.
Mr. Cravens believed that he had a choice whether his case
would serve as a test case. When Mr. Cravens agreed to have his
21
Mr. Seery's testimony: "I was having trouble selecting
cases beyond those two that I thought would be good vehicles for
that."
- 37 -
case serve as a test case, he did so without condition. He
believed that he would win his case because he had correctly
reported his tax liabilities, as reduced by reason of his
participation in the Kersting programs.
Mr. Seery selected the Hongsermeier case because it was his
impression that the Hongsermeiers had used their own funds to pay
the principal of a Kersting leverage loan, rather than using a
"nontaxable distribution" from a Kersting holding company.22
Mr. Seery also selected the Hongsermeiers because they had
participated in the CAT-FIT program, which Mr. Seery viewed as
the strongest Kersting program from the standpoint of sustaining
the interest deductions claimed.
Mr. McWade analyzed between 400 and 500 project cases; he
selected test cases that he thought would be representative of
all Kersting programs for all years in dispute. Mr. McWade
selected "clean" cases; i.e., cases that did not include issues
other than Kersting interest deductions. Mr. McWade tried to
avoid cases that were unique or atypical of the Kersting
programs. Although Mr. McWade selected at least five of the test
cases, he could not recall the specific cases that he selected.
In June 1986, Mr. McWade and Mr. Seery agreed on the dockets
that were to serve as the test cases. By letter dated June 10,
22
Mr. Seery's impression was not quite right. The Court
found in Dixon II that the Hongsermeiers were unique insofar as
they paid $250 per month out-of-pocket (rather than use the
proceeds from a leverage loan) to satisfy the interest due on
a CAT-FIT primary loan. See Dixon II, 62 T.C.M. (CCH) at 1480,
1991 T.C.M. (RIA), at 91-3023.
- 38 -
1986, Mr. McWade notified Judge Goffe that he and Mr. Seery had
selected the following 14 dockets to serve as test cases with
respect to the Kersting project:
Case Name Docket No.
Dixon v. Commissioner 9382-83
Cravens v. Commissioner 16900-83
Rina v. Commissioner 17640-83
Thompson v. Commissioner 19321-83
Young v. Commissioner 4201-84
Cravens v. Commissioner 15135-84
DuFresne v. Commissioner 15907-84
Thompson v. Commissioner 31236-84
Owens v. Commissioner 40159-84
Young v. Commissioner 22783-85
Young v. Commissioner 30010-85
Thompson v. Commissioner 30965-85
DuFresne v. Commissioner 30979-85
1
Hongsermeier v. Commissioner 29643-86
1
By order dated Aug. 13, 1986, the Court severed the
Hongsermeiers from docket No. 17445-82 (the Aaronson consolidated
petition filed by Mr. Nevels) and assigned them new docket No.
29643-86. See supra note 18 and accompanying text.
With the exception of the Cravens case assigned docket No.
16900-83, and the Hongsermeier case assigned docket No. 17445-82,
each of the test case petitioners had filed pro se petitions. By
August 1986, Mr. Seery had entered his appearance in each of the
test cases with the exception of the Young cases assigned docket
Nos. 4201-84, 22783-85, and 30010-85, the DuFresne case assigned
docket No. 30979-85, and the Thompson case assigned docket No.
30965-85.
3. Test Case Array
The test case petitioners had participated in Kersting
programs during the taxable years 1975 through 1983 as follows:
- 39 -
Taxable Year 1975
Program Petitioner(s)
CAT-FIT Owens
MAURIER LEASING1 Owens
NORWICK 20/20 Owens
Taxable Year 1976
Program Petitioner(s)
UNIVERSAL LEASING Owens
FORBES 30/30 Owens
Taxable Year 1977
Program Petitioner(s)
CAT-FIT Dixon
ESCON LEASING Dixon
FARGO 30/30 Dixon
NORWICK 20/20 Owens
Taxable Year 1978
Program Petitioner(s)
CAT-FIT Hongsermeier
CAT-FIT Dixon
UNIVERSAL LEASING Hongsermeier
ESCON LEASING Dixon
ESCON LEASING Hongsermeier
MAHALO 30/30 Owens
MAHALO 60/60 Dixon
Taxable Year 1979
Program Petitioner(s)
CAT-FIT Hongsermeier
CAT-FIT Dixon
UNIVERSAL LEASING Hongsermeier
ANSETH LEASING Rina
ANSETH LEASING Young
ESCON LEASING Hongsermeier
ESCON LEASING Dixon
ESCON LEASING Thompson
CANDACE 60/60 Dixon
CANDACE 60/60 Cravens
CANDACE 60/60 Rina
- 40 -
CANDACE 60/60 Thompson
CANDACE 60/60 Young
CHARTER 80,000 Rina
CHARTER 120,000 Young
INVESTORS 80,000 Rina
INVESTORS 120,000 Young
Taxable Year 1980
Program Petitioner(s)
CAT-FIT Dixon
CAT-FIT DuFresne
CAT-FIT Hongsermeier
ANSETH LEASING Hongsermeier
ANSETH LEASING Rina
ANSETH LEASING Young
ESCON LEASING Dixon
ESCON LEASING Hongsermeier
ESCON LEASING Thompson
CANDACE 60/60 Cravens
CANDACE 60/60 Rina
DELTA 40/40 Hongsermeier
DELTA 60/60 Cravens
DELTA 60/60 Dixon
DELTA 60/60 DuFresne
DELTA 60/60 Rina
DELTA 60/60 Thompson
DELTA 60/60 Young
CHARTER 40,000 Rina
CHARTER 80,000 Rina
CHARTER 120,000 Dixon
CHARTER 120,000 DuFresne
CHARTER 120,000 Thompson
CHARTER 120,000 Young
INVESTORS 80,000 DuFresne
INVESTORS 80,000 Rina
INVESTORS 80,000 Thompson
INVESTORS 120,000 Dixon
INVESTORS 120,000 Young
Taxable Year 1981
Program Petitioner(s)
ANSETH LEASING Young
ESCON LEASING Dixon
DELTA 60/60 Young
CHARTER 120,000 Dixon
CHARTER 120,000 DuFresne
CHARTER 120,000 Young
- 41 -
INVESTORS 80,000 DuFresne
INVESTORS 120,000 Dixon
INVESTORS 120,000 Young
Taxable Year 1982
Program Petitioner(s)
ANSETH LEASING Young
CHARTER 120,000 DuFresne
CHARTER 120,000 Young
INVESTORS 80,000 DuFresne
INVESTORS 120,000 Young
Taxable Year 1983
Program Petitioner(s)
ANSETH LEASING Young
CHARTER 120,000 DuFresne
INVESTORS 80,000 DuFresne
1
Maurier Leasing, a subch. S leasing program, was
considered by the Court in Pike v. Commissioner, 78 T.C. 822
(1982).
The notice of deficiency issued to the Thompsons for the
taxable year 1981 states in pertinent part: "Based on
examination information from the 1978, 1979, and 1980 returns,
the investment interest is generated from the interest deduction
tax shelter. The purported payees cannot be identified from the
1981 income tax return filed by the taxpayers." Respondent has
not been able to identify specifically the Kersting programs that
the Thompsons participated in during 1981. However, the record
suggests that, in addition to the Kersting programs that the
Thompsons participated in during 1979 and 1980, the Thompsons
participated in the Anseth Leasing Program during 1981.
If the Thompson and Cravens cases had been removed from the
test case array, there would have been no reduction in coverage
- 42 -
of the test cases. In other words, each program in which the
Thompsons and Cravenses participated during the years in issue
was also a program before the Court in which one or more of the
other test case petitioners had participated.
IV. The Maui Session (February 1987)
After Messrs. Seery and McWade had selected the test cases,
they initiated settlement negotiations and began to prepare the
test cases for trial.23 Their trial preparations included work
on a proposed stipulation of facts and an attempt to take
Mr. Kersting's deposition. During this period (June 1986 or
thereabout), Mr. Seery and Mr. Kersting's attorney, L.T. Bradt
(Mr. Bradt), discussed using the 1981 search of Mr. Kersting's
office as a basis for filing a motion to shift the burden of
proof to respondent in the test cases.
A. Trial Notices
By letter dated July 30, 1986, Judge Goffe informed
Messrs. Seery and McWade that the test cases would be set for
trial during a special session of the Court commencing on
February 9, 1987, in Wailuku, Maui, Hawaii (the Maui session).
Judge Goffe's letter also informed Messrs. Seery and McWade that
he intended to notify each Kersting petitioner who had not filed
a piggyback agreement that his or her case would be set for trial
during the Maui session.
23
Settlement negotiations between Mr. McWade and Mr. Seery
are discussed in greater detail infra pp. 78-80.
- 43 -
In August 1986, the Court issued orders setting the 14 test
cases for trial during the Maui session. By letter dated
August 5, 1986, Judge Goffe informed all Kersting petitioners who
had not already executed piggyback agreements that their cases
would be set for trial at the Maui session unless they executed
piggyback agreements by September 29, 1986. Judge Goffe's letter
states as follows:
August 5, 1986
Dkt #
Dear _______________:
Your case involves matters concerning promotions
by Henry Kersting. Cases with issues identical to the
issues in your case have been set for trial on
February 9, 1987, at the courtroom of the Circuit Court
for the Second Circuit in Wailuku, Maui, Hawaii.
In order to conserve the time and expense of the
taxpayers, the government and the Court, all of the
cases with identical issues will be tried at one time
unless the parties agree in advance, in writing, to be
bound by the outcome of the cases set for trial. In
most of the pending cases, the parties have so agreed
to be bound.
You should contact at your earliest convenience the
lawyer for the government in the Kersting cases if you
decide to agree to be bound. He is Mr. Kenneth McWade,
PJKK Federal Building, Room 3304, Box 50089, 300 Ala
Moana Boulevard, Honolulu, Hawaii 96850. His telephone
number is (808) 546-7333. If, however, you do not wish
to be bound, you should advise my office promptly, in
writing at the above address, in order that your case
may be set for trial on February 9, 1987. In either
event, you must advise Mr. McWade or me by
September 29, 1986.
If you fail to advise Mr. McWade by September 29,
1986, that you wish to be bound and have executed a
stipulation to be bound by that time and if you fail to
advise me by September 29, 1986, that you wish to have
your case set for trial, it will automatically be set
for trial on February 9, 1987. If your case is set for
- 44 -
trial and you do not appear for trial, your case will
likely be dismissed and you will be required to pay all
of the income tax which the government contends you
owe, plus interest thereon as provided by law.
William A. Goffe
Judge
In November 1986, the Court issued orders notifying Kersting
petitioners who had not filed piggyback agreements that their
cases were set for trial at the Maui session. As additional
Kersting project cases were docketed and identified, the Court
issued orders setting them for trial at the Maui session, subject
to being stricken if the parties executed a piggyback agreement.
B. Piggyback Agreements
As early as June 1985, Kersting program participants had
begun executing piggyback agreements (1985 piggyback
agreements),24 drafted by Messrs. McWade and Seery, that stated
as follows:
Stipulation of Settlement for Tax Shelter Adjustments
With respect to all adjustments in respondent's
notice of deficiency relating to the Kersting interest
deduction tax shelter(s), the parties stipulate to the
following terms of settlement:
1. The term Kersting programs refers to interest
expense deductions or other related deductions
associated with various programs promoted by Henry
Kersting.
2. The Kersting program deduction adjustments
shall be redetermined on the same basis that the same
program adjustments are resolved with respect to
taxpayers trying the same program adjustments at the
24
Before 1987, there was no uniform format for piggyback
agreements. In 1987 or early 1988, respondent's Tax Shelter
Branch issued a standard form of piggyback agreement.
- 45 -
June 10, 1985 session of the Court in Honolulu, Hawaii,
or such session as these cases may be adjourned or
continued to by the Court (hereinafter "TRIED CASE").
3. All issues involving the Kersting programs
shall be resolved as if the petitioner(s) in this case
is the same as the taxpayers in the TRIED CASE;
4. A decision shall be submitted in this case
when the decision in the TRIED CASE is entered;
5. Following entry of the decision in this case,
petitioner(s) consents to the assessment and collection
of the deficiencies, attributable to the adjustments
formulated by reference to the Tax Court's opinion,
notwithstanding the restrictions contained in I.R.C.
§ 6213(a);
6. The petitioner(s) in this case will testify or
provide information in any case involving the same tax
shelter adjustments, if subpoenaed; and
7. The petitioner(s) in this case consents to the
disclosure of all tax returns and tax return
information for the purpose of respondent's discovering
or submitting evidence in any case involving the same
Kersting shelter adjustments.
The parties agree to this stipulation of
settlement.
Piggyback agreements executed by Kersting program
participants after 1985 differed from those executed in 1985. In
particular, post-1985 piggyback agreements stated as follows:
Stipulation of Settlement for Tax Shelter Adjustments
With respect to all adjustments in respondent's
notice of deficiency relating to the Kersting interest
deduction tax shelter(s), the parties stipulate to the
following terms of settlement:
1. The Kersting interest deduction tax shelter
adjustments shall be redetermined on the same basis
that the same tax shelter adjustments are resolved with
respect to taxpayers trying the same shelter
adjustments at the February 9, 1987 session of the
Court in Wailuku, Maui, Hawaii, or such session as
- 46 -
these cases may be adjourned or continued to by the
Court (hereinafter "TRIED CASE").
2. All issues involving the Kersting interest
deduction tax shelter(s) shall be resolved as if the
petitioner(s) in this case is the same as the taxpayers
in the TRIED CASE;
3. A decision shall be submitted in this case
when the decision in the TRIED CASE becomes final under
I.R.C. § 7481;
4. Following entry of the decision in this case,
petitioner(s) consent to the assessment and collection
of the deficiencies, attributable to the adjustments
formulated by reference to the Tax Court's opinion,
notwithstanding the restrictions contained in I.R.C.
§ 6213(a);
5. The petitioner(s) in this case will testify or
provide information in any case involving the same tax
shelter adjustments, if subpoenaed; and
6. The petitioner(s) in this case consents to the
disclosure of all tax returns and tax return
information for the purpose of respondent's discovering
or submitting evidence in any case involving the same
shelter adjustments.
7. If the Court determines the I.R.C. § 6621(d)
penalties are applicable in the test case controlling
petitioner's(s') case, then the petitioner(s) concedes
that I.R.C. § 6621(d) is applicable to any underpayment
of tax determined in their case(s) attributable to the
Kersting interest deduction tax shelter(s), if such
underpayment exceeds $1,000.00 in any one taxable year.
8. With respect to adjustments in respondent's
notice of deficiency relating to additions to the tax
under I.R.C. § 6653(a), the parties agree to the
following:
(a) Respondent concedes that the
petitioner(s) are not liable for additions to tax under
I.R.C. § 6653(a) or § 6653(a)(1) or § 6653(a)(2) for
any year prior to the taxable year 1982.
The parties agree to this stipulation of
settlement.
- 47 -
In sum, whereas paragraph 4 of the 1985 piggyback agreements
states that a decision will be entered in the piggyback case
following entry of decision in the test cases, paragraph 3 of the
post-1985 piggyback agreements states that a decision will be
entered in the piggyback case once the decision in the test cases
becomes final.25 See Gridley v. Commissioner, T.C. Memo. 1997-
210. Unlike 1985 piggyback agreements, post-1985 piggyback
agreements state (at paragraph 7) that petitioners agree to be
bound to the Court's holding in the test cases respecting the
applicability of increased interest under section 6621(c) on any
underpayment of tax of more than $1,000. Further, while 1985
piggyback agreements make no reference to additions to tax, post-
1985 piggyback agreements state (at paragraph 8) that petitioners
are not liable for additions to tax for negligence for any year
before the taxable year 1982.26
25
Despite this distinction, respondent did not move for
entry of decision--upon entry of decisions in the Kersting test
cases in early 1992--in any of the cases in which Kersting
petitioners had executed the 1985 version of the piggyback
agreement. Respondent has taken the position that no decisions
should be entered in any of the piggyback cases until the
decisions in the test cases become final. Cf. Abatti v.
Commissioner, 859 F.2d 115 (9th Cir. 1988), affg. 86 T.C. 1319
(1986).
26
Although the record does not reveal why post-1985
piggyback agreements limit respondent's concession of additions
to tax for negligence to taxable years before 1982, a plausible
explanation for selecting 1982 as the line of demarcation would
be that the Tax Court had released its opinion in Pike v.
Commissioner, 78 T.C. 822 (1982), in May 1982, putting taxpayers
on notice for 1982 and later taxable years that Mr. Kersting's
programs did not generate legitimate interest deductions.
- 48 -
When Messrs. McWade and Seery drafted the piggyback
agreements, Mr. Seery did not consider the possibility that a
test case might be settled.27
Nontest case petitioners Ronald L. and Mattie E. Alverson
(docket No. 17646-83) executed their piggyback agreement in June
1985. Nontest case petitioners Anthony E. and Carol A. Eggers
(docket No. 7323-84), John L. and Terry E. Huber (docket No.
20119-84), Stanley C. and Sharon A. Titcomb (docket No. 17992-
95), and Richard B. and Donna G. Rogers (docket No. 17993-95)
executed piggyback agreements in late November 1986. Nontest
case petitioners Norman W. and Barbara L. Adair (docket No.
35608-86) executed their piggyback agreement in March 1987.
Nontest case petitioners Willis F. McComas, II and Marie D.
McComas (docket No. 19464-92), Wesley Armand and Sherry Lynn
Cacia Baughman (docket No. 621-94), Joe A. and JoAnne Rinaldi
(docket No. 7205-94), and Norman A. and Irene Cerasoli (docket
No. 9532-94) did not execute piggyback agreements for their cases
on these dockets.
C. Mr. Seery's Withdrawals as Counsel
During late 1986 and early 1987, and shortly before the Maui
session, Mr. Seery began to withdraw as counsel in the Kersting
cases in the circumstances described below.
27
A piggyback agreement that binds the piggyback case to
the outcome of the test case, whether by litigation or
settlement, is not unprecedented. See, e.g., Fisher v.
Commissioner, T.C. Memo. 1994-434.
- 49 -
1. The Thompsons
In 1985, the Thompsons had retained Samuel M. Huestis
(Mr. Huestis) to prepare an estate plan for them. Eventually,
the scope of Mr. Huestis' representation was extended to include
settlement of the Thompsons' 1978 tax liabilities and their
dispute with Mr. Kersting, as described infra pp. 56-67.
One result of that dispute was Mr. Huestis' letter of
September 10, 1986, to Mr. Seery, notifying him that the
Thompsons were seeking substitute counsel and requesting the
Thompson files. On September 15, 1986, Mr. Seery sent the
Thompson files to Mr. Huestis and informed him that the Thompsons
were test case petitioners. Mr. Seery indicated that he was
withdrawing as the Thompsons' counsel in the Tax Court.
On October 28, 1986, Mr. Huestis wrote to Mr. Seery to
express dissatisfaction with the sufficiency of the Thompsons'
files and to warn Mr. Seery that his earlier representation of
the Thompsons, while he was also apparently representing
Mr. Kersting, could be viewed as a conflict of interest and lead
to an action for "professional negligence".
On October 31, 1986, Mr. Seery filed motions to withdraw as
counsel in the Thompsons' cases.28 The Court granted Mr. Seery's
motions in November 1986.
28
Mr. Seery had entered his appearance only in the
Thompson cases assigned docket Nos. 19321-83 and 31236-84, not
docket No. 30965-85.
- 50 -
In the interim, Mr. Huestis assisted the Thompsons in
locating and interviewing Mr. DeCastro to serve as their counsel
in the Tax Court.29 On November 15, 1986, Mr. Thompson and
Mr. DeCastro's associate, Phillip Hoskins, executed a retainer
agreement under which Mr. Thompson agreed to pay Mr. DeCastro
$5,000 for his effort to negotiate a settlement of the Thompson
tax cases. The agreement provided that the retainer fee was
limited to settlement negotiations and did not include
preparation for or representation at trial. In early January
1987, Mr. DeCastro filed an entry of appearance in the Thompson
cases.
2. The Test Cases
On November 7, 1986, Mr. Seery filed a motion to change
the place of trial of the test cases from Maui to Honolulu.
Mr. Seery asserted that a trial in Maui would be inconvenient and
a hardship to Mr. Kersting, who lived and operated a business in
Honolulu. Mr. Seery's motion included the statement that
4. Mr. Kersting is providing the financial
support for the litigation of this and the related
cases and the additional expense involved in
transporting witnesses and staff to Wailuku as well
as paying for accommodations for the staff while in
Wailuku is a great financial burden to him.
On November 14, 1986, the Court issued an order denying
Mr. Seery's motion to change the place of trial. In so doing,
29
Mr. Huestis had initially referred the Thompsons to a
law firm, Loeb & Loeb, in Los Angeles, California. The Loeb firm
declined to represent the Thompsons because of the short time to
prepare for the Maui session and the incompleteness of the
Thompson files.
- 51 -
the Court noted that the motion "implies that * * * [Mr. Seery]
represents not only petitioners but also Henry Kersting, the
promoter of the tax shelters which are the subject of this
litigation." The Court went on to observe that, if Mr. Seery
were representing both Mr. Kersting and petitioners, the dual
representation would constitute a conflict of interest. The
Court attached to the order copies of several authorities
concerning conflicts of interest, including Adams v.
Commissioner, 85 T.C. 359 (1985). Mr. Seery subsequently filed
motions to withdraw as counsel in the Kersting project cases
(both test cases and nontest cases), citing concerns about a
possible conflict of interest. The Court granted Mr. Seery's
motions.
By letter dated December 12, 1986, Mr. Kersting informed
Kersting program participants that Judge Goffe had "inferred"
that Mr. Seery might have a conflict of interest. Although
Mr. Kersting denied that he was represented by Mr. Seery, he
stated that he and Mr. Seery had decided that it would be prudent
for Mr. Seery to withdraw as counsel. Mr. Kersting further
stated that substitute counsel had been retained to represent
test case and nontest case petitioners alike.
D. Entries of Appearance by Chicoine and Hallett
Following Mr. Seery's withdrawal, Mr. Bradt recommended that
Mr. Kersting hire Mr. Izen to serve as counsel for the test
- 52 -
cases.30 However, Mr. Kersting, with his son-in-law, an
attorney, Roger Moseley (Mr. Moseley), contacted Robert J.
Chicoine (Mr. Chicoine) and Darrell D. Hallett (Mr. Hallett)
(collectively Chicoine and Hallett), to determine whether they
would represent the test case petitioners at the Maui session.
On November 22, 1986, Mr. Kersting sent Mr. Hallett a
letter describing the Kersting programs. Shortly thereafter,
Mr. Kersting interviewed Mr. Hallett in Hawaii. On December 9,
1986, Chicoine and Hallett reached an agreement with Mr. Kersting
to represent the test case petitioners (other than the
Thompsons). On December 12, 1986, Mr. Kersting wrote to Kersting
program participants informing them that Mr. Seery had withdrawn
as counsel and that Chicoine and Hallett had been retained. At
the same time, either Mr. Kersting or Chicoine and Hallett
informed the test case petitioners that they would have to
provide Chicoine and Hallett with written authorization to enter
appearances in their cases.
Although Mr. Seery sent Chicoine and Hallett his files for
the test cases, most of the documents that Mr. Seery had intended
to use at trial remained in Mr. Kersting's possession. By
letter dated December 19, 1986, Chicoine and Hallett reminded
Mr. Kersting that they needed all documents in the possession of
Mr. Kersting and Mr. Seery that pertained to the Kersting
programs in dispute in the Tax Court.
30
Mr. Bradt and Mr. Izen had been law partners from 1978
to 1981.
- 53 -
By letter dated January 7, 1987, Chicoine and Hallett
outlined the conditions underlying their agreement with
Mr. Kersting to represent the test case petitioners in the Tax
Court. Chicoine and Hallett's letter states in pertinent part:
Our representation is conditioned upon the
following however:
1. We will represent only the individuals
selected as test cases and who request us to do so. We
are not representing or acting on behalf of any other
taxpayers or litigants who have invested in various
companies in which you are affiliated and who have
stipulated to be bound by the outcome of the litigation
or desire legal advice with respect to whether they
should accept the Internal Revenue Service's settlement
proposal.
2. All parties understand and agree that under
the circumstances, the Petitioners involved in the test
cases who have expressly authorized us to represent
them will be our clients and that we do not represent
you individually, although you have agreed with those
Petitioners that you will pay the legal fees to defer
[sic] the costs of their defense. We will discuss the
fee arrangement with each of the Petitioners in the
test cases and their perception of any possible
conflict of interest which we would require that they
waive.
3. It is understood that there will be no
restrictions on the advice which we may provide to our
clients and after review of the relevant facts and
documents, we are free to propose such settlements as
we may deem appropriate. We need not proceed with
trial in any situation if which we consider our
position to be indefensible or frivolous.
In early January 1987, Messrs. Chicoine and Hallett filed
entries of appearance as counsel in each of the test cases other
than the Thompson and Cravens cases.
As discussed in greater detail infra pp. 100-106, at the
time of Mr. Seery's withdrawal from the Cravens cases,
- 54 -
Mr. Cravens and Mr. McWade had agreed to a settlement of the
Cravens cases. After reaching an agreement with Mr. McWade, Mr.
Cravens did not authorize Chicoine and Hallett to enter an
appearance in his cases.
E. Evidentiary Issues
After undertaking to represent the test case petitioners,
Chicoine and Hallett decided to challenge their deficiency
notices on the ground that the search of Mr. Kersting's office in
January 1981 had been illegal. Chicoine and Hallett thereupon
filed motions for leave to file amendments to the petitions and
lodged the amendments with the Court. The amendments included
arguments that the materials seized by the Internal Revenue
Service during the search of Mr. Kersting's office should be
suppressed at trial of the test cases and that the burden of
proof and burden of going forward with evidence should be shifted
to respondent. On January 14, 1987, the Court granted Chicoine
and Hallett's motions for leave to file amendments to the
petitions and subsequently directed respondent to file answers to
the petitions as amended.
1. The Maui Session
Although the test cases were originally scheduled for trial
at the Maui session, the trial was delayed by the need to use the
Maui session to receive testimony and evidence on the evidentiary
issues raised by Chicoine and Hallett.
Mr. McWade and Henry E. O'Neill (Mr. O'Neill), another trial
attorney assigned to the Honolulu District Counsel Office,
- 55 -
appeared on behalf of respondent at the Maui session.
Mr. DeCastro appeared at the Maui session on behalf of the
Thompsons. The Cravenses did not appear at the Maui session.
Following the Maui session, the Court ordered respondent and
petitioners, by May 18 and June 17, 1987, respectively, to file
opening and reply briefs addressing the evidentiary issues raised
by Chicoine and Hallett. On motions by the parties, the Court
extended the dates for the filing of opening and reply briefs to
June 8 and August 10, 1987, respectively.
2. Dixon I Opinion
On February 11, 1988, the Court issued its Dixon I opinion
rejecting Chicoine and Hallett's evidentiary arguments.
Specifically, the Court held that petitioners had failed to
establish standing to contest the Kersting search. Dixon v.
Commissioner, 90 T.C. 237 (1988).
By order dated July 1, 1988, the Court set the test cases
for trial in San Diego, California, on January 9, 1989. By order
dated October 24, 1988, the Court granted Mr. Izen's motion to
reconsider and set the test cases for trial in Honolulu, Hawaii,
on January 9, 1989.
V. Kersting Disputes With Program Participants
Before the trial of the test cases, Mr. Kersting had
disputes, summarized below, with the Thompsons and the
Alexanders.
- 56 -
A. The Thompsons
1. The Bauspar Program
On August 13, 1979, the Thompsons purchased a condominium
unit in Wahiawa, Hawaii (the Wahiawa property), from Pacific
Universal Corp. (not a Kersting company). On April 24, 1981, the
Thompsons entered a Kersting program known as Bauspar--not one of
the Kersting programs in dispute at the trial of the test cases--
to effect the payoff of seller-provided financing on the Wahiawa
property. The Thompsons executed a first mortgage and promissory
note reflecting a loan from Bauspar, Inc. (Bauspar), in the
principal amount of $80,000. The Thompsons agreed to repay the
$80,000 Bauspar loan, with interest at 7 percent per year,
through monthly payments of principal and interest of $532.24 for
a 10-year period, followed by a balloon payment of $69,182.47.31
In conjunction with the Bauspar loan, the Thompsons agreed to
purchase $80,000 worth of Bauspar stock. The Thompsons borrowed
$80,000 to purchase the Bauspar stock from another Kersting
company, Paragon Investments, Inc. (Paragon), at an annual
interest rate of 18 percent. The Thompsons further agreed to
participate in a "savings program" by depositing $1,200 per month
into an account with Citizen's Financial, Inc. (Citizen's
Financial), another Kersting company.
On August 12, 1982, the Thompsons agreed to sell the Wahiawa
property to Kevin and Ada Shea for $122,500 by an "Agreement of
31
It appears that the Thompsons actually made monthly
payments of $535 to Bauspar.
- 57 -
Sale" under which the Thompsons apparently took back a purchase
money mortgage on the property. The Thompsons continued to
participate in the Bauspar program until 1986 when the Sheas
decided to sell the Wahiawa property to a third party.
On January 30, 1985, Mr. Kersting sent Mr. Thompson a
schedule listing the interest payments that Mr. Thompson had made
during 1984 as follows:
Payee Amount
Bauspar, Inc. $6,420.00
Paragon Investments, Inc. 9,611.04
Citizens Financial, Inc. 14,400.00
Upon sale of the Wahiawa property by the Sheas in 1986,
Bauspar received a check in the amount of $75,511.74 in
satisfaction of the principal amount remaining due on the
Thompsons' loan from Bauspar.
2. Deterioration of Thompson/Kersting Relationship
While working on the Thompsons' estate plan, Mr. Huestis
asked Mr. Kersting for an accounting of the Thompsons'
investments in Kersting programs. By letter dated March 3, 1986,
Mr. Kersting responded by providing Mr. Huestis a summary list of
the Kersting programs that the Thompsons had participated in
during 1977, 1978, 1979, 1980, and 1981. By letter dated
March 12, 1986, Mr. Huestis informed Mr. Kersting that the
Thompsons wished to terminate their participation in all Kersting
programs and obtain a complete accounting of their investments.
Mr. Huestis also requested that all future communications
- 58 -
regarding the matter be directed to Mr. Huestis rather than to
the Thompsons.
By letter dated March 17, 1986, Mr. Kersting complained to
Mr. Huestis about his "assertive approach" and said he would
continue to communicate directly with the Thompsons. By letter
dated March 17, 1986, Mr. Kersting wrote to Mr. Thompson,
confirmed that he would terminate Mr. Thompson's programs, and
inquired whether Mr. Thompson still had any stock certificates
issued in connection with his participation in Kersting programs.
Mr. Kersting's letter also states that Mr. Thompson would incur
tax liability for capital gains that would be realized upon the
termination of his accounts in the Kersting programs.
On March 21, 1986, Mr. Huestis again wrote to Mr. Kersting,
stating that the Thompsons were disappointed with Mr. Kersting's
failure to respond to their requests or to assist them with the
tax problems arising from their participation in his programs.
By letter to the Thompsons dated March 25, 1986, Mr. Kersting
confirmed that he would liquidate their investments, as discussed
with Mr. Thompson in a recent telephone conversation.
Mr. Kersting requested that Mr. Thompson endorse all relevant
stock certificates and return them to Mr. Kersting so that the
proceeds from the sale of stock represented by such certificates
could be used to retire Mr. Thompson's debts to Kersting
companies.
By letter dated March 31, 1986, Mr. Kersting wrote to
Mr. Thompson and admitted that he was having difficulty
- 59 -
reconciling Mr. Thompson's Bauspar account because Earl LeMond,
Mr. Kersting's son-in-law and the manager of the Bauspar program,
did not keep reliable records. Nonetheless, Mr. Kersting
prepared an accounting of Mr. Thompson's Bauspar account
indicating that Mr. Thompson had paid $90,769.72 under the
program and had received nontaxable dividends of $27,000 and
Federal tax and State income tax savings (presumably from
interest deductions) of $36,307.79 and $9,000, respectively.
Mr. Kersting further indicated that, in light of Mr. Thompson's
apparent dissatisfaction, he would waive the normal requirement
that the Bauspar program run for a 10-year period, allow
Mr. Thompson to terminate the program prematurely, and pay
Mr. Thompson $27,000 reflecting 3 years of "equity build-up" in
the program. On the basis of his accounting, Mr. Kersting
concluded that Mr. Thompson would realize a net gain of $8,538.07
from the Bauspar program. Mr. Kersting advised Mr. Thompson to
check his accounting carefully, and that, if necessary, Mr.
Kersting would make adjustments in Mr. Thompson's favor to avoid
a legal dispute.
On March 31, 1986, Mr. Kersting wrote a second letter to
Mr. Thompson stating that the Thompsons owed a total of $11,844
to Avalon Acceptance Corp., Aztec Acceptance Corp., Mahalo
Acceptance Corp., Lombard Acceptance Corp., and Candace, for
interest due on leverage notes during 1983 and 1984.
Mr. Kersting's letter states in pertinent part:
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I will assume that you will take the position
that you should not be paying interest on notes which
produced deductions which you might not have used.
While this, of course, would not go well with a bank or
Credit Union (they would charge you interest whether
you use the deductions or not) I am willing to make
adjustments to your advantage. To get that underway I
suggest that you tell us which of the deductions were
claimed by you in 1983 and 1984.
* * * * * * *
To keep the spirit of accommodation alive and to remove
all elements of dissatisfaction we are quite willing to
lean over into your direction. It has troubled me
considerably that of all people you would be displeased
with our services.
On May 6, 1986, Mr. Thompson wrote to Mr. Kersting
requesting a full accounting for his participation in the Bauspar
program. Mr. Thompson informed Mr. Kersting that the property
subject to the Bauspar mortgage had been sold. Mr. Thompson also
said that he was reminding Mr. Kersting that, upon his retirement
in 1982, he had asked to terminate his participation in the
programs for which Mr. Kersting was now seeking interest payments
for leverage loans.
Beginning in June 1986, Mr. Thompson stopped making the
$1,200 monthly deposits to Citizens Financial as required under
the Bauspar program. At the same time, Mr. Thompson ignored
Mr. Kersting's written requests to explain his failure to make
the deposits. Further, on June 23, 1986, at the suggestion of
Mr. Huestis, the Thompsons retained John A. Chanin (Mr. Chanin),
an attorney practicing in Honolulu, to assist them in their
dispute with Mr. Kersting. Mr. Chanin assigned the matter to his
associate, Keith Y. Yamada (Mr. Yamada).
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On August 1, 1986, Mr. Yamada spoke with Mr. Kersting by
telephone and requested a detailed accounting of the amounts that
the Thompsons had paid to Bauspar and Citizen's Financial, as
well as a status report on the promissory notes executed by the
Thompsons in favor of Bauspar, Signet Financial, Inc., and
Paragon. Following the telephone call from Mr. Yamada,
Mr. Kersting called Mr. Thompson. During this conversation,
Mr. Thompson reminded Mr. Kersting that the Wahiawa property had
been sold. Mr. Kersting stated that he would provide Mr. Chanin
with copies of the documents relating to Mr. Thompson's
participation in the Bauspar program as soon as Mr. Thompson
provided Mr. Kersting with a written authorization to release
them.
By letter dated August 23, 1986, Mr. Kersting notified the
Thompsons that he had turned their file over to Mr. Moseley for
collection and that he sensed that litigation was imminent.
Mr. Kersting's letter states in pertinent part:
Since the odds, however, are in favor of imminent
litigation I consider it to be my obligation to point
out to you the consequences:
The day after you have allowed your attorneys to file
suit I will declare all notes which you have executed
to our companies in default and begin collection
proceedings. We will make an effort to collect from
you not only the $11,844.00 of interest on promissory
notes of which we have sent you billings several times
we will also file suit to collect the principal of all
notes which we hold. The aggregate sum is well in
excess of $250,000.00, as you know.
I will also ask you to return to us the $40,000.00 we
advanced to you after the First Savings debacle. We
will start collection proceedings on the $75,000.00
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note which you executed in favor of FEDERATED FINANCE
COMPANY to facilitate the acquisition of your stock in
First Savings & Loan Ass. We will ask you to pay a
pre-payment penalty on your mortgage on the house in
Wahiawa.
We will NOT arrange for you a capital gain in your
BAUSPAR HOLDINGS INC. stock which I had considered--
even though not due you because of premature withdrawal
from the Plan--and we will NOT render assistance in
saving you capital gains taxes on the re-capture of
basis in your stock holdings.
We will NOT provide legal assistance free of cost to
you any longer in US Tax Court proceedings. You will
have to retain your own attorney to make an appearance
for you on February 9/1987 in US Tax Court.
By letter dated August 24, 1986, Mr. Kersting notified
Mr. Seery that he expected to be in litigation with the Thompsons
and directed Mr. Seery not to "render any services, at our
expense," to the Thompsons.
By letter dated August 28, 1986, Mr. Huestis notified
Mr. Moseley that he represented the Thompsons in connection with
their Kersting transactions and the pending Tax Court litigation.
Mr. Huestis advised Mr. Moseley to direct all future
communications regarding the Thompsons to Mr. Chanin.32
By letter dated September 5, 1986, Mr. Kersting again
notified Mr. Seery of his dispute with the Thompsons and
the likelihood of litigation. Mr. Kersting included a copy
of Mr. Huestis' August 28, 1986, letter to Mr. Moseley.
32
As previously mentioned, this was around the time that
Mr. Seery began the process of withdrawing as counsel for the
Thompsons, following Mr. Huestis' notification to Mr. Seery that
the Thompsons were in the process of retaining substitute
counsel.
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Mr. Kersting told Mr. Seery that he considered it "mandatory"
that the Thompsons be removed as test case petitioners. On
September 24, 1986, Mr. Kersting again wrote to Mr. Seery,
reminding him of the need to remove the Thompsons from the list
of test cases. During this period, Mr. Thompson began talking
with other Kersting program participants about filing a class
action lawsuit against Mr. Kersting.
On January 1, 1987, Mr. Kersting wrote to Bill Witthorne, a
Kersting program participant, requesting help in dealing with
Mr. Thompson. Mr. Kersting's letter states in pertinent part:
Yet, I consider it important that someone would bring
home to Jack the dangers of the action he has in mind.
He has been hoodwinked by the attorneys out in
California and I think he is blind to the
ramifications. Can you think of anyone in California
who is close to Jack and willing to talk to him?
That same day Mr. Kersting wrote to Benness M. Richards, another
Kersting program participant, stating in pertinent part:
We have been unsuccessful over the last six months or
so to convince Jack that he will be better off with the
legal representation provided by us. Neither has
anyone be [sic] able to bring home to him that the IRS
does NOT make him a better deal than offered to all the
other Petitioners.
On March 10, 1987, Mr. DeCastro and Mr. Huestis informed
Mr. Thompson that Mr. Kersting would not return the Thompsons'
promissory notes. Mr. DeCastro indicated that he wanted to
discuss the possible involvement of his firm in bringing legal
action against Mr. Kersting.
On April 10, 1987, Mr. Thompson wrote a letter to other
Kersting program participants, saying that Mr. Kersting had
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deceived him. In his letter, Mr. Thompson said that he had gone
to Mr. Kersting to reduce his tax liabilities but that he now
believed the cost to him would be great because the Internal
Revenue Service was challenging Mr. Kersting's programs.
Mr. Thompson suggested that the biggest worry for Kersting
program participants was Mr. Kersting's "ultimate weapon", the
promissory notes. Mr. Thompson enclosed a copy of a letter that
he had received from Mr. Kersting as an example of what the
others might face.33 Mr. Thompson informed the other
participants that, although Mr. Kersting had promised to cancel
all promissory notes in exchange for the surrender of the
Kersting company stock that was purchased with the proceeds of
the primary loan, Mr. Thompson had tried to surrender his
Kersting company stock but Mr. Kersting had refused to cancel
Mr. Thompson's promissory notes. Mr. Thompson indicated that
he no longer trusted Mr. Kersting, and that he had retained
Mr. DeCastro.
By letter dated May 5, 1987, Mr. Yamada advised Mr. Thompson
that a lawsuit against Mr. Kersting would have merit, and that a
class action lawsuit should be considered. Around this time,
Mr. DeCastro had proposed to file suit on behalf of the Thompsons
against Mr. Kersting in Federal District Court.
33
Although the Court's copy of Mr. Thompson's Apr. 10,
1987, letter does not include a copy of a letter from
Mr. Kersting, we assume that Mr. Thompson circulated
Mr. Kersting's letter of Aug. 23, 1986.
- 65 -
On May 26, 1987, Mr. Huestis called Mr. DeCastro and learned
that, after Mr. Kersting had obtained a copy of Mr. Thompson's
April 10, 1987 letter, Mr. Moseley had written to Mr. DeCastro
on behalf of Mr. Kersting and proposed a settlement of the
Kersting/Thompson dispute. During a later meeting that day with
Mr. Thompson, Mr. Huestis agreed to contact another lawyer in
Honolulu, Charles R. Kozak (Mr. Kozak), to discuss whether
Mr. Kozak might represent the Thompsons in a lawsuit against
Mr. Kersting.
On May 27, 1987, Mr. Huestis contacted Mr. Kozak on behalf
of the Thompsons. Mr. Kozak informed Mr. Huestis that he had
represented two other Kersting participants (David L. Bigelow34
34
David L. Bigelow and Patricia L. Bigelow had
participated in the CAT-FIT program during the taxable years
1975 and 1976. In Bigelow v. Commissioner, T.C. Summary 1983-6
(docket No. 3147-78S), the Court held that the Bigelows were
entitled to interest deductions that they had claimed under the
CAT-FIT program, partly on the basis of evidence that the
Bigelows had successfully sued a related Kersting finance company
in State court. Because the Bigelows' case was tried under the
small tax case procedure, the case was not subject to appeal and
is not treated as precedent for any other case. See sec.
7463(b).
Mr. Kozak had represented Mr. Bigelow in a lawsuit against
Mr. Kersting for payment of the "equity build-up" in a mortgage
funding program (presumably Bauspar) following Mr. Bigelow's
termination of the program. Mr. Bigelow won the suit and
collected damages. According to Mr. Kozak, Mr. Bigelow had
prevailed by virtue of Mr. Kersting's promise not to enforce
notes that Mr. Bigelow had signed in connection with his
participation in other Kersting programs. Mr. Bigelow used
Mr. Kersting's written promise that he would not enforce
promissory notes to prevent Mr. Kersting from asserting the
principal on the notes as a defense or offset to Mr. Bigelow's
claim to the equity buildup in the mortgage funding program.
- 66 -
and Michael Provan35) and that he knew the Kersting programs and
how to locate Mr. Kersting's assets.36 On June 2, 1987,
Mr. Huestis agreed to send a copy of the Thompson file to
Mr. Kozak. On the same date, Mr. Huestis notified Mr. Yamada
that the Thompsons did not plan to retain the Chanin firm to
bring suit against Mr. Kersting.
Messrs. Bigelow, Provan, and Thompson all asked Mr. Kozak to
investigate the filing of a lawsuit against Mr. Kersting. On
August 6, 1987, Mr. Kozak wrote to Mr. Thompson and suggested
that there was a good chance of obtaining a large judgment
against Mr. Kersting through a class action lawsuit, but that
collection of any such judgment would be uncertain. In addition,
Mr. Kozak's letter states in pertinent part:
As you know, Kersting is now embroiled with the
IRS on behalf of his clients. I recently had a
conference with Ken McWade, local counsel for the IRS.
He tells me the trial of these cases will be no sooner
than late Spring 1988. I suspect 12-18 months is a
more realistic date. Also McWade stated he is 100%
sure Kersting will be unable to show any "purposive"
function of his corporations other than to avoid taxes.
Several witnesses including yourself are available to
McWade to prove Kersting never had any intention of
enforcing the notes he had his clients execute. Also,
I am suspicious that Kersting's representation that his
35
Mr. Kozak had represented Mr. Provan when he had been
sued as a director of First Savings. The representation ended
with a settlement with the company that provided First Savings'
officers and directors liability insurance. Mr. Kozak did not
represent Mr. Provan in any tax controversies with the Internal
Revenue Service related to the Kersting programs.
36
As discussed in greater detail, infra pp. 115-116,
Mr. Kozak and his wife, Susan K. Kozak, had participated in one
or more of the Kersting programs that were the subject of this
Court's opinion in Pike v. Commissioner, 78 T.C. 822 (1982).
- 67 -
companies are making loans, leasing cars and factoring
accounts in any meaningful business sense is without
any merit.
Further, I believe we will find that Kersting did
not do many of the "house keeping" accounting and legal
matters which needed to be done to qualify his schemes
before the IRS, even if there was an arguable business
purpose position for his schemes under the tax code.
In my estimation, those clients of Kersting who
continue to be represented by Kersting's lawyers are
headed towards a nightmare. Interest continues to
mount on the taxes due. By the time the pilots finally
get a decision from the tax court, they will be in
terrible financial condition. Of course, they will
still have to pay the tax since bankruptcy will not
terminate their tax liability.
Those who are smart enough should disassociate
themselves from Kersting's lawyers now, obtain their
own counsel, offer their testimony as part of their
negotiations with the IRS and buy out as cheap as they
can now!
There is no evidence in the record that the Thompsons have
ever filed a lawsuit against Mr. Kersting or that Mr. Kersting
has ever filed a lawsuit against the Thompsons. There is no
documentation in the record to support Mr. Thompson's statement
to Mr. Kersting in 1986 that in 1982 he had asked Mr. Kersting to
terminate Mr. Thompson's participation in the Kersting programs.
B. The Alexander Dispute
As previously mentioned, Mr. Alexander first met
Mr. Kersting in Los Angeles in the early 1960's. In the mid-
1970's, Mr. Alexander lent over $100,000 to Mr. Kersting to
assist him in the acquisition of Cosmopolitan Financial Corp.
Mr. Alexander's creditor's interest in Cosmopolitan evolved into
a stock interest in Charter Financial. Mr. Alexander also lent
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$80,000 to Mr. Kersting's subchapter S leasing corporations in
the 1970's.
In 1977, Mr. Alexander, a minority shareholder of First
Savings, met with Mr. Kersting to discuss the possible
acquisition of the company. Mr. Alexander participated in the
acquisition of First Savings and added to his First Savings stock
holdings in the process. Mr. Alexander participated in certain
Kersting programs at issue in Dixon II during the taxable years
1974 through 1977.
In 1980, Mr. Alexander brought suit against Mr. Kersting
in Hawaii State court seeking the repayment or return of
approximately $450,000 that Mr. Alexander claimed he had lent to
or invested with Mr. Kersting. Mr. Kozak initially represented
Mr. Alexander in this litigation. Mr. Kersting and/or his
companies eventually filed counterclaims in excess of $4 million
against Mr. Alexander. Mr. Moseley represented Mr. Kersting in
the Alexander litigation.
In March 1982, Mr. Alexander received a telephone call from
Internal Revenue Service Special Agents George Scott and Mike
Duncan, who were interested in questioning Mr. Alexander
regarding Mr. Kersting's various programs. The record does not
reflect whether Mr. Alexander ever agreed to be questioned by the
agents.
The Alexander/Kersting litigation eventually was submitted
to arbitration during a week-long proceeding in July 1987.
During the arbitration proceeding, Mr. Kersting discovered that
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Messrs. Alexander, Kozak, and Matsumoto had contacted Mr. McWade
to discuss whether the Government would pay a finder's fee
for information pertaining to Mr. Kersting's programs.
Mr. Alexander's discussions with Mr. McWade on the subject of
a finder's fee are discussed in greater detail, infra pp. 106-
115.
In a letter dated July 24, 1987, Mr. Kersting brought his
dispute with Alexander to the attention of Chicoine and Hallett,
stating as follows:
Dear Darrell:
I have spent the better part of this week in
arbitration hearings concerning a case whereby we are
attempting to accomplish an offset of debt owed us by a
Mr. Denis Alexander against certain obligations we have
to him. The matter has been going on for more than six
years and has become sheer agony.
During the course of the proceedings, however, certain
matters came to the surface which will become apparent
to you as you will read the enclosed material. The
material will disclose a conspiracy between McWade,
DEnis [sic] Alexander, an accountant by the name of
Gilbert Matsumoto and an attorney by the name of
Charles Kozak.
Here are some short facts to illuminate the case:
DEnis [sic] Alexander was a long-time friend going back
more than 25 years, until we locked horns over the debt
referred to above.
Gilbert Matsumoto is an accountant who was for years
the tax preparer for our Finance Company in Aiea,
Federated Finance Company, and for about 10 to 14 of
our clients which we had referred to him. He had given
me an opinion with respect to the viability of the
SubChapter S concept which we employed in the mid-70s
for our Leasing Companies. He, in fact, did the filing
of SubChapter S qualification forms for us with the IRS
in Fresno, Calif. and did some of the Tax Returns. I
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adapted the SubChapter S principles on the strength of
his advise [sic].
Charles Kozak is an attorney here in town who was at
one time a shareholder in one of our SubChapter S
Leasing Companies and also a participant in other
programs. He did some legal work for us in the mid-70s
in chasing a dead-beat by the name of Feliciano and he
obtained judgement for us. He became an adversary
after he had made no lease payments on a car which we
had leased to him which compelled us to repossess the
car. He was delinquent by more than one year. He has
stirret [sic] up trouble for me ever since.
These three characters now conspired with McWade to
initiate criminal proceedings again against me and, as
you will read, already discussed among themselves how
to divide the "finders fee" (more precisely the Judas
ducats) which they expected to receive from IRS. As we
took Alexanders [sic] testimony this week it became
apparent to Kozak that he had acted unethically and he
read a statement into the records that "he had advised
his client (Alexander) not to engage in reporting me to
the IRS in order to extract from me a settlement of his
claims" which, of course, is self-defeating since he
was an active participant in the scheme.
I have reason to believe that all of this led nowhere.
If even entrapment and subsequent raid on our premises
did not yield the evidence for the CID characters to
take me out of circulation the Kozak / Alexander /
Matsumoto / McWade conspiracy had no prospect of
success. More than a year has gone by since these rats
tried to make money by setting me up for execution.
I will assume that this incident will become a piece
of the mosaic which should be made known to the US Tax
Court Judge in support of my contention that IRS and
it's [sic] representatives have conspired to ruin my
business and inflict harm on me personally, one way or
another.
Following the arbitration hearing, Mr. Moseley filed a
complaint with the Supreme Court of the State of Hawaii, Office
of Disciplinary Counsel (HODC), accusing Mr. Kozak of conflict of
interest and of attempting to extort money from Mr. Kersting in a
civil suit. On March 17, 1988, Mr. Kozak submitted a written
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response to the HODC in response to Mr. Moseley's complaint.
Mr. Kozak alleged that he had been offered inducements by the
Internal Revenue Service in exchange for his cooperation in an
Internal Revenue Service investigation of Mr. Kersting,
suggested that HODC should contact Mr. McWade, denied that he
used the threat of Internal Revenue Service litigation against
Mr. Kersting, and denied any conflict of interest. On April 12,
1988, Mr. Kozak wrote another letter to HODC stating that the
Internal Revenue Service had agreed to pay Mr. Kozak and
Mr. Alexander for their cooperation in an Internal Revenue
Service investigation of Mr. Kersting. At the evidentiary
hearing in this proceeding, Mr. Kozak testified that his
statements to HODC that the Internal Revenue Service had agreed
to pay him for cooperation in an investigation of Mr. Kersting
were false.
On July 12, 1988, the arbitrator released his Arbitration
Decision and Award denying all claims and counterclaims between
Messrs. Alexander and Kersting.37 The arbitrator's decision
37
Following the issuance of the arbitration decision, the
Alexanders claimed a net operating loss (NOL) on their 1988 tax
return in the amount of $321,000 identified as amounts "expended
for the purpose of starting new businesses deemed to be
unretrievable by the American Arbitration Association". The
Alexanders later claimed an NOL in the amount of $360,260 on
their 1990 tax return and an NOL carryforward of $201,955 and a
loss "due to fraud" in the amount of $129,000 on their 1991 tax
return. The Alexanders' 1991 tax return included the following
statement:
The loss was $450,000. $321,000 was claimed on the
1988 returns. $129,000 was not claimed because
(continued...)
- 72 -
turned largely on the lack of credibility of both parties.
The record does not reflect the outcome of Mr. Kersting's
complaint filed with HODC against Mr. Kozak.
C. Collection Actions
In Dixon II, the Court described Mr. Kersting's 1980 dunning
letter to more than 30 program participants and several lawsuits
brought during the period 1983-86 in the names of Kersting
corporations against Kersting program participants to collect
amounts purportedly due on promissory notes. See Dixon II, 62
T.C.M. (CCH) at 1466-1467, 1505-1506, 1991 T.C.M. (RIA), at 91-
3007 to 91-3008, 91-3048 to 91-3050. Summarized below are the
Court's findings and conclusions in Dixon II regarding the
collection lawsuits.
1. Steve Hane
In 1983, a Kersting company, Atlas Funding, commenced an
action on a $30,000 renewal primary note for a stock subscription
plan against Kersting program participant Steve Hane. The Court
noted that the Hane litigation was the only example in the record
37
(...continued)
recovery was expected in the future. In 1991 the
assets on which the recovery was anticipated
disappeared because the corporation was absorbed and
ceased to exist.
Upon examination of the Alexanders' returns for 1990 and
1991, the Commissioner disallowed the claimed NOL's and fraud
loss. After the Alexanders agreed to these adjustments, the
Commissioner issued a notice of deficiency to the Alexanders
determining accuracy-related penalties attributable in part to
the disallowed losses. In Alexander v. Commissioner, T.C.
Summary 1997-80 (docket No. 8948-95S), the Court sustained the
Commissioner's determinations.
- 73 -
of litigation on a primary note. The Court concluded that the
evidence of the Hane litigation was inconsequential because of
the lack of any testimony about the matter and the fact that
Atlas Funding dismissed the action voluntarily after obtaining a
default judgment.
2. Carl Mott, George Vermef, and Robert Peterson
In Dixon II, the Court found that Kersting corporations
pursued collection lawsuits in 1985-86 on leverage loans against
Kersting program participants Carl Mott, George Vermef, and
Robert Peterson. The Court noted that while Carl Mott had been
sued only for interest on leverage loans, Messrs. Vermef and
Peterson had been sued for both interest and principal on
leverage loans. The Court found that there was no explanation in
the record how Messrs. Vermef and Peterson could have owed
principal on leverage loans that would be consistent with the way
the Kersting programs were intended to operate nor with the way
that they apparently actually operated. Further, the Court found
that the judgments entered against Mr. Vermef were vacated after
the parties agreed to settle the cases and that a default
judgment entered against Mr. Peterson later was set aside on
Mr. Peterson's motion. The Court summarized its conclusions
regarding collection activities and litigation as follows:
Five Kersting corporations commenced actions
against Carl Mott based upon a year of unpaid interest
on 15 leverage notes, but the principal amounts of the
notes were not in issue. The record is replete with
copies of checks, drawn on personal bank accounts other
than Liberty Bank or Hawaii National Bank, that
petitioners used to pay interest on leverage notes.
- 74 -
Respondent does not dispute that Kersting insisted on
these interest payments, but maintains that to the
extent they were made they must be characterized as
fees to Kersting for providing tax deductions.
Consequently, that Carl Mott allegedly failed to pay
interest on leverage notes is of no significance to the
substance of his or anybody else's leverage loans.
* * * * * * *
As illustrated by Kersting's pay-or-else letter
to over 30 clients on September 25, 1980, and his 1986
correspondence with the Thompsons, his overriding
concern was to be compensated by means of leverage loan
interest. It was this amount that even he often
referred to as a "fee" or a deductible "cost" of tax
deductions. In encouraging clients by means of the
September 25, 1980, letter to "discharge the debt to
which you are a party," he sought only small amounts
that could not have represented typical primary or
leverage loans. His letters to the Thompsons indicate
that he only threatened or pursued collection of
principal obligations when the investor neglected or
refused to pay leverage loan interest. This rare
occurrence, which Kersting did not testify he either
intended or expected, is not sufficient to transform
any of petitioners' loans from Kersting corporations
into genuine recourse indebtedness.
Dixon II, 62 T.C.M. (CCH) at 1505-1506, 1991 T.C.M. (RIA), at 91-
3049 to 91-3050.
VI. Settlements
A. Internal Revenue Service Policy
1. National Office Position
After a tax shelter project is created and a project
attorney and a project Appeals officer are appointed, an official
project settlement offer is determined by the project Appeals
officer, the project attorney, and District Counsel. The project
attorney and project Appeals officer review the strengths and
weaknesses of the particular tax shelter and evaluate the hazards
- 75 -
of litigation to determine an appropriate project settlement
offer. Upon determination of the project settlement offer, the
terms of the offer are reported to the Tax Shelter Branch in the
National Office for dissemination to Internal Revenue Service
field offices (particularly the examination and appeals
functions) throughout the country to ensure that similarly
situated taxpayers are treated consistently.
Once a tax shelter project is assigned to a particular
District Counsel office, that office has the authority to settle
any individual case in the project. District Counsel generally
is expected to adhere to the official project settlement offer.
Nevertheless, District Counsel has the authority in special
circumstances to settle individual tax shelter project cases on a
basis different from the project settlement offer. For example,
District Counsel could deny a project settlement offer to the
shelter promoter or a participant who had helped to market the
program. In addition, District Counsel might eliminate an
addition to tax (such as negligence) because of the participant's
lack of education or sophistication in financial matters.
District Counsel can alter or modify an official project
settlement offer without prior approval of the National Office.
However, District Counsel is required to notify the Tax Shelter
Branch of any change or modification to the official project
settlement offer in order to allow the Tax Shelter Branch to
disseminate the revised offer to Internal Revenue Service offices
throughout the country.
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The National Office did not maintain a policy prohibiting
the settlement of a test case. However, the Commissioner's
practice of withdrawing project settlement offers once the
project test cases have been set for trial would serve to bar
settlements in test cases and nontest cases alike.38
2. Regional Counsel
Benjamin C. Sanchez (Mr. Sanchez) served as Regional Counsel
for the Western Region during the period in question. His view
of District Counsel's settlement authority in tax shelter cases
differed from the National Office view. In Mr. Sanchez' view,
District Counsel had authority to settle tax shelter project
cases only on the basis of the official project settlement offer.
Mr. Sanchez believed that District Counsel was obliged to adhere
strictly to the official project settlement offer because of the
overriding need to ensure consistent treatment of tax shelter
project cases. Although Mr. Sanchez acknowledged that District
Counsel technically had authority to settle a tax shelter project
case on a basis different from the official project settlement
offer, Mr. Sanchez believed that it would be improper to do so.
In his view, disciplinary or other adverse career consequences
might follow if District Counsel deviated from the official
project settlement offer in settling a case.
38
Of course, District Counsel might be reluctant to settle
a test case at a time that removal of the case from the test case
array would require delay in the trial to allow the parties to
select a replacement case.
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Mr. Sanchez expected that he would be informed by District
Counsel of settlements in tax shelter project cases that deviated
from the official project settlement offer.
B. Official Kersting Project Settlement Offer (7-Percent
Reduction of Deficiency or Out-of-Pocket Expenses)
Between January 1982 and mid-1986, the terms of the official
Kersting project settlement offer were stated as follows:
You will be allowed your actual out-of-pocket
expenses, in essence, the interest you actually paid
to Henry Kersting on the prepayment loan, or leverage
loan, which amount equals approximately 7% of the
determined deficiencies in most cases. In addition,
if you reported capital gain income from the Kersting
transactions, or recaptured the difference between your
adjusted basis in the stock and your outstanding
indebtedness, then an appropriate adjustment will be
made to reflect this fact. In addition, if you are
involved in a leasing plan, to the extent there are
additional allowable I.R.C. Section 162 expenses which
were not claimed on the return, an appropriate
allowance will be made for settlement purposes. If
you were involved in the Uniform Gift to Minors Act
program, referred to as KAT-FIT (sic), to the extent
you can establish compliance with the Clifford Trust
rules, then an appropriate allowance for the deductions
will be made. The government will concede the
negligence penalties, I.R.C. Section 6653(1) and I.R.C.
Section 6653(a)(2), as well as the I.R.C. Section
6621(c) interest.
The 7-percent reduction of the deficiency reflected a deduction
equal to an average of the actual out-of-pocket expenses in
approximately 25 Kersting project cases. For this purpose, the
Commissioner treated the "interest" paid on Kersting leverage
loans as the out-of-pocket expense. From respondent's
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perspective, the 7-percent settlement offer was equivalent to
allowing a deduction for a theft loss in the year of payment.39
Under the 7-percent settlement offer, the Commissioner
would: (1) Concede the negligence addition to tax and increased
interest imposed on tax-motivated transactions pursuant to
section 6621(c); (2) concede an annual deduction under section
162 or 212 to leasing program participants for expenses that
exceeded the out-of-pocket adjustment; (3) concede the deficiency
in full to participants in the CAT-FIT program who could provide
information on how the funds paid to the minor child were used
and establish that such use did not give rise to constructive
receipt of income by the parents; and (4) make appropriate
adjustments if the taxpayer had reported capital gains upon the
surrender of stock certificates to Mr. Kersting. The purpose of
these concessions and adjustments was to provide similar
treatment of all Kersting program participants who wished to
settle their cases.
C. Deviations From Official Project Settlement Offer
1. Modified 7-Percent Settlement Offer
Between April and September 1986, Mr. McWade and Mr. Seery
conducted settlement negotiations that led Mr. McWade to offer a
settlement that deviated from the official project settlement
39
Respondent's position represented a concession insofar
as the allowance as a deduction of a theft loss of payments
induced by misrepresentation is postponed until the year of
discovery. See sec. 165(e); Bellis v. Commissioner, 61 T.C. 354,
357 (1973), affd. 540 F.2d 448 (9th Cir. 1976).
- 79 -
offer in one significant respect. Specifically, by September
1986, Mr. McWade and Mr. Seery had agreed to modify the 7-percent
settlement offer to incorporate a new feature they called the
"shelter burnout" that would apply in cases involving more than 1
taxable year. The shelter burnout feature grew out of Mr.
Seery's contention that Mr. Kersting's programs could be viewed
as a tax deferral mechanism.40 Mr. McWade agreed with Mr. Seery,
for settlement purposes, to allow a shifting of the initial
year's deficiency to a later year as a "shelter burnout". For
example, in a case involving 2 taxable years, the taxpayer's
liability for statutory interest under section 6601 was computed
under the modified 7-percent settlement offer by treating the
taxpayer's tax liability for the earlier of the 2 years as having
been incurred on the due date for payment of tax for the later
year. Under this approach, the total amount of the taxpayer's
underlying tax deficiencies remained the same, but the taxpayer's
liability for interest on the deficiencies was reduced by the
amount of such interest that otherwise would have accrued on the
deficiency for the earlier year of the 2-year period. Variations
of this approach were used in cases involving more than 2 taxable
years. The modified 7-percent settlement offer negotiated by
40
In Dixon II, the Court considered and rejected the
argument that Mr. Kersting's programs resulted in mere tax
deferral. The Court arrived at this conclusion through a
detailed analysis of the Cravenses' tax returns for 1979 and
1980. See Dixon II, 62 T.C.M. (CCH) at 1483-1484, 1991 T.C.M.
(RIA), at 91-3026.
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Mr. Seery and Mr. McWade provided that the Commissioner would
settle any additions to tax for fraud on a case-by-case basis.
By letter dated September 29, 1986, Mr. Seery informed
Kersting program participants of the terms of the modified 7-
percent settlement offer and suggested that they give serious
consideration to the proposal. Mr. McWade informed Mr. Seery
that, because the trial of the test cases had been set for
February 1987, the modified 7-percent settlement offer would be
withdrawn on December 31, 1986, and that Kersting program
participants interested in accepting the settlement should
contact Mr. McWade by November 10, 1986, in order to allow time
to complete the necessary computations before the withdrawal of
the offer.
On October 10, 1986, Mr. Kersting issued a letter to
Kersting program participants in which he characterized the
modified 7-percent settlement offer as "grossly inadequate."
Messrs. Sims and McWade did not notify the National Office,
Regional Counsel, or the Appeals Office that they had
incorporated the burnout feature in their offer to settle
Kersting project cases.
2. 20-Percent Settlement Offer
Between September and December 1986, Mr. McWade and Mr. Sims
began to offer 20-percent settlements that were based on the same
general approach as their modified 7-percent settlement offer
that included the burnout feature. The 20-percent settlement
approach originated in late 1986 in separate negotiations between
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Mr. Sims and Mr. Chicoine and between Mr. McWade and
Mr. DeCastro. The enhanced 20-percent settlement offer reflected
the perceptions of Messrs. Sims and McWade that the evidentiary
issues raised by Chicoine and Hallett increased respondent's
risks of litigation.
The 20-percent settlement offer was not disseminated in
writing by either Mr. Sims or Mr. McWade. The existence of the
20-percent settlement offer became known, if at all, through a
combination of Mr. Kersting's letters to program participants
and calls that Mr. McWade received from Kersting program
participants. Messrs. Sims and McWade did not request approval
from or otherwise inform the National Office, Regional Counsel,
or the Appeals Office before making the 20-percent settlement
offer.
Following the February 1987 Maui session, the Honolulu
Appeals Office once again began to offer Kersting program
participants a deduction for their cash out-of-pocket expenses,
or if substantiation was not available, a reduction of the
deficiency by 7 percent, with a waiver of the additions under
section 6653(a)(1) and (2). The Honolulu Appeals Office did not
learn that Mr. McWade had negotiated 20-percent settlement offers
until mid-1988, following issuance of the Court's opinion in
Dixon I. At that time, the Honolulu Appeals Office determined
not to extend such offers because it saw no reason to deviate
from the official 7-percent project settlement offer.
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3. Negotiations for 50-Percent Settlement Offer
In January 1987, Messrs. Sims and Chicoine continued their
efforts to negotiate a settlement of the Kersting project cases.
Initially, their discussions concerned a higher percentage
settlement if Mr. Kersting would agree to quit the tax shelter
business. They eventually abandoned their discussions to link
the settlement offer with Mr. Kersting's future conduct.
By letter dated January 16, 1987, Mr. Chicoine notified
Mr. Kersting that he believed he had arrived at an agreement with
Mr. Sims to settle all the Kersting cases docketed in the Tax
Court by allowing 50 percent of the claimed interest deductions.
Mr. Chicoine's letter further states that Chicoine and Hallett
would agree to represent Kersting program participants desiring
to settle their cases on these terms for a flat fee of $550 per
case.
On January 19, 1987, Mr. Kersting wrote a letter to program
participants stating that a 50-percent settlement had been
negotiated. Mr. Kersting recommended that the 50-percent
settlement be accepted; he included with his letter a form for
program participants to use to authorize Chicoine and Hallett to
represent them for purposes of settlement. As a result of
Mr. Kersting's letter, approximately 300 Kersting program
participants contacted Chicoine and Hallett seeking
representation.
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In the meantime, Mr. Sims consulted Barbara Leonard, Deputy
Regional Counsel for the Western Region. She directed him to
terminate negotiations based upon a 50-percent settlement.
Upon learning of Mr. Kersting's letter, Mr. DeCastro called
Mr. Chicoine to inquire about the terms of the purported 50-
percent settlement. Mr. DeCastro stated that the terms of the
purported settlement were better than the terms he had
received for his clients and that he intended to attempt to
obtain the same terms for his clients. During his conversation
with Mr. Chicoine, Mr. DeCastro threatened to "make trouble" for
Mr. Chicoine unless he referred clients residing in California to
Mr. DeCastro for further representation. Mr. Chicoine flatly
rejected Mr. DeCastro's proposal.
Following the release of Mr. Kersting's January 19, 1987,
letter, Mr. Sims received numerous telephone calls from Kersting
program participants and attorneys seeking to accept the 50-
percent settlement. Following his conversation with
Mr. Chicoine, Mr. DeCastro called Mr. Sims to express concern
that Mr. Chicoine's clients might obtain more favorable
settlements than the settlements offered to Mr. DeCastro's
clients.
By letter to Mr. Chicoine dated February 4, 1987, during the
week immediately preceding the Maui session, Mr. Sims denied that
he had agreed to a 50-percent settlement of the Kersting project
cases. Mr. Sims' letter states in pertinent part:
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1. I have not settled any of the Kersting cases
with you.
2. The government has not made any new, blanket
offer to settle these cases (other than our old 7%
offer); nor has the government made any offer to wholly
or partially concede any of the issues presented by
these cases. To the extent that you may disagree with
this statement, any such offer of concession that you
believe has been made by me or any other government
official is hereby withdrawn.
3. We do not have a workable basis for settlement
of any case or any group of cases. If you should
attempt to represent to the Court that you have such a
basis, either in order to obtain a continuance of the
trials in this matter or to attempt to force the
government into unagreed-to settlements or concessions,
I will dispute this firmly.
Before the start of the Maui session, Judge Goffe held a chambers
conference with Messrs. Chicoine, Hallett, Sims, McWade, O'Neill,
and DeCastro. Although Mr. Chicoine told Judge Goffe that the
parties had reached a basis of settlement, Mr. Sims denied that
there was a settlement. Mr. Sims said that he had "pulled
the plug" on a proposed 50-percent settlement because
Mr. Kersting had interfered with the negotiations.
4. Revival of 20-Percent Settlement Offer
During spring 1987, Mr. Chicoine continued to explore with
Mr. McWade the possibility of a global settlement. By letter
dated April 13, 1987, Mr. Chicoine provided Kersting program
participants with a detailed status report addressing
developments at the Maui session as well as settlement
negotiations. Mr. Chicoine's letter also stated that the firm's
representation of nontest case taxpayers was not intended to
extend to general representation in all matters but was limited
- 85 -
to the acceptance of an Internal Revenue Service settlement
offer.
On April 16, 1987, Mr. Chicoine wrote to Mr. Kersting and
confirmed that he would be meeting Mr. McWade in Hawaii the
following week to discuss the possible settlement of six cases.
Mr. Chicoine warned Mr. Kersting not to address the subject of
the status of settlement negotiations in his letters to Kersting
program participants, inasmuch as his comments could be
detrimental to such negotiations. On or about April 27, 1987,
Mr. Chicoine informed Mr. Kersting that he would recommend that
Kersting program participants accept a 20-percent settlement
offer.
By letter dated May 22, 1987, Mr. Kersting provided
Mr. Hallett with information pertaining to a purported 30-percent
settlement negotiated by Mr. DeCastro on behalf of Benness M. and
Jane Richards.41 Mr. Kersting stated that he was attempting to
obtain information respecting additional settlements negotiated
by Mr. DeCastro. Between May 1987 and February 1988,
Mr. Kersting wrote no fewer than seven letters to Chicoine and
Hallett strongly objecting to their communication of a 20-percent
settlement offer to Kersting program participants. In his
41
In Richards v. Commissioner, T.C. Memo. 1997-149,
supplemented by T.C. Memo. 1997-299, affd. without published
opinion 165 F.3d 917 (9th Cir. 1998), we observed that the
settlement may have been detrimental to Mr. and Mrs. Richards
insofar as the original deficiency had been computed using an
excessive tax rate (70 percent) and may have been based in part
upon the disallowance of legitimate non-Kersting interest
deductions. See supra p. 27.
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May 22, 1987 letter, Mr. Kersting objected to Chicoine and
Hallett's recommendation of a 20-percent settlement in pertinent
part as follows:
As I have done several times now I ask you again NOT to
communicate to anyone of my friends a prospect of a 20%
settlement. The 50% flop has left a $40,000.00 to
$50,000.00 scar with us. It was a lesson I will take
with me to the other side. I trust that you have
reconsidered by now your position in the matter and
that you will NOT go into an adverse stance to me and
my enterprises. I assure you that the jolt of April
27th has not worn off yet.
On June 10, 1987, Mr. Kersting forwarded to Mr. Chicoine a
letter that he had received from Mr. DeCastro pertaining to a
settlement that Mr. DeCastro purportedly negotiated on behalf of
Boyd S. and Jeannette F. Proctor. By letter dated June 16, 1987,
Mr. Chicoine responded to Mr. Kersting, stating that he was
satisfied that the Proctors did not receive a settlement in
excess of 50 percent as Mr. Kersting had suggested because the
figures in question did not include the Proctors' liability for
statutory interest. Mr. Chicoine concluded that the settlement
was in the range of a 14-percent reduction of the Proctors'
deficiency.
On November 4, 1987, Mr. Kersting sent Mr. Hallett a letter
which states in pertinent part:
Here I asked you about a year ago to defend my
friends, here I had high hopes and reasonable
expectation that you would work with us, that we would
work on consensus and to the common benefit of my
friends and here I find that you not only do not care
to do that, you are actually moving into an adversary
position. And this after I have paid you an enormous
amount of legal fees and after I have disciplined
myself over and over again to keep my temper as I
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observe a widening rift between the attorneys who are
supposed to work for us and who are, instead, looking
after their strangly [sic] perceived protection from
liability. My interest in these proceedings and what
I consider to be the best interest of my friends is
arrogantly overlooked and we are, if your scheme of
things would prevail, relegated to onlookers to a
spectacle for which we are compelled to pay but in
which we are not allowed to take part. It is simply
absurd.
On January 12, 1988, Mr. Kersting issued a letter
encouraging nontest case Kersting program participants who had
paid $550 to Chicoine and Hallett for representation in the
settlement process to "recall your funds".
By letter dated January 20, 1988, Mr. Chicoine notified the
test case petitioners represented by his firm that Mr. McWade was
offering a 20-percent settlement. Mr. Chicoine's letter states
in pertinent part:
Mr. McWade has stated that you may settle your case
along the grounds set forth above. Since you are a
test case, however, you will not be permitted to
withdraw if you wish to enter into the settlement
proposed. Accordingly, we would enter into an
agreement with Mr. McWade that regardless of the
outcome of the trial, you would be allowed the
settlement. Thus, if the case were lost in its
entirety, your tax deficiency would be calculated in
accordance with the settlement.
By letter dated January 22, 1988, Mr. Hallett informed
Mr. Kersting that Chicoine and Hallett were seeking an opinion
from an expert on legal ethics whether it would be appropriate
for the firm to accept new clients seeking to settle Kersting
project cases. However, Mr. Hallett stated that the firm would
continue to inform its existing clients regarding the status of
settlement discussions.
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By letter dated January 29, 1988, Mr. Chicoine sent
Mr. Kersting copies of proposed stipulated decisions reflecting
settlements that Mr. Chicoine had negotiated with Mr. McWade in
three Kersting cases.42 Mr. Chicoine stated that Chicoine and
Hallett were obliged to inform all Kersting program participants
who had retained his firm that Mr. McWade was continuing to offer
settlements despite Mr. Kersting's misrepresentations in his
letters to Kersting program participants that no settlement was
being offered.
By letter dated February 5, 1988, John A. Strait, Associate
Professor of Law at the University of Puget Sound School of Law
(Professor Strait), responded to Chicoine and Hallett's request
for an expert opinion regarding their ethical obligations as
counsel in the Kersting project. Professor Strait advised
Chicoine and Hallett that the firm did not have an attorney/
client relationship with, or owe attorney/client duties to,
Mr. Kersting, but that Chicoine and Hallett did have an
attorney/client relationship with the test case petitioners as
well as the nontest case Kersting program participants who had
sent Chicoine and Hallett the $550 retainer and authorization
forms. Concerning the nontest case clients, Professor Strait
concluded that Chicoine and Hallett were obliged to "evaluate
settlement proposals and to transmit to them your recommendation
42
Mr. Chicoine's letter identified the taxpayers as
Muller, Lipsky, and Mellows. The record does not reflect the
terms of the settlements in these cases.
- 89 -
with the explanation of what the options might be as to the
desirability of accepting any settlement proposal."
On February 6, 1988, Mr. Kersting wrote to Mr. Hallett
stating in pertinent part:
I take it from our phone conversation yesterday that
you are intent now to trigger the melt-down on me and
our corporations with which you have threatened me now
for months. And if I have absorbed all this correctly,
you will do this mainly out of concern that some of my
friends might sue you at some time down the line if you
do not advise them of a "settlement" which you perceive
to be available.
The bitter irony of all this is that there was only a
remote possibility that anyone of my friends would sue
you. If you go through with your threat to cause a run
on us you will have THE CERTAINTY that there will be
litigation. It will be hell after this.
On February 8, 1988, Mr. Kersting wrote a letter to Kersting
program participants warning them that Chicoine and Hallett soon
would circulate the details of a 20-percent settlement offer.
Mr. Kersting urged Kersting program participants not to hire
Chicoine and Hallett for purposes of settlement and instead to
await the Court's decision regarding the evidentiary issues
raised by Chicoine and Hallett on behalf of the test cases.
During this period, Mr. Kersting threatened to sue Chicoine and
Hallett if they reported the settlement offer.
On February 9, 1988, Mr. Chicoine issued two letters, one
addressed to the firm's clients and one addressed to Kersting
program participants who had contacted Chicoine and Hallett
regarding representation. These letters served as status reports
on the Tax Court case and settlement negotiations. Mr. Chicoine
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reported that Mr. McWade had offered to settle docketed Tax Court
cases in accordance with the previously described 20-percent
settlement offer, recommended that program participants seriously
consider the settlement, and suggested that those who desired to
settle on these terms should contact Chicoine and Hallett.
On February 20, 1988, Mr. Kersting wrote to Chicoine and
Hallett stating in pertinent part: "I hereby revoke your
appointment as counsel for the test cases".
On February 23, 1988, Mr. Chicoine wrote to Mr. McWade
seeking a 20-percent settlement on behalf of test case
petitioners Terry D. and Gloria K. Owens. Mr. Chicoine's letter
states in pertinent part:
Mr. Owens understands that not all cases will settle
and you wish to proceed to trial with some test cases.
It is hoped that under the circumstances he may be
withdrawn as a test case. If this is not possible,
he still wishes to settle the case and enter into an
agreement which will permit him to settle the case
regardless of the outcome of the trial.
Mr. and Mrs. Owens subsequently decided that they would not
continue efforts to settle their case.
In early March 1988, Chicoine and Hallett began receiving
requests from Kersting program participants for return of the
$550 retainer fee. Although Chicoine and Hallett returned the
full amount of the fee to all those who requested it, they were
informed that they might be billed for a "minimal amount"
reflecting the firm's costs associated with the opening of files
and issuance of status reports.
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On March 9, 1988, Mr. Kersting issued a letter to program
participants characterizing Chicoine and Hallett as "scoundrels",
and stating that he had fired them and retained Mr. Izen to
represent the test cases (excluding the Thompsons and the
Cravenses).
By letter dated April 22, 1988, Mr. Chicoine notified
Kersting program participants that the Court had ruled in the
Government's favor in Dixon I; he restated his support for the
20-percent settlement offer described in his February 9, 1988,
letter and revealed that, because of a disagreement with
Mr. Kersting, Chicoine and Hallett would withdraw as counsel for
the test cases.43
Mr. Kersting later carried out his threat to sue Chicoine
and Hallett for legal malpractice. Mr. Izen served as an expert
witness for Mr. Kersting in his lawsuit against Chicoine and
Hallett.
By letter dated April 8, 1988, Mr. McWade notified
Mr. DeCastro that, after June 15, 1988, respondent would no
43
Coincidentally, on Apr. 20, 1988, Mr. DeCastro wrote a
letter to a client, James Losey, expressing similar sentiments in
favor of settlement of the Kersting cases. After outlining the
deadlines that Mr. McWade had set for the acceptance of
outstanding settlement offers, Mr. DeCastro's letter states in
pertinent part:
There is now an urgent need for your friends and
acquaintances to consult their legal counsel and
seriously consider settling their case with the IRS.
The evidence continues to build against the taxpayers
in these cases and despite Mr. Kersting's assurances,
we feel the trial will be won by the IRS. The result
would be very serious for the taxpayers.
- 92 -
longer consider settlements, other than on the basis of allowing
out-of-pocket expenses, and that out-of-pocket settlements would
no longer be available after October 3, 1988. By memorandum
dated October 19, 1988, the Acting Chief of the Tax Shelter
Branch notified the Assistant Commissioner for Examination (with
copies to the Director of the Appeals Office, Mr. McWade, and
several National Office executives) that, because the Kersting
test cases had been set for trial in January 1989, the
Kersting project settlement offer would be withdrawn, effective
October 28, 1988.
D. The Thompson Settlement
1. Initial Thompson Settlement Agreement
In early December 1986, Mr. McWade and Mr. DeCastro
discussed settlement of the cases of a number of Mr. DeCastro's
clients, including the Thompsons. Mr. Sims was aware of the
McWade-DeCastro discussions when he also met with Mr. DeCastro in
December 1986 at the Honolulu District Counsel Office and
generally discussed with Mr. DeCastro settlement arrangements for
the Thompson cases.
On December 23, 1986, Mr. McWade mailed a letter to
Mr. DeCastro enclosing proposed decision documents for the
Thompsons as well as several other taxpayers with cases before
the Court. Mr. McWade's letter states in pertinent part:
Dear Mr. DeCastro:
Enclosed herewith are the Decision documents, as
per our conference, in the above-captioned cases.
Please sign the original and one copy of the Decision
document, in the space provided, and return them to
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this office for signing and filing with the Court. The
remaining copy is for your records.
As previously indicated, the Decision documents in
John R. and Maydee Thompson will not be filed with the
Court until the Decision becomes final in the test
cases. In the interim, the Thompsons can make an
advance payment, as discussed at our conference, and
stop the accrual of any additional liability for
interest.
In response, on December 30, 1986, Mr. DeCastro executed three
separate decision documents on behalf of the Thompsons agreeing
to the following deficiencies:
Year Deficiency Additions to Tax
1979 --- ---
1980 $34,425 ---
1981 30,000 ---
The December 1986 settlements that Mr. McWade extended to
Mr. DeCastro's clients differed from the 7-percent official
Kersting project settlement offer used by respondent's Appeals
Office. In particular, the Thompson settlement included the
burnout feature and was based on a reduction of the deficiencies
that respondent had determined against the Thompsons of
approximately 19 percent as follows:
Year Adjustment Deficiency Settlement % Reduction
1979 $39,477 $18,161 ---
1980 72,840 24,838 $34,425
Total 42,999 34,425 20%
1981 $80,782 36,295 30,000 17
All years total 79,294 64,425 19
The adjustments for each year consisted solely of the
disallowance of deductions that the Thompsons had claimed with
respect to Kersting programs.
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On December 30, 1986, Mr. Thompson sent a letter to
Mr. McWade enclosing checks for $34,000 and $25,545 that were
intended as payments of interest on the Thompsons' tax
liabilities for the taxable years 1980 and 1981, respectively.44
2. First Revision of Thompson Settlement
On January 27, 1987, Mr. Huestis sent a letter to
Mr. DeCastro stating that Mr. Thompson did not understand the
terms of his settlement. On February 3, 1987, Mr. DeCastro
responded to Mr. Huestis as follows:
Dear Sam:
Thanks for your letter of January 27, 1987
indicating questions which Jack Thompson has regarding
the proposed settlement. I will respond in the order
of your questions:
1. The only years in dispute are 1979, 1980 and
1981.
2. For each year, the amounts claimed due by the
I.R.S. by category are:
1979 1980 1981 Total
Tax deficiency $18,161 $24,838 $36,295 $79,294
Penalty 908 1,242 19,757 21,907
Interest 19,977 24,838 27,976 72,791
39,046 50,918 84,028 173,992
3. By the terms of the proposed settlement, the
following amounts are due to be paid by Jack:
44
Many Kersting program participants, like the Thompsons,
made interest payments on or immediately before Dec. 31, 1986,
in order take advantage of the full deductibility of interest
in 1986. The deductibility of payments of personal interest was
subject to phase-out for taxable years beginning after Dec. 31,
1986, pursuant to TRA sec. 511(b), 100 Stat. 2246.
- 95 -
1979 1980 1981 Total
Tax deficiency 0 $34,425 $30,000 $64,425
Interest 0 35,275 24,270 59,545
0 69,700 54,270 123,970
As you can see, this amounts to a substantial
reduction in tax liabilities.
4. Jack correctly understands that his recent
payment of $59,545 was entirely applied to interest.
5. The IRS is willing to settle with Jack only on
the basis that his test case remains active. The terms
are not contingent upon any specific testimony or
degree of cooperation and will be filed upon completion
of the test case. Jack need only testify, at the trial
and is only technically a defendant. Unless some
dramatic changes in schedule occur, there will be no
depositions. Essentially, Jack need only testify, be
protected from Kersting, and does not need to prepare a
full-blown defense.
6. As indicated, the IRS insists upon Jack
continuing as a test case defendant for its own
purposes. That is presently a condition of the
settlement. In addition, we simply do not trust
Kersting to act in accordance with his promises and
staying in the case appears to be wise insurance to
obtain cancellation of the notes, etc.
7. I enclose a copy of a letter we have sent to
Kersting's attorney regarding the notes issue for your
information.
8. If we are unable to obtain a cancellation of
notes and recovery of funds invested for Jack through
negotiation, we will certainly look to retain John
Chanin or other local counsel for that purpose.
On February 6, 1987, Mr. Huestis reviewed Mr. DeCastro's letter
with Mr. Thompson and was satisfied that Mr. Thompson understood
the status of his case.
On March 13, 1987, following the Maui session, Mr. McWade
sent Mr. DeCastro a revised decision for docket No. 31236-84
reducing the Thompsons' tax deficiency for 1980 from $34,425 to
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$33,000. Mr. Sims reviewed and approved Mr. McWade's letter to
Mr. DeCastro. Although the record contains no explanation for
this revision of the Thompson settlement, the revision
effectively increased the Thompson settlement from 19 percent to
approximately 20 percent. On April 7, 1987, Mr. DeCastro sent
Mr. Thompson a letter informing him that the Internal Revenue
Service had reduced his tax liability for 1980 by approximately
$1,000. Mr. DeCastro also informed Mr. Thompson that this
reduction would also save him approximately $1,000 in interest.
On June 4, 1987, the Court granted respondent's Motion to
Withdraw Stipulation of Settlement for Tax Shelter Adjustments in
the Thompson cases at docket Nos. 19321-83 and 31236-84.45
Mr. McWade filed the motions on the stated ground that, because
the Thompsons had been designated as test cases, it was
inappropriate for the Thompson piggyback agreements to remain in
effect. Mr. McWade's motions stated that Mr. DeCastro did not
object to the granting of the motions. Because Messrs. McWade
and DeCastro had previously agreed to settle the Thompson cases,
the above-referenced motion is the first instance in which the
Court was misled by the failure of counsel who were in the know
to disclose that the Thompson cases had been settled.
45
The Thompsons had not signed a piggyback agreement for
their case at docket No. 30965-85. The only other test case
petitioners who had signed piggyback agreements were the Dixons,
in their case at docket No. 9382-83, and Mr. Rina, in his case at
docket No. 17640-83. All the piggyback agreements signed by test
case petitioners had been signed in June 1985 and were in the
form of the 1985 agreement set forth supra pp. 44-45.
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On June 15, 1987, Mr. DeCastro sent a $63,000 cashier's
check "in partial payment of the total amount due" to the
Internal Revenue Service Center in Fresno, California, on behalf
of the Thompsons. The remittance was made with respect to the
Thompsons' three docketed cases and included a request that the
matter be referred to a problems resolution officer "so that we
can determine the balance due and conclude this matter." On
June 17, 1987, the Commissioner "transferred" $775 of the $63,000
payment to the Thompsons' account for 1988 and applied the
$62,225 balance to the Thompsons' account for 1979.46 As of June
1987, the Thompsons had paid a total of $121,770 towards their
tax liabilities (tax and interest) for the taxable years 1979,
1980, and 1981.
On July 10, 1987, Mr. DeCastro wrote to Mr. McWade
transmitting a Notice of Overdue Tax received by the Thompsons
with respect to their 1981 income tax liability. Mr. DeCastro
asked Mr. McWade to contact him regarding the notice and to send
him "copies of the decisions entered in this matter." On
July 24, 1987, Mr. McWade sent Mr. DeCastro copies of proposed
decision documents for the Thompson cases. Mr. McWade informed
Mr. DeCastro that "per our understanding, since the Thompsons are
46
The record does not reflect the basis for the
Commissioner's transfer of $775 of the payment to the Thompsons'
account for 1988. Because the 1988 tax year had not even started
on the date of the transfer, there can be no reasonable
explanation for the transfer; perhaps it was a typographical
error and was intended to refer to the taxable year 1978, which
Mr. Huestis had settled on the Thompsons' behalf.
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involved as a test case, the documents are being held in our
files, and will be signed and filed with the Court when the test
case litigation has been completed." The revised decision
documents prepared by Mr. McWade set forth the Thompsons' tax
liabilities as follows:
Year Deficiency Additions to Tax
1979 --- ---
1980 $33,000 ---
1981 30,000 ---
On August 5, 1987, Mr. DeCastro sent copies of the proposed
decision documents to the Thompsons.
3. Second Revision of Thompson Settlement
Before the trial of the test cases, Mr. DeCastro informed
Mr. McWade that the Thompsons were having financial difficulties
and that he did not think that it was fair to require the
Thompsons to remain as test case petitioners. Mr. DeCastro
expressed concern to Mr. McWade about the amount of legal fees
the Thompsons would incur as test case petitioners and informed
Mr. McWade that he would attempt to have the Thompsons removed
from the list of test cases. Mr. McWade told Mr. DeCastro that
he did not want the Thompsons to be removed as test case
petitioners because he did not want to change the test cases so
close to trial. Mr. DeCastro thought that Mr. McWade's desire to
retain the Thompsons on the list of test cases was caused by
administrative or technical concerns.
Mr. DeCastro and Mr. McWade resolved their respective
concerns by further modifying the Thompson settlement. In
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particular, Mr. McWade agreed to reduce the Thompsons'
deficiencies in an amount sufficient to compensate them for the
cost of having an attorney represent them at the trial of the
test cases. Mr. DeCastro estimated that his legal fees for
representing the Thompsons at the trial of the test cases would
be approximately $60,000. Under the revised settlement
agreement, the Thompsons' tax deficiencies were reduced to the
following:
Year Deficiency Additions to Tax
1979 --- ---
1980 $15,000 ---
1981 15,000 ---
By reason of the Thompsons' having previously remitted $121,770
to the Internal Revenue Service for the taxable years 1979, 1980,
and 1981, Mr. DeCastro and Mr. McWade calculated that the above-
described reductions of the Thompsons' deficiencies would
generate refunds of tax and interest to the Thompsons of
approximately $60,000. Mr. DeCastro and Mr. McWade understood
that the refunds generated by the reduced deficiencies would be
used for the purpose of paying the Thompsons' attorney's fees to
Mr. DeCastro.
Although Mr. McWade and Mr. DeCastro agreed to revise the
Thompson settlement in this manner before the trial of the test
cases, the first written confirmation of their agreement appears
after the trial, in the form of an April 10, 1989, memorandum
from Mr. McWade to Tom Stevens (Mr. Stevens), Chief of Special
Procedures in the Collection Division of the Honolulu District
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Director's Office, requesting that the latter process a refund to
the Thompsons in the amount of $30,000.47
E. The Cravens Settlement
By letter dated September 29, 1986, Mr. Seery informed
Mr. Cravens of the terms of the modified 7-percent settlement
offer. On October 28, 1986, Mr. McWade disseminated the modified
7-percent settlement offer by form letter mailed to all known
Kersting program participants, including the Cravenses.48
Considering the nature and purpose of the form letter, it appears
that issuance of the letter to the Cravenses, who had already
been designated test case petitioners, was inadvertent.
On October 15, 1986, Mr. Cravens wrote to Mr. Seery asking
him to explain how the proposed settlement offer affected him and
to give him a recommendation. By letter dated October 23, 1986,
Mr. Seery advised Mr. Cravens to consult a tax preparer or
accountant because the offer was complicated in its application
to his case. Mr. Seery also noted that Mr. Cravens could take
advantage of the unlimited deduction for personal interest in
effect for 1986 by paying the liability in full in 1986 whether
or not he settled his case.49
47
The full text of Mr. McWade's memorandum is set forth
infra p. 137.
48
Mr. McWade's letter included a statement that the
modified 7-percent settlement offer would be withdrawn on
Dec. 31, 1986.
49
See supra note 44 regarding the Thompsons' interest
payment.
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On October 31, 1986, Mr. Cravens again wrote to Mr. Seery
with questions about the settlement offer. In the letter,
Mr. Cravens informed Mr. Seery that he had paid a cash bond
against the deficiency for 1979 and felt "in good shape for that
year." Mr. Cravens then asked whether respondent's determination
to include a dividend in his income for 1980 would be eliminated
to reduce the deficiency for that year. If so, Mr. Cravens
indicated that he would pay the amount that would be due, "and
not take the gamble on the courts" since the amount due would be
"catastrophic" if he lost. In closing, Mr. Cravens offered to
pay Mr. Seery for the extra effort on his case, and reminded him
that the deadline for accepting the settlement offer was drawing
near.
As previously mentioned, Mr. Seery began to withdraw as
counsel for test case petitioners following the Court's
November 14, 1986, order indicating that Mr. Seery might have a
conflict of interest.
Sometime after receiving Mr. McWade's October 28, 1986,
letter, Mr. Cravens contacted Mr. McWade by telephone with the
intent of settling his case. Mr. Cravens took notes of his
conversation with Mr. McWade, which indicate that they discussed:
(1) Eliminating the dividend adjustment for 1980; (2) eliminating
all penalties for both 1979 and 1980; (3) backing out the tax
already paid with respect to the capital gains that the Cravenses
had reported for 1980; and (4) eliminating statutory interest for
1979. Mr. McWade told Mr. Cravens that he would call him back
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with figures reflecting "the amount due for the settlement."
Mr. McWade called Mr. Cravens back on December 15, 1986.
On December 16, 1986, Mr. Cravens wrote to Mr. McWade
confirming the terms of his settlement as follows:
Dear Ken:
As per our telephone conversation 12/15/86, I am
enclosing a check for $10,678.67. According to the
amount we agreed on via telephone, the figures break
down like this:
Deficiency for 1979 and 1980 $9,782.16
Less cash bond 4,508.00
Total 5,274.16
Plus 1.02474 interest 5,404.51
Total due 10,678.67
I wish to thank you for being so agreeable and
assisting me in settling this matter.
Mr. Cravens' payment of $10,678.67 on December 16, 1986, was
processed on December 31, 1986, pursuant to a payment posting
voucher bearing Mr. McWade's initials. The payment posting
voucher provided for the application of the funds as follows:
Year Advance Payment Designated Interest
1979 $3,000.00 $3,000.00
1980 2,274.16 2,404.51
Total 5,274.16 5,404.51
Mr. Cravens believed his settlement assured that he could
neither win nor lose at the trial of the test cases. At the time
that he entered into his settlement, Mr. Cravens was not aware
that Mr. McWade intended to allow the Cravenses the better of the
above-described settlement or the outcome based upon the Court's
opinion following the trial of the test cases.
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Although Mr. Cravens intended to accept the modified 7-
percent settlement offer, the Cravenses' settlement was less
favorable to them than the modified 7-percent settlement offer.
In particular, the Cravenses' correct tax liabilities for 1979
and 1980 were $4,508 and $5,893.45, respectively, for a total of
$10,401.45.50 Thus, the Cravens settlement in the amount of
$9,782.16 represents a reduction of approximately 6 percent of
the correct amount of the Cravenses' deficiencies. In addition,
the Cravens settlement was not structured to include the burnout
feature. At the time that Mr. Cravens settled his cases, Messrs.
Sims and McWade were offering 20-percent settlements with the
burnout feature to Mr. DeCastro's clients and Chicoine and
Hallett's clients.
Mr. McWade was aware that Mr. Cravens was a test case when
he spoke to Mr. Cravens about settling his cases. Mr. McWade
told Mr. Cravens that the Cravenses would have to continue as
test case petitioners as a condition of the settlement.
Mr. McWade did not tell Mr. Cravens to cooperate with the
Government in the trial of the test cases, or to keep his
settlement a secret. Mr. McWade did not tell Mr. Cravens that he
had to settle so-called open years, nor did Mr. McWade examine
50
The $4,508 figure for 1979 is consistent with the
deficiency notice issued to the Cravenses for that year. The
$5,893.45 figure for 1980 represents the Cravenses' correct tax
liability after eliminating the dividend adjustment set forth in
the notice of deficiency for 1980 and backing out the tax on the
capital gain that the Cravenses had reported on their 1980 tax
return.
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Mr. Cravens' returns for years still open under the applicable
statute of limitations to determine whether he had claimed
Kersting deductions for years not before the Tax Court.
Mr. McWade initially told Mr. Cravens that his settlement
assured that the Cravenses could not win or lose in the trial of
the test cases. Mr. McWade also told Mr. Cravens that, by reason
of the settlement, the Cravenses did not need an attorney.
Mr. Cravens therefore concluded that he no longer needed legal
representation. When Mr. Cravens asked Mr. McWade why he had to
remain a test case despite his settlement, Mr. McWade responded
that to remove the Cravenses from the group of test cases would
cause a delay in the trial of the test cases while a replacement
test case was selected.
After Mr. Seery's withdrawal from their cases, the Cravenses
did not retain new counsel. When Mr. Kersting asked Mr. Cravens
why the Cravenses had failed to authorize Chicoine and Hallett to
represent them, Mr. Cravens informed Mr. Kersting that he had
settled his cases.
On December 13, 1988, within 1 month before the trial of the
test cases, which began January 9, 1989, Mr. McWade forwarded to
the Cravenses proposed decision documents fixing their tax
liabilities for 1979 and 1980, to be signed and returned to
Mr. McWade. The proposed decision documents provided as follows:
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Year Deficiency Additions to Tax
1979 $3,606.40 ---
1980 6,175.76 ---
The $3,606.40 figure for 1979 represents a 20-percent reduction
of the $4,508 deficiency that respondent determined against the
Cravenses for that year. However, the derivation of the
$6,175.76 figure for 1980 is not known; it exceeded the correct
deficiency of $5,893.45 for 1980, including adjustments
eliminating both the capital gains that the Cravenses reported
for that year and respondent's alternative determination that the
Cravenses failed to report dividends paid to them by Candace.
The sum of the two figures ($9,782.16) is equal to the total tax
deficiency Messrs. Cravens and McWade had previously agreed
to, as shown by Mr. Cravens' letter of December 16, 1986, to
Mr. McWade.
Mr. Sims approved Mr. McWade's decision to forward decision
documents to the Cravenses for their signature 1 month before
trial of the test cases, believing that the Cravenses had
accepted the 20-percent settlement offer. When Mr. Cravens
testified at the trial of the test cases, Mr. Sims continued to
believe that Mr. Cravens was entitled to the 20-percent
settlement. On December 23, 1988, the Cravenses signed the
decision documents and returned them to Mr. McWade.
When Mr. Cravens appeared at the trial of the test cases, he
was surprised and suspicious when Mr. McWade informed him that he
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would be entitled to the better of his settlement or the Tax
Court's decision in the test cases.
F. The Alexander Understanding
On June 3, 1986, Mr. Alexander wrote to Mr. Matsumoto,
suggesting that they might "blow the whistle" on Mr. Kersting.
Mr. Alexander's letter displays animosity and resentment against
Mr. Kersting arising out of their unresolved dispute, which had
not yet been submitted to arbitration. Shortly after writing to
Mr. Matsumoto, Mr. Alexander listened in on a telephone
conference call between Mr. McWade and Mr. Matsumoto as confirmed
in a subsequent letter that Mr. Alexander wrote to Mr. Kozak.
Mr. Alexander's letter to Mr. Kozak, dated July 16, 1986, states:
Dear Chuck:
I just had a long phone conversation with Gilbert
Matsumoto relative to blowing the whistle on you know
who. During this long phone call Gilbert "patched" me
in to his phone while he called McWade, the attorney
at the IRS. I must say Gilbert's phone mechanism works
very well, I heard every word McWade said and he did
not know I was on the line. Gilbert instructed me not
to say anything.
After the conversation with McWade Gilbert agreed to
call you and fill you in on the latest information.
McWade will be now talking to Myron Chang, the IRS
attorney on the Criminal Investigation side of the IRS.
McWade also said to go ahead with the Affidavits and
then we can discuss with himself and with Myron Chang
what the next step will be. In the conversation with
McWade, Gilbert also discussed the amount of "finder's
fee" and method of payment to the person(s) supplying
the information. It was very clear to me that the fees
are negotiable and that they could be on the amount
assessed or the amount collected. This is also
negotiable and from their eagerness to get you know who
I believe the fees could be sizeable.
- 107 -
My suggestion to Gilbert was to go ahead with you and
draft the Affidavits, at least yours and mine and we
(you, Gilbert and me) would review the Affidavits
before sitting down with McWade and Myron Chang. The
conversation with McWade ended with him saying he would
get back to Gilbert after another meeting with Chang,
however, we should go ahead with drafting the
Affidavits.
Chuck, as Gilbert may have told you, this means blowing
the whistle on 1400 of you know who's [sic] clients, 10
or 12 of which are Gilbert's clients. As you and I
discussed, when the Nazi knows that 1400 of his
client's [sic] are going to be clobbered and that he
will have the Criminal Investigation Division of the
IRS coming down on him I think he will be inclined to
pay me my money.
In the weeks that followed, Messrs. Alexander and Kozak prepared
draft affidavits for submission to Mr. McWade.
On August 12, 1986, Mr. Alexander sent copies of his draft
affidavit to Messrs. Matsumoto and Kozak by overnight mail. On
August 15, 1986, Messrs. Alexander, Matsumoto, and Kozak held a
conference call regarding the affidavits. In a letter to Messrs.
Kozak and Matsumoto dated August 16, 1986, Mr. Alexander stated
as follows:
Dear Chuck & Gilbert:
Following our conference call of yesterday, August
15th, I am submitting the following for both of your
considerations:
1. I suggest that we submit to the IRS AFFIDAVITS in
DRAFT FORM ONLY.
2. It is against my better judgment to submit executed
and notarized affidavits without having some idea what
the IRS will do and what they will pay.
3. They can make their determination (s) and eat up 30
days based on drafts or I should say final drafts. We
can agree verbally to execute the final drafts when
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they tell us exactly what else they want and what they
will do for us.
4. With executed affidavits we would leave ourselves
open to the following:
a. They could investigate and audit all our past tax
returns.
b. They could refuse immunity.
c. They could claim Alexander was an associate/
conspirator with Kersting.
d. They could claim Alexander was in violation of IRS
regulations by not turning Kersting in years ago.
e. They could claim Alexander knew the notes were a
"sham" tax avoidance/evasion scheme early on and under
IRS regulations Alexander was obligated to report this
to IRS early on.
4. [sic] I understand that Gilbert is not expecting a
large fee for his cooperation in this matter, however,
I have told Gilbert that if the IRS payment to me for
this testimony is a large amount that I will contribute
something toward whatever amount Gilbert's 8 or 10
clients will be forced to pay as a result of my
testimony.
5. What does Chuck expect for his role in this
matter???
On August 20, 1986, Mr. Kozak sent a letter to Mr. McWade,
enclosing draft affidavits from both himself and Mr. Alexander.
Mr. Kozak's letter states: "We are willing to negotiate an
arrangement with the IRS, wherein we would execute the affidavits
enclosed and provide testimony consistent with the affidavits or
in clarification thereof." The draft affidavits that Mr. Kozak
sent to Mr. McWade contained information regarding the various
Kersting programs in dispute in the test cases. Mr. Kozak's
draft affidavit alleged that Mr. Kersting refused to pay David
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Bigelow the "equity" in a mortgage funding program and that
Mr. Provan knew other airline pilots who were "shocked and angry
that Kersting would attempt to collect these notes after he had
assured them the notes would not be collectable." Both draft
affidavits alleged that Mr. Kersting had sued Mr. Alexander for
over $500,000 on the basis of promissory notes with respect to
which Mr. Alexander "never received any money whatsoever or
anything of value in exchange for the promissory notes." Mr.
Alexander's draft affidavit alleged that: (1) Mr. Alexander was
in litigation with Mr. Kersting "over funds Kersting supposedly
was to invest in auto leasing and factoring at Universal Leasing
and Federal Finance & Mortgage", and that "Kersting refused to
pay the yield or return the funds"; (2) "no client of Kersting's
has ever repaid a promissory note * * * with funds other than
provided by Kersting through his closed circulation of funds from
one Kersting controlled entity to another"; and (3) Mr. Alexander
believed that Mr. Kersting's only legitimate business was the
purchase of First Savings, in which Mr. Alexander was a
shareholder.
Mr. Alexander's affidavit reveals that Mr. Alexander
expected a "quid pro quo" for his testimony, as follows:
"9. Affiant is ready and willing to testify to the above facts
or any others within his knowledge concerning Kersting provided
an agreement quid pro quo can be worked out through affiant's
representatives, Charles R. Kozak and Gilbert Matsumoto."
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Mr. Kozak submitted his draft affidavit to Mr. McWade in
August 1986 in an effort to have Mr. McWade eliminate the
deficiencies in Mr. Kozak's case, assigned docket No. 25812-81,
concerning the Kozaks' tax liabilities for 1973, 1974, and 1975,
arising from their participation in Pike programs.
Messrs. Alexander, Kozak, and Matsumoto met Mr. McWade in
Hawaii in early September 1986. During the meeting, Mr. McWade
informed Mr. Alexander that his authority was limited and that
there were a number of prerequisites to payment of an informant's
award or "finder's fee". The prerequisites that Mr. McWade
mentioned included the submission of an affidavit, an Internal
Revenue Service investigation, and an assessment resulting from
the information provided. The amount of an award was not
discussed during the meeting. Mr. McWade suggested that
Mr. Alexander should see Myron Chang, head of the Internal
Revenue Service Criminal Investigation Division in Honolulu, to
determine whether the Criminal Investigation Division was
interested in Mr. Alexander's affidavit. Mr. McWade told
Mr. Kozak that he could do nothing to reduce the Kozaks' tax
deficiencies.
Mr. Alexander's efforts to cooperate with the Internal
Revenue Service remained dormant until Mr. Alexander again met
with Mr. McWade in late 1988 to discuss his tax liabilities for
the years 1974, 1975, 1976, and 1977. During this meeting,
Mr. McWade told Mr. Alexander to search his records for
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documentation to support the Alexanders' reporting position for
the years 1974 through 1977.
On October 20, 1988, Mr. Alexander sent a letter to
Mr. McWade enclosing copies of several documents purporting to
substantiate the Alexanders' position that they realized a loss
of $55,152.04 in 1975 on a sale of real estate to the Cadillac
Drive Apartments partnership, as opposed to the $59,080 capital
gain determined in the notice of deficiency.
On December 8, 1988, Jean Samuels (Ms. Samuels), an Appeals
auditor in the Honolulu Appeals Office, sent a two-page
memorandum to Mr. McWade addressing Mr. Alexander's October 20,
1988, letter. Ms. Samuels recommended one adjustment to the
notice of deficiency for 1975 in the Alexanders' favor.
Specifically, Ms. Samuels concluded that the Alexanders had
substantiated a higher cost basis in the property that they sold
to the Cadillac Drive Apartments partnership than had been used
in the notice of deficiency. Giving effect to this higher basis
would have reduced the Alexanders' capital gain on the sale by
$23,084. Taking into account the corresponding adjustment to the
section 1202 deduction previously allowed in the notice of
deficiency, Ms. Samuels recommended a net decrease of $11,542 to
the Alexanders' taxable income as determined in the notice of
deficiency. However, Ms. Samuels referred to certain covenants
in an agreement of sale in the file before her, and cautioned
Mr. McWade that the consideration paid to the Alexanders on the
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sale may actually have been higher than the amount used in the
notice of deficiency.
If Ms. Samuels' recommended adjustment to the notice of
deficiency issued to the Alexanders for 1974 and 1975 had been
accepted, the total adjustments for 1975 would have been reduced
from $127,562 to $116,020, but the deficiency would not have been
eliminated.
Mr. McWade believed that Mr. Alexander was familiar with the
operation of Mr. Kersting's various programs. Before the trial
of the test cases, Mr. McWade arrived at a general understanding
with Mr. Alexander that the Alexanders' tax liabilities for the
taxable years 1974, 1975, 1976, and 1977 would be reduced in
exchange for Mr. Alexander's agreement to serve as an undeclared
consultant or assistant to Mr. McWade during the trial of the
test cases. Mr. McWade's understanding with Mr. Alexander is
reflected in decision documents that were executed by Mr. McWade
on April 6, 1989, and approved by Mr. Sims. In particular,
Mr. McWade executed a stipulated decision in docket No. 2758-80
conceding the deficiencies determined against the Alexanders for
the taxable years 1974 and 1975 and allowing the Alexanders
overpayments for the taxable years 1974 and 1975 in the amounts
of $2,133 and $811, respectively. In sum, Mr. McWade completely
eliminated all deficiencies determined against the Alexanders for
the taxable years 1974 and 1975 and relieved the Alexanders of
the concessions that they had made before the issuance of the
notice of deficiency for those years. The stipulation
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accompanying the decision document submitted to the Court in
docket No. 2758-80 states as follows:
STIPULATION
It is hereby stipulated that the following
statement shows the petitioners’ income tax liabilities
for the taxable years 1974 and 1975:
1974
NET TAX ASSESSED AND PAID . . . . . . . . . . $3,646.00
Payments: April 15, 1975 $1,513.00
December 15, 1984 2,133.00
Total payments $3,646.00
TAX LIABILITY . . . . . . . . . . . . . . . $1,513.00
OVERPAYMENT . . . . . . . . . . . . . . . . $2,133.00
I.R.C. §§ 6512(b)(2)(B) and 6511(b)(2)(B)
Return filed April 15, 1975
No claim filed
No agreement executed
Deficiency notice mailed November 29, 1979
1975
NET TAX ASSESSED AND PAID . . . . . . . . . . $1,114.00
Payments: April 15, 1976 $303.00
December 15, 1984 811.00
Total payments $1,114.00
TAX LIABILITY . . . . . . . . . . . . . . . . $303.00
OVERPAYMENT . . . . . . . . . . . . . . . . . $811.00
I.R.C. §§ 6512(b)(2)(B) and 6511(b)(2)(B)
Return filed April 15, 1976
No claim filed
No agreement executed
Deficiency notice mailed November 29, 1979
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At the time that Mr. McWade submitted the above-described
decision document to the Court, respondent's legal file did not
include any explanation of the elimination of the Alexanders'
deficiencies for the taxable years 1974 and 1975. The Court
entered the parties' stipulated decision in docket No. 2758-80 on
April 13, 1989.
On April 6, 1989, Mr. McWade also executed a stipulated
decision in docket No. 30413-86, approved by Mr. Sims, conceding
in full the deficiencies determined against the Alexanders for
the taxable years 1976 and 1977 as follows:
ORDERED AND DECIDED: That there are no
deficiencies in income taxes due from, or overpayments
due to, the petitioners for the taxable years 1976 and
1977;
That there are no additions to the taxes due from
the petitioners for the taxable years 1976 and 1977,
under the provisions of I.R.C. § 6653(a); and
That there are no additions to the taxes due from
the petitioners for the taxable years 1976 and 1977,
under the provisions of I.R.C. § 6621(c).
On April 6, 1989, Messrs. Sims and McWade signed a Counsel
Settlement Memorandum relating to the Alexanders’ case at docket
No. 30413-86, which states as follows:
The above-entitled case is being settled on the
basis that there are no deficiencies in income taxes
due from, nor overpayments due to, the petitioners for
the taxable years 1976 and 1977.
Discussion: The above-entitled case is part of
the Kersting interest deduction tax shelter program.
The basis for settlement represents allowance of
petitioners’ out-of-pocket expense, approximately 7% of
the deficiency, and concession of penalties for
settlement purposes.
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If more than one year is involved, the settlement
reflects a shelter burn-out for the first half of
petitioners’ participation, and a disallowed deduction
for the later years.
Non-Kersting Issues: None.
The Counsel Settlement Memorandum signed by Messrs. Sims and
McWade contains two false statements: (1) That the basis for
settlement represents the Alexanders' out-of-pocket expenses; and
(2) that the case did not include any non-Kersting issues.
The Court entered the parties' stipulated decision in docket No.
30413-86 on April 13, 1989.
The stipulated decisions described above reflect
Mr. McWade's general understanding with Mr. Alexander, made
before the trial of the test cases, to reduce the Alexanders' tax
liabilities, in exchange for Mr. Alexander's cooperation and
assistance at the trial of the test cases.
G. The Kozak Decision
On July 23, 1981, the Commissioner issued a joint notice of
deficiency to Mr. Kozak and his wife, Susan K. Kozak, disallowing
subchapter S losses and interest deductions that the Kozaks
claimed on their tax returns for 1973, 1974, and 1975 with
respect to their participation in Kersting programs that were the
subject of Pike v. Commissioner, 78 T.C. 822 (1982). The Kozaks
filed a petition with the Court, assigned docket No. 25812-81,
contesting the notice of deficiency.
On May 12, 1986, Mr. McWade filed a motion for order to show
cause why a decision should not be entered in the Kozaks' case
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consistent with the Court's opinion in the Pike case, less out-
of-pocket expenditures. The Kozaks did not respond to the
Court's order, and on September 30, 1986, the Court entered an
Order and Decision against the Kozaks for deficiencies in tax in
the amounts of $1,641, $1,844, and $902 for the taxable years
1973, 1974, and 1975, respectively, reflecting approximately a 7-
percent reduction of the deficiencies that respondent had
determined against the Kozaks.
VII. Pretrial Developments
A. The Kersting Deposition--Postponed (January 1987)
On November 17, 1986, Mr. Seery and Mr. McWade signed a
stipulation to take Mr. Kersting's deposition in Honolulu. On
January 7, 1987, the day to which the deposition had been
adjourned, Mr. Bradt and Mr. Moseley filed a motion for
protective order with the Court on behalf of Mr. Kersting. Judge
Goffe denied the motion in a telephone conference call with the
parties on the morning of January 7, 1987.
Mr. Seery did not appear at the deposition because he had
withdrawn or was in the process of withdrawing from the Kersting
project test cases. Mr. Moseley appeared at the deposition and
stated that Mr. Kersting would not be deposed until Mr. Kersting
was provided with copies of any prior statements he had made to
the Internal Revenue Service. Although Mr. Kersting was not
deposed on January 7, 1987, Messrs. McWade, Moseley, and Chicoine
agreed on a procedure for respondent to review a large number of
documents produced by Mr. Kersting at that time.
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The following colloquy ensued upon Mr. DeCastro's appearance
at the deposition, at a time when Mr. DeCastro had already
executed and delivered the initial Thompson settlement agreement
to Mr. McWade:
MR. McWADE: Let the record show that Mr. Luis
DeCastro from Los Angeles, who represents Mr. Thompson,
has arrived.
(Off the record.)
MR. MOSELEY: Not to stray from the subject, but I
could, for the record, find out, you represent Mr. --
MR. DeCASTRO: Thompson.
MR. MOSELEY: Thompson. He's one of the test
cases that were designated?
MR. McWADE: Yes.
MR. MOSELEY: I would just like for the record to
object to Mr. DeCastro's appearance here. And the
objection is on the basis that I have been informed
that Mr. DeCastro has informed at least some of the
petitioners' counsel that in fact they are planning to
settle Mr. Thompson's case, and if they are planning to
settle Mr. Thompson's case, then essentially his
appearance at a deposition of my client would not be
appropriate. I just want to enter that for the record.
And I'm going to go on, then, with the description of
what I was talking about in terms of the other
documents.
MR. McWADE: If we can take a break here, just so
I can advise Mr. DeCastro of where we are at this
point.
There is no further mention of the possible settlement of the
Thompson cases appearing in the transcript of the January 7,
1987, proceedings. As discussed below, Mr. Kersting eventually
was deposed in October 1988.
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B. John Doe Summons/Assessments of Promoter Penalties
In early 1987, Mr. O'Neill, on behalf of the Honolulu
District Examination Division, requested the Justice Department
to initiate legal proceedings to serve Mr. Kersting with a John
Doe Summons (summons).51 The purpose of the summons was to
compel Mr. Kersting to identify the participants in
Mr. Kersting's programs during the taxable years 1984, 1985, and
1986, and to aid the Internal Revenue Service in developing a
case against Mr. Kersting for so-called promoter penalties under
sections 6700 and 6701.
On May 15, 1987, the U.S. Attorney's Office filed a petition
in the Federal District Court for Hawaii to serve Mr. Kersting
with the summons. The summons requested production of all books
and records in Mr. Kersting's custody and control relating to
participants in Mr. Kersting's programs for 1984, 1985, and 1986.
The summons specifically requested production of customer lists
and similar documents containing the names, addresses, and other
identifying information of the participants. Mr. Kersting moved
to quash the summons.
51
Sec. 7609(f) provides that the Secretary may issue a
John Doe summons, i.e., a summons that does not identify the
person with respect to whose liability the summons is issued,
only with court approval after the Secretary establishes that:
(1) The summons relates to the investigation of a particular
person or ascertainable group or class of persons; (2) there is a
reasonable basis for believing that such person or group or class
of persons may fail or may have failed to comply with any
provision of any internal revenue law; and (3) the information
sought to be obtained and the identity of the person or persons
with respect to whose liability the summons is issued are not
readily available from other sources.
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On July 1, 1987, the District Court granted the Government's
petition to serve Mr. Kersting with the summons. Mr. Kersting
produced some documents to Revenue Agent Larry Tahara in response
to the summons but did not fully comply with the summons.
Mr. Kersting challenged the summons during protracted summons
enforcement proceedings that followed.
Following an August 1987 hearing, the District Court ordered
Mr. Kersting to produce the summoned documents by February 1988.
After another hearing in March 1988, the District Court, in May
1988, held Mr. Kersting in contempt and threatened him with fines
if the summoned documents were not produced. During this period,
Mr. Izen filed a motion to intervene in the summons proceedings
on behalf of his test case petitioners. The District Court
denied Mr. Izen's motion.
Both Mr. Kersting and Mr. Izen appealed the District Court's
decision enforcing the summons to the Court of Appeals for the
Ninth Circuit. The Court of Appeals remanded the case to the
District Court to determine whether Mr. Kersting had
substantially complied with the summons so as to moot the
appeals. See United States v. Kersting, 891 F.2d 1407, 1410-1411
(9th Cir. 1989). Despite its remand, the Court of Appeals
considered and rejected Mr. Kersting's arguments that the
District Court erred in concluding that the Internal Revenue
Service acted in good faith in issuing the summons. See id. at
1411-1413. Mr. Kersting eventually produced the summoned
documents.
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As previously mentioned supra pp. 18-19, in October 1989,
the Commissioner assessed promoter penalties of $1,545,201 and
$2,330,000 against Mr. Kersting pursuant to sections 6700 and
6701, respectively, for the years 1982 through 1988.
C. Chicoine and Hallett's Withdrawal as Counsel
By February 1988, Mr. Kersting's dissatisfaction with
Chicoine and Hallett over evaporation of the 50-percent
settlement and their promotion and reporting of 20-percent
settlements led him to terminate their employment as counsel for
the test cases and to encourage their other Kersting program
clients to recall their settlement retainers. In April 1988, the
Court granted Chicoine and Hallett's motions to withdraw their
appearances as counsel for test case petitioners.
D. Mr. Izen's Entry of Appearance
In February 1988, Mr. Kersting retained Mr. Izen to
represent the test case petitioners, other than the Thompsons and
the Cravenses. At the time, Mr. Izen had no experience
representing test case taxpayers in the Tax Court, although he
did have experience representing taxpayers who had signed
piggyback agreements to be bound by the outcome of test cases in
a tax shelter project.
Mr. Izen filed entries of appearance as counsel for test
case petitioners during February 1988 through January 1989.
Mr. Izen examined the deductions claimed by the test case
petitioners he represented to determine whether they were
representative of the Kersting programs. Mr. Izen analyzed the
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various Kersting programs and documents regarding each of the
test case petitioners that he represented. On the basis of his
analysis, Mr. Izen determined that the test case petitioners that
he represented would be representative of the nontest cases.
On April 29, 1988, Mr. Izen filed a motion to compel
Chicoine and Hallett to provide him with the client files and
papers of certain test case petitioners he represented. On
June 6, 1988, Mr. Chicoine filed an objection to Mr. Izen's
motion, asserting that Chicoine and Hallett had returned to
Mr. Izen's clients all original documents that had been provided
to Chicoine and Hallett. By order dated July 11, 1988, the Court
denied Mr. Izen's motion as moot.
From the beginning of his representation of the test case
petitioners until late 1995, Mr. Izen's fees were paid by check
signed by Mr. Kersting and written on bank accounts of
corporations controlled by Mr. Kersting. Commencing December
1995, Mr. Izen's fees have been paid from a "pool" or "fund"
contributed by a group of test and nontest case petitioners.
E. The Kersting Deposition (October 1988)
On July 8, 1988, respondent served Mr. Kersting and the test
case petitioners with a notice of deposition pursuant to Rule 75.
On July 25, 1988, Mr. Kersting served Mr. McWade with an
objection stating, inter alia, that Mr. Kersting should not be
deposed because he had reason to believe that he was under
criminal investigation. Mr. Kersting's objection included
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allegations that Mr. Alexander was assisting the Government in
the criminal investigation.
On August 25, 1988, Mr. McWade filed a motion to take
Mr. Kersting's deposition in the test cases. Mr. McWade attached
a number of documents to his motion for the purpose of refuting
Mr. Kersting's allegations that he was under criminal
investigation. In particular, Mr. McWade attached copies of the
affidavits that Messrs. Alexander and Kozak had submitted to
Mr. McWade in August 1986, as well as copies of the various
documents and letters circulated between Messrs. Alexander,
Matsumoto, and Kozak during that same period. See supra pp. 106-
111. By order dated August 30, 1988, the Court granted
Mr. McWade's motion to depose Mr. Kersting.
During October 24 through 27, 1988, Mr. Kersting was deposed
in Honolulu. Mr. Bradt represented Mr. Kersting at the
deposition. Mr. McWade, along with Jeffrey A. Hatfield
(Mr. Hatfield), and Thomas A. Dombrowski (Mr. Dombrowski),
questioned Mr. Kersting on behalf of respondent.52 Mr. Izen and
Mr. DeCastro questioned Mr. Kersting on behalf of their clients.
Mr. Cravens did not participate in the deposition.
Mr. Kersting did not bring any documents to the deposition;
he claimed that the documents had already been produced in
52
Messrs. Dombrowski and Hatfield were both trial
attorneys with the Office of Chief Counsel assigned to the
San Diego District Counsel Office. In September 1988,
Messrs. Dombrowski and Hatfield were assigned to assist
Mr. McWade in the trial of the Kersting test cases.
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response to respondent's summons. During the deposition, the
parties conducted a telephone conference call with Judge Goffe
regarding Mr. Kersting's failure to produce the requested
documents. As a result of the conference call, the parties
agreed that Mr. McWade could inspect documents that Mr. Kersting
had produced in response to the summons. Mr. McWade's review of
these documents was intended to satisfy Mr. Kersting's obligation
to produce documents at his deposition. Mr. Kersting and
Mr. Bradt agreed to this procedure.
VIII. Trial of Test Cases (January 1989)
The trial of the test cases was conducted before Judge Goffe
during January 9 through 27, 1989, at Honolulu, Hawaii.
Respondent was represented at the trial by Messrs. McWade,
Dombrowski, and Hatfield. Mr. Sims attended the trial but did
not enter an appearance for respondent. Mr. Sims and Mr. McWade
did not inform Judge Goffe, the National Office, the Regional
Office, or Mr. Izen of the Thompson and Cravens settlements or
the Alexander understanding before or during the January 1989
trial of the test cases.
Respondent issued subpoenas duces tecum to all test case
petitioners, directing them to appear, testify, and produce
documents at the trial of the test cases. Each of the eight test
case petitioners testified during the trial of the test cases.
Mr. Hatfield conducted the cross-examination of test case
petitioners Dixon, Owens, Young, DuFresne, Rina, and
Hongsermeier. Mr. McWade conducted the cross-examination of
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Messrs. Cravens, Thompson, Moseley, and Kersting, and the direct
examination of Messrs. Kersting, Toyota, Ing, and Alexander.
Mr. Dombrowski conducted the direct examination of Alice Combs
and Margo Akamine, Mr. Kersting's bookkeepers.
A. Mr. Cravens
Following Mr. Seery's withdrawal from the Cravens cases in
early 1987, Mr. Cravens did not retain substitute counsel because
he regarded his cases as settled. Mr. Cravens arrived in Hawaii
1 day before he was scheduled to testify at the trial of the test
cases. The Government paid Mr. Cravens' travel, food, and
lodging expenses while he was in Hawaii.53
Mr. McWade prepared and submitted to the Court requested
findings of fact respecting Mr. Cravens' participation in the
disputed Kersting programs. When Mr. Cravens testified during
the trial of the test cases, he made a brief statement to the
Court about his participation in the Kersting programs, told the
Court and the parties that he had absolutely nothing to hide, and
said that he would answer any questions to the best of his
ability.
Mr. McWade cross-examined Mr. Cravens at the trial and
elicited testimony to support respondent's proposed finding of
fact that Mr. Cravens' primary reason for participating in the
Kersting programs was to obtain tax benefits. Mr. Cravens
53
Inasmuch as respondent subpoenaed all the test case
petitioners, it is assumed that they were all reimbursed for
their expenses. See sec. 7610.
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testified that he participated in Stock Subscription Plans in
1979 (Candace) and 1980 (Delta), and that he closed out his
participation in the Kersting programs by endorsing his stock
certificates and returning them to Mr. Kersting in exchange for
the return of his promissory notes.
Mr. McWade introduced exhibits at the trial pertaining to
Mr. Cravens' participation in Kersting programs that were
referred to in the stipulation of facts that had been signed by
Mr. McWade and Mr. Cravens. Mr. Izen briefly cross-examined
Mr. Cravens after Judge Goffe asked what right Mr. Izen had to
question a test case petitioner who was not his client. In the
absence of an objection from Mr. Cravens, and in light of
Mr. McWade's assent to a brief cross-examination, Judge Goffe
stated: "I'll permit a certain amount of questioning, but we'll
just see where it goes." Mr. DeCastro did not question
Mr. Cravens, nor did the Court.
Mr. Cravens never informed the Court that he had settled his
case because he believed the matter was common knowledge.
Mr. Cravens had no intention of having a secret settlement.
Following the trial, the Cravenses did not file any briefs with
the Court.
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B. Mr. Thompson
Mr. Thompson appeared at the trial of the test cases and
produced eight pages of documents in response to the subpoena
duces tecum issued by Mr. McWade.54 The Government paid
Mr. Thompson's travel, food, and lodging expenses.
Mr. DeCastro conducted direct and redirect examinations of
Mr. Thompson. Mr. DeCastro questioned Mr. Thompson about his
participation in the acquisition of First Savings as well as the
Bauspar program to show that the Thompsons had financial dealings
with Mr. Kersting other than through the programs at issue in the
trial. Mr. Thompson testified that, following a forced merger
between First Savings and First Federal Savings of Honolulu,
Mr. Kersting returned the Thompsons' $20,000 initial investment
in First Savings. Mr. Thompson further testified that he lost
$80,000 in the Bauspar program.
Mr. McWade cross-examined Mr. Thompson. Mr. Thompson had
never met Mr. McWade until he was scheduled to testify. Pursuant
54
When Mr. McWade moved to have the Thompson documents
admitted as evidence during Mr. Thompson's testimony, Mr. Izen
objected on the grounds that he had not had an opportunity to
review them. Although Judge Goffe initially questioned whether
Mr. Izen should be permitted to object to the admission of the
Thompson documents, Mr. DeCastro indicated that he had no
objection. Judge Goffe then called a brief recess to allow
Mr. Izen to review the documents and indicated that he would
allow Mr. Izen to subject Mr. Thompson to a voir dire
examination. Following the recess, Mr. Izen raised a limited
objection to the admissibility of the documents insofar as they
contained statements of Mr. Kersting's opinion of the tax laws.
Judge Goffe overruled Mr. Izen's objection and admitted the
documents in evidence as respondent's exhibit SL. Mr. Izen was
allowed to cross-examine Mr. Thompson without limitation.
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to a stipulation of facts, Mr. McWade introduced exhibits at the
trial of the test cases pertaining to the Thompsons'
participation in the disputed Kersting programs. During
Mr. McWade's cross-examination, Mr. Thompson made the following
statement:
Mr. McWade: When did you terminate your
participation in these plans, Mr. Thompson?
Mr. Thompson: In--let's see--1984. No, wait a
minute; 1982. I retired, and I went to my retirement
party, came home, and I had notice from the Internal
Revenue Service regarding my 1978 taxes. And I went up
to the house, called him up, and said, "Henry, I've got
a problem." And he said to just send it to him and
he'd take care of it.
Two and half years later he was still taking care
of it. I still didn't know what was wrong. And I was
becoming very disenchanted with his taking care of it.
To be quite honest with you, I went to an attorney over
it.
And an agent actually came to our house and was
interested in my paying him $23,346, as I remember, on
the spot.
In the interim period I had received no notice
that our house had a lien slapped on it from the
Internal Revenue Service, but I didn't know about this.
But anyway, this was all the thing that brought
all my investments with Mr. Kersting to a head. I got
absolutely no support that was effective from him. I
wanted to know what the problem was so that I could
address it--not in a manner of putting a band-aid on
it; I wanted it settled. I was retired. I couldn't go
on with this business that, "Oh, we'll go to court and
they'll never get us," and all of this business that we
had. I was out money, lots of it: $80,000, on the one
hand. And $23,000 goes over 100--pretty easy, right
then.
I was in the process of doing a trust. I went to
the attorney that was running that for me, and he wrote
a letter to Kersting wanting to know what he had done,
and got a rotten letter back from him. I tried to get
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him to do something for me on the 1978 situation, and
there wasn't anything happening.
The procedure went through a tax firm in Los
Angeles known as Loeb & Loeb, and I wound up with the
DeCastro Law Corporation by way of their direction, and
made several discoveries that were startling to me.
And of course, I settled. To be quite honest, I had to
get out of this. I was not going to spend my life--
Mr. McWade: Well, let me--
Mr. Thompson: --doing all this.
Mr. McWade: Let me stop you here for a moment.
Mr. Thompson: Okay. I'm sorry. I beg your
pardon.
Mr. McWade: Mr. Thompson, can you tell me: have
we been successful in getting the lien removed from
your house?
The subject of the Thompson settlement did not arise again during
Mr. Thompson's testimony at the trial of the test cases.55
Mr. McWade followed the colloquy quoted above by asking
Mr. Thompson whether he had ever tendered stock certificates to
Mr. Kersting. Mr. Thompson responded that, contrary to
Mr. Kersting's promises, he tried twice (through Mr. DeCastro and
Mr. Chanin) to tender his stock certificates to Mr. Kersting in
exchange for the cancellation of his promissory notes but had
been refused.
55
In Dixon II, Judge Goffe interpreted Mr. Thompson's
remarks concerning settlement as pertaining to the resolution
of Mr. Thompson's tax liability for 1978--a year for which the
Thompsons had not been issued a notice of deficiency. See Dixon
II, 62 T.C.M. (CCH) at 1472-1473, 1991 T.C.M. (RIA), at 91-3014
to 91-3015. In retrospect, and in the light of what has come
out, it is more likely that Mr. Thompson in his above-quoted
testimony was referring to the settlement on his behalf that
Mr. DeCastro had negotiated with Mr. McWade.
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Mr. McWade prepared and submitted to the Court requested
findings of fact respecting the Thompsons' participation in
the disputed Kersting programs. Mr. McWade relied upon
Mr. Thompson's testimony at trial to support respondent's
proposed findings of fact that Mr. Thompson "lost $80,000
maintained in the savings program with the Kersting company."
Mr. Izen was permitted to cross-examine Mr. Thompson.
Mr. Izen questioned Mr. Thompson about his purported $80,000 loss
from the Bauspar program, Mr. Thompson's dispute with
Mr. Kersting, and Mr. Kersting's threats to bring a lawsuit
against the Thompsons.56
C. Mr. Kersting
Mr. McWade subpoenaed Mr. Kersting to testify at the trial
of the test cases. Mr. Kersting testified extensively at the
trial of the test cases regarding the Kersting programs in
dispute. As discussed in greater detail below, Judge Goffe
concluded in Dixon II that Mr. Kersting's testimony lacked
credibility.
Mr. Kersting testified about the First Savings acquisition.
In particular, Mr. Kersting testified that the acquiring group of
approximately 40 investors (including Mr. Thompson) had been
56
Mr. Thompson testified that the $80,000 loss arose from
Mr. Kersting's failure to remit to the Thompsons the buildup in
the forced savings leg of the Bauspar transaction under which the
Thompsons had paid $1,200 per month to Citizen's Financial, Inc.
Mr. Thompson testified that Mr. Kersting treated the $1,200
payments as interest payments, rather than as contributions to a
savings plan.
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required to pledge their First Savings stock to secure a loan
from First Hawaiian Bank to provide partial financing for the
acquisition. Mr. Kersting further testified that, following the
initial acquisition, he arranged for the acquiring group to
relinquish their interest in First Savings and become
shareholders of a newly organized Kersting holding company known
as Investors Financial Corp. (Investors Financial), which was to
be a holding company for First Savings. Mr. Kersting testified
that initially he had been erroneously informed that regulatory
approval was not required for Investors Financial to serve as a
holding company for First Savings. Mr. Kersting testified that
the Federal Home Loan Bank Board eventually approved Investors
Financial as a holding company for First Savings.
D. Mr. Alexander
Mr. McWade subpoenaed Mr. Alexander to testify at the trial
of the test cases. The Government paid Mr. Alexander's travel,
food, and lodging expenses while he was in Hawaii. Unlike most
witnesses, Mr. Alexander remained in Hawaii during the entire
trial; this was pursuant to arrangement with Mr. McWade so that,
as previously described, Mr. Alexander could serve as an
undeclared consultant or assistant to Mr. McWade. The record
does not reflect the extent to which Mr. McWade actually relied
upon Mr. Alexander as an assistant or consultant during the trial
of the test cases.
Mr. McWade's direct examination of Mr. Alexander focused
largely on the details of the First Savings acquisition.
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Mr. Alexander's testimony regarding the transaction differed from
Mr. Kersting's testimony in one material respect. Specifically,
contrary to Mr. Kersting's testimony, Mr. Alexander testified
that the Federal Home Loan Bank Board denied Mr. Kersting's
application for Investors Financial to serve as a holding company
for First Savings.57 Mr. Alexander further testified that
Mr. Kersting "watered down" the First Savings shares by issuing
additional Investors Financial shares to individuals other than
the original acquiring group. Mr. Alexander testified that when
he questioned Mr. Kersting about the matter, Mr. Kersting stated
that there was no problem with issuing additional Investors
Financial shares because Mr. Kersting could have the shares
returned at any time.
Mr. Alexander testified that in February 1980, Federal
banking authorities forced First Savings to merge with First
Federal Savings of Honolulu. Mr. Alexander testified that,
following the forced merger, Mr. Kersting returned the initial
investments of some members of the original acquiring group but
that Mr. Kersting did not return Mr. Alexander's investment of
approximately $125,000.
Under direct examination by Mr. McWade, Mr. Alexander
admitted that he had filed a lawsuit against Mr. Kersting, which
resulted in the arbitration proceeding in July 1987, and that he
57
In Dixon II, the Court found that Investors Financial
was not approved as a holding company for First Savings and that
Investors Financial had no other assets. See Dixon II, 62 T.C.M.
(CCH) at 1447, 1991 T.C.M. (RIA), at 91-2987.
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was not on good terms with Mr. Kersting. Under cross-examination
by Mr. Izen, Mr. Alexander admitted that he had talked with
Mr. McWade about submitting an affidavit concerning
Mr. Kersting's programs. When asked by Mr. Izen whether he and
Mr. McWade had discussed a reduction of Mr. Alexander's tax
liability in exchange for the affidavit, Mr. Alexander responded,
"Specifically, no."58 Mr. Izen's cross-examination of
Mr. Alexander included questions concerning Mr. Alexander's
various dealings with Mr. Kersting, including First Savings and
Mr. Alexander's participation in the Kersting programs at issue
in the trial.
After Mr. Izen had questioned Mr. Alexander about his
participation in the Kersting programs at issue in the trial,
Mr. McWade elicited testimony from Mr. Alexander (on redirect
examination) that Mr. Kersting had represented to Mr. Alexander
and others that the promissory notes underlying the interest
expense deductions would not be called for payment.
58
Mr. Izen questioned Mr. Alexander as follows:
Mr. Izen: Have you ever offered * * * Mr. McWade,
or any other person connected with the Internal Revenue
Service, an affidavit concerning your testimony
concerning these tax shelters?
Mr. Alexander: We talked about it.
Mr. Izen: Did you ever offer to them to testify
in return for reducing your own personal taxes? The
amount of.
Mr. Alexander: Specifically, no.
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E. Mr. DeCastro
Mr. DeCastro attended the trial of the test cases and
conducted Mr. Thompson's direct examination. Following the
trial, Mr. DeCastro filed an eight-page brief with the Court on
behalf of the Thompsons. Mr. DeCastro's brief included an
argument that the Thompsons entered into the Kersting programs in
dispute with the intention of making a profit. This argument was
based upon the Thompsons' prior investment experience with
Mr. Kersting, including their participation in the First Savings
acquisition. Mr. DeCastro's brief also acknowledged that "one
of the primary motives for the stock purchase was to realize
the substantial tax savings promised by the Kersting plan".
Mr. DeCastro also argued, contrary to Mr. Thompson's testimony,
that the promissory notes signed by the Thompsons "are valid and
enforceable." Mr. DeCastro filed no reply brief on behalf of the
Thompsons.
F. Comfort Letters
The record in the trial of the test cases included evidence
that Mr. Kersting had assured certain Kersting program
participants, whom Mr. Kersting referred to as "nervous Nellies",
that their primary loan obligations could be satisfied in full at
any time by mere surrender of the associated stock certificates.
In Dixon II, the Court summarized the evidence as follows:
[Mr. Kersting] testified that he provided so-called
"comfort letters" only to those "nervous Nellies" who
insisted on having them, which did not include any of
petitioners.
- 134 -
We do not doubt that Kersting only provided these
personalized comfort letters to investors who insisted
and that petitioners were not among that group. It
does not necessarily follow, however, that the policy
embodied in the letters was unknown or unavailable to
petitioners or other investors. In fact, the record
contains several indications, covering a span of
several years, that Kersting applied this policy to
everyone whether they requested personalized comfort
letters or not:
(1) Thompson testified that Kersting assured him
of the policy at the outset, and no other petitioner
testified that he tendered stock to Kersting and was
refused. Kersting's refusal to accommodate Thompson is
reasonably attributed to the serious falling out that
occurred previously and to Thompson's apparent refusal
to pay leverage loan interest.
(2) Kersting described a 1976 Forbes Acceptance
Stock Subscription Plan to Mil Harr this way: "The
deal is self-liquidating as you can retire all of your
debt by simple surrender of the stock certificate
issued to you."
(3) Gabriele Kersting sent a form letter to Owens
also relating to the 1976 Forbes Acceptance Stock
Subscription Plan, in which she advised him to "Keep
the [stock] certificate in a safe place as you will
need it later to retire the $30,000.00 note."
(4) In a form letter transmitting initiating
documents for the Leasing Corporation Plan of Universal
Leasing, Kersting stated: "All of your debt, except
your monthly payment obligation, can be discharged at
any time at your option by surrender of the stock
certificate which will be issued to you after we have
received the executed documents from you."
(5) In a form letter marking the first anniversary
of a Leasing Corporation Plan for Anseth Leasing,
Kersting noted that "you do have the continuing option
to retire the existing notes by a sale to your
corporation of the stock which you have acquired."
(6) Although in the form of a personalized
comfort letter, Kersting wrote expansively in 1977:
"there is, of course, no problem to reassure you of the
self-sustaining and self-liquidating aspects of the
transaction. We would, in fact, issue a letter to
every participant in the deal outlining that
- 135 -
understanding if it would not weaken YOUR position with
the IRS."
(7) In another personalized comfort letter, this
time from 1978, Kersting again wrote broadly: "As to
the obligation under the promissory notes and
subscription agreements there is no ongoing obligation
as far as we are concerned. We will always repurchase
the stock issued at a price sufficient to allow a
borrower to discharge all of his debt."
(8) In a 1980 credit-reference letter to a third
party, Kersting wrote that the investor's "liabilities
at * * * [the time of his stock purchases] and from
there on would be equal to the assets acquired. His
debt can be canceled at any time of his choice by the
sale of the assets in his possession."
(9) Dixon received a 1985 form letter that told
him how to terminate his participation in his Charter
Financial stock purchase plan by returning an endorsed
stock certificate, after which his notes and stock
certificate would be canceled and notes marked "paid"
would be returned to him. The letter contained similar
unused "cancellation" lines for leasing corporation
stock certificates and acceptance corporation stock
certificates.
Dixon II, 62 T.C.M. (CCH) at 1499-1500, 1991 T.C.M. (RIA), at 91-
3043 to 3044-91.
G. Mr. Izen's Introduction of Evidence of Collection Litigation
During the trial of the test cases, Mr. Moseley testified
(on direct examination by Mr. Izen) that he had represented
several Kersting companies in collection litigation against
several Kersting program participants.59 When Mr. Izen attempted
59
Before the trial of the test cases, Mr. McWade became
aware of the Kersting collection cases through settlement
discussions with Kersting program participant Lou Galli.
Mr. McWade subsequently discovered that certain corporations
controlled by Mr. Kersting had obtained collection judgments
against no fewer that 10 Kersting program participants. In
addition, Mr. McWade issued a subpoena to Mr. Kersting requesting
(continued...)
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to offer collection litigation records into evidence through
Mr. Moseley, Judge Goffe initially questioned why Mr. Izen had
not obtained the documents before trial so that the documents
could have been subjected to the stipulation process. Mr. Izen
responded that, although he had requested the documents from
Mr. Kersting earlier, ultimately he had relied upon the subpoena
that respondent had served on Mr. Kersting, and he had only
recently received the documents.
During Mr. Moseley's testimony, Mr. Izen offered into
evidence records from the bankruptcy case of Mr. Provan
indicating that certain corporations controlled by Mr. Kersting
were creditors of Mr. Provan. The Court sustained Mr. McWade's
objections to admission of these records on grounds of relevance
and incompleteness.60 The Court also sustained Mr. McWade's
objections to the admission of several documents pertaining to
collection litigation against George Vermef, although these
documents were later admitted into evidence through
Mr. Kersting's testimony.61
59
(...continued)
the production of records of any other collection actions against
Kersting program participants.
60
The documents in question did not reveal the particular
debts that the Kersting corporations had apparently asserted
against Mr. Provan.
61
Judge Goffe's treatment of the collection litigation
evidence is summarized supra pp. 72-74. Mr. Izen's bringing up
the collection litigation again, following the evidentiary
hearing, is described infra pp. 196-197.
- 137 -
IX. Posttrial Developments
A. First Thompson Refund
Around the time of the Dixon II trial, Mr. DeCastro asked
Mr. McWade to arrange for the Thompsons to receive a refund of
$30,000 of their advance payments, in accordance with the second
revision of the Thompson settlement. In a memorandum dated
April 10, 1989, Mr. McWade requested Mr. Stevens to process a
$30,000 refund to the Thompsons. Mr. McWade's April 10, 1989,
memorandum states:
The above-named taxpayers are part of the Kersting
Interest Deduction Project. Because their case was
designated as one of the "test cases", the basis for
settlement agreed to prior to trial cannot be finalized
until after the Court enters its decision, projected to
be after mid-year 1990.
The basis for settlement will result in
approximate deficiencies, as follows:
Tax Year Deficiencies Interest Total
1980 $15,000.00 $19,241.66 $34,241.66
1981 $15,000.00 $15,191.44 $30,191.44
Based upon the enclosed transcript, the taxpayers
have made advance payments as follows:
Tax Year Advance Payment
1979 $63,000.00
1980 $35,373.09
1981 $145.88
In an effort to minimize the interest expense to
the government, it is requested that $30,000.00 of
advance payment be refunded to the taxpayers, the
allocations and/or inter-year adjustments being made,
as necessary.
Following the refund, there will be sufficient
advance payments to full pay the agreed deficiencies,
plus accrued interest, with a $4,085.87 reserve.
- 138 -
Mr. McWade's memorandum apparently did not raise any
concerns in the Special Procedures office.62 On July 11, 1989,
the Government issued a refund check to the Thompsons in the
amount of $30,000. The Thompsons endorsed the check to DeCastro
Law Corp. without depositing it in their own checking account.
On August 3, 1989, Mr. DeCastro wrote a letter to Mr. McWade
confirming the revision of the Thompson settlement that had been
agreed to before the trial of the test cases. Mr. DeCastro's
letter states in pertinent part as follows:
Re: Jack and Maydee Thompson
Dear Ken:
Please confirm following is our agreement with
respect to settlement of above taxpayer's cases for
open years:
We have agreed that the total taxes due for all
the open years are $15,000 for 1980 and $15,000 for
1981.
Further, in the event a final decision in this
case is more favorable they are to receive the benefit
of such decision.
Please sign below so I can have for my files.
Mr. McWade signed the letter and returned it to Mr. DeCastro.
On August 24, 1989, Mr. DeCastro wrote to Mr. McWade
requesting that Mr. McWade arrange for the Thompsons to receive
the balance of their refund. Mr. DeCastro's letter states in
pertinent part:
62
Mr. Stevens was not called to testify at the evidentiary
hearing.
- 139 -
Dear Ken:
The following are my calculations of the refund
due the Thompsons:
1980 Deficiency: $15,000
Interest on Deficiency: 15,300 $30,300
(To 12-31-86)
1981 Deficiency: $15,000
Interest on Deficiency 12,150 27,150
Total Tax and Interest due to 12-31-86 $57,150
Amount Paid 12-31-86 ($25,545 plus $34,269) $59,814
Overpayment as of 12-31-86 2,664
Additional amount paid
on account 6-11-87 63,000
TOTAL OVERPAYMENT DUE TAXPAYER $65,664
Please calculate the interest due on the
overpayment and arrange to refund the balance due them
(less the $30,000 recently received).
Thanks for your cooperation.
On October 3, 1989, Mr. DeCastro sent the Thompsons a letter
reporting that Mr. McWade had confirmed that they were due a
large refund, plus interest, which would not be refunded until
the Court issued its opinion in the test cases. Mr. DeCastro
advised the Thompsons that, because the Internal Revenue Service
would be paying interest, he believed it was fair to add interest
to the Thompsons' bill.
On or about November 6, 1989, Mr. McWade received an undated
letter from Mr. Thompson which stated in pertinent part as
follows:
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Dear Mr. McWade:
There are some questions in mind that I feel you can
help me answer.
Owing to the fact that the Kersting hearing is behind
and my testimony is complete I ask; have I completed my
portion of this case? If in fact my portion is
complete I question the requirement for counsel any
longer.
Secondly--I received a check from IRS in the amount of
thirty thousand dollars--($30,000). I endorsed this
over to DeCastro Law Corp; this did not retire the
billed amount. I am completely amazed at the billings
we are receiving. I am now in receipt of additional
billings that exceed realistic amounts. In fact the
total comes to sixty six thousand two hundred forty
three and 66/100 dollars ($66,243.66). At some point I
know a reconciliation will come. Luis says don't be
concerned. I am very concerned, I am the one being
billed.
Thirdly--it was Maydee and me who stood up to be
counted at the hearing. In crossing paths with former
friends I know not whether they will be friendly or
not. The percentage is still in my favor. And soon
now I feel that all will have to come to grips with
reality in this matter. So be it, it is a factor in
our lives.
Fourth--I came forward to help bring about justice for
Henry Kersting. While it is true that I was aware that
a measure of direct animosity would result, and I
accepted this. Maydee has experienced additional
illness this I am very sorry about.
Most emphatically I did not expect to be a channel
through which IRS funneled funds to any law firm.
Certainly not in this magnitude. I have the feeling at
this point that I am correct in this--the bill is to
[sic] much. I want to know the exact legal position I
occupy. We have been frustrated long enough. We wish
to close this chapter.
Ken we spent little time with you, however Maydee and I
both agree, we like you. I hope as Maydee does that
you are on your way out of the smoking habit. I truly
hope that this will be accepted in the context I feel.
I guess I am tired of this matter. All the broken
- 141 -
dreams the Kersting fraud has shattered are everywhere
I look. I only know a few by comparison.
Best regards, Jack
The payment of Mr. DeCastro's legal fees is also discussed in a
letter dated November 17, 1989, from Mr. DeCastro to Mr. Huestis
which states in pertinent part:
Thank you for your letter regarding the matter of
the Thompsons' fees. As I have told Jack, we are
looking for payment of his fees to the IRS, not him. I
am enclosing a copy of my letter to him in this regard
for your information.
I am not sure how there got to be any confusion on
this score, but hope this lays that to rest. We have
been told by the IRS that they will not release any
additional funds until after the judgment and in the
meantime we give Jack and Maydee our statements to keep
them informed of the balances.
Just to make it all very clear, we are looking
only to the payments from the IRS for our fees and do
not expect Jack and Maydee to come up with money on
that score.
Mr. DeCastro sent a similar letter to the Thompsons on the same
date.
B. Mr. Izen's Motion To Reopen Record
On January 23, 1991, Mr. Izen filed a motion to reopen the
record in the trial of the test cases to receive newly discovered
evidence. In particular, Mr. Izen sought to introduce evidence
that certain Kersting program participants had reported a capital
gain upon the termination of their participation in a particular
Kersting program and later filed a claim for refund based upon
the Commissioner's determination that the transaction was a sham.
Mr. Izen argued that the Commissioner's denial of the taxpayers'
- 142 -
refund claims constituted an admission against interest.
Respondent opposed Mr. Izen's motion on the grounds that the
taxpayers in question had claimed Kersting interest deductions
for the 3 taxable years before the year that they reported a
capital gain, and that the Commissioner had accepted those tax
returns as filed. Respondent asserted that under the
circumstances it was not inequitable for the Commissioner to deny
the taxpayers the claimed refunds. On February 26, 1991, the
Court denied Mr. Izen's motion.
C. Dixon II Opinion
Messrs. Sims and McWade did not inform Judge Goffe, the
National Office, Regional Counsel, or Mr. Izen of the Thompson
and Cravens settlements or the Alexander understanding before the
issuance of the Court's Dixon II opinion.
On December 11, 1991, the Court filed its Dixon II opinion.
In particular, the Court rejected Mr. Izen's contention that the
cases should be dismissed for lack of jurisdiction on the ground
that the notices of deficiency issued to his clients were
invalid. The Court also sustained respondent's disallowance of
the interest deductions claimed with respect to the Kersting
stock purchase, stock subscription, leasing corporation, and CAT-
FIT plans. The Court determined that the loans were sham
transactions lacking economic substance and that the loans did
not constitute genuine indebtedness. Finally, the Court
sustained respondent's determinations against test case
petitioners who had been charged with additions to tax for
- 143 -
negligence, failure to file a timely return, and the increased
rate of interest for substantial understatement of income tax
attributable to tax-motivated transactions.
D. Disclosure of Thompson Settlement
On March 13, 1992, the Court entered decisions pursuant to
its Dixon II opinion in each of the test cases. The Court
entered decisions in the Thompson cases consistent with the
notices of deficiency issued to the Thompsons as follows:
Additions to Tax
Sec. Sec. Sec.
Year Deficiency 6653(a) 6653(a)(1) 6651(a)(1)
1979 $18,161.00 $908 --- ---
1980 24,838.00 --- --- ---
1981 36,294.52 --- $1,958.28 $4,934.32
The decisions provided that the Thompsons were liable for 50
percent of the interest due on the deficiency for 1981 pursuant
to section 6653(a)(2) as well as increased interest pursuant to
section 6621(c).
By letter dated April 23, 1992, Mr. McWade forwarded to
Mr. DeCastro waiver agreements which, if executed by
Mr. DeCastro, would authorize the Internal Revenue Service to
enter assessments against the Thompsons before expiration of the
90-day appeal period prescribed by section 7481. Mr. McWade's
letter stated that, on the basis of the Thompsons' earlier
payments, there would be due a refund of approximately $56,873.03
- 144 -
for 1979, 1980, and 1981. Finally, the letter stated that the
Thompsons' refund was attributable to the resolution of Kersting
interest deduction programs, including the Bauspar program. Mr.
DeCastro signed the waivers and returned them to Mr. McWade on
April 27, 1992. Mr. Sims and Mr. McWade initialed the waivers on
May 1, 1992. By letter dated May 8, 1992, Mr. DeCastro wrote to
Mr. Thompson stating in pertinent part: "Finally I have been
advised that the Infernal [sic] Revenue Service is processing a
refund to you. I expect to be in excess of $55,000 [sic] so as I
mentioned it will finally take care of my bill and leave some
left over for you."
During this same period, Mr. Sims informed Larry Martucci
(Mr. Martucci), an Associate Chief of Appeals in the San
Francisco Appeals Office,63 that a Kersting test case petitioner
had accepted the project settlement offer made to all Kersting
petitioners, but, because the petitioner was one of the test
cases, he had tried his case. Mr. Sims told Mr. Martucci that
the Court had entered a decision in the case in accordance with
its opinion. Mr. Martucci told Mr. Sims that he did not know
what could be done. Mr. Martucci told Mr. Sims that, at a
minimum, Mr. Sims should contact Mr. Sanchez, Regional Counsel
for the Western Region, Office of Chief Counsel.
63
From November 1988 through March 1992, Mr. Martucci
supervised the Appeals officers assigned to the Honolulu Appeals
Office, including Gary Lipetzky and Mel Iwane. Mr. Martucci
first became aware of the Kersting tax shelter project in 1988 or
1989 when the project was in District Counsel jurisdiction and no
longer with the Appeals Office.
- 145 -
During the week of April 13, 1992, Mr. Sims contacted Jerry
Li (Mr. Li), another Associate Chief of Appeals in San Francisco,
about the need to assess amounts in the Thompson cases that were
less than the amounts set forth in the Tax Court's decisions.
Mr. Sims did not mention the Thompsons' participation in the
Bauspar program in his conversation with Mr. Li. Mr. Li told
Mr. Sims that he would have to check with his superiors before
processing the case. Mr. Li asked Mr. Sims for a memorandum
explaining the situation.
Mr. Sims and Mr. McWade sent Mr. Li a memorandum dated
May 8, 1992, which states:
Forwarded herewith are the administrative files
for the above-entitled cases, which were part of the
test cases in the Kersting Interest Deduction Program.
As per our discussion, the petitioners indicated a
desire to settle their cases, based upon the then
outstanding settlement offer, prior to the trial of the
test cases. Because of the stipulations of settlement
of tax shelter issues filed in the remaining non-test
cases, we felt settlement with petitioners, as test
cases, without trial was inappropriate. In lieu of a
stipulated settlement, we agreed to allow petitioners
the better of the settlement or trial results, once the
litigation was completed. Petitioners also established
their entitlement to additional actual losses
associated with another of Mr. Kersting's programs,
Balspar [sic]. We agreed to reflect the tax
consequences of such transactions in the final
determination of their tax liability for the respective
years.
The Court has now rendered its opinion in the
Kersting test case litigation and entered its decision.
In accordance with our agreement with petitioners, the
tax liabilities to be assessed in these cases, the
decision notwithstanding, are as follows:
- 146 -
I.R.C. Sections
Year Deficiency 6651(a)(1) 6653(a)(1) 6653(a)(2) 6621(c)
1979 -0- N/A -0- N/A -0-
1980 $15,000.00 N/A N/A N/A -0-
1981 $15,000.00 -0- -0- -0- -0-
In order to expedite the closing of these cases,
petitioners, through counsel, have executed waivers of
the limitations contained in I.R.C. § 6213(a), copies of
which are included in the files. Immediate processing
of the assessments are [sic] therefore appropriate.
If you have any questions regarding the processing
of this matter, pleased contact me at (808) 541-3350.
Shortly after receiving this memorandum, Mr. Li called Gary
Lipetzky (Mr. Lipetzky), an Appeals officer in Honolulu, who had
begun to gather information about the Bauspar program.
Mr. Lipetzky informed Mr. Li that he was the key Appeals officer
on the Bauspar program and that he had not formulated any
settlement offer for that program.
Mr. Li subsequently contacted his supervisor, Ron Wise
(Mr. Wise), Assistant Chief of Appeals in San Francisco, about
Mr. Sims' request. On May 22, 1992, Mr. Wise talked to Mr. Sims
about the Thompson cases. Mr. Sims told Mr. Wise that the
Thompsons had been selected as Kersting test cases, the Thompsons
had their own attorney, Mr. Kersting had threatened to sue the
Thompsons, Mr. Kersting had denied the Thompsons the return
on one of their investments, and Mr. Kersting considered
Mr. Thompson to be a renegade. Mr. Sims told Mr. Wise that he
and Mr. Thompson had worked out an informal arrangement that
the Thompsons would receive the better of the Tax Court decision
or the best settlement allowed to other Kersting program
- 147 -
participants before the trial. Mr. Sims told Mr. Wise that he
was concerned about the piggyback cases because the Thompsons
would be getting a better settlement and the Government had won
all the test cases.
Mr. Wise believed that Mr. Sims' request to make an
assessment that differed from a Tax Court decision required
higher level approval. On May 15, 1992, Mr. Wise forwarded
Mr. Sims' May 8, 1992, memorandum to his supervisor, Christian G.
Beck, Chief of the San Francisco Appeals Office. Mr. Wise told
Mr. Sims that he did not have authority to process his request
and indicated he was going to seek approval from Danny Cantalupo
(Mr. Cantalupo), Regional Director of Appeals for the Western
Region. On May 22, 1992, Mr. Cantalupo informed Peter D. Bakutes
(Mr. Bakutes) Deputy Regional Counsel (Tax Litigation) for the
Western Region, that the Appeals Office had received a request
from Mr. Sims to make an assessment in a Kersting test case on a
basis that differed from the Tax Court's decisions.
Under the management structure of the Western Regional
Counsel's Office, Mr. Bakutes reported directly to Mr. Sanchez.
As Deputy Regional Counsel, Mr. Bakutes was responsible for
general oversight of tax litigation in the Western Region,
including tax shelter cases, and for evaluating how such cases
should be handled. Mr. Bakutes had experience with tax shelter
procedures before becoming Deputy Regional Counsel. Mr. Bakutes
expected that, in the Western Region, a project attorney and the
attorney's manager would contact the Regional Office if they
- 148 -
wished to settle a project case on grounds different from the
official project settlement offer. Mr. Sanchez considered Mr.
Bakutes his key executive staff person and had directed all
District Counsel, including Mr. Sims, to discuss any unusual or
novel matters with Mr. Bakutes.
Mr. Bakutes and Mr. Cantalupo immediately informed
Mr. Sanchez about the Thompson settlement. This was the first
time Mr. Sanchez heard of the Thompson settlement. No one in the
Western Regional Counsel's Office knew of the unusual settlement
of Kersting cases before May 22, 1992. No one in the Western
Regional Office had approved the settlements.
Mr. Sanchez immediately called Mr. Sims, who admitted the
basic facts regarding the Thompson settlement arrangement.
Mr. Sims stated that his motivation for the settlement was to
prevent Mr. Kersting from perpetrating a fraud on the Court.
Mr. Sims stated that the best way to do this was to have at least
one attorney not paid by Mr. Kersting participate in litigating
the test cases.
After discussing the matter with Mr. Sims, Mr. Sanchez
contacted Mr. DeCastro and learned more of the details
surrounding the settlement. Mr. DeCastro informed Mr. Sanchez
that Mr. Sims and Mr. McWade had agreed to a proposal to keep the
Thompsons in the litigation by rebating to the Thompsons an
amount sufficient to pay their legal fees. Mr. Sanchez told
- 149 -
Mr. DeCastro that Mr. Sims had no authority to enter into such a
settlement.64
Mr. Sanchez promptly notified David Jordan (Mr. Jordan),
Acting Chief Counsel (National Office) of the basic facts
surrounding the Thompson settlement. Mr. Jordan told Mr. Sanchez
that Chief Counsel attorneys in the Tax Litigation Division in
the National Office would be brought into the matter for two
reasons: The gravity of the situation and the role of the Tax
Litigation Division in the National Office as the prime liaison
of the Internal Revenue Service with the Tax Court. Mr. Jordan
and Mr. Sanchez agreed that the Tax Court had to be notified
immediately.
Mr. Sanchez assigned Mr. Bakutes to investigate the matter
on behalf of Regional Counsel. Mr. Bakutes spent several weeks
gathering facts, so that the matter could be reported to the Tax
Court. Mr. Bakutes recognized that he needed to move quickly
because the period for appealing the decisions entered in the
Thompson cases would expire on June 11, 1992.
64
Mr. Sanchez believed that Mr. Sims was acting outside
the scope of his employment and authority when he deviated from
the terms of the official project settlement offer in the
Thompson cases, and when he purportedly used as a basis for
settlement a transaction (Bauspar) that had occurred in a tax
year over which he, as District Counsel, had no jurisdiction. We
observe that the Thompsons' participation in the Bauspar program
apparently originated in 1981--one of the years that the
Thompsons had pending before the Court--although the record does
not detail the deductions, if any, claimed by the Thompsons with
respect to the Bauspar program on their 1981 return.
- 150 -
On May 29, 1992, Mr. Sims sent a letter to Mr. DeCastro
informing him that the Thompson settlement had been rejected by
Regional Counsel, stating in pertinent part as follows:
As I'm sure you recall, on or about October, 1986,
you approached Ken McWade of this office with an offer
to settle * * * [the Thompson] cases based on the
Government's then outstanding settlement position for
the Kersting project. At that time, I informed you
that, since the Thompsons' cases had been designated as
test cases in the Kersting project litigation, I would
not approve of any settlement of these cases prior to
trial. Nonetheless, I represented to you that I would
exert my personal best efforts to see that the
Thompsons were not disadvantaged by my decision not to
settle. I also advised you that I was not in a
position to guarantee success inasmuch as approval of a
higher authority might be required. Finally, I advised
you that if the test case petitioners won, we would
allow you to enjoy that result. I am certain that both
you and I left with the clear understanding as a result
of what I had said, the [sic] we remained adversaries
with respect to the litigation.
Mr. Sims' letter further states that, absent an appeal, the
Internal Revenue Service would assess the full deficiencies in
the Thompson cases, consistent with the Court's Dixon II opinion,
plus all applicable statutory additions to tax. The total
assessment, including interest, would have been $302,396.12.
On June 1, 1992, Mr. Sims sent Mr. Sanchez a copy of
Mr. DeCastro's August 3, 1989 letter, signed by Mr. McWade,
acknowledging the second revision to the Thompson settlement. On
June 2, 1992, Mr. Sanchez and Mr. Bakutes had a conference call
with Messrs. Sims, McWade, and DeCastro. During the call,
Mr. DeCastro claimed that Mr. Thompson had a profit motive and
that Mr. Thompson's testimony was stronger on this point than
that of any of the other test case petitioners. Mr. DeCastro
- 151 -
also denied that the Thompson settlement was attributable in any
way to the Thompsons' participation in the Bauspar program.
On June 2, 1992, Mr. Bakutes directed Mr. Sims to send him
immediately the files in the Kersting test cases.
Mr. Bakutes assigned Mr. Dombrowski to assist him in
formulating respondent's position with respect to the settlement
arrangement. On June 3, 1992, Mr. Bakutes directed
Mr. Dombrowski to prepare motions to vacate the decisions in the
Thompson cases.
On June 3, 1992, Mr. Li prepared a memorandum summarizing
his earlier conversations with Mr. Sims, stating in pertinent
part as follows:
Per Bill Sims, the main reason for the lower deficiency
to be assessed was that the Thompsons wanted to settle
their case, based upon the then outstanding settlement
offer prior to the trial of the test cases. Sims
stated that because of the stipulations of settlement
of tax shelter issues filed in the remaining non-test
cases, Honolulu District Counsel felt settlement with
the petitioners, as test cases, without trial was
inappropriate.
Bill then stated to me that also Mr. Thompson was taken
by Mr. Kersting and that Mr. Thompson was considered a
traitor by all of the other Kersting's investors.
Mr. Thompson helped the government's case against
Mr. Kersting promotion with his testimony about the
Kersting promotion. Mr. Thompson was cooperative with
District Counsel and therefore District Counsel will
reduce the tax deficiency for all three years.
On June 4, 1992, Mr. Sims informed Mr. Bakutes that "Except
for the Thompson and Cravens cases, neither Ken nor I entered
into any 'best of both worlds' settlements, agreements, or
understandings, oral or written, formal or informal, with any
- 152 -
taxpayer or taxpayer's representative in any Kersting project
case."
On or about June 11, 1992, Mr. Sanchez decided that
Messrs. Sims and McWade should no longer have any authority over
the Kersting cases. At that time, Mr. Bakutes reassigned all 14
test case dockets to Mr. Dombrowski, and all the nontest cases in
the Kersting project to Mr. O'Neill. On June 12, 1992,
Mr. Sanchez informed Mr. Sims that he had withdrawn Mr. Sims'
delegation of authority to settle any matters relating to the
Kersting project, and that management of the Kersting project was
reassigned to Mr. Bakutes.
While Mr. Bakutes was carrying out his orders from
Mr. Sanchez, Mr. Jordan directed two senior attorneys in the Tax
Litigation Division in the National Office, Thomas J. Kane
(Mr. Kane), and Steven M. Miller (Mr. Miller), to investigate the
Thompson settlement on behalf of the National Office.
Messrs. Kane and Miller conducted in-house depositions and
interviewed various individuals who had participated in the test
case trial and the Thompson settlement. Mr. Bakutes directed
Mr. Dombrowski to provide information to aid Messrs. Kane and
Miller in their investigation.
E. Disclosure of Cravens Settlement
The Cravens case for the 1980 taxable year was the only test
case that required a computation for entry of decision under Rule
155. The computation was required in order to account for the
capital gain that the Cravenses had reported for 1980 on their
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surrender of their shares in Candace. An adjustment was also
required in order to eliminate respondent's alternative
determination that the Cravenses had unreported dividend income
for 1980. The Cravens case was the only test case presenting
these two issues.
On January 14, 1992, Mr. McWade forwarded a decision
document for the 1980 tax year to the Cravenses for their
signature. The decision was formulated by reference to the Tax
Court's December 11, 1991, opinion, as well as respondent's
computation for entry of decision, together with a computation
statement explaining how the decision was reached. Mr. O'Neill
prepared the aforementioned computations. Mr. O'Neill was not
aware at the time that Mr. McWade had entered into an agreement
to settle the Cravens cases before trial. The computation
statement accompanying respondent's computation for entry of
decision indicates that the proposed decision was based upon a
complete disallowance of the interest deductions listed in the
notice of deficiency issued to the Cravenses for 1980.
On January 30, 1992, the Cravenses signed the decision
documents and returned them to Mr. McWade. On February 4, 1992,
Mr. McWade signed the same documents and submitted them to the
Court. On March 13, 1992, the Court entered decisions in the
Cravens cases as follows:
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Additions to Tax
Sec. Sec. Sec.
Year Deficiency 6653(a) 6653(a)(1) 6651(a)(1)
1979 $4,508.00 $225.40 --- ---
1980 5,893.45 294.67 --- ---
The decisions entered in the Cravens cases did not
give effect to the settlement between Mr. Cravens and Mr. McWade.
Mr. Sims testified that he allowed the Court to enter decisions
in the Cravens cases for the full amount of the deficiencies as
computed by reference to the Court's opinion after the trial of
the test cases because he intended to honor his agreement with
the Cravenses by ensuring that a lower assessment would be
processed by the Appeals Office.
Mr. Sims spoke to Mr. Cravens about the difference between
the numbers in his settlement agreement and the larger numbers in
the Rule 155 computation and the decision documents. Mr. Sims
believed that Mr. Cravens understood that an assessment
consistent with his settlement would be made administratively.
However, when Messrs. Sims and McWade sent the Cravens cases to
the San Francisco Appeals Office for closing and assessment, they
did not request or instruct the Appeals Office to assess amounts
in accordance with the arrangement reached with Mr. Cravens in
December 1986.
Shortly after Messrs. Sanchez and Bakutes discovered the
Thompson settlement, Messrs. Sims and McWade disclosed the
Cravens settlement to them.
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F. Respondent's Motions To Vacate
On June 9, 1992, respondent filed motions for leave to file
motion to vacate the decisions that the Court had entered against
the Thompsons, the Cravenses, and Mr. Rina. Respondent's motions
included allegations that, before the trial of the test cases,
Messrs. McWade and Sims had entered into contingent settlement
agreements with the Thompsons and the Cravenses that were not
disclosed to the Court or to the other test case petitioners or
their counsel. Respondent requested the Court to conduct an
evidentiary hearing to determine whether the agreements with the
Thompsons and Cravenses had affected the trial of the test cases
or the opinion of the Court.
On June 22, 1992, the Court granted respondent's motions to
vacate filed in the Thompson and Cravens cases, vacated the
decisions entered in those cases, and ordered the parties to file
agreed decisions with the Court, or otherwise move as
appropriate. The Court denied respondent's request for an
evidentiary hearing. Also on June 22, 1992, the Court denied
respondent's motion to vacate the decision entered against
Mr. Rina, stating:
The Court has reviewed the testimony of Cravens,
the testimony of Thompson, the stipulated facts and
stipulated exhibits relating to the Cravenses and the
Thompsons, and the exhibits offered through Thompson as
a witness. The Court finds that these reviewed items
had no material effect on the opinion which the Court
filed on December 11, 1991, as that opinion relates to
petitioner Rina. If the reviewed items were stricken
from the record, the Court would file an opinion in all
material respects like the opinion it filed on
December 11, 1991 (with the exception of certain
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portions relating specifically and expressly to the
Cravenses or the Thompsons), and the Court's findings,
analyses, and conclusions relating to petitioner Rina
would remain the same. * * *
G. Attempted Discovery by Counsel for Nontest Case Petitioners
By letters dated June 24 and August 12, 1992, Messrs. Jones
and O'Donnell jointly requested that Mr. Dombrowski provide
informal discovery regarding the Thompson and Cravens
settlements. The earlier of the two letters included allegations
that Mr. Kersting withheld documents from the test case
petitioners that would have described "an underlying business of
great substance" because Mr. Kersting feared that the information
would increase his personal tax liability. Respondent declined
to respond to the informal discovery requests and did not allow
Messrs. Jones and O'Donnell to participate in any of the in-house
investigations conducted by Messrs. Bakutes, Dombrowski, Kane,
and Miller.
H. Closing of Thompson Cases/Further Refunds
In July 1992, Mr. DeCastro filed a motion for entry of
decision in accordance with the terms of the Thompson settlement
set forth in Mr. DeCastro's letter to Mr. McWade dated August 3,
1989; i.e., deficiencies of zero, $15,000, and $15,000 for the
taxable years 1979, 1980, and 1981, respectively. On August 20,
1992, respondent filed objections, with respondent's Motions for
Entry of Decision and respondent's Memoranda of Points and
Authorities, to Mr. DeCastro's motion for entry of decision.
Respondent's Motions for Entry of Decision described the facts
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discovered by Messrs. Miller, Kane, and Dombrowski in their
investigation of the Thompson settlement. Respondent alleged
that, sometime before the test case trial, Messrs. Sims and
McWade had agreed to settle the Thompson cases by reducing the
Thompsons' deficiencies in amounts sufficient to compensate the
Thompsons for their projected attorney's fees. Respondent
alleged that this "New Agreement" was designed--and constituted
an agreement by Messrs. Sims and McWade--to pay Mr. DeCastro's
legal fees. Respondent alleged that the "New Agreement" was
unauthorized and had no legal basis. Consequently, respondent
asked the Court to enter decisions in the Thompson cases
consistent with the initial McWade-DeCastro agreement of December
1986, which had allowed the Thompsons a reduction of
approximately 19 percent of their deficiencies with the burnout
feature; i.e., deficiencies of zero, $34,425, and $30,000 for the
taxable years 1979, 1980, and 1981, respectively.
On August 26, 1992, the Court granted Mr. DeCastro's motions
for entry of decision and entered decisions in the Thompson cases
as follows:
Year Deficiency Additions to Tax
1979 --- ---
1980 $15,000 ---
1981 15,000 ---
In January 1993, respondent entered assessments against the
Thompsons for the taxable years 1979, 1980, and 1981 based upon
the decisions entered by the Court in August 1992. Shortly
thereafter, the Thompsons received a refund check for $32,225,
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dated February 19, 1993, which the Thompsons endorsed to DeCastro
Law Corp.
The refund of $32,225 to the Thompsons was based upon the
conclusion that, as of December 30, 1986, when the Thompsons
first remitted a total of $59,545 as interest payments for the
years 1979, 1980, and 1981, the Thompsons' total tax liability
for those years, as reflected in the Court's decisions entered
on August 26, 1992, was approximately $57,500--comprising $30,000
in tax and $27,500 in interest. Accordingly, the Thompsons'
December 1986 remittance of $59,545 resulted in an overpayment
of approximately $2,045. In addition to this overpayment, on
June 17, 1987, the Thompsons had made an additional payment of
$62,225 towards their tax liability for 1979. The $32,225 refund
paid to the Thompsons on February 19, 1993, represents the
difference between the Thompsons' $62,225 payment and the $30,000
refund that the Thompsons had previously received in July 1989.
Following the receipt of the $32,225 refund, Mr. DeCastro
wrote to Mr. Dombrowski to complain that respondent had erred in
computing the amount of the Thompsons' overpayment. After
review of the matter, Mr. Dombrowski prepared a memorandum to
Mr. Bakutes dated September 17, 1993, requesting approval to
process an additional refund to the Thompsons of approximately
$32,000. Mr. Dombrowski stated that, in calculating the prior
refund of $32,225, respondent had erroneously treated the $62,225
payment that the Thompsons made in June 1987 as a cash bond
rather than an advance payment of tax. Viewing the $62,225
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payment as an advance payment of tax, Mr. Dombrowski concluded
that the Thompsons were entitled to interest on the resulting
overpayment.
Mr. Bakutes approved Mr. Dombrowski's request. Shortly
thereafter, Mr. Dombrowski requested the Fresno Appeals Office to
adjust the Thompsons' account, resulting in the Thompsons'
receipt of a third refund check, dated October 22, 1993, for
$32,116.68.
In November 1993, the Thompsons received a fourth refund
check for $4,107.93 with respect to their overpayment for the
taxable years 1979, 1980, and 1981. Presumably this check
reflected a refund of the overpayment of approximately $2,045
(with interest) that arose from the Thompsons' December 1986
payment of $59,545.
In sum, the Thompsons were refunded $98,449.61 of the
$121,770 that they paid for the taxable years 1979, 1980, and
1981. Of the $98,449.61 in refunds, the Thompsons assigned
$62,225 to DeCastro Law Corp.
As mentioned supra note 2, the Court of Appeals for the
Ninth Circuit held that the Thompson decisions became final
pursuant to section 7481(a)(1), despite the attempts by Messrs.
Sticht and Izen to appeal those decisions on behalf of nontest
case petitioners who sought to intervene.
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I. Closing of Cravens Cases
On July 1, 1992, Mr. Dombrowski wrote to the Cravenses
enclosing documents that were intended to enable them to
determine the proper decisions to be entered in their cases.
Mr. Dombrowski stated that, upon receipt of the Cravenses'
response, he would coordinate the matter with Mr. Bakutes to
determine the terms of agreed decisions that respondent would be
willing to submit to the Tax Court. On July 3, 1992, Mr. Cravens
responded to Mr. Dombrowski's letter with a written chronology of
the events leading to the settlement of his cases in December
1986.
On August 25, 1992, the Court entered agreed decisions in
the Cravens cases consistent with the proposed decisions that
Mr. McWade forwarded to the Cravenses in December 1988. The
decisions provide that the Cravenses are liable for deficiencies
for the taxable years 1979 and 1980 in the amounts of $3,606.40
and $6,175.76, respectively, and that the Cravenses are not
liable for any additions to tax. The decision for 1979 includes
a stipulation that the agreed deficiency does not take into
account advance payments in the amounts of $4,508 and $6,000 that
the Cravenses made in May 1983 and December 1986, respectively.
The decision for 1980 includes a stipulation that the agreed
deficiency does not take into account an advance payment in the
amount of $4,678.67 that the Cravenses made in December 1986.
On October 26, 1992, the Regional Director of Appeals for
the Western Region wrote a memorandum to the San Francisco
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Appeals Office requesting that the Cravens cases be closed in
accordance with special closing instructions. The intent of
these instructions as stated in the memorandum was "to cause the
taxpayers' 1979 and 1980 accounts to zero out with no further
amounts due." This was to be accomplished by adjusting the
interest that would otherwise have become due on the assessments
made in accordance with the stipulated decision previously
entered by the Tax Court on August 25, 1992. The memorandum
explained the proposed interest adjustment as follows:
The amount of interest being assessed has been
adjusted because the decision document tendered to
petitioners and subsequently filed with the Court in
settlement of this case did not comport with District
Counsel's 1986 settlement offer. The settlement offer
provided that the first year deficiency would be
shifted to the second year. Accordingly, there would
have been no deficiency for 1979 and the deficiency for
1980 would have been increased to $9,782 ($3,606 +
$6,176). The amount of interest being assessed has
been adjusted because this provision was not included
in the decision documents and because the decision
documents in this case were not promptly prepared and
filed with the Tax Court in December 1986 when the case
was settled. The balance of the adjustment relates to
computational errors in District Counsel's original
computation of the amounts due.
The authority stated in the memorandum for reducing the amounts
due from the Cravenses was section 6404(a)(1), relating to
excessive assessments, and section 6404(e)(1), relating to
abatement of interest.
As mentioned supra note 2, the Court of Appeals for the
Ninth Circuit held that the Cravens decisions became final
pursuant to section 7481(a)(1), despite the attempts by Messrs.
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Sticht and Izen to appeal those decisions on behalf of Kersting
project nontest case petitioners who sought to intervene.
PROCEDURAL HISTORY OF EVIDENTIARY HEARING
I. Developments Before Evidentiary Hearing
A. Referral of Thompson and Cravens Settlements to Office of
Inspector General
When Mr. Sanchez learned of the Thompson and Cravens
settlements, he decided to refer the matters to the Department
of the Treasury, Office of the Inspector General (the OIG).65 On
June 30, 1992, Robert J. Wilson (Mr. Wilson), Special Litigation
Assistant, General Legal Services, Western Region, made a written
referral to the OIG. In the referral, Mr. Wilson alleged that
Messrs. Sims and McWade had entered into undisclosed, contingent
settlements with the Thompsons and the Cravenses. The referral
further alleged that the Thompsons' deficiencies had been reduced
to pay their attorney's fees. Mr. Wilson's referral further
alleged that Messrs. Sims and McWade had grossly violated
procedures, and that Mr. McWade might have made false statements.
Mr. Wilson served as the liaison between the Western
Regional Counsel's Office and the OIG. Mr. Sanchez believed that
the Region's referral to the OIG ended his investigatory
65
The Office of the Inspector General (Dept. of the
Treasury) was established under the Inspector General Act
Amendments of 1988, Pub. L. 100-504, 102 Stat. 2515, codified as
amended at 5 U.S.C. app. at 1381 (1994). The Inspector General's
duties include the conduct, supervision, and coordination of
audits and investigations to prevent and/or detect fraud and
abuse in the Treasury Department and the reporting of possible
criminal violations to the Attorney General.
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authority over the matter and that his only remaining
responsibility was to assist the OIG with its investigation.
Upon receipt of the referral, OIG assigned Senior Special
Agent Leland D. Halleck (Mr. Halleck) to investigate the matter.
Mr. Sanchez directed Mr. Dombrowski to provide Mr. Halleck with
all documents in respondent's possession that Mr. Halleck might
request and to answer Mr. Halleck's questions. As part of his
investigation, Mr. Halleck considered whether there had been any
bribery in violation of 18 U.S.C. section 201. A violation of
this section had not been included in the Internal Revenue
Service referral but was added by the OIG. Mr. Halleck was not
restricted from investigating any other possible violations
relating to the Thompson and Cravens settlements.
Mr. Halleck interviewed Messrs. Sims and McWade in October
1992. Messrs. Sims and McWade told Mr. Halleck that they would
not allow any of the Kersting test case petitioners to settle
because: (1) They did not want the test case litigation
delayed;66 (2) they would have had to find replacement cases with
66
As indicated supra pp. 41-42, removal of the Thompson
and Cravens cases from the test case array in January 1987 would
not necessarily have caused a delay in the trial of the test
cases insofar as the Kersting programs in which the Thompsons and
Cravenses had participated during the years in issue were before
the Court in other test cases. On the other hand, removal of the
Cravens cases might have caused the remaining test case
petitioners to argue that the Cravens cases should be replaced
because Mr. Cravens was the only test case petitioner to report
capital gains upon the termination of his Kersting program. In
any event, the nearly 2-year delay in the trial of the test cases
after Chicoine and Hallett were allowed to file amendments to
petitions raising evidentiary issues provided ample time for
(continued...)
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similar characteristics; and (3) they were concerned about the
possible effect on the other Kersting project cases. The OIG
report includes Mr. Sims' affidavit, executed October 29, 1992,
which states that it was his recollection that the final version
of the Thompson settlement agreement was agreed to before the
trial of the test cases. Mr. Sims' affidavit also includes the
following statement: "I can recall numerous discussions with
McWade concerning our own trial strategy as well as discussions
concerning the anticipated strategies of both Izen and DeCastro,
but no discussions whatsoever concerning any ‘settlement’."
On December 9, 1992, the OIG report prepared by Mr. Halleck
was completed. The OIG report concluded that Messrs. Sims and
McWade had: (1) Agreed to special arrangements with the
Thompsons and the Cravenses; and (2) provided a special
arrangement for the Thompsons designed to compensate them for
their attorney's fees. Mr. Halleck concluded that Messrs. Sims
and McWade had not benefited financially or otherwise by agreeing
to the special arrangements.
In Mr. Halleck's opinion, Messrs. Sims' and McWade's
agreement to arrange a refund to be used to pay the Thompsons'
legal fees violated 31 C.F.R. section 0.735.30(a)(5) (making a
decision outside of official channels).
66
(...continued)
Messrs. Sims and McWade to disclose the Thompson and Cravens
settlements to the Court and to reach agreement with test case
petitioners' counsel for selection of replacement cases.
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B. Revival of 7-Percent Settlement Offer
In January 1993, Mr. O'Neill notified all known Kersting
nontest case petitioners that the Commissioner would settle their
cases on a basis "consistent with the original project settlement
offer that was extended to Kersting investors before the trial
of the test cases": A 7-percent reduction of the deficiency,
elimination of all additions to tax, and interest imposed at the
normal rate prescribed in section 6621; the burnout feature was
not provided for. The settlement offer, which was extended for
only 60 days, was accepted by a few Kersting petitioners.
C. Disciplinary Actions
On July 29, 1993, Mr. Sanchez sent Notices of Proposed
Disciplinary Action to Messrs. Sims and McWade. The notices
asserted that Messrs. Sims and McWade had violated:
(1) Department of the Treasury Minimum Standards of Conduct,
section 0.735-30(a)(2) (an employee shall avoid any action which
might result in or create the appearance of giving preferential
treatment to any person); (2) Department of the Treasury Minimum
Standards of Conduct, section 0.735-30(a)(6) (an employee shall
avoid any action that might adversely affect the confidence of
the public in the integrity of the Government); and (3) Internal
Revenue Service Rule of Conduct 214.5 (an employee will not
intentionally make false or misleading verbal or written
statements in matters of official interest). The notices
proposed to suspend both Messrs. Sims and McWade for 14 calendar
days without pay.
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Mr. Sanchez' Notices of Proposed Disciplinary Action to
Messrs. Sims and McWade listed the following reasons for the
proposed disciplinary actions: (1) Negotiating an unauthorized
settlement agreement with the Thompsons; (2) basing the Thompson
settlement on unaudited and insufficiently documented losses from
an unrelated shelter; (3) allowing the Thompsons a settlement
that provided them more favorable treatment than other taxpayers;
(4) compensating the Thompsons for their attorney's fees; and (5)
not informing the Tax Court of the Thompson settlement
arrangements.
Mr. Sims responded in writing to Mr. Sanchez on
September 14, 1993. Nonetheless, Mr. Sanchez sustained the
Notice of Proposed Disciplinary Action issued to Mr. Sims.
Mr. McWade retired from the Internal Revenue Service
effective October 2, 1993, rather than accept a transfer to the
Los Angeles District Counsel Office. On November 2, 1993,
Mr. Jordan approved Mr. Sanchez' proposed disciplinary action.
Mr. Sims was suspended from duty without pay for 14 days and was
transferred to the San Francisco Regional Counsel Office, where
he was assigned nonsupervisory duties as a Special Litigation
Assistant in the General Litigation area.
D. Indictment of Mr. Izen
On May 3, 1995, following an investigation by the Criminal
Investigation Division of the Internal Revenue Service, a Federal
grand jury indicted Mr. Izen on four counts of conspiracy and
money laundering under 18 U.S.C. sections 371 and 1956(a)(3)(A)
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and (B). Approximately 1 year later, in May 1996, shortly before
commencement of the evidentiary hearing, the indictment was
dismissed. Mr. Izen testified at the commencement of the
evidentiary hearing that the indictment had been a distraction
that made it difficult for him to prepare for the evidentiary
hearing, but that he had participated in discovery and was ready
to go forward and participate in the evidentiary hearing on
behalf of the test case petitioners.
E. Pretrial Conference (July 1995)
On July 17, 1995, the Court held a pretrial conference on
the record for the purpose of addressing various issues,
including the scheduling of the evidentiary hearing,
identification of the parties who would participate in the
evidentiary hearing, and scheduling of discovery. The Court also
commented at the conference that the Thompson and Cravens
settlements appeared to share some characteristics with so-called
Mary Carter agreements.
Respondent was represented at the conference by Mr. O'Neill
and Mr. Dombrowski. During the conference, Mr. O'Neill
questioned whether Mr. Izen should be disqualified as counsel
because he would probably be called as a witness at the
evidentiary hearing. During the conference, the Court questioned
whether Mr. Dombrowski should represent respondent at the
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evidentiary hearing, in view of his participation as counsel in
the trial of the test cases.67
F. Pretrial Conference (January 1996)
On January 16, 1996, the Court held a second pretrial
conference on the record to obtain oral status reports from the
parties respecting discovery and the stipulation process, to
establish the format for the evidentiary hearing, and to discuss
possible conflicts of interest affecting counsel.68
Specifically, the Court and the parties discussed possible
conflicts of interest of Mr. Izen and Mr. DeCastro.
G. Denial of Respondent's Motion To Disqualify Mr. Izen
On February 12, 1996, respondent filed a motion to
disqualify Mr. Izen as counsel on the ground that he would be a
necessary witness at the evidentiary hearing.69 By order dated
April 1, 1996, the Court noted that, because Mr. Izen was likely
to testify at the evidentiary hearing, Mr. Izen's testimony might
in some sense prove to be adverse to the interests of his
clients. With these concerns in mind, and relying on ABA Model
67
While both Messrs. Dombrowski and O'Neill testified at
the evidentiary hearing, neither of them served as respondent's
counsel at the evidentiary hearing.
68
By order dated May 2, 1996, the Court indicated that it
would defer ruling on the assignment of the burden of proof and
the standard of proof to be applied in these cases.
Nevertheless, the Court established a procedure for the orderly
presentation of evidence at the evidentiary hearing.
69
On Oct. 4, 1995, respondent had filed a motion to
disqualify Mr. Izen as counsel on similar grounds. By order
dated Oct. 17, 1995, the Court had denied respondent's motion
without prejudice to renew pending the completion of discovery.
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Rules of Professional Conduct rules 1.7(b) and 3.7(a), the Court
directed Mr. Izen to contact each of his clients in writing and
to inform them of the potential for a conflict of interest and to
file a report with the Court revealing whether his clients
consented to his remaining as counsel.70 On April 22, 1996, Mr.
Izen filed a report with the Court, attaching thereto a copy of a
letter that he had written to each of his clients describing the
possible conflict of interest along with executed waivers signed
by his clients consenting to his continued representation of them
at the evidentiary hearing. By order dated April 23, 1996, the
Court denied respondent's motion to disqualify Mr. Izen, citing
the consents of his clients to his continued representation of
them and the financial hardship that his disqualification would
impose on them. In so doing, the Court rejected the suggestions
of Messrs. Sticht and Jones that Mr. Izen should associate
himself with additional counsel for the conduct of the
evidentiary hearing.
70
ABA Model Rules of Professional Conduct rule 1.7(b)
states in pertinent part that a lawyer shall not represent a
client if the representation may be materially limited by the
lawyer's own interests unless that lawyer reasonably believes the
representation will not be adversely affected and the client
consents after consultation. ABA Model Rules of Professional
Conduct rule 3.7(a) states in pertinent part that a lawyer
generally shall not act as advocate at a trial in which the
lawyer is likely to be a necessary witness. See Ewing v.
Commissioner, 91 T.C. 396, 397 n.2 (1988), affd. without
published opinion 940 F.2d 1534 (9th Cir. 1991); Para Techs.
Trust v. Commissioner, T.C. Memo. 1992-575.
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H. Mr. DeCastro's Withdrawal
By order dated April 3, 1996, the Court directed
Mr. DeCastro to show cause why he should not be disqualified from
serving as counsel or otherwise representing the Thompsons at the
evidentiary hearing.71 On April 10, 1996, the Court received a
letter from Mr. DeCastro stating that he had withdrawn his
representation of the Thompsons and that they would retain
substitute counsel to represent them at the evidentiary hearing.
By order dated April 11, 1996, the Court discharged as moot its
order to show cause dated April 3, 1996. Mr. Huestis entered his
appearance on behalf of the Thompsons at the evidentiary hearing.
I. Discovery of Alexander Decisions and Referral to Office of
Inspector General
Shortly before commencement of the evidentiary hearing, the
parties discovered that decisions had been entered in the
Alexander cases eliminating their deficiencies for 1974, 1975,
1976, and 1977.72 On May 10, 1996, Martha Sullivan
(Ms. Sullivan), successor to Mr. Sanchez as Regional Counsel,
Western Region, referred the matter to the OIG. The referral
questioned whether the Alexanders had received a beneficial
71
Again, the Court relied primarily upon ABA Model Rules
of Professional Conduct rules 1.7(b) and 3.7(a) as the bases for
its order.
72
It appears that the Alexander correspondence that had
been attached to Mr. McWade's motion to take Mr. Kersting's
deposition, filed in the test cases on Aug. 25, 1988, piqued
Mr. Sticht's curiosity and led him to request discovery of the
Alexander files of the Internal Revenue Service for the taxable
years 1974-77.
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resolution of their tax cases that was inconsistent with the
settlements offered to other Kersting program participants.
Ms. Sullivan's referral to the OIG was assigned to
Mr. Halleck. On July 29, 1996, the OIG informed Ms. Sullivan
that the OIG would take no further action. The stated grounds
were the expiration of the period of limitations for criminal
prosecution of any acts of wrongdoing by Messrs. Sims and McWade
and the OIG's prior investigation and report.
J. Mr. Izen's Motion To Compel Production of Documents and
Issuance of Protective Orders
On April 26, 1996, the Court granted Mr. Izen leave to file
a Motion to Compel Answers to Deposition Questions and Production
of Documents.73 Mr. Izen argued that the Court should rule that
the crime-fraud exception to the attorney-client privilege
applies to these cases and that various witnesses, including
Messrs. Thompson, DeCastro, Sims, McWade, and a number of
additional Government attorneys, were barred from asserting
the attorney-client privilege in response to outstanding
discovery requests.74 The Court initially ordered respondent,
Mr. Thompson, and Mr. DeCastro to file responses to Mr. Izen's
73
Leave to file the motion to compel was necessary insofar
as the motion was filed beyond the Mar. 29, 1996, deadline for
completing discovery as set forth in the Court's order dated
Sept. 14, 1995, as amended by order dated Dec. 28, 1995.
74
The documents that the Government declined to produce
were listed in a privilege log and supplemental privilege log
that were attached to Mr. Sticht's Supplement to Petitioners'
Motion for Court Order Permitting Department of Treasury to
Disclose Information Pursuant to Privacy Act and Response to
Objections to Notice of Deposition filed Apr. 8, 1996.
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motion attaching thereto any documents alleged to be privileged
for in camera inspection. However, on May 6, 1996, Mr. Sticht
filed an objection to Mr. Izen's motion, arguing that it would be
inappropriate and potentially harmful to petitioners' cases for
the Court to review respondent's documents before the evidentiary
hearing, and that Mr. Izen's motion violated a private agreement
between Messrs. Izen and Sticht concerning discovery matters.
Mr. Sticht further stated that he could not support Mr. Izen's
motion insofar as it pertained to Messrs. Thompson, DeCastro, and
Huestis, without a privilege log describing the documents in
dispute.
On May 6, 1996, the Court issued an order amending its prior
order directing respondent, Mr. Thompson, and Mr. DeCastro to
submit documents to the Court for in camera inspection. On
May 9, 1996, the Court issued an order directing Messrs. DeCastro
and Huestis to appear at the call of the calendar at the
commencement of the evidentiary hearing and file with the Court
written responses to Mr. Izen's motion to compel and privilege
logs describing any disputed documents. Messrs. DeCastro
and Huestis complied with the Court's order. In addition,
Mr. Huestis filed motions to quash trial subpoenas duces tecum
that Mr. Sticht had served on Messrs. Thompson and Huestis.
On May 15, 1996, pursuant to the Court's directive and in
response to trial subpoenas duces tecum that Mr. Sticht had
served on Mr. Huestis and Mr. Thompson, Mr. Huestis filed a
response, attaching thereto a privilege log. On May 17, 1996,
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Mr. Huestis filed a supplemental privilege log. On May 24, 1996,
following an in camera review of the documents that Mr. Huestis
claimed were privileged, the Court ruled that the majority of the
documents in question were not protected from disclosure. In
response to the Court's ruling, Mr. Huestis made an oral motion
for a protective order on behalf of Mr. Thompson requesting that
the parties maintain the confidentiality of all documents
identified in Mr. Huestis' privilege logs. On June 10, 1996, the
Court issued an order granting Mr. Huestis' oral motion for
protective order. In particular, the Court placed under seal
Exhibits 943-AMD through 975-ANJ, 978-ANM, and 979-ANN, and
directed the parties to maintain the confidentiality of the
documents. By order dated June 26, 1996, the Court placed
additional exhibits under seal, including Exhibits 995-ANO
through 1015-AOI and 1018. The Court's order also placed under
seal a relevance memorandum filed by Mr. Sticht on June 24, 1996.
The Court indicated that the affected parties would be given
notice and an opportunity to respond before the Court lifted its
protective orders with respect to these documents.75
K. Burden of Proof and Rule 145 Order
By order dated May 2, 1996, the Court announced that it
would defer ruling on assignment of the burden of proof and
75
By order dated Aug. 27, 1998, the Court directed the
parties to file reports with the Court stating in detail any
objection to the lifting of the Court's protective orders. As
discussed in greater detail below, the Court will lift its
protective orders dated June 10 and 26, 1996.
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standard of proof to be applied with respect to the evidentiary
hearing. Nevertheless, the Court prescribed a structure for the
orderly presentation of witnesses at the evidentiary hearing. In
particular, consistent with the Court's view that respondent was
in the best position in the first instance to present the Court
with the facts critical to an understanding of the misconduct of
respondent's attorneys in the trial of the test cases, the Court
directed that respondent's case would be put on first.
Respondent's witnesses were to be called to testify in turn,
subjected to direct examination by respondent, and then passed to
Mr. Sticht, Mr. Izen, and Mr. Jones, respectively, for additional
direct or cross-examination.76 Following the examination of
respondent's witnesses, Mr. Sticht's remaining witnesses would be
called to testify in turn, subjected to direct examination by
Mr. Sticht, and then passed to respondent, Mr. Izen, and
Mr. Jones, respectively, for additional direct or cross-
examination. This process would be repeated for Mr. Izen's and
Mr. Jones' witnesses.
In the same order, the Court invoked Rule 145, which
provides that, on the Court's own motion, the Court may order
witnesses excluded from the courtroom so that they cannot hear
76
Because each of the parties listed many of the same
witnesses in their trial memoranda, the Court ruled that those
witnesses would be subjected to direct examination by each
party’s counsel who had listed the witness in his trial
memorandum, regardless of the order in which the witness was
passed to the party.
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the testimony of other witnesses.77 The Court further directed
that any witness testifying at the evidentiary hearing would be
precluded from discussing his or her testimony with any other
witness or providing any other witness with a transcript of his
testimony.
II. The Evidentiary Hearing
The evidentiary hearing in these cases was conducted in
Los Angeles on May 13 to 30, 1996, June 10 to 26, 1996, and
August 18, 1997. The Court heard testimony from 29 witnesses
during the evidentiary hearing and received approximately 500
exhibits. The transcripts of the proceedings consist of more
than 6,700 pages. In addition, between May 13, 1996, and
October 6, 1997, the parties filed with the Court a stipulation
of facts and first through sixth supplemental stipulations of
facts.
77
Rule 145(a) is designed to prevent witnesses from
tailoring their testimony to that of prior witnesses and to
minimize altered testimony. See Thompson v. Commissioner, 92
T.C. 486, 494 (1989).
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A. Testimony78
1. Mr. Cravens
Mr. Cravens appeared at the evidentiary hearing and
confirmed and expressly adopted every aspect of his prior
testimony at the Dixon II trial. Mr. Cravens testified that he
did not intend to have a secret settlement, that he did not
change his testimony at the original trial even though he had
settled his case, that he would not have "sold out" the other
pilots for money or a greater settlement offer, and that he had
no disputes with Mr. Kersting when he testified at the original
trial. Mr. Cravens testified that his testimony at the trial of
the test cases was incomplete insofar as he had failed to testify
that he believed that the promissory notes that he had signed
were valid and enforceable.
Mr. Cravens testified that he did not keep the fact that he
had settled his case a secret before the trial of the test cases.
He discussed his settlement with Mr. Kersting several times
78
The following summaries of the testimony of various
witnesses at the evidentiary hearing are provided for the sake of
convenience and are not part of the Court's findings of fact.
Also, these summaries do not cover the testimony of all witnesses
who testified at the evidentiary hearing.
On the basis of our observations at trial and our review
of the record, we conclude that the testimony of Messrs. Sims
and McWade lacks credibility, particularly their testimony
regarding the reasons for and circumstances surrounding the
Thompson and Cravens settlements and the Alexander understanding.
Mr. Alexander's testimony lacks credibility because of its
evasiveness, particularly his misleading response at the original
trial concerning his understanding with Mr. McWade regarding
reduction of the Alexanders' tax liabilities. See supra note 58.
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before the trial. Mr. Kersting was concerned that Mr. Cravens'
settlement would affect his testimony. Mr. Cravens told
Mr. DeCastro that he was representing himself at the trial
because he had settled and did not need to incur the legal
expense. Mr. Cravens was uncertain whether he informed Mr. Izen
of his settlement.
Mr. Cravens understood that he would testify at the trial of
the test cases "that I sold the stock and received a profit off
the stock, and * * * that I paid taxes on the sale of the stock."
These are the two reasons he recalls being selected as a test
case by Mr. Seery. Mr. Cravens assured Mr. Kersting that he was
going to testify truthfully regardless of his settlement.
Between the time of his December 1986 settlement and the
trial of the test cases in January 1989, Mr. Cravens received
"reams of documents" relating to the trial that he paid no
attention to and did not question. Before the trial of the test
cases, Mr. Cravens did not know the identities of the remaining
test case petitioners. Mr. Cravens had never met any of the
other test case petitioners, and he never participated in any
joint strategy sessions to prepare for trial. Mr. Cravens did
not understand the difference between being a witness and
allowing his case to serve as a test case.
Upon his arrival in Hawaii, Mr. Cravens met Mr. McWade in
person for the first time. Until Mr. Cravens arrived at the
trial, he was not sure of his exact role in the process, although
he believed that his testimony would be very important to the
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outcome. Mr. Cravens became surprised and suspicious when
Mr. McWade told him that he would receive a refund of the money
he had paid pursuant to his settlement if the petitioners in test
cases prevailed at trial. Mr. Cravens was not prepared for this
"change" in his settlement. Mr. Cravens asked Mr. McWade about
the change, but did not get a satisfactory answer. Mr. Cravens
had the impression that Mr. McWade did not want to discuss the
subject. Mr. Cravens denied that he had an added incentive to
testify at the trial because he was told he could get his money
back if the taxpayers won. He thought that all he could do was
testify truthfully to the matters that had caused his case to be
selected as a test case.
Mr. Cravens recalled that Mr. DeCastro's demeanor outside
the courtroom was "very anti-taxpayer * * * at least Kersting
taxpayers." Mr. Cravens had lunch with Mr. McWade and a group of
other persons before testifying at the trial of the test cases.
The group did not discuss Mr. Cravens' testimony during lunch.
After lunch, Mr. McWade informed Mr. Cravens that he would have
to make a statement to the Court because he was not represented
by an attorney who could ask him questions. Mr. McWade did not
tell Mr. Cravens what to say in his statement to the Court, or
how to respond to Mr. McWade's questions.
2. Mr. Thompson
Mr. Thompson appeared at the evidentiary hearing and
testified that he retained Mr. DeCastro to negotiate a settlement
in his tax cases and that it was his understanding in December
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1986 that his cases were settled for a fixed amount although he
would receive a refund if the test case petitioners prevailed at
trial. Mr. Thompson further testified that, by virtue of his
settlement, he had informed Mr. DeCastro that he would not pay
attorney's fees for representation at the trial of the test
cases.
Mr. Thompson testified that the testimony that he provided
at the trial of the test cases was completely truthful, that his
testimony was not coached by either Mr. DeCastro or Mr. McWade,
and that he wanted to testify in part to influence Mr. Kersting
to withdraw his threats. Mr. Thompson testified that the $80,000
Bauspar loss that he mentioned in his testimony at the trial of
the test cases was not an out-of-pocket loss but the loss of the
returns he expected as a result of his participation in the
Bauspar program.
3. Mr. Alexander
Mr. Alexander appeared at the evidentiary hearing only after
Mr. Sticht made several unsuccessful attempts to serve him with a
subpoena. Mr. Alexander's credibility as a witness at the
evidentiary hearing was severely impaired by his evasive
testimony and total lack of recall of the circumstances that led
to the decisions eliminating his tax liabilities for 1974, 1975,
1976, and 1977. Mr. Alexander testified that he did not receive
a "finder's fee" for the information or assistance that he
provided to Mr. McWade during the trial of the test cases, nor
would he admit that he had arrived at an understanding with
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Mr. McWade for any reduction of the tax liabilities on his joint
returns for the years 1974, 1975, 1976, and 1977.
4. Mr. McWade
Mr. McWade appeared at the evidentiary hearing and testified
that, when settlement discussions first arose in the Thompson
and Cravens cases, he believed he had a problem with conflicting
Government policies. In particular, Mr. McWade testified that
while he was obliged by Internal Revenue Service policy to treat
similarly situated taxpayers alike, the Internal Revenue Service
also had a policy against settling test cases.79 Mr. McWade did
not confer with anyone in the National Office or the Regional
Counsel's office regarding resolution of the conflict that he
perceived; Mr. Sims was the only person with whom Mr. McWade
discussed the alleged conflicting policies. Mr. McWade did not
feel any obligation to coordinate the Thompson settlement
arrangement with the National Office or Regional Counsel because
he had discussed the arrangements with Mr. Sims.
Mr. McWade testified that the Thompson settlement was
revised in the summer of 1989 in order to dispose of the Bauspar
issue. Mr. McWade denied that the Thompson settlement was
revised to provide a means for the Thompsons to pay
Mr. DeCastro's attorney's fees.
79
Contrary to Mr. McWade's testimony, we found that the
Internal Revenue Service did not maintain a policy prohibiting
the settlement of a test case. See supra p. 76.
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Mr. McWade initially testified that he informed Messrs.
Dombrowski and Hatfield about the Thompson and Cravens settlement
agreements before the trial of the test cases. However,
Mr. McWade later testified that he may have not informed Messrs.
Dombrowski and Hatfield of the agreements. Mr. McWade testified
that he had no recollection that he had informed Mr. O'Neill
about the Thompson and Cravens settlement agreements.80
Mr. McWade denied offering Mr. Alexander any inducements to
either cooperate with the Government or testify at the trial of
the test cases. Mr. McWade acknowledged that Mr. Alexander
provided assistance to him in understanding certain aspects of
the Kersting programs during the trial of the test cases.
Mr. McWade did not provide the Court with any credible
explanation or justification of the decisions entered in the
Alexander cases for the taxable years 1974 through 1977, which
completely wiped out the deficiencies previously determined on
the statutory notices.81
Mr. McWade denied that Mr. DeCastro passed information to
him regarding Mr. Izen's trial strategy or that Mr. DeCastro
80
Messrs. Dombrowski, Hatfield, and O'Neill denied having
any knowledge of the Thompson and Cravens settlements before
their discovery in 1992.
81
Contrary to the Court's Dixon II opinion, the decisions
in the Alexander cases for 1974 and 1975 reflected overpayments
of $2,133 and $811, respectively, while the decisions in the
Alexander cases for 1976 and 1977 reflected no deficiencies. See
supra pp. 112-115.
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otherwise acted as a "mole" or "plant" for respondent with
respect to the Kersting test cases.
5. Mr. Sims
Mr. Sims testified that he approved the Thompson and Cravens
settlements with the understanding that he would do his best to
process the proposed decisions but that he did not guarantee the
outcome. Mr. Sims testified that Mr. McWade's letters to
Mr. DeCastro stating that the decisions would be filed with the
Court later indicate that Mr. McWade misunderstood Mr. Sims'
intentions. Mr. Sims further testified that decisions could not
be entered in the Thompson and Cravens cases before the trial
of the test cases out of concern that taxpayers who had signed
piggyback agreements would argue that they were entitled to
similar settlements. Mr. Sims characterized as an oversight his
approval of Mr. McWade's decision to forward decision documents
to the Cravenses for their signature 1 month before trial of the
test cases.
With regard to the Thompson settlement, Mr. Sims testified
that he felt it was important to keep Mr. DeCastro in the case
because, unlike Mr. Izen, Mr. DeCastro was not being paid by
Mr. Kersting. However, Mr. Sims testified that he was aware, as
early as December 1986, that Mr. DeCastro did not believe that
Kersting interest deductions could be defended in court.
Mr. Sims further testified that he felt sympathy for Mr. Thompson
because of Mr. Kersting's threats and that he suggested that
Mr. Thompson's participation in the Bauspar program could be used
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to offset or reduce the Thompsons' tax liability. Mr. Sims was
unable to confirm that he reviewed Mr. Thompson's Bauspar records
as a basis for revising the Thompson settlement agreement.
Mr. Sims testified that he and Mr. McWade had reached an
agreement in principle with Mr. DeCastro before the trial of the
test cases to further reduce the Thompsons' tax liabilities.
Mr. Sims testified that he did not know the basis upon which
the Alexander cases were settled and that he never discussed the
settlements with either Mr. McWade or Mr. Alexander.
Mr. Sims denied that Mr. DeCastro passed information to the
Government regarding Mr. Izen's trial strategy or that
Mr. DeCastro otherwise acted as a "mole" or "plant" for
respondent with respect to the Kersting test cases.
6. Mr. DeCastro
Mr. DeCastro testified that the settlement agreement that he
negotiated with Mr. McWade assured the Thompsons of the better of
the pretrial settlement or the outcome in the trial of the test
cases and that the agreement was not contingent on Mr. Sims' best
efforts.
Mr. DeCastro testified that the final revision to the
Thompson settlement was agreed to before the trial of the test
cases, that the revision was made to account for the attorney's
fees that Mr. Thompson would incur in the trial of the test
cases, and that Mr. Thompson's participation in the Bauspar
program was not the basis for the revision.
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Mr. DeCastro testified that Mr. McWade considered various
elements in negotiating settlements in Kersting cases, including
the level of the taxpayer's participation in the Kersting
programs and whether the taxpayer had escaped liability in other
years by virtue of the expiration of the period of limitations.
Mr. DeCastro denied passing any information to
Messrs. McWade or Sims regarding Mr. Izen's trial strategy or
that he otherwise acted as a "mole" or "plant" for respondent
with respect to the Kersting test cases.
7. Mr. Izen
Mr. Izen was the first witness to testify at the evidentiary
hearing.
Mr. Izen testified that he had several discussions with
Mr. DeCastro, beginning with Mr. Kersting's deposition in October
1988 through the eve of the trial of the test cases, during which
he revealed his trial strategy to Mr. DeCastro. Mr. Izen
testified that he attempted to "enlighten" Mr. DeCastro, who was
openly pessimistic regarding the chances for success in the trial
of the test cases.
Mr. Izen testified that Mr. DeCastro was upset on the eve of
trial of the test cases that all documentation needed to support
the test case petitioners' position had not been made available
to petitioners. Mr. Izen testified that he did not serve a
subpoena on Mr. Kersting before the trial of the test cases
because he had relied upon the subpoena that Mr. McWade had
served on Mr. Kersting.
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Mr. Izen testified that he met Mr. DeCastro, with
Mr. Hongsermeier and Mr. Bradt, in a hotel room on the eve of
trial of the test cases. Mr. Izen testified that he discussed
confidential matters with Mr. Hongsermeier in Mr. DeCastro's
presence that he would not have revealed to Mr. DeCastro had he
known of the settlement that Mr. DeCastro had negotiated on
behalf of the Thompsons. Mr. Izen testified that he was aware
that respondent planned to rely on the so-called comfort letters
at the trial of the test cases, inasmuch as some of the letters
were included in stipulations of fact filed with the Court, and
that he informed Mr. DeCastro that he would offer evidence of
collection actions brought by various Kersting companies against
Kersting program participants to counter the comfort letters.
Mr. Izen testified that Mr. DeCastro grabbed notes out of
his hand during the trial of the test cases, that Mr. DeCastro
was in a position to overhear Mr. Izen's conversations with his
witnesses during the trial of the test cases, and that Mr. Izen
observed Mr. DeCastro conducting a "private" conversation with
Mr. McWade during the trial of the test cases. Mr. Izen
testified that his allegations in oral argument before the Court
of Appeals for the Ninth Circuit in the DuFresne appeal that
Mr. DeCastro was a "mole" or "plant" for respondent during the
trial of the test cases were not based upon personal knowledge
but that Mr. Izen only wanted the opportunity to prove the point.
Mr. Izen did not provide any further evidence that Mr. DeCastro
- 186 -
was a mole or plant who passed Mr. Izen's trial strategy to
Messrs. Sims or McWade.
Mr. Izen denied having personal knowledge, at the time that
Messrs. Thompson and Cravens testified at the trial of the test
cases, that Messrs. Thompson and Cravens had entered into
settlement agreements with Mr. McWade.
B. Mr. Sticht's Allegations of Potential Witness Intimidation
During the evidentiary hearing, following the testimony of
Lois Fisher (Ms. Fisher) on June 12, 1996, Mr. Sticht made the
following statement to the Court:
But if there's any intention to obstruct or
interfere with the presentation of any of my clients'
cases in this trial, in this courtroom, or even to
interfere with their presentation by outside
harassment, intimidation or other means that are
normally used to influence or attempt to influence the
independent presentation of the case in any trial, and
I want to go on record today, stating that I reserve
the right to revisit this day in much the same way that
has been alleged in the past with respect to the 1989
trial.
* * * * * * *
So, I will also state to the Court, along these
lines, and I use Ms. Fisher as the segue to this final
point, that at least two, possibly three of my clients,
have received what I believe are properly characterized
as potential intimidation for their presentation of
this case. Now, that is something I'm going to leave
at that point, without specifics and details, today.
Following Mr. Sticht's remarks, the Court stated that, while the
Court would respect Mr. Sticht's request not to pursue the matter
immediately, Mr. Sticht was "obligated to put it to rest or to
present it in a way that will enable it to be resolved".
Mr. Sticht did not return to the subject of potential witness
- 187 -
intimidation during the remainder of the evidentiary hearing,
which, as described below, eventually led to a further
evidentiary hearing held on August 18, 1997.
C. Mr. Bradt's June 12, 1996, Letter to Mr. Kersting
Mr. Bradt first testified at the evidentiary hearing on
June 10, 1996. Mr. Bradt testified that he had no direct
knowledge that Mr. DeCastro passed Mr. Izen's trial strategy to
Mr. McWade, but that he suspected the same by virtue of
Mr. McWade's opposition to Mr. Izen's efforts to introduce
evidence concerning collection litigation through Mr. Moseley.
See supra pp. 135-136.
Mr. Jones recalled Mr. Bradt to testify on June 14, 1996,
for the purpose of rebutting testimony by Mr. O'Neill on the
propriety of the summons issued by respondent to Mr. Kersting in
1987. During Mr. Sticht's examination of Mr. Bradt, Mr. Sticht
offered into evidence a one-page facsimile of a letter that Mr.
Bradt had sent Mr. Kersting in Hawaii at 10:15 a.m. on June 12,
1996, which apparently was then inadvertently forwarded by
Mr. Kersting's secretary to Mr. Sticht's office in Los Angeles
at 10:52 a.m. on the same day. Mr. Bradt's letter includes a
discussion of testimony presented by Mr. Sticht's witness,
Ms. Fisher, on June 10 and 11, 1996, and testimony presented by
Mr. O'Neill. Mr. Bradt's letter refers to a letter that
Mr. Sticht wrote to Ms. Fisher. Mr. Bradt's letter also includes
disparaging remarks regarding Mr. Sticht's trial strategy and
tactics.
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Mr. Bradt asserted that his letter to Mr. Kersting was
subject to the attorney-client privilege. Mr. Bradt declined to
disclose how he had obtained a copy of Mr. Sticht's letter to
Ms. Fisher.
Pursuant to the Court's order excluding witnesses from the
courtroom, Mr. Bradt had not been in the courtroom when either
Ms. Fisher or Mr. O'Neill had testified.82 Mr. Izen admitted that
he had disclosed Ms. Fisher's testimony to Mr. Bradt so that he
could prepare Mr. Kersting to testify in rebuttal of Ms. Fisher's
testimony. Similarly, Mr. Jones admitted that he had disclosed
Mr. O'Neill's testimony to Mr. Bradt in order to prepare Mr.
Bradt to testify in rebuttal. Mr. Sticht suggested that Mr.
Bradt's letter would tend to inflame Mr. Kersting against Ms.
Fisher.83
82
The Court had ruled that Mr. Bradt would not be allowed
in the courtroom until Mr. Kersting had testified.
83
Mr. Sticht's receipt and disclosure to the Court of
Mr. Bradt's letter to Mr. Kersting raise interesting questions
concerning the professional responsibilities of attorneys.
Compare Committee on Professional Responsibility, Ethical
Obligations Arising Out of an Attorney's Receipt of Inadvertently
Disclosed Information, 50 The Record of the Association of the
Bar of the City of New York 660 (1995), with Committee on
Professional Responsibility, The Attorney's Duties to Report the
Misconduct of Other Attorneys and to Report Fraud on a Tribunal,
47 The Record of the Association of the Bar of the City of New
York 905 (1992). The disclosures by Messrs. Izen and Jones that
were prompted by the introduction of Mr. Bradt's letter also
raise questions of possible conflict between the operation of
Rule 145 and the need to prepare a witness to testify and bring
documents in response to a subpoena duces tecum. Compare Berry
Petroleum Co. v. Commissioner, 104 T.C. 584, 609-611 (1995),
affd. on other issues without published opinion 142 F.3d 442 (9th
Cir. 1998), with Smith v. Commissioner, 92 T.C. 1349 (1989), and
(continued...)
- 189 -
D. Denial of Mr. Izen's Motion To Refer Thompson and Cravens
Settlements and Alexander Agreement to Department of Justice
(Public Integrity Section)
On June 26, 1996, Mr. Izen filed a Motion to Refer the
Thompson and Cravens Settlements and the Alexander Agreement to
the Department of Justice (Public Integrity Section) for
prosecution. Mr. Izen identified approximately 17 alleged crimes
associated with the Thompson and Cravens settlements and the
Alexander understanding and asked the Court to refer those
matters to the Department of Justice for prosecution. By order
dated June 26, 1996, the Court denied Mr. Izen's motion.
III. Developments Following Initial Evidentiary Hearing
A. Denial of Respondent's Motion for Further Hearing Regarding
Potential Witness Intimidation
On October 28, 1996, after completion of the bulk of the
evidentiary hearing, respondent filed a motion to take additional
evidence concerning Mr. Sticht's unresolved allegations at the
evidentiary hearing of potential witness intimidation. During
this same period, the parties filed with the Court third, fourth,
and fifth supplemental stipulations of facts that did not comply
with the Court's Rules concerning stipulations and amounted to
little more than a proffer of documents subject to an extensive
list of objections.
83
(...continued)
Thompson v. Commissioner, 92 T.C. 486 (1989). None of these
questions have been resolved; they became moot with respect to
Mr. Kersting and Mr. Bradt by reason of Mr. Kersting's failure to
testify at the evidentiary hearing.
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In a response to respondent's motion, Mr. Sticht alleged
(and the record now shows) that Mr. Sticht's clients received
unsolicited phone calls and written communications from
Mr. Kersting and from Joseph A. Peterman (Mr. Peterman), a
Kersting program participant and nontest case petitioner,84
throughout these proceedings encouraging them to ask Mr. Sticht
to cooperate and otherwise present a unified case with the test
case and nontest case petitioners represented by Messrs. Izen and
Jones, promising financial assistance in the form of
disbursements from a "legal defense fund" in exchange for such
cooperation, and ridiculing Mr. Sticht's representation of his
clients.85
On January 30, 1997, the Court issued an order denying
respondent's motion. Although the Court expressed concern over
Mr. Sticht's allegations, the Court was not persuaded that the
activities in question satisfied the legal definition of witness
intimidation. See, e.g., Griffith v. Commissioner, T.C. Memo.
84
Mr. Peterman currently has eight cases docketed with
the Court all of which appear to involve Kersting adjustments:
docket Nos. 1676-84, 36324-85, 19467-86, 23493-90, 12628-91,
7155-92, 15005-93, and 3029-94. Mr. Peterman executed piggyback
agreements in the first five dockets listed above.
85
Mr. Kersting's various letters to Mr. Sticht's clients
are included within the exhibits associated with the parties'
fourth supplemental stipulations of facts, filed Nov. 27, 1996.
On Aug. 11 and Aug. 18, 1997, Mr. Sticht filed a Status
Report and a First Supplemental Status Report, respectively,
attaching thereto copies of letters, some of which contain
obscene and inflammatory statements, that Mr. Peterman had sent
to Mr. Sticht and his clients.
- 191 -
1988-123; see also United States v. Thompson, 76 F.3d 442, 452-
453 (2d Cir. 1996); United States v. Elwell, 984 F.2d 1289, 1293-
1294 (1st Cir. 1993). Nevertheless, the Court directed
Mr. Sticht to file a report with the Court identifying any of his
witnesses who may have declined to testify at the evidentiary
hearing, including a brief summary of the testimony that such
witnesses were expected to provide, with a view to arriving at an
agreement among the parties to stipulate such testimony or, if
that should not be possible, to having a further hearing to
receive such testimony. The Court further directed the parties
to cooperate in the elimination of the various objections
associated with the fourth and fifth supplemental stipulations of
facts.
Mr. Sticht subsequently filed a report with the Court
identifying Mr. Kersting, Richard B. Rogers (Mr. Rogers), and
JoAnne Rinaldi (Ms. Rinaldi) as persons who were scheduled to,
but did not, testify at the evidentiary hearing and providing a
summary of the testimony expected from each witness. At
approximately the same time, respondent filed a response with the
Court stating that the parties were unable to eliminate many of
the objections raised with respect to the documents attached to
the parties' fourth and fifth supplemental stipulations of facts.
With a view to completing the record in these cases, the
Court ordered a further evidentiary hearing for the purpose of
receiving the testimony of Mr. Kersting and Ms. Rinaldi. It was
hoped that Mr. Kersting's testimony would eliminate some or all
- 192 -
of the parties' objections to the documents attached to the
parties' fourth and fifth stipulations of fact, and that having
Ms. Rinaldi testify would complete the record insofar as she
might have declined to testify at the initial evidentiary hearing
because of perceived intimidation. However, the Court rejected
Mr. Sticht's request to call Mr. Rogers to testify on the grounds
that: (1) Mr. Rogers' testimony was not related to the documents
attached to the parties' fourth and fifth stipulations of fact;
(2) there was no indication that Mr. Rogers had declined to
testify during the initial evidentiary hearing because of
perceived intimidation;86 and (3) Mr. Sticht's proffer of
Mr. Rogers' testimony revealed that the testimony, which
primarily concerned the First Savings acquisition, would amount
to an attempt to retry the Dixon test cases on the merits or
would concern a transaction that was not in issue in the trial of
the test cases.
B. Supplemental Evidentiary Hearing (August 18, 1997)
On July 24, 1997, Mr. Kersting filed a Motion for Protection
or to Quash asserting that the supplemental evidentiary hearing
and production of the documents identified in the subpoena that
Mr. Sticht had served on him in May 1996 (before the initial
evidentiary hearing) would amount to an attempt to retry the
86
On June 17, 1997, at the initial evidentiary hearing,
Mr. Sticht stated on the record that he was reconsidering whether
Mr. Rogers' testimony was necessary in light of other evidence
already in the record.
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test cases. By order dated July 25, 1997, the Court denied
Mr. Kersting's motion as moot on the ground that Mr. Sticht's
subpoena had expired on June 26, 1996--the date of adjournment of
the original evidentiary hearing.
Mr. Sticht was unable to locate Mr. Kersting for purposes
of service of a new subpoena directing him to appear and testify
at the evidentiary hearing. Nevertheless, on August 7, 1997,
Mr. Kersting filed a Second Motion for Protection or to Quash
Subpoena asserting that he was too ill to travel from Hawaii to
Los Angeles for the evidentiary hearing because of recent cancer
surgery. Because Mr. Kersting did not appear at the supplemental
evidentiary hearing, the Court later denied Mr. Kersting's motion
as moot.
On August 18, 1997, the Court conducted a supplemental
evidentiary hearing in these cases in Los Angeles. Ms. Rinaldi
was the sole witness at the supplemental evidentiary hearing.
Ms. Rinaldi testified that she participated in the Kersting
programs during the taxable years 1980 and 1983-91 with her
husband, a flight engineer for American Airlines, with a view
towards profiting as a stock holder and for the tax benefits.87
Ms. Rinaldi testified that she believed that Kersting promissory
notes were enforceable against her. Ms. Rinaldi testified that
she relied upon and was assured by the various "Dear Friend"
letters that Mr. Kersting sent to her during the period 1981 to
87
Ms. Rinaldi testified that she legally separated from
her husband in 1994.
- 194 -
1992. Ms. Rinaldi did not consult with a certified public
accountant regarding her tax liability until after the Court
released its opinion in Dixon II.
C. Denial of Mr. Izen's Motion To Compel Production of
Documents
On August 29, 1997, Mr. Izen submitted to the Court a
document that the Court filed as a supplement to Mr. Izen's
motion to compel filed April 26, 1996. Relying on a recent case,
In re Grand Jury Subpoena Duces Tecum, 112 F.3d 910 (8th Cir.
1997), Mr. Izen argued that respondent could not rely upon the
attorney-client privilege, executive privilege, or the attorney
work product doctrine in these cases as bases for refusing to
disclose documents.
By order dated September 4, 1997, the Court denied
Mr. Izen's motion to compel. The Court denied Mr. Izen's motion
as moot insofar as Mr. Izen sought to compel the testimony of
Messrs. Thompson, DeCastro, Sims, and McWade, and to compel
Messrs. Thompson and DeCastro to produce documents. In so
ruling, the Court noted that Mr. Thompson had waived the
attorney-client privilege, produced the documents requested in
discovery, and testified at the evidentiary hearing. In
addition, the Court had heard testimony from Messrs. DeCastro,
Sims, McWade, and additional Government witnesses. Further, the
Court denied Mr. Izen's motion insofar as Mr. Izen moved to
compel respondent to produce documents. Specifically, although
the Court declined to decide whether the admitted Government
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misconduct in the presentation and trial of the test cases in
Dixon v. Commissioner, docket No. 9382-83, et al., amounted to
fraudulent or criminal conduct, the Court did conclude that the
disputed documents did not contain material subject to the crime-
fraud exception, i.e., legal advice obtained in the furtherance
or in aid of a future fraudulent scheme or criminal activity.
Moreover, the Court rejected Mr. Izen's contention that
respondent's activities since May 1992 amounted to an effort to
"cover up" what Mr. Izen alleged to be fraudulent or criminal
conduct. On the basis of a review of respondent's privilege log
and supplemental privilege log, the Court held that the documents
described therein qualified for protection from disclosure
pursuant to the corresponding privilege(s) relied upon by
respondent.
D. Denial of Mr. Sticht's Motion To Reopen Record
On October 10, 1997, Mr. Sticht filed a Motion to Reopen
the Record seeking to submit to the Court a written offer of
proof comprising a written declaration by Mr. Rogers, a nontest
case petitioner, along with numerous documents that purport to
describe some connection or link between the series of
transactions underlying Mr. Rogers' participation in the First
Savings acquisition and his related participation in the
Investors Financial stock purchase plan. Mr. Sticht's motion
included allegations that Messrs. Thompson, Alexander, DeCastro,
Kozak, and McWade compromised the trial of the test cases "by
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making an incomplete an inaccurate presentation" of the First
Savings acquisition.88
By order dated November 24, 1997, the Court denied
Mr. Sticht's motion on the ground that the materials that
Mr. Sticht was seeking to submit to the Court should have been
offered into evidence during the initial evidentiary hearing in
May and June 1996, where all of the implicated parties had been
called to testify. Insofar as Mr. Sticht was arguing that there
was a meaningful link or connection between the First Savings
acquisition and the Investors Financial stock purchase plan, the
Court further observed that the First Savings acquisition was not
among the Kersting programs at issue in the trial of the test
cases, and that petitioners' theory of a link between the two
transactions would be ripe for consideration only if respondent
were to move for entry of decision based in part on adjustments
attributable to the First Savings acquisition.
E. Denial of Mr. Izen's Motion To Take Judicial Notice
On April 9, 1998, Mr. Izen filed a Motion to Take Judicial
Notice, asserting that the Court is obliged by rule 201 of the
Federal Rules of Evidence to take notice that the Hawaii District
88
The bulk of the testimony presented at the trial of the
test cases concerning the First Savings acquisition was offered
by Messrs. Kersting and Alexander. Although their testimony
concerning the transaction generally was consistent, the Court in
Dixon II apparently accepted Mr. Alexander's testimony that
Federal regulators rejected Investors Financial as a holding
company for First Savings despite Mr. Kersting's testimony to the
contrary. See Dixon II, 62 T.C.M. (CCH) at 1447, 1991 T.C.M.
(RIA), at 91-2987.
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Court held that "the note indebtedness involved in the present
case (tried previously before Judge Goffe) is legally viable and
collectible under Hawaii state law." By order dated April 14,
1998, the Court indicated that Mr. Izen's motion would be decided
in the Court's opinion in these cases.
On November 2, 1998, Mr. Izen filed a Petition for Mandamus
with the Court of Appeals for the Ninth Circuit for a writ of
mandamus directing this Court to grant Mr. Izen's Motion to Take
Judicial Notice. By order filed December 16, 1998, the Court of
Appeals denied Mr. Izen's petition.
All materials attached to Mr. Izen's motion, which concern
Kersting program participant Carl Mott,89 were received in
evidence at the trial of the test cases and considered by Judge
Goffe in Dixon II. See discussion of collection cases supra pp.
72-74. Mr. Izen's motion, which amounts to another attempt to
retry matters previously decided in Dixon II, goes beyond the
scope of the mandate of the Court of Appeals in its remand of
these cases and will be denied.
89
Mr. Izen's continued reliance on the collection
litigation concerning Carl Mott indicates that Mr. Izen regards
the collection litigation as a complete rebuttal to all evidence
in the record that Mr. Kersting and program participants did not
intend or expect that promissory notes would be enforced in
accordance with their purported terms. In so doing, Mr. Izen
ignores the Court's conclusion in Dixon II, 62 T.C.M. (CCH) at
1505-1506, 1991 T.C.M. (RIA), at 91-3048 to 91-3050, that,
even if an obligation to pay leverage loan “interest” were
enforceable, it would properly be characterized as a
nondeductible “fee” for creating tax deductions rather than as
“interest”.
- 198 -
F. Denial of Mr. Sticht's Motions for Release From Piggyback
Agreements
On June 9, 1998, Mr. Sticht filed Motions for Release from
Piggyback Agreement on behalf of nontest case petitioners
Richard B. and Donna G. Rogers, Anthony E. and Carol A. Eggers,
and John L. and Terry E. Huber. Mr. Sticht contends that
Mr. Seery's apparent conflict of interest, at a time when
Mr. Seery represented the Rogerses, the Eggerses, and the Hubers,
provides an independent basis for releasing nontest case
petitioners from their piggyback agreements. In the alternative,
Mr. Sticht contends, in light of respondent's misconduct in the
trial of the test cases, that the Court should conclude that
respondent did not comply with the terms of the piggyback
agreements.
On June 9, 1998, Mr. Sticht filed a Motion to Sever Case and
for Entry of Decision; Or Alternatively to Sever Case and Set for
Trial on behalf of Joe A. and JoAnne Rinaldi in docket No. 7205-
94. The Rinaldis' case at docket No. 7205-94 concerns the
Rinaldis' tax liabilities for 1990 and 1991 and is based upon a
notice of deficiency issued after the disclosure of the
misconduct in the trial of the test cases. Because the Rinaldis
did not sign a piggyback agreement in docket No. 7205-94,
Mr. Sticht contends that the Court's opinion in Dixon II does not
bind the Rinaldis. Mr. Sticht contends, relying upon the
misconduct of respondent's attorneys in the trial of the test
cases, that the Court should either enter a decision in the
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Rinaldis' favor or sever the Rinaldis' case from the consolidated
cases and set the case for trial.
On July 7, 1998, respondent filed objections to Mr. Sticht's
motions. Respondent contends that the validity of the piggyback
agreements in dispute is not affected by either events occurring
during the trial of the test cases or Mr. Seery's alleged
conflict of interest.
On July 10, 1998, Mr. Jones filed an opposition to
Mr. Sticht's motions asserting that it would be premature to
grant the motions.90
As discussed in greater detail infra pp. 284-295 and pp.
300-302, we will deny Mr. Sticht's motions.
G. Reports Regarding the Court's Protective Orders
By order dated August 27, 1998, the Court directed
Messrs. Huestis and Sticht to file reports with the Court
detailing any objection to the lifting of the Court's protective
orders dated June 10 and 26, 1996. Mr. Huestis filed a report
with the Court objecting to the lifting of the Court's protective
orders on the ground that Mr. Kersting might attempt to use the
records in question to harass the Thompsons. Mr. Sticht and
respondent filed separate reports with the Court indicating no
objection to the lifting of the protective orders. As discussed
90
On July 20, 1998, Mr. Sticht filed a Motion to Strike
allegedly scandalous and impertinent matters from Mr. Jones'
opposition. On Aug. 6, 1998, the Court denied Mr. Sticht's
motion to strike.
- 200 -
in greater detail infra pp. 302-305, we will lift the protective
orders.
ULTIMATE FINDINGS OF FACT
Messrs. Sims and McWade negotiated a series of contingent
settlement agreements with Mr. DeCastro in respect of the
Thompsons' tax liabilities in advance of the trial of the test
cases. The final Thompson settlement agreement provided for a
reduction in the Thompsons' tax liabilities for 1979, 1980, and
1981 for the purpose of generating refunds of tax and interest
that were used to pay Mr. DeCastro's attorney's fees. The
refunds actually made were more than sufficient for this purpose;
the excess was received and retained by the Thompsons. The
Thompson settlement was not based upon or influenced by the
Thompsons' participation in the Bauspar program.
Messrs. Sims and McWade negotiated a contingent settlement
agreement with Mr. Cravens in respect of the Cravenses' tax
liabilities for 1979 and 1980 in advance of the trial of the test
cases. Messrs. Sims and McWade misled Mr. Cravens as to the
nature and legal effect of his settlement and the need for
counsel at the trial of the test cases. In so doing, they
foreclosed the possibility that the Cravenses would become
clients of Chicoine and Hallett, and later, of Mr. Izen. They
thereby reduced the effectiveness of Mr. Cravens' presentations
to the Court from the point of view of all petitioners; the
likelihood that Mr. Cravens would have informed counsel for test
- 201 -
case petitioners that his cases had been settled was also
reduced.
Messrs. Sims and McWade were the only persons in the
Honolulu District Counsel Office with knowledge of the Thompson
and Cravens settlements before and during the trial of the test
cases. Other than Mr. Stevens, no one else within the Internal
Revenue Service was aware of the Thompson and Cravens settlements
before or during the trial of the test cases through the times
that the Court issued its Dixon II opinion and entered the
initial decisions in the test cases.
Before the trial of the test cases, Mr. McWade intentionally
misled the Court, with the complicity of Mr. DeCastro, by not
disclosing the settlement of the Thompson cases when he moved to
set aside the Thompson piggyback agreements. At the trial of the
test cases, Messrs. Sims, McWade, and DeCastro intentionally
misled the Court regarding the status of the Thompson cases by
not disclosing the settlement of the Thompson cases. At the
trial of the test cases, Messrs. Sims and McWade intentionally
misled the Court in similar fashion regarding the settlement of
the Cravens cases.
Mr. McWade allowed Mr. Alexander to offer misleading
testimony to the Court during the trial of the test cases
regarding his understanding that his tax liabilities would be
reduced in exchange for providing assistance to Mr. McWade.
Mr. DeCastro did not act as a Government "mole" during the
trial of the test cases or convey any of Mr. Izen's trial
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strategies or confidential information to the Government. Cf.
Kersting v. United States, 865 F. Supp. at 671-674.
Mr. Izen had no knowledge, before and at the trial of the
test cases through the times that the Court issued the Dixon II
opinion and entered the initial decisions in the test cases, that
Messrs. Thompson and Cravens had entered into settlement
agreements with Mr. McWade.
OPINION
The Court of Appeals for the Ninth Circuit vacated this
Court's decisions in Dixon II and remanded the test cases for an
evidentiary hearing "to determine the full extent of the admitted
wrong done by the government trial lawyers." DuFresne v.
Commissioner, 26 F.3d at 107. The Court of Appeals, citing
Arizona v. Fulminante, 499 U.S. at 309, directed the Court to
consider "whether the extent of misconduct rises to the level of
a structural defect voiding the judgment as fundamentally unfair,
or whether, despite the Government's misconduct, the judgment can
be upheld as harmless error." Id. Further, the Court of Appeals
directed the Court to consider on the merits all motions of
intervention filed by parties affected by Dixon II. See id.
Pursuant to this last direction, the Court consolidated the cases
of three groups of petitioners to allow them to participate in
the evidentiary hearing: Test case and nontest case petitioners
represented by Mr. Izen, nontest case petitioners represented by
Mr. Jones, and nontest case petitioners represented by
Mr. Sticht.
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While the parties have primarily addressed the specific
issues posed by the mandate of the Court of Appeals, whether the
Government misconduct constitutes a structural defect or harmless
error, our analysis is not limited to these issues. At the
inception of this proceeding, the Court raised the issue whether
the Thompson and Cravens settlements share significant
characteristics with improper "Mary Carter" agreements; Mr. Izen
has consistently maintained throughout this proceeding that the
Government misconduct amounted to fraud on the Court; and
Mr. Sticht has asserted that nontest case petitioners were not
only harmed by the Government misconduct, but also by Mr.
Kersting's interference in the attorney-client relationships
between test case petitioners and their counsel. In an effort to
spread the blame, respondent has asked the Court to find that
Mr. Izen, as well as Mr. Kersting, was aware of the Thompson and
Cravens settlements at or before the trial of the test cases.
Before turning to our analysis of the foregoing issues, we
will address the burden of proof in this proceeding.
I. Burden of Proof
The Court deferred ruling on the parties' requests for
assignment of the burden of proof and the fixing of the standard
of proof for purposes of the evidentiary hearing. The Court
nevertheless placed on respondent the initial burden of coming
forward with evidence and prescribed a structure for the orderly
presentation of witnesses at the evidentiary hearing.
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The burden of proof consists of two burdens--the burden of
production of evidence and the burden of persuasion. See
Wigmore, Evidence in Trials at Common Law, secs. 2485 to 2488
(Chadbourn rev. 1981). Assignment of the burden of proof and
fixing the standard of proof serve a procedural function by
delineating the parties' obligations respecting the presentation
of evidence at trial.
Although assignment of the burden of proof was not resolved
before the evidentiary hearing, the Court is satisfied that the
evidentiary hearing has produced a record that contains all
relevant facts necessary for the Court to discharge its
obligations under the mandate. The parties' versions of the
facts as set forth in their respective proposed findings of fact
generally are in accord,91 with one immaterial exception
discussed infra pp. 209-211. Consequently, from a purely
procedural standpoint, assignment of the burden of proof and
fixing the standard of proof are not necessary.
We likewise are convinced that assignment of the burden of
proof is not necessary for the Court to decide whether the Sims-
McWade misconduct resulted in a structural defect in the trial of
the test cases. The structural defect question raises a legal
91
In those instances where the parties have not agreed
with respect to a particular fact, or the record does not clearly
reflect the date of a particular event, the Court generally has
adopted the finding of fact proposed by the test case and nontest
case petitioners.
- 205 -
issue requiring the Court to apply a settled body of case law to
essentially agreed facts.
In contrast, assignment of the burden of proof and fixing
the standard of proof have greater substantive significance with
respect to harmless error analysis. As discussed in greater
detail infra pp. 233-236, harmless error analysis ultimately
requires the Court to consider whether the Sims-McWade misconduct
affected the outcome in the trial of the test cases. Because the
assignment of the burden of proof, and particularly the standard
of proof, could influence the outcome of the Court's harmless
error analysis, we will decide the issue.
Proper placement of the burden of proof in these cases for
purposes of the evidentiary hearing is not easily resolved and
raises some perplexing questions. Rule 142(a) provides the
general rule that the burden of proof (or burden of persuasion)
will be upon the taxpayer, except as otherwise provided by
statute or determined by the Court.92 See Welch v. Helvering,
290 U.S. 111 (1933). Normally, the taxpayer bears the initial
burden of producing enough evidence to make a prima facie case;
i.e., evidence to support a finding contrary to the
Commissioner's determination. See Rockwell v. Commissioner, 512
92
Under sec. 3001 of the Internal Revenue Service
Restructuring and Reform Act of 1998, Pub. L. 105-206, 112 Stat.
726, Congress enacted new sec. 7491, which provides, effective
with respect to examinations commenced after July 22, 1998, that
the burden of proof shifts to the Commissioner when the taxpayer
produces credible evidence in opposition to the Commissioner's
determination of a deficiency and satisfies other requirements.
- 206 -
F.2d 882, 885 (9th Cir. 1975), affg. T.C. Memo. 1972-133. Where
the taxpayer succeeds in producing evidence supporting a finding
contrary to the Commissioner's determination, the burden of
production or burden of going forward with evidence shifts to the
Commissioner. See Bernuth v. Commissioner, 470 F.2d 710, 714 (2d
Cir. 1972), affg. 57 T.C. 225 (1971). The taxpayer nonetheless
continues to bear the ultimate burden of persuasion.
There is a well-recognized exception to the normal placement
of the burden of proof in cases where the Commissioner determines
that the taxpayer is liable for an addition to tax for fraud. In
such cases, the Commissioner bears the burden of proving fraud by
clear and convincing evidence. See sec. 7454(a); Smith v.
Commissioner, 91 T.C. 1049, 1053 n.3 (1988), affd. 926 F.2d 1470
(6th Cir. 1991).
The Court has also recognized an exception to the normal
rule respecting the placement of the burden of proof in motions
practice. For example, in Pietanza v. Commissioner, 92 T.C. 729
(1989), supplemented by T.C. Memo. 1990-524, affd. without
published opinion 935 F.2d 1282 (3d Cir. 1991), the parties filed
cross-motions to dismiss for lack of jurisdiction. The taxpayers
moved to dismiss on the ground that the Commissioner had failed
to issue a valid notice of deficiency; the Commissioner moved to
dismiss on the ground that the taxpayers had failed to file a
timely petition. Because the very existence of the notice of
deficiency was in dispute, the Court held that the Commissioner
should bear the burden of proof on the point because it would be
- 207 -
unfair to require the taxpayer to prove "the nonexistence of a
notice which they swear they have never seen and which respondent
is unable to provide." Pietanza v. Commissioner, supra at 736-
737.
Because these cases are not now before the Court in the
normal posture of a deficiency case, the parties agree that the
Court should disregard Rule 142(a). The parties also agree that
the Court should instead look to rule 60(b) of the Federal Rules
of Civil Procedure to determine the proper assignment of the
burden of proof, notwithstanding that the decisions in the test
cases have not become final.93 Under that rule a party may move
to be relieved from a final judgment, order, or proceeding, in
the case of fraud, misrepresentation, or other misconduct of an
adverse party. Normally, the moving party bears the burden of
producing clear and convincing evidence that relief should be
granted under that rule. See Anderson v. Cryovac, Inc., 862 F.2d
910 (1st Cir. 1988). Predictably, respondent and petitioners
each argue that the burden of proof should be imposed on the
other side.
Respondent contends that, because petitioners "now seek to
affirmatively invalidate the Court's Dixon II opinion",
petitioners bear the burden of proof as the moving parties.
93
Rule 1(a) states that, where there is no applicable rule
of procedure, "the Court or the Judge before whom the matter is
pending may prescribe the procedure, giving particular weight to
the Federal Rules of Civil Procedure to the extent that they are
suitably adaptable to govern the matter at hand."
- 208 -
Further, relying on cases such as Jones v. Aero/Chem Corp., 921
F.2d 875, 878-879 (9th Cir. 1990), Drobny v. Commissioner, 113
F.3d 670, 678 (7th Cir. 1997), and England v. Doyle, 281 F.2d
304, 309 (9th Cir. 1960), respondent maintains that the proper
standard of proof is clear and convincing evidence irrespective
of whether the theory of relief is structural defect, reversible
error, fraud on the Court, or attorney misconduct under rule
60(b)(3) of the Federal Rules of Civil Procedure.
Relying on virtually the same authorities, petitioners
counter that respondent should bear the burden of proof and that
the standard of proof is clear and convincing evidence.
Petitioners reason that respondent should bear the burden of
proof insofar as it was respondent who moved for an evidentiary
hearing before the appeal of the test cases and again after the
Court of Appeals remanded the test cases to the Court for an
evidentiary hearing on the significance of the misconduct of
respondent's attorneys.
We note that the decisions entered by the Court in the test
cases have not become final. Timely appeals were taken and the
test cases are before the Court pursuant to the mandate of the
Court of Appeals, which vacated the decisions for further
proceedings.
We disagree with petitioners' contention that respondent
should bear the burden of proof on the technical ground that
respondent is the moving party. Nonetheless, the unusual aspects
of these cases persuade us that it would be inappropriate to
- 209 -
place the burden of proof on petitioners. First, we observe that
in Arizona v. Fulminante, 499 U.S. at 295-296, the Supreme Court
ruled that the State had the burden of proving that the erroneous
admission of the defendant's confession was harmless beyond a
reasonable doubt. By analogy, respondent should bear the burden
of proving that the admitted misconduct of his attorneys was
harmless and had no material effect on the outcome of the trial.
In addition, we note that respondent has had direct and immediate
access to the critical witnesses and most of the relevant
documents since May 1992, when respondent first discovered the
misconduct in question. Further, respondent conducted an initial
investigation of the misconduct, to the exclusion of all private
parties, shortly after discovering the misconduct. Finally,
respondent, by asserting various privileges in response to
Mr. Izen's motion to compel production of documents, succeeded in
protecting from discovery various documents generated during
respondent's investigation. Taken together, these factors
persuade us that the interests of justice are better served by
placing the burden of proof on respondent, and we so hold.
Because these cases concern attorney misconduct in the civil
context, the standard of proof and persuasion that we apply is
clear and convincing evidence. See, e.g., Bunch v. United
States, 680 F.2d 1271, 1283 (9th Cir. 1982) (attorney
misconduct).
For purposes of completeness, we briefly address the
immaterial exception alluded to above. That exception arises
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from respondent's requests for findings of fact and argument that
Mr. Izen was aware of the Cravens and Thompson settlements at the
time of the trial before Judge Goffe.94 Placing the burden of
proof on respondent--for reasons discussed above--we have found
that Mr. Izen was not aware of the settlements. However, the
record contains evidence, such as Mr. Kersting's, Mr. Moseley's,
and Mr. Bradt's knowledge of the settlements, Mr. Bradt's prior
partnership with Mr. Izen and their cooperation and sharing of
information during the evidentiary hearing, and statements by Mr.
Cravens--which he ultimately recanted on grounds of uncertainty
and lack of clear recollection--from which it could be inferred
that Mr. Izen had been informed or had become aware of the
settlements at or before the trial of the test cases.95 Although
such evidence does not suffice to require a finding to that
effect, we might have found, if petitioners had to bear the
94
Respondent has not carried through and addressed the
significance for these cases of Mr. Izen's awareness or lack of
awareness of the settlements. We do not believe that Mr. Izen's
awareness of the settlements would have any bearing on our
conclusion that the Court's decisions on the tax deficiencies of
the test case petitioners should be reinstated. Although
nondisclosure of the settlements by Mr. Izen--if he had been
aware of them--would have amounted to misconduct on his part, we
would not regard such misconduct as having any bearing on the
reinstatement of the decisions in the test cases. See discussion
infra pp. 230-232 of Mr. Kersting's misconduct.
95
We recognize that there is circumstantial evidence that
Mr. Izen was not aware of the Thompson and Cravens settlements.
If Mr. Izen had been aware of the Thompson settlement, it does
not seem likely that he would have allowed Mr. DeCastro to attend
the meeting that he held with Mr. Hongsermeier on the eve of the
trial of the test cases or shared other information with Mr.
DeCastro. It is also likely that Mr. Izen would have brought the
settlements to the Court's attention before respondent did.
- 211 -
burden of proof on that question, that petitioners had not
carried that burden.96
We regard the exception as immaterial because we are
satisfied that our conclusions and the outcome would remain the
same, even if we were to conclude that Mr. Izen had been aware of
the settlements. We would so conclude on essentially the same
grounds on which we reject Mr. Sticht's argument over
Mr. Kersting's interferences with the attorney-client
relationships of the attorneys whom he employed to represent the
test case petitioners. See infra pp. 230-232.
II. Structural Defect
A. Case Law
The Court of Appeals for the Ninth Circuit vacated this
Court's decisions in the test cases and remanded the cases with
directions "to conduct an evidentiary hearing to determine the
full extent of the admitted wrong done by the government trial
lawyers" and to consider "whether the extent of misconduct rises
to the level of a structural defect voiding the judgment as
fundamentally unfair, or whether, despite the government's
96
This would have been made even more likely by
Mr. Kersting's failure to appear and testify at the evidentiary
hearing, which might have brought into play the doctrine of
Wichita Terminal Elevator Co. v. Commissioner, 6 T.C. 1158, 1165
(1946), affd. on other grounds 162 F.2d 513 (10th Cir. 1947),
that the failure of a party to introduce evidence within his
possession or control which, if true, would be favorable to him,
gives rise to the presumption that if produced it would be
unfavorable. Mr. Kersting's assertions in his motion to quash
subpoena that he was too sick to attend the evidentiary hearing
might have been well taken, but consideration could have been
given to alternative means of obtaining his testimony.
- 212 -
misconduct, the judgment can be upheld as harmless error."
DuFresne v. Commissioner, 26 F.3d at 107.
The term "structural defect" normally refers to the
violation of a fundamental constitutional right occurring during
a criminal trial that affects the very framework within which the
trial proceeds, so that the trial cannot reliably serve its
function as a vehicle for determination of guilt or innocence.
See Arizona v. Fulminante, supra at 309-310. The presence of a
structural defect in a criminal trial requires automatic
reversal of the conviction and a new trial. See, e.g., id.;
Chapman v. California, 386 U.S. 18 (1967).
Significantly, not all constitutional errors occurring
during a trial result in a structural defect in the proceedings.
To the contrary, there are a number of constitutional errors,
characterized as lesser "trial errors", that are susceptible to
harmless error analysis.
In Arizona v. Fulminante, 499 U.S. 279 (1991), a plurality
opinion, the Supreme Court discussed the distinction between a
constitutional violation that causes a structural defect in a
trial and a constitutional violation that is subject to harmless
error analysis. A majority of the Justices concluded that the
admission of the defendant's coerced confession at his murder
trial did not constitute a structural defect requiring automatic
reversal of the defendant's conviction. However, a separate
majority further concluded that the defendant was entitled to a
new trial because the State of Arizona had failed to meet its
- 213 -
burden of establishing beyond a reasonable doubt that the
admission of the confession was harmless error. See id. at 295-
296.
The Supreme Court described the distinction between a
constitutional violation that may be characterized as a trial
error as opposed to a structural defect as follows:
Since this Court's landmark decision in Chapman v.
California, 386 U.S. 18 (1967), in which we adopted the
general rule that a constitutional error does not
automatically require reversal of a conviction, the
Court has applied harmless-error analysis to a wide
range of errors and has recognized that most
constitutional errors can be harmless. See, e.g.,
Clemons v. Mississippi, 494 U.S. 738, 752-754
(1990)(unconstitutionally overbroad jury instructions
at the sentencing stage of a capital case); Satterwhite
v. Texas, 486 U.S. 249 (1988)(admission of evidence at
the sentencing stage of a capital case in violation of
the Sixth Amendment Counsel Clause); Carella v.
California, 491 U.S. 263, 266 (1989)(jury instruction
containing an erroneous conclusive presumption); Pope
v. Illinois, 481 U.S. 497, 501-504 (1987)(jury
instruction misstating an element of the offense); Rose
v. Clark, 478 U.S. 570 (1986)(jury instruction
containing an erroneous rebuttable presumption); Crane
v. Kentucky, 476 U.S. 683, 691 (1986)(erroneous
exclusion of defendant's testimony regarding the
circumstances of his confession); Delaware v. Van
Arsdall, 475 U.S. 673 (1986)(restriction on a
defendant's right to cross-examine a witness for bias
in violation of the Sixth Amendment Confrontation
Clause); Rushen v. Spain, 464 U.S. 114, 117-118, and
n.2 (1983)(denial of a defendant's right to be present
at trial); United States v. Hasting, 461 U.S. 499
(1983)(improper comment on defendant's silence at
trial, in violation of the Fifth Amendment Self-
Incrimination Clause); Hopper v. Evans, 456 U.S. 605
(1982)(statute improperly forbidding trial court's
giving a jury instruction on a lesser included offense
in a capital case in violation of the Due Process
Clause); Kentucky v. Whorton, 441 U.S. 786
(1979)(failure to instruct the jury on the presumption
of innocence); Moore v. Illinois, 434 U.S. 220, 232
(1977)(admission of identification evidence in
violation of the Sixth Amendment Confrontation Clause);
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Brown v. United States, 411 U.S. 223, 231-232
(1973)(admission of the out-of-court statement of a
nontestifying codefendant in violation of the Sixth
Amendment Confrontation Clause); Milton v. Wainwright,
407 U.S. 371 (1972)(confession obtained in violation of
Massiah v. United States, 377 U.S. 201 (1964));
Chambers v. Maroney, 399 U.S. 42, 52-53
(1970)(admission of evidence obtained in violation of
the Fourth Amendment); Coleman v. Alabama, 399 U.S. 1,
10-11 (1970)(denial of counsel at a preliminary hearing
in violation of the Sixth Amendment Counsel Clause).
The common thread connecting these cases is that
each involved "trial error"--error which occurred
during the presentation of the case to the jury, and
which may therefore be quantitatively assessed in the
context of other evidence presented in order to
determine whether its admission was harmless beyond a
reasonable doubt. In applying harmless-error analysis
to these many different constitutional violations, the
Court has been faithful to the belief that the
harmless-error doctrine is essential to preserve the
"principle that the central purpose of a criminal trial
is to decide the factual question of the defendant's
guilt or innocence, and promotes public respect for the
criminal process by focusing on the underlying fairness
of the trial rather than on the virtually inevitable
presence of immaterial error." Van Arsdall, supra, at
681 (citations omitted).
* * * * * * *
The admission of an involuntary confession--a
classic "trial error"--is markedly different from the
other two constitutional violations referred to in the
Chapman footnote [Chapman v. California, 386 U.S. 18,
23 n.8 (1967)] as not being subject to harmless-error
analysis. One of these violations, involved in Gideon
v. Wainwright, 372 U.S. 335 (1963), was the total
deprivation of the right to counsel at trial. The
other violation, involved in Tumey v. Ohio, 273 U.S.
510 (1927), was a judge who was not impartial. These
are structural defects in the constitution of the trial
mechanism, which defy analysis by "harmless-error"
standards. The entire conduct of the trial from
beginning to end is obviously affected by the absence
of counsel for a criminal defendant, just as it is by
the presence on the bench of a judge who is not
impartial. Since our decision in Chapman, other cases
have added to the category of constitutional errors
which are not subject to harmless error the following:
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unlawful exclusion of members of the defendant's race
from a grand jury, Vasquez v. Hillery, 474 U.S. 254
(1986); the right to self-representation at trial,
McKaskle v. Wiggins, 465 U.S. 168, 177-178 n.8 (1984);
and the right to public trial, Waller v. Georgia, 467
U.S. 39, 49, n.9 (1984). Each of these constitutional
deprivations is a similar structural defect affecting
the framework within which the trial proceeds, rather
than simply an error in the trial process itself.
"Without these basic protections, a criminal trial
cannot reliably serve its function as a vehicle for
determination of guilt or innocence, and no criminal
punishment may be regarded as fundamentally fair."
Rose v. Clark, 478 U.S., at 577-578 (citation omitted).
Id. at 306-310.
The Court of Appeals for the Ninth Circuit recently relied
upon the Supreme Court's opinion in Arizona v. Fulminante, supra,
to support its holding that a defendant's absence from the
courtroom when the jury returned the death sentence did not
result in a structural defect in the proceedings. See Rice v.
Wood, 77 F.3d 1138, 1144 (9th Cir. 1996). The Court of Appeals
further concluded that the error was harmless because the
defendant's absence from the courtroom did not have a
"substantial and injurious effect or influence" in determining
the jury's verdict. Id. at 1144 (citing Brecht v. Abrahamson,
507 U.S. 619, 623 (1993) (quoting Kotteakos v. United States, 328
U.S. 750, 776 (1946))).
B. Arguments
Messrs. Izen and Jones argue that the Government misconduct
in these cases resulted in a structural defect on the ground
that their clients, both test case and nontest case petitioners,
were deprived of a fair trial. Messrs. Izen and Jones argue that
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the Government misconduct included the illegal search of
Mr. Kersting's office, the issuance of erroneous notices of
deficiency intended to pressure taxpayers, secret settlements
with the Thompsons, Cravenses, and Alexanders, the use of
Mr. Thompson as a conduit for the payment of Mr. DeCastro's
attorney's fees, Mr. McWade's misrepresentations to Mr. Cravens
regarding the terms and effect of his settlement, and
respondent's denial of Mr. Jones' request to participate in the
discovery/investigation process that respondent undertook in
1992. Messrs. Izen and Jones contend that the confluence of all
of these factors amounted to Government misconduct so egregious
as to prevent the test case petitioners from fully developing
their positions at trial.
In the alternative, but in reliance upon the same factors,
Messrs. Izen and Jones contend that the Government misconduct
resulted in reversible error in the trial of the test cases.
Mr. Izen further asserts that: (1) The Government misconduct
resulted in a fraud upon the Court; and (2) respondent's use of
Mr. DeCastro to "infiltrate" petitioners' camp requires a new
trial. We will address separately the latter two contentions.
Mr. Izen contends that the proper remedy in these cases is
entry of decision in favor of all petitioners. In the
alternative, Mr. Izen contends that all petitioners should be
awarded a new trial. Mr. Jones contends that the Court should
order respondent to show cause why respondent should not be
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barred from further proceedings against all Kersting
petitioners.97
Mr. Sticht also contends that the Government's misconduct
resulted in a structural defect in the trial of the test cases,
but he characterizes the defect differently. Mr. Sticht asserts
that the Court effectively was precluded from supervising the
trial process because Judge Goffe was not informed of the
Thompson and Cravens settlement agreements. In conjunction with
this argument, Mr. Sticht maintains that nontest case petitioners
were deprived of procedural due process insofar as their
decisions to execute piggyback agreements, as opposed to
accepting one of the Government's settlement offers before the
trial, were made without knowledge that two test case petitioners
had decided to settle their cases. Mr. Sticht relies on United
States v. Noushfar, 78 F.3d 1442 (9th Cir. 1996), and Riley v.
Deeds, 56 F.3d 1117, 1121 (9th Cir. 1995), for the proposition
that an "abdication of judicial control over" a trial constitutes
a structural defect. Citing United States v. Annigoni, 96 F.3d
1132, 1143-1147 (9th Cir. 1996), Mr. Sticht argues in the
alternative that, even if the Government misconduct did not cause
a structural defect in the trial of the test cases, these cases
are not amenable to harmless error analysis because the impact of
97
Our research does not disclose any case in which this
Court has invoked such an extraordinary remedy, and petitioners
have brought no such case to our attention. A new trial normally
is the proper remedy in the case of a structural defect or
reversible error in a trial. See Arizona v. Fulminante, 499 U.S.
279 (1991).
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the misconduct "cannot be fairly assessed without engaging in
sheer speculation". In short, taking a different route from
Mr. Izen and Mr. Jones, Mr. Sticht would bring his clients to the
same destination: that nontest case petitioners are entitled to
entry of decisions that no deficiencies are due in their cases.
In response to respondent's contention that the Government
misconduct did not result in a structural defect because Mr. Izen
was not inhibited in fully and fairly presenting his clients'
cases, Mr. Sticht asserts that nontest case petitioners
nevertheless were harmed by Mr. Kersting's firing of Chicoine and
Hallett at a time when they were attempting to settle the
Kersting project cases. Mr. Sticht further suggests (in very
general terms) that Mr. Izen's performance at the trial of the
test cases was deficient and that the trial of the test cases
should have included an attorney who was not being paid by
Mr. Kersting.
C. Summary of Government Misconduct
Our first step in deciding whether the Government misconduct
resulted in a structural defect in the trial of the test cases is
to describe and characterize the Government misconduct.
Messrs. Sims and McWade negotiated a series of contingent
settlement agreements in the Thompson and Cravens cases in
advance of the trial of the test cases under which the Thompson
and Cravens would receive the more favorable of: (1) The Tax
Court's decision if the test case petitioners should prevail in
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the Tax Court; or (2) the agreed decisions based on the
settlements of their test cases.
Messrs. Sims and McWade were the only persons in the
Honolulu District Counsel Office with knowledge of the Thompson
and Cravens settlements before and during the trial of the test
cases. Other than Mr. Stevens no one else within the Internal
Revenue Service was aware of the Thompson and Cravens settlements
before or during the trial of the test cases up to the times that
the Court issued its Dixon II opinion and entered the initial
decisions in the test cases.
Before the trial of the test cases, Mr. McWade intentionally
misled the Court, with the complicity of Mr. DeCastro, by not
disclosing the settlement of the Thompson cases when he moved to
set aside the Thompson piggyback agreements. Messrs. Sims,
McWade, and DeCastro intentionally misled the Court regarding the
status of the Thompson cases at the trial of the test cases.
When Mr. Thompson alluded to his settlement during his testimony
at the trial of the test cases, Mr. McWade interrupted Mr.
Thompson in order to divert him from the subject and thus
intentionally prevented Judge Goffe from learning about the
Thompson settlement. Messrs. Sims and McWade also intentionally
misled the Court regarding the status of the Cravens cases at the
trial of the test cases.
The decisions entered in the Thompson cases provided for
agreed reductions in the Thompsons' tax liabilities for 1979,
1980, and 1981 that generated refunds of tax and interest that in
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turn were used to pay Mr. DeCastro's attorney's fees. The
refunds actually made were more than sufficient for this purpose;
the excess was received and retained by the Thompsons. Contrary
to McWade's testimony at the evidentiary hearing, the Thompson
settlement was not based upon or influenced by the Thompsons'
participation in the Bauspar program.
Although the contingent aspect of the secret settlement
agreements provided an ostensible incentive for Messrs. Thompson
and Cravens to defend vigorously the Kersting interest deductions
that they had reported on their tax returns, the record shows
that the secret settlements had the effect of diluting the
adversarial character of the Thompsons' and Cravenses'
presentations of their cases to the Court.
Mr. Thompson's testimony at the trial of the test cases
reveals that he strongly defended the position that he had
participated in the Kersting programs with the objective of
making a profit. However, Mr. Thompson was the only test case
petitioner to testify that Mr. Kersting had assured him that his
promissory notes would not be enforced. Although Mr. Thompson's
testimony on this point merely served to corroborate Mr.
Kersting's statements to other Kersting program participants in
the comfort letters, the circumstances indicate that Mr. Thompson
participated in the trial of the test cases in part to lay the
groundwork for a defense against Mr. Kersting's earlier threats
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to collect on Mr. Thompson's promissory notes.98 Considering
Mr. Thompson's mixed motivations, Mr. Thompson was not fully
representative of the class of Kersting program participants
interested in contesting the Commissioner's determinations
disallowing Kersting interest deductions.
Mr. Thompson's testimony aside, Mr. Thompson's settlement
agreement placed his counsel, Mr. DeCastro, in a conflict of
interest. In particular, Mr. Thompson's settlement agreement was
altered so that Mr. DeCastro's attorney's fees in effect would be
paid out of tax refunds that were guaranteed to be paid to the
Thompsons. In short, with Mr. Thompson serving as a conduit,
Messrs. Sims and McWade arranged for the Government to pay
Mr. DeCastro's attorney's fees to ensure that Mr. Thompson would
ostensibly remain a test case petitioner. As observed by the
Court of Appeals, Mr. DeCastro "was the main beneficiary of the
[Thompson] settlement". DuFresne v. Commissioner, 26 F.3d at
107. Mr. DeCastro's additional legal fee paid from the refunds
generated by the final Thompson settlement--$62,225--was
disproportionately high in relation to the amount remaining in
issue for the Thompsons--$30,000 plus interest.
The record indicates that Mr. DeCastro had concluded before
the trial of the test cases that Kersting program participants
98
Although Judge Goffe was not informed of Mr. Thompson's
settlement, Mr. Thompson's dispute with Mr. Kersting was
disclosed to Judge Goffe through Mr. Thompson's testimony.
Consequently, Judge Goffe was able to weigh Mr. Thompson's
credibility on this point.
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did not have a viable case. He candidly admitted as much to
Mr. Izen on the eve of the trial. Consistent with this view,
Mr. DeCastro had advised his clients, including the Thompsons, to
try to obtain the best settlements they could get and not abide
the outcome of the trial of the test cases. Before the final
sweetening of the Thompson settlement, Mr. DeCastro had
effectively represented his clients, including the Thompsons, in
obtaining a number of settlements (with the burnout feature) on
the order of 20 percent.
Against this background, Mr. DeCastro's conflict in the
Thompson cases became acute when he agreed, in the context of the
final sweetening of the Thompson settlement to provide the
wherewithal to pay his legal fees, to continue to participate in
Messrs. Sims' and McWade's scheme to keep the Thompsons among the
test cases petitioners and to provide the masquerade of trial
representation for the Thompsons as one of the test cases.
Before the trial of the test cases, Mr. DeCastro had written to
Mr. Huestis that Mr. Thompson's participation in the trial
"appears to be wise insurance to obtain cancellation of the
notes".
Mr. McWade, with the knowledge of Mr. Sims, negotiated a
contingent settlement agreement with Mr. Cravens in advance of
the trial of the test cases. However, Mr. McWade intentionally
misled Mr. Cravens as to the nature and legal effect of his
settlement and the need for counsel at the trial of the test
cases. Mr. McWade improperly advised Mr. Cravens that, by virtue
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of his settlement, Mr. Cravens could not win or lose and would
not need an attorney to represent him at the trial of the test
cases. In so doing, Mr. McWade foreclosed the possibility that
the Cravenses would become clients of Chicoine and Hallett, and
later, of Mr. Izen, and thereby reduced the effectiveness of
Mr. Cravens' presentations to the Court from the point of view of
all petitioners. The likelihood that Mr. Cravens would have
informed counsel for test case petitioners that his cases had
been settled was also thereby reduced.
Mr. Cravens relied upon Mr. McWade's advice and appeared at
the trial of the test cases without counsel, whereupon he was
informed by Mr. McWade that he would enjoy the better of the Tax
Court decision in the trial of the test cases or the previously
arranged settlement agreement. We have no doubt that Mr. Cravens
would have been better prepared and would have offered a more
complete case had he been represented by counsel at the trial of
the test cases. At a minimum, counsel could have assisted
Mr. Cravens in completing his testimony regarding his motivations
for participating in Kersting programs and his belief that his
promissory notes were valid.
During the trial of the test cases and thereafter, Messrs.
Sims and McWade intentionally misled the Court and the remaining
test case petitioners regarding the status of the Thompson and
Cravens cases. Messrs. Sims and McWade consciously continued
their efforts to mislead the Court during the evidentiary hearing
by denying that the Thompson settlement was a vehicle for paying
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Mr. DeCastro's legal fees for representing the Thompsons at the
trial of the test cases, by testifying that the Thompson
settlement was attributable to the Thompsons' participation in
the Bauspar program, and by trying to cover up the bases for the
stipulated decisions that were entered by the Court in the
Alexander cases.
Mr. McWade also failed to disclose to the Court his
understanding with Mr. Alexander and allowed Mr. Alexander to
offer misleading testimony to the Court during the trial of the
test cases. Although we are unable to find that Mr. McWade and
Mr. Alexander agreed before the trial to a specific reduction of
the Alexanders' tax liabilities in exchange for Mr. Alexander's
assistance to Mr. McWade during the trial of the test cases, we
are convinced that Mr. McWade and Mr. Alexander had a general
understanding that the Alexanders' tax liabilities would be
reduced. In this regard, Mr. Alexander misled the Court when he
ambiguously answered "Specifically, no." to Mr. Izen's question
at trial whether Mr. Alexander had an agreement with Mr. McWade
to reduce his tax liabilities.99
99
Mr. Alexander's response could be understood as a
statement (consistent with the Court's finding in these cases)
that, although Mr. Alexander did not reach an agreement with
Mr. McWade for a specific reduction in the amount of his tax
deficiencies, he and Mr. McWade had a general understanding that
Mr. Alexander's tax liabilities would be reduced. Considering
the ambiguity in Mr. Alexander's response, it seems surprising
that Mr. Izen did not pursue the matter further. In any event,
by virtue of Mr. McWade's duty of candor toward the Court, see
ABA Model Rules of Professional Conduct rule 3.3, Mr. McWade was
obliged to disclose his understanding with Mr. Alexander to the
Court.
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In sum, the record in these cases reveals a scheme by
Messrs. Sims and McWade to mislead the Court and manipulate the
test case procedure in a misplaced effort to enhance the already
overwhelming likelihood that respondent would prevail on the
merits of the Kersting adjustments and their continuing efforts
at the evidentiary hearing to cover up what they had done.
D. Discussion
Petitioners unanimously advance the view that the Government
misconduct should be considered a structural defect. We are
convinced that Messrs. Sims' and McWade's misconduct diluted the
adversarial character of the presentation of what the Court and
the other petitioners were led to believe were the Thompson and
Cravens test cases. To conclude, however, that the Government
misconduct resulted in a structural defect in the trial of the
test cases, one also must accept the proposition that the harm
caused by the Government misconduct pervaded and altered the
basic constitution of the trial mechanism in all the test cases.
As previously indicated, Messrs. Izen and Jones contend that
the Government misconduct in these cases includes the alleged
illegal search of Mr. Kersting's office and the issuance of
erroneous notices of deficiency. However, Messrs. Izen and Jones
disregard the fact that every court considering the matter has
rejected the contention that the search of Mr. Kersting's office
was illegal. See Kersting v. United States, 865 F. Supp. at 674-
675. In addition, the Court held in Dixon I that petitioners
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lack standing to contest the alleged violation of Mr. Kersting's
Fourth Amendment rights. Further, there is no credible evidence
in the record that respondent issued notices of deficiency to
Kersting program participants that were so erroneous as to render
them invalid.100 Consequently, we will limit our consideration to
the misconduct associated with the secret settlements that
Messrs. Sims and McWade entered with Messrs. Thompson and Cravens
and Mr. McWade's understanding with Mr. Alexander.
The impact of the Government misconduct in these cases must
be evaluated in the context in which it occurred. Specifically,
whereas the typical structural defect case arises in a trial of a
single criminal defendant, the test case procedures employed in
these cases concern the tax liabilities of more than 1,300
Kersting program participants who agreed to be bound by the
outcome in a trial of eight test case petitioners, six of whom
were represented by Mr. Izen.
Although we are convinced that the Thompson and Cravens
settlements had the effect of diluting or diminishing the
adversarial character of the presentation of their cases, we are
100
There is no evidence in the record that such errors as
have been discovered in Kersting project statutory notices were
attributable to an improper intention of pressuring taxpayers.
However, the existence of such errors, see, e.g., Richards v.
Commissioner, T.C. Memo. 1997-149, supplemented by T.C. Memo.
1997-299, affd. without published opinion 165 F.3d 917 (9th Cir.
1998), should alert nontest case petitioners and their counsel in
nontest cases not yet disposed of to review their notices and
carefully compare them with their return positions for the
taxable years in question.
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equally convinced that the Thompson and Cravens settlements
neither prevented Mr. Izen from fully and fairly presenting his
clients' cases to the Court nor resulted in any reduction in the
effectiveness of his presentation on their behalves. There is no
indication in the record that the Thompson and Cravens
settlements affected Mr. Izen's trial preparation or trial
strategy, or his trial tactics or presentation. Although Mr.
Thompson's testimony at the trial of the test cases that Mr.
Kersting had orally assured him that his promissory notes would
be canceled in exchange for the return of Kersting stock may have
surprised Mr. Izen, the record reveals that Mr. Izen was well
aware that respondent intended to rely on the so-called comfort
letters to establish the same point. Mr. Izen's strategy--
conceived before the trial of the test cases and continuing
through the evidentiary hearing--was to rebut the comfort letters
with evidence that Kersting corporations had initiated collection
litigation against Kersting program participants who failed to
make loan payments. In addition to developing the testimony of
the test case petitioners that he represented, Mr. Izen cross-
examined Messrs. Thompson, Cravens, and Alexander during the
trial of the test cases. Considering all the facts and
circumstances, we are convinced that the misconduct of Messrs.
Sims and McWade in connection with the Thompson and Cravens
settlements and the Alexander understanding did not alter the
basic framework within which the trial of the test cases was
conducted. We are convinced that the trial of the test cases
- 228 -
served its fundamental function as the vehicle for redetermining
the tax liabilities of the broad array of test case petitioners
represented by Mr. Izen.
We are not persuaded by Mr. Sticht's argument that the Court
effectively was precluded from supervising the trial of the test
cases because Judge Goffe was not informed of the Thompson and
Cravens settlement agreements. Judge Goffe was aware that
Messrs. Thompson and Alexander were hostile towards Mr. Kersting.
Although a disclosure of the Thompson and Cravens settlements and
the Alexander understanding would have given Judge Goffe a more
comprehensive basis for weighing their credibility, we do not
equate Judge Goffe's lack of knowledge of the settlements with
the proposition that he was precluded from supervising the trial
of the test cases. To the contrary, the record in the trial of
the test cases and the evidentiary hearing shows that Judge Goffe
accurately assessed the credibility of Messrs. Thompson, Cravens,
Alexander, and Kersting and maintained firm control of the
proceedings.
The Ninth Circuit cases that Mr. Sticht relies upon for the
proposition that the nondisclosures to the Court precluded Judge
Goffe from supervising the trial of the test cases are readily
distinguishable from the facts at hand. In United States v.
Noushfar, 78 F.3d at 1144-1145, the Court of Appeals held that
there was a structural defect in a criminal trial in which the
trial judge abdicated control of the presentation of evidence by
allowing the jury to take into the jury room tapes of the
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defendants' conversations that had never been played in open
court. In Riley v. Deeds, 56 F.3d at 1119, the Court of Appeals
held that there was a structural defect in a criminal trial in
which, in the trial judge's absence, the trial judge's law clerk
convened the court and permitted the court reporter to read back
part of the victim's testimony to the jury. Considering the
obvious distinctions between the errors of omission of the trial
judges in the jury trial cases relied upon by Mr. Sticht, and
Judge Goffe's role in the trial of the test cases, we reject Mr.
Sticht's structural defect argument.
We likewise reject Mr. Sticht's argument that a structural
defect occurred by reason of respondent's failure to inform
nontest case petitioners who signed piggyback agreements that
two test case petitioners had received contingent settlements.
Although Mr. Sticht characterizes this failure as a structural
defect, Mr. Sticht's argument amounts to little more than a
breach of contract theory--a matter we address more fully below.
In any event, we restate our earlier conclusion that the trial of
the test cases served its fundamental function as the vehicle for
redetermining the tax liabilities of Mr. Izen's test case
petitioners to embrace the broader proposition that the nontest
case petitioners who signed piggyback agreements received what
they bargained for, an opinion and a series of decisions on the
merits in Dixon II that covers a broad array of Kersting programs
for the taxable years 1975 through 1983.
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Mr. Sticht contends that Mr. Izen's representation of test
case petitioners does not provide a sound basis for concluding
that the Government misconduct did not cause a structural defect
in the trial of the test cases. In particular, Mr. Sticht points
to Mr. Kersting's interference in the Chicoine and Hallett
settlement negotiations and his eventual firing of Chicoine and
Hallett, and Mr. Izen's alleged lack of preparation for the
trial, as evidence that nontest case petitioners were not
afforded due process.
Mr. Kersting, the shelter promoter, had the incentive and
initially the resources to finance the test case litigation. By
so doing, Mr. Kersting positioned himself to influence or
determine the choice of counsel hired to represent the test case
petitioners, creating the potential for conflicts of interest.
Mr. Kersting repeatedly used his control of the purse strings to
interfere in the attorney-client relationships of participants
in his programs, as evidenced by his attempts to initiate
Mr. Seery's withdrawal as test case counsel for the Thompsons
and his efforts to forestall dissemination to Kersting program
participants of Internal Revenue Service settlement offers
solicited by Mr. Seery and by Chicoine and Hallett. The pattern
of interference continued in Mr. Kersting's firing of Chicoine
and Hallett as counsel for test case petitioners and encouraging
nontest case petitioners to recall their settlement retainers
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from Chicoine and Hallett.101 The record of the evidentiary
hearing contains evidence that Mr. Kersting participated in and
perhaps orchestrated efforts to create disaffection among
Mr. Sticht's clients.
It is also ironic--if true--that Mr. Kersting did not inform
Mr. Izen of the Thompson and Cravens settlements at or before the
trial of the test cases. If Mr. Kersting had informed Mr. Izen
and Mr. Izen had informed Judge Goffe, the trial might have been
somewhat delayed, but the tax liabilities of the nonsettling
Kersting test case and nontest case petitioners would have been
finally resolved long ago, with attendant avoidance or reduction
101
A lawyer who planned or helped to promote a tax shelter
or is otherwise under the control of a tax shelter promoter has a
conflict of interest in representing participants in the tax
shelter because he will not (or may not) give disinterested
advice regarding settlement offers that may conflict with his
original advice or the interests of the promoter. See Ewing v.
Commissioner, 91 T.C. at 397 n.2; Para Techs. Trust v.
Commissioner, T.C. Memo. 1992-575.
Chicoine and Hallett, in their retainer agreements with the
test case petitioners and by their actions, made clear that
although they were not averse to obtaining additional business,
they had no conflict of interest and that their primary loyalty
was to their clients. Mr. Kersting fired Chicoine and Hallett
when, on the basis of their independent appraisal of the weakness
of the Kersting programs, they tried to obtain the most favorable
settlements available on behalf of as many participants, test
case and nontest case petitioners, as possible. Because of his
potential personal liability for both promoter penalties and
Federal income taxes, and his financial interest in trying to
vindicate himself and his programs, Mr. Kersting scuttled the
settlements, fired Chicoine and Hallett, and found another
attorney to represent the test case petitioners in the trial of
the test cases. Mr. Kersting's lack of sensitivity to the
conflict issue and counsel's obligation to issue disinterested
advice to clients is exemplified by his misplaced emphasis in
mischaracterizing Chicoine and Hallett's actions as primarily
stemming from fear of suit by their clients.
- 232 -
of interest costs, legal fees, and expenditure of private party,
administrative, attorney, and judicial resources.
Nevertheless, Mr. Kersting's misconduct does not somehow tip
the scale in favor of finding a structural defect in the trial of
the test cases. While Mr. Kersting endeavored to keep all the
nontest case petitioners under his wing through his numerous
"Dear Friend" letters and through the hiring and firing of
counsel for test case petitioners, nontest case petitioners
should have been alerted to the potential for and presence of
conflicts between their interests and those of Mr. Kersting by
Mr. Seery's withdrawal as counsel, as well as by the firing of
Chicoine and Hallett. However, neither Mr. Kersting's payment of
Mr. Izen's fees, nor our review of the record in Dixon II,
suggests that Mr. Izen's representation of the test case
petitioners was inadequate, in the sense that there is anything
more that he or any other attorney could have done that would
have led to a different outcome.
At the end of the day, the Government misconduct in these
cases is not readily comparable to any of the fundamental
constitutional violations that the Supreme Court has identified
as a structural defect, e.g., denial of the right to counsel or
the right to self-representation, the right to an impartial
judge, or the right to a public trial. In this regard, we are
mindful of the Supreme Court's statement in Arizona v.
Fulminante, 499 U.S. 279 (1991), that most constitutional errors
are amenable to harmless-error analysis. Considering all the
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facts and circumstances, including the unique nature of the test
case procedure, the specific configuration adopted for the trial
of the Kersting test cases, and Mr. Izen's ability fully and
fairly to present his clients' cases during the trial, we find
that the Government misconduct did not result in a trial that was
fundamentally unfair. See id. at 308; see also Greer v. Miller,
483 U.S. 756, 768 (1987) (Stevens, J., concurring). Stated
differently, although we disapprove Messrs. Sims' and McWade's
misconduct, as well as the misconduct of Mr. Kersting and
Mr. DeCastro, we do not conclude that their misconduct resulted
in a structural defect in the trial of the test cases mandating
either a new trial or entry of decisions in petitioners' favor.
III. Harmless Error Analysis
Although we have concluded that the Sims-McWade misconduct
did not result in a structural defect in the trial of the test
cases, we must consider whether petitioners are entitled to a new
trial on the ground that the misconduct resulted in reversible
error as opposed to harmless error. See Arizona v. Fulminante,
supra at 307-308. Although structural defect inquiries have
generally been limited to criminal cases, reversible versus
harmless error analysis appears in civil as well as criminal
cases.102
The Court's Rules of Practice and Procedure set forth the
principle of harmless error as follows:
102
See generally Traynor, "The Riddle of Harmless Error"
(1970).
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Rule 160. HARMLESS ERROR
No error in either the admission or exclusion of
evidence, and no error or defect in any ruling or order
or in anything done or omitted by the Court or by any
of the parties, is ground for granting a new trial or
for vacating, modifying, or otherwise disturbing a
decision or order, unless refusal to take such action
appears to the Court inconsistent with substantial
justice. The Court at every stage of a case will
disregard any error or defect which does not affect the
substantial rights of the parties.
Rule 160 is "substantially the same as" rule 61 of the Federal
Rules of Civil Procedure. See 60 T.C. 1144; see also Fed. R.
Crim. P. 52(a).
In civil cases, an error related to admission of evidence or
attorney misconduct is considered harmless if there is no
prejudicial effect and/or the error did not affect the judgment.
See Chalmers v. City of Los Angeles, 762 F.2d 753, 761-762 (9th
Cir. 1985); see also Mateyko v. Felix, 924 F.2d 824, 827-828 (9th
Cir. 1991) (new trial is warranted only if misconduct affected
the verdict). The standard of proof in such cases is normally
clear and convincing evidence. See, e.g., Bunch v. United
States, 680 F.2d at 1283.
The Supreme Court has adopted a similar standard for
reviewing errors associated with prosecutorial misconduct in
criminal cases. See United States v. Bagley, 473 U.S. 667
(1985); Smith v. Phillips, 455 U.S. 209 (1982); United States v.
Agurs, 427 U.S. 97 (1976); Giglio v. United States, 405 U.S. 150
(1972); Brady v. Maryland, 373 U.S. 83 (1963); Napue v. Illinois,
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360 U.S. 264 (1959).103 In criminal cases, the Government
generally is obliged to show beyond a reasonable doubt that the
alleged error did not affect the verdict. See Arizona v.
Fulminante, supra at 295-296; Chapman v. California, 386 U.S. at
24.
Consistent with the approach of the cases on harmless error
in both the civil and criminal contexts, our inquiry is not
focused on the merits of the matter or the correctness of the
result in Dixon II, as such, but on what Justice Roger Traynor,
in his seminal essay, "The Riddle of Harmless Error" (1970),
called the "effect on the judgment" test of harmless error. Id.
at 22.104 We therefore will assess the effects of the Sims-McWade
misconduct in the cases at hand in the light of evidence
presented at the trial of the test cases and the evidentiary
hearing in order to determine whether the Government misconduct
was material to the outcome of the trial of the test cases.
Arizona v. Fulminante, supra at 307-308; United States v. Bagley,
supra at 679-680 n.9.
103
Although these criminal cases concern the prosecutor's
use of false testimony, as well as the prosecutor's suppression
of exculpatory and impeachment evidence, we believe they are
sufficiently analogous to the cases at hand where, at a minimum,
the Thompson and Cravens secret settlements and the Alexander
understanding could be viewed either as evidence that was
improperly admitted or impeachment evidence that was improperly
excluded.
104
For a more recent espousal of the same test in a
discussion limited to criminal cases see Edwards, “To Err Is
Human, But Not Always Harmless: When Should Legal Error Be
Tolerated?”, 70 N.Y.U.L. Rev. 1167 (1995).
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Although our task has been made onerous by the magnitude of
the record of the original trial and the evidentiary hearing, the
task has been facilitated by the Court's detailed and
discriminating findings of fact and discussion of law in Dixon
II, as required by section 7459(a). We are not confronted by the
opacity of a jury general verdict or cursory findings by a trial
judge sitting without a jury. See Traynor, supra at 22-25. We
reject Mr. Sticht's assertions that we are engaging in sheer
speculation or embarking on uncharted waters in proceeding with
the reversible error versus harmless error analysis mandated by
the Court of Appeals. The road map provided by the Court's
findings and opinion in Dixon II could not be more detailed and
specific in relation to the record of the trial and the
evidentiary hearing.
We therefore will first review the Court's Dixon II opinion
and then consider the relative importance of the testimony and
evidence of Messrs. Thompson, Cravens, and Alexander to the
Court's holdings in Dixon II.
A. Review of Dixon II
The Court's opinion in Dixon II contains a detailed
description of the various Kersting programs and a comprehensive
analysis in support of the Court's determination to sustain
respondent's disallowances of Kersting interest deductions. In
Dixon II, the Court held that the Kersting loans were sham
transactions lacking economic substance, that the loans did not
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constitute genuine debt, and that interest was not "paid" on
Kersting loans within the meaning of section 163.
1. Mr. Kersting's Lack of Credibility
In Dixon II, the test case petitioners bore the burden of
proof and were required to show by a preponderance of the
evidence that respondent's determinations disallowing Kersting
interest deductions were erroneous. See Rule 142(a). As
discussed below, it is evident the test case petitioners' efforts
to satisfy their burden of proof were frustrated by the lack of
credibility of their principal witness, Mr. Kersting.
Judge Goffe made it abundantly clear in Dixon II, on the
bases of both his observations of Mr. Kersting at trial and his
review of the record, that Mr. Kersting lacked credibility,
particularly his testimony having a bearing on the tax viability
of his programs. Examples cited by Judge Goffe as evidence of
Mr. Kersting's lack of credibility included his false testimony
regarding: (1) The filing of tax returns for Kersting
corporations; (2) the reasons behind the closing of Kersting
accounts at Hawaii National Bank; (3) the level of Gabriele
Kersting's participation in daily corporate operations; (4) the
reasons for the frequent creation of new acceptance corporations;
and (5) the methods used to value Kersting stock. See Dixon II,
62 T.C.M. (CCH) at 1482, 1484, 1487, 1991 T.C.M. (RIA), at 91-
3024 to 91-3025, 91-3026 to 91-3027, 91-3029 to 91-3031.
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2. Sham Analysis
The Dixon II opinion reveals that Judge Goffe relied upon
evidence that was both qualitatively and quantitatively
substantial in support of the conclusion that the Kersting stock
transactions in dispute were shams. Although acknowledging that
some Kersting corporations engaged in businesses unrelated to the
disputed Kersting programs, Judge Goffe concluded that the
viability and activities of the various Kersting corporations
were not determinative of whether the specific Kersting
transactions in dispute were shams. See id. at 1485-1486, 1991
T.C.M. (RIA), at 91-3028; see also ACM Partnership v.
Commissioner, T.C. Memo. 1997-115, affd. on this issue 157 F.3d
231, 260 (3d Cir. 1998).
Judge Goffe reviewed the relevant testimony and particular
circumstances of each test case petitioner and concluded that the
presence of several factors common to all of them invariably
required the finding that petitioners had no subjective business
purpose for engaging in the Kersting programs other than tax
avoidance. In particular, Judge Goffe found that the test case
petitioners entered into the Kersting programs without specific
knowledge about the Kersting corporations involved, the
industries in which they operated, and the impact of prevailing
economic conditions on their investment decisions, and without
obtaining the assistance of an independent adviser. Judge Goffe
further found that the test case petitioners entered into the
Kersting programs without regard to whether the purchase price
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for the stock that they purported to purchase was reasonable and
appropriate. See Dixon II, 62 T.C.M. (CCH) at 1486-1491, 1991
T.C.M. (RIA), at 91-3027 to 91-3034. Indeed, Judge Goffe found
that Mr. Kersting had failed to explain clearly, consistently, or
credibly how he had determined the value of Kersting stock upon
both its sale and reacquisition from test case petitioners and
other Kersting program participants. See id. at 1487, 1991
T.C.M. (RIA), at 91-3030.
Judge Goffe noted that Mr. Cravens had testified that his
purpose for entering into the Kersting programs was "mainly" for
tax shelter, that Mr. Cravens had failed to offer any other
reason for his participation in the Kersting programs, and that
Mr. Cravens had opened and closed two Kersting programs (stock
subscription plans) during a 2-year period (1979 and 1980)
without any economic profit or loss other than being out-of-
pocket the cash payments on his leverage notes. See id. at 1488,
1991 T.C.M. (RIA), at 91-3031.
As with several other test case petitioners, Judge Goffe
disregarded Mr. Thompson's testimony that he expected to profit
from his participation in the Kersting programs on the ground
that Mr. Thompson's testimony was vague and not supported by the
record. Judge Goffe rejected Mr. Thompson's argument that his
participation in the First Savings acquisition contributed to his
profit motive for participating in the Kersting programs at
issue. See id. at 1489-1490, 1991 T.C.M. (RIA), at 91-3032 to
91-3033.
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Judge Goffe further concluded that the test case petitioners
failed to show that the Kersting programs had economic substance
beyond the creation of tax benefits. Relying primarily upon the
manner in which Mr. Kersting actually operated the programs,
Judge Goffe found that there was little if any likelihood of
either corporate profitability or shareholder profitability.
Even assuming some level of corporate profitability and a
related increase in the value of Kersting stock, Judge Goffe
found it significant that no evidence was offered either through
Mr. Kersting or the test case petitioners that Kersting program
participants were ever in a position to sell their stock at an
increased value relative to the purchase price of the stock.
Finally, Judge Goffe found that Mr. Kersting routinely
disregarded standard corporate practices. See id. at 1491-1494,
1991 T.C.M. (RIA), at 91-3034 to 91-3038.
Consistent with his findings that the test case petitioners
had no business purpose for entering into the Kersting programs
other than tax avoidance and that the transactions lacked
economic substance, Judge Goffe held that the stock transactions
were shams.
3. Lack of Genuine Debt/Waltz of Funds
After concluding that the stock transactions were shams,
Judge Goffe went on to consider whether the primary and leverage
loans constituted genuine debt that qualified for deduction under
section 163(a). Judge Goffe independently examined each of the
Kersting programs and loans in dispute.
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i. Subscription Interest
Relying upon the specific language in the stock subscription
agreements underlying the stock subscription plan and the leasing
corporation plan, Judge Goffe held that the agreements, standing
alone, did not create an unconditional debt obligation. See id.
at 1494-1496, 1991 T.C.M. (RIA), at 91-3038 to 91-3040.
Judge Goffe further denied deductions for subscription
interest under the Stock Subscription and Leasing Corporation
Plans on the ground that such interest was not "paid" within the
meaning of section 163(a). In so holding, Judge Goffe focused on
Mr. Kersting's practice of carrying out a circular flow of checks
among Kersting corporations and investors at the same bank on the
same day--the so-called waltz of funds. See, e.g., Davison v.
Commissioner, 107 T.C. 35 (1996), affd. per curiam 141 F.3d 403
(2d Cir. 1998). In particular, Judge Goffe identified two
specific instances in which Mr. Kersting waltzed funds affecting
Stock Subscription Plans. In one instance, Mr. Kersting waltzed
primary loan funds; in the other instance, he waltzed leverage
loan funds. Relying upon evidence that there were several other
potential waltz situations across the board with respect to the
stock purchase plan, the stock subscription plan, and the leasing
corporation plan, Judge Goffe found that waltzes were essential
elements of all the Kersting stock transactions. See Dixon II,
62 T.C.M. (CCH) at 1496-1499, 1991 T.C.M. (RIA), at 91-3040 to
91-3043.
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ii. Primary Loans
Judge Goffe determined that several features of the primary
loans prevented them from being genuine debt in substance.
First, Judge Goffe found that Mr. Kersting and program
participants had an understanding at the commencement of a
program, as reflected in a number of so-called comfort letters,
that a primary loan obligation could be satisfied in full at any
time by a mere surrender of the associated stock certificate. In
so finding, Judge Goffe rejected Mr. Kersting's testimony that he
did not represent to program participants that they could
exchange their stock for cancellation of a primary note at any
time. To the contrary, Judge Goffe listed the following nine
items in support of his conclusion that Mr. Kersting applied the
policy outlined in his so-called comfort letters to all program
participants: (1) Mr. Thompson's testimony that Mr. Kersting
assured him of the exchange policy; (2) Mr. Kersting's
description of a stock subscription plan to Mil Harr; (3)
Gabriele Kersting's form letter to test case petitioner Terry D.
Owens describing a stock subscription plan; (4) Mr. Kersting's
form letter describing a leasing corporation plan; (5)
Mr. Kersting's form letter issued on the first anniversary of a
leasing corporation plan; (6) Mr. Kersting's acknowledgment in a
comfort letter that such a letter would be issued to "every
participant * * * if it would not weaken YOUR position with the
IRS"; (7) Mr. Kersting's broad statement in a later comfort
letter that "We will always repurchase the stock issued at a
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price sufficient to allow a borrower to discharge all of his
debt"; (8) Mr. Kersting's statements in a credit-reference letter
written on behalf of a program participant; and (9) a form letter
issued to test case petitioner Jerry R. Dixon describing the
process for the termination of his participation in a stock
purchase plan. See id. at 1499-1500, 1991 T.C.M. (RIA), at 91-
3043 to 91-3044.
Continuing his analysis, Judge Goffe concluded that, even
assuming that there was no prearranged understanding between
Mr. Kersting and program participants, neither Mr. Kersting nor
the program participants ever contemplated that the principal
obligation on a primary loan would be paid except by a surrender
of the underlying stock. Judge Goffe reached this conclusion
after finding that: (1) No evidence was produced of a primary
note ending up in the hands of anyone not associated with
Mr. Kersting; (2) primary loans issued during later years
included an express notation that they were nonnegotiable and
nonassignable; and (3) primary loans were unsecured, with the
primary notes failing to list even the purchased stock as
collateral. See id. at 1500, 1991 T.C.M. (RIA), at 91-3044.
Judge Goffe further concluded that program participants would not
have assumed liability for the high level of debt that the
primary loans represented, considering their lack of
understanding of the Kersting corporations in which they were
purportedly investing, "unless they had no expectation or
intention of ever paying off those loans with cash". Id.
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Judge Goffe found additional support for his conclusion that
the primary loans did not constitute genuine debt in
Mr. Kersting's backdating of documents relevant to the loan
transactions and the apparent waltz of primary loan funds under
the stock purchase plan and the leasing corporation plan. See
id. at 1500-1502, 1991 T.C.M. (RIA), at 91-3044 to 91-3046.
Judge Goffe held in the alternative that, even assuming that
the primary loans represented genuine debt, the test case
petitioners had failed to show that they actually "paid" interest
on the primary loans within the meaning of section 163(a)
inasmuch as Mr. Kersting apparently waltzed leverage loan funds
that were used to pay interest on primary loans. See id. at
1502, 1991 T.C.M. (RIA), at 91-3046.
iii. Leverage Loans
Judge Goffe determined that leverage loans did not represent
genuine debt because of several factors, including the waltzing
of funds, backdating of documents, substance not following form,
and mutual expectations that program participants would not incur
personal liability for the principal amounts of the leverage
loans. See id. at 1502-1503, 1991 T.C.M. (RIA), at 91-3046 to
91-3047.
4. Collection Litigation
As previously discussed, Mr. Izen offered evidence on behalf
of test case petitioners that various Kersting corporations
initiated collection actions against Kersting program
participants in an attempt to rebut respondent's evidence that
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there was a mutual understanding between Mr. Kersting and his
program participants that primary and leverage loans would not be
enforced. Judge Goffe rejected the collection litigation
evidence as a basis for sustaining the validity of the Kersting
loans as follows:
As illustrated by Kersting's pay-or-else letter
to over 30 clients on September 25, 1980, and his 1986
correspondence with the Thompsons, his overriding
concern was to be compensated by means of leverage loan
interest. It was this amount that even he often
referred to as a "fee" or a deductible "cost" of tax
deductions. In encouraging clients by means of the
September 25, 1980, letter to "discharge the debt to
which you are a party," he sought only small amounts
that could not have represented typical primary or
leverage loans. His letters to the Thompsons indicate
that he only threatened or pursued collection of
principal obligations when the investor neglected or
refused to pay leverage loan interest. This rare
occurrence, which Kersting did not testify he either
intended or expected, is not sufficient to transform
any of petitioners' loans from Kersting corporations
into genuine recourse indebtedness.
Id. at 1506, 1991 T.C.M. (RIA), at 91-3049 to 91-3050.
5. CAT-FIT Plan
Judge Goffe found that the record in the trial of the test
cases did not provide a basis for the Court to understand fully
how the CAT-FIT program operated or how Mr. Kersting intended the
program to operate.105 In any event, Judge Goffe concluded that:
(1) The CAT-FIT program was a sham transaction that provided no
economic benefit other than the creation of tax losses; (2) the
105
The test case petitioners who participated in the CAT-
FIT program included the Dixons, DuFresnes, Owenses, and
Hongsermeiers. See Dixon II, 62 T.C.M. (CCH) at 1507, 1991
T.C.M. (RIA), at 91-3050 to 91-3051.
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CAT-FIT primary loan did not constitute genuine debt because the
parties never contemplated that such loans would be paid except
by means of a redemption of the investment certificate;106 (3)
CAT-FIT participants did not pay interest on primary loans
insofar as Mr. Kersting waltzed leverage loan funds; (4) the CAT-
FIT leverage loan did not constitute genuine debt inasmuch as (a)
Kersting program participants failed to demonstrate how the
leverage loan principal obligations were satisfied or intended to
be satisfied;107 and (b) Mr. Kersting waltzed leverage loan funds;
and (5) the CAT-FIT primary and leverage loans did not result in
allowable interest deductions under the rationale of Goldstein v.
Commissioner, 364 F.2d 734 (2d Cir. 1966) (form of transaction
will not be exalted over substance when sole objective of
transaction is an interest deduction, even if transaction has
some minimal economic gain potential), affg. 44 T.C. 284 (1965).
See Dixon II, 62 T.C.M. (CCH) at 1508-1509, 1991 T.C.M. (RIA), at
91-3051 to 91-3053.
106
Judge Goffe further concluded that the CAT-FIT primary
loan did not constitute genuine debt insofar as the record
indicated that Mr. Kersting had waltzed primary loan funds. See
Dixon II, 62 T.C.M. (CCH) at 1508, 1991 T.C.M. (RIA), at 91-3052.
107
In this regard, Judge Goffe rejected the test case
petitioners' attempt to show that CAT-FIT leverage loans were
genuine recourse debt through evidence of collection litigation
brought against George Vermef. See Dixon II, 62 T.C.M. (CCH) at
1509, 1991 T.C.M. (RIA), at 91-3053.
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6. Additions to Tax
i. Negligence
Judge Goffe sustained respondent's determinations that the
test case petitioners were liable for additions to tax for
negligence. In particular, Judge Goffe found that the test case
petitioners failed to show that they were unsophisticated
taxpayers, that they relied upon independent return preparers or
tax advisers, the nature of any professional advice that they may
have received, or that any such professional advice was based
upon a disclosure of all of the relevant facts. See id. at 1512-
1513, 1991 T.C.M. (RIA), at 91-3056 to 91-3057.108
ii. Late Filing
Judge Goffe sustained respondent's determination that the
Thompsons were liable for the addition to tax for late filing
under section 6651(a)(1) for 1981 on the ground that they did not
contest the matter and were deemed to have conceded the point.109
See id. at 1513, 1991 T.C.M. (RIA), at 91-3057.
iii. Substantial Understatement
Judge Goffe sustained respondent's determination that the
Youngs and the DuFresnes were liable for additions to tax for
108
Although Judge Goffe sustained respondent's
determinations that the test case petitioners were liable for
additions to tax for negligence, nontest case petitioners who
signed post-1985 piggyback agreements were to be relieved of
liability for such additions to tax for tax years before 1982.
See supra pp. 43-45.
109
We note that the Thompsons had no need to contest this
addition to tax by virtue of their settlement agreement.
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substantial understatements of their income tax liabilities for
the taxable years 1982 and 1983 at a rate equal to 10 percent of
the underpayment. In short, the Youngs and the DuFresnes had
contested the addition to tax only insofar as their liabilities
depended upon respondent's prevailing on their deficiencies to a
sufficient extent to exceed the substantial understatement
threshold of section 6661(b)(1)(A) (deficiency must exceed
greater of 10 percent of the tax required to be shown on the
return, or $5,000). See id. at 1513-1514, 1991 T.C.M. (RIA), at
91-3058.
iv. Increased Interest
Judge Goffe sustained respondent's determinations that the
Thompsons were liable for interest computed at the increased rate
prescribed in section 6621(c) for 1981, that the Youngs were
liable for such increased interest for the taxable year 1982, and
that the DuFresnes were liable for such increased interest for
the taxable years 1982 and 1983.110 In short, Judge Goffe
sustained these determinations on the ground that the Court had
already determined that the test case petitioners' underpayments
were attributable to "tax motivated transactions"; viz, sham
transactions, as provided in section 6621(c)(3)(A)(v). See id.
at 1514, 1991 T.C.M. (RIA), at 91-3058.
110
Nontest case petitioners who signed post-1985 piggyback
agreements agreed to be bound by the Court’s determination in the
test cases regarding the applicability of sec. 6621(c).
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B. Discussion
Whether the Government misconduct in these cases constitutes
reversible error as opposed to harmless error does not turn on
the "culpability of the prosecutor" but on whether nondisclosure
of the Thompson and Cravens settlements and the Alexander
understanding was material to the outcome in Dixon II. See Smith
v. Philips, 455 U.S. at 219; Brady v. Maryland, 373 U.S. at 87;
Mateyko v. Felix, 924 F.2d at 827-828; Chalmers v. City of Los
Angeles, 762 F.2d at 761-762. We evaluate the impact of the
Government misconduct on the outcome in Dixon II on the basis of
the entire record.
1. Mr. Cravens
Mr. McWade's settlement agreement with Mr. Cravens placed
a cap on the Cravenses' tax liabilities for 1979 and 1980.
However, we have found that Mr. McWade deliberately misled
Mr. Cravens regarding the nature and effect of his settlement.
In particular, Mr. McWade initially misinformed Mr. Cravens that
he could neither win nor lose at the trial of the test cases as
the basis for advising him that he need not retain counsel.
Relying on this misinformation and bad advice, Mr. Cravens
appeared at the trial of the test cases without counsel. Mr.
Cravens was surprised when Mr. McWade informed him immediately
before his testimony at the trial of the test cases that he would
receive the better of his earlier settlement or a Tax Court
decision in favor of the test case petitioners.
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Mr. Cravens' testimony at the trial of the test cases was
brief. Mr. Cravens testified that he participated in stock
subscription programs in 1979 (Candace) and 1980 (Delta).
Mr. Cravens testified that he participated in the Kersting
programs mainly for the tax benefits; he did not offer any other
motivation for his participation. Mr. Cravens did not testify
regarding the validity of his promissory notes or his level of
sophistication as an investor. Mr. Cravens testified that he
closed out his participation in the Kersting programs by
endorsing his stock certificates and returning them to Mr.
Kersting in exchange for his promissory notes.
Although we believe that Mr. Cravens' testimony at the trial
of the test cases was truthful in all material respects, we do
believe that counsel could have assisted Mr. Cravens in
presenting a more detailed and better organized case,
particularly with regard to Mr. Cravens' motivation for
participating in Mr. Kersting's programs and Mr. Cravens' view of
the validity of his promissory notes.
We have also found that Messrs. Sims and McWade misled the
Court and the remaining parties to these cases by not disclosing
the Cravens settlement before the trial of the test cases. We
recognize that Judge Goffe might have removed the Cravens cases
from the test case array had he been informed of their settlement
before the trial. Indeed, an argument can be made that Judge
Goffe would have removed the Cravens cases from the test case
- 251 -
array, inasmuch as the remaining test cases provided full
coverage of the Kersting programs and taxable years in dispute.
Under the circumstances, we must weigh the impact of the
Government misconduct in the Cravens cases on two levels. First,
because Mr. McWade led Mr. Cravens to believe that he did not
need counsel at the trial of the test cases, we must consider
whether Mr. Cravens' pro se status (and attendant lack of
preparation and organization) was material to the outcome in the
trial of the test cases. Second, because Judge Goffe might
have removed the Cravens cases from the test case array if he had
known that they had been settled, we must consider whether Mr.
Cravens' testimony was material to the outcome in Dixon II. As
discussed in greater detail below, we are convinced that the
outcome in Dixon II would not have been different irrespective of
whether Mr. Cravens had been represented at trial by competent
counsel or whether Judge Goffe would have excluded Mr. Cravens'
testimony in its entirety.
i. Sham Analysis
We will assume that, but for Mr. McWade's interference,
Mr. Cravens would have appeared at the trial of the test cases
with counsel and testified (consistent with the testimony of the
other test case petitioners) that he participated in the Kersting
programs with a view towards making a profit and that his
promissory notes constituted genuine indebtedness. Nevertheless,
on the basis of our review of Dixon II, we are convinced that
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Mr. Cravens' testimony would not have changed Judge Goffe's
conclusion that the test case petitioners had no business purpose
for participating in the Kersting programs. Judge Goffe relied
upon factors common to all test case petitioners in rejecting
their testimony that they had entered into the Kersting
transactions with a view towards making a profit on stock
appreciation. Specifically, Judge Goffe found that the test case
petitioners participated in the Kersting programs without regard
to whether the purchase price for the stock that they purported
to purchase was reasonable and appropriate, and without specific
knowledge about the Kersting corporations involved, the
industries in which they operated, or the impact of prevailing
economic conditions on their investment decisions. Under the
circumstances, we are convinced that Mr. Cravens' pro se status
was not material to Judge Goffe's holding that the test case
petitioners had no business purpose for participating in the
Kersting transactions.
We are also convinced that Mr. Cravens' testimony was not
material to Judge Goffe's holding that the test case petitioners
lacked a business purpose for participating in the Kersting
programs. In particular, although Mr. Cravens testified that he
participated in the Kersting programs mainly for the tax
benefits, we are convinced, upon the basis of Judge Goffe's
comprehensive analysis of the test case petitioners' lack of
business purpose, that Mr. Cravens' testimony on this point was
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cumulative of other evidence in the record and was not material
to Judge Goffe's holding.
Judge Goffe also concluded that the test case petitioners
failed to prove that the Kersting programs had economic substance
beyond the creation of tax benefits. Relying primarily upon the
manner in which Mr. Kersting actually operated the programs,
Judge Goffe found that there was little if any likelihood of
either corporate profitability or shareholder profitability, that
there was no evidence that Kersting program participants were in
a position to sell their stock at an increased value relative to
the purchase price of the stock, and that Mr. Kersting routinely
disregarded standard corporate practices. Because Judge Goffe
focused on the manner in which Mr. Kersting actually operated the
programs, we are convinced that Mr. Cravens' pro se status was
not material to Judge Goffe's holding that the Kersting programs
lacked economic substance.
Similarly, we are convinced that Mr. Cravens' testimony was
not material to Judge Goffe's holding on this point. Although
Mr. Cravens had terminated his participation in consecutive stock
subscription plans in 1979 and 1980 without any economic benefit,
we note that none of the test case petitioners presented any
evidence that they enjoyed any economic benefit from their
participation in the Kersting programs in dispute. In this
light, we are convinced that Mr. Cravens' testimony was
cumulative of other evidence and was not material to Judge
Goffe's holding that the test case petitioners failed to prove
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that the Kersting programs had economic substance beyond the
creation of tax benefits.
ii. Lack of Genuine Debt/Waltz of Funds
Judge Goffe also concluded that the test case petitioners
failed to show that Kersting promissory notes constituted genuine
debt or that interest was actually "paid" on the loans within the
meaning of section 163(a). As previously mentioned, Mr. Cravens
participated in consecutive stock subscription plans in 1979 and
1980. Relying upon the specific language used in stock
subscription agreements underlying the stock subscription plan
and the leasing corporation plan, Judge Goffe held that the
agreements, standing alone, did not create an unconditional debt
obligation. Judge Goffe further denied deductions for
subscription interest under the Stock Subscription Plan and the
leasing corporation plan on the ground that such interest was
not "paid" within the meaning of section 163(a) by virtue of
Mr. Kersting's waltz of funds. In particular, Judge Goffe
identified two specific instances in which Mr. Kersting waltzed
funds affecting stock subscription plans. In one instance, the
waltz concerned primary loan funds, while in the other the waltz
concerned leverage loan funds. Considering the bases for Judge
Goffe's analyses on these points, we are convinced that neither
Mr. Cravens' pro se status nor his testimony was material to
Judge Goffe's holdings that the test case petitioners failed to
show that Kersting promissory notes constituted genuine debt or
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that interest was actually "paid" on Kersting loans within the
meaning of section 163(a).
In sum, we conclude that the Government misconduct relating
to the Cravens cases constituted harmless error with respect to
Judge Goffe's holdings that the Kersting transactions were shams,
that the loans underlying the various Kersting programs did not
constitute genuine indebtedness, and that interest was not paid
on Kersting loans within the meaning of section 163(a).
2. Mr. Thompson
Mr. McWade's settlement agreement with Mr. Thompson placed a
cap on the Thompsons' tax liabilities for the taxable years 1979,
1980, and 1981, and ensured that the Thompsons would receive
refunds of tax and interest previously remitted to respondent
for those years. The Thompson settlement was amended shortly
before the trial of the test cases to assure that the refunds
that the Thompsons would receive would be more than sufficient
to pay Mr. DeCastro's attorney's fees. The Thompson settlement
created conflicts of interest for Mr. Thompson and Mr.
DeCastro.111
By virtue of his settlement, Mr. Thompson was in a position
to use the trial of the test cases as a forum either to attempt
to further reduce his personal tax liabilities by contesting
111
Mr. DeCastro's conflict in the Thompson cases became
acute when he agreed, in the context of the final revision to the
Thompson settlement, to participate in Messrs. Sims and McWade's
scheme to keep the Thompsons among the test cases petitioners and
to provide the masquerade of trial representation for the
Thompsons as one of the test cases.
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respondent's deficiency determinations or to air his grievances
against Mr. Kersting and possibly achieve some advantage against
Mr. Kersting's threats to collect on Mr. Thompson's promissory
notes. Our review of Mr. Thompson's testimony at the trial of
test cases, which testimony was both favorable and detrimental
to the cause of the test case petitioners, suggests that
Mr. Thompson may have viewed the trial of the test cases as an
opportunity to attempt to attain both objectives. On the one
hand, Mr. Thompson sought to prove that, because of his prior
involvement in the First Savings acquisition, he had a legitimate
business purpose; i.e., a profit motive, for participating in
Mr. Kersting's programs. On the other hand, Mr. Thompson was the
only test case petitioner to testify that Mr. Kersting had orally
assured him that promissory notes would not be enforced.
Despite Mr. Thompson's apparently conflicting objectives, we
are convinced that Mr. Thompson's testimony at the trial of the
test cases was truthful. Although Mr. Thompson testified that
Mr. Kersting had assured him that promissory notes would not be
enforced, Mr. Thompson's testimony merely corroborated
Mr. Kersting's written assurances or comfort letters to so-called
"nervous Nellies". Moreover, in a March 1986 letter, Mr.
Kersting had confirmed to Mr. Thompson that his promissory notes
would be canceled if Mr. Thompson would surrender all relevant
stock certificates to Mr. Kersting. It appears that Mr. Kersting
later reneged on this confirmation by requiring that Mr. Thompson
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also pay $11,844 to Mr. Kersting for interest purportedly due on
certain leverage loans; i.e., Mr. Kersting's fees.112
We have found that Messrs. Sims and McWade misled the Court
and the remaining parties to these cases by not disclosing the
Thompson settlement before the trial of the test cases. As with
Mr. Cravens, an argument can be made that Judge Goffe would have
removed the Thompson cases from the test case array, inasmuch as
the remaining test cases provided full coverage of the Kersting
programs and taxable years in dispute. Proceeding on the
assumption that Judge Goffe would have precluded Mr. Thompson
from testifying at the trial of the test cases, we consider
whether Mr. Thompson's testimony was material to the outcome in
Dixon II.
i. Sham Analysis
Judge Goffe relied upon factors common to all the test case
petitioners in rejecting their testimony that they had entered
into the Kersting transactions with a business purpose. Those
factors included the test case petitioners' participation in the
Kersting programs without regard to whether the purchase price
for the stock they purported to purchase was reasonable and
appropriate, and without specific knowledge about the Kersting
corporations involved, the industries in which they operated, or
the impact of prevailing economic conditions on their investment
112
In Dixon II, Judge Goffe concluded that interest
payments on leverage loans reflected Mr. Kersting's fee for
generating interest deductions. Dixon II, 62 T.C.M. (CCH) at
1506, 1991 T.C.M. (RIA), at 91-3050.
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decisions. Although Mr. Thompson's testimony regarding profit
motive was favorable to the test case petitioners' cause, Judge
Goffe rejected his testimony as vague and unsupported by the
record. Because Judge Goffe rejected the testimony of all the
test case petitioners in holding that they had not entered into
the Kersting transactions with a business purpose, we are
convinced that Mr. Thompson's testimony was not material to Judge
Goffe's holding on the point.
Judge Goffe also held that the test case petitioners had
failed to prove that the Kersting transactions had economic
substance beyond the creation of tax benefits. In particular,
Judge Goffe focused on the manner in which Mr. Kersting actually
operated the programs, the lack of corporate profitability or
shareholder profitability, the absence of any evidence or
likelihood that Kersting program participants were or would ever
be in a position to sell their stock at an increased value
relative to the purchase price of the stock, and Mr. Kersting's
routine disregard of standard corporate practices. Because Judge
Goffe focused on the manner in which Mr. Kersting actually
operated the programs, we are convinced that Mr. Thompson's
testimony was not material to Judge Goffe's holding that the
programs lacked economic substance.
ii. Lack of Genuine Debt/Waltz of Funds
Judge Goffe relied upon the specific language of the stock
subscription agreements underlying the Stock Subscription Plan
and the Leasing Corporation Plan to conclude that the agreements,
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standing alone, did not create unconditional debt obligations.
Considering the narrow basis for Judge Goffe's holding, we are
convinced that Mr. Thompson's testimony was not material to this
holding.
Judge Goffe sustained respondent's disallowance of
deductions for subscription interest under the stock subscription
plan and the leasing corporation plan on the ground that such
interest was not "paid" within the meaning of section 163(a) by
virtue of Mr. Kersting's practice of waltzing loan funds. Judge
Goffe identified two specific instances in which Mr. Kersting
waltzed funds affecting both primary and leverage loans
underlying the stock subscription plan. Mr. Thompson's testimony
was not material to Judge Goffe's finding that Mr. Kersting made
a practice of waltzing loan funds.
Judge Goffe held that primary loans, although recourse in
form, did not represent genuine debt in substance because of
several factors. First, Judge Goffe found that Mr. Kersting and
program participants had an understanding at the commencement of
a program that a primary loan obligation could be satisfied in
full at any time by a mere surrender of the associated stock
certificate. In so holding, Judge Goffe rejected Mr. Kersting's
testimony that he did not represent to program participants that
they could exchange their stock for cancellation of a primary
note at any time. To the contrary, Judge Goffe listed nine
items, including Mr. Thompson's testimony on the subject, in
support of his finding of a pervasive stock surrender policy.
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Although Judge Goffe listed Mr. Thompson's testimony first
among the nine items identified in support of the Court's holding
on the point, we are convinced for the reasons set forth below
that Mr. Thompson's testimony was cumulative of other evidence
and was not material to this holding.
Although Mr. Thompson was the only test case petitioner to
testify that Mr. Kersting had assured him that promissory notes
would not be enforced, Judge Goffe listed eight additional items,
including a number of comfort letters, in support of his holding
that there was a pervasive stock surrender policy. In short,
there is ample evidence in the record, independent of
Mr. Thompson's testimony, to support Judge Goffe's holding on the
point. Along the same lines, we observe that the record in the
trial of the test cases reveals that, at one time or another,
each of the test case petitioners had terminated various Kersting
programs by endorsing their stock certificates and returning them
to Mr. Kersting in exchange for the return of their promissory
notes marked "paid".
Even assuming for the sake of argument that Mr. Thompson's
testimony was material to Judge Goffe's finding that there was
a pervasive stock surrender policy, we are convinced that
Mr. Thompson's testimony was not material to the final outcome in
Dixon II. In particular, Judge Goffe's analysis of the validity
of primary loans was not limited to his holding that Mr. Kersting
and program participants had an understanding regarding the stock
surrender policy. To the contrary, Judge Goffe also found that,
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regardless of whether there was a prearranged understanding,
Mr. Kersting and program participants never contemplated that the
principal obligation on a primary loan would be paid except by a
surrender of the stock. In so holding, Judge Goffe found it
significant that: (1) No evidence was produced of a primary
note ending up in the hands of anyone not associated with
Mr. Kersting; (2) primary loans issued during later years
included an express notation that they were nonnegotiable and
nonassignable; and (3) primary loans were unsecured, with the
primary notes failing to list even the purchased stock as
collateral.
In completing his analysis, Judge Goffe found further
support for his holding that the primary loans did not constitute
genuine debt by virtue of Mr. Kersting's waltz of primary loan
funds underlying the stock subscription plan, the apparent waltz
of funds under the stock purchase plan and the leasing
corporation plan, and Mr. Kersting's practice of backdating
documents relating to the loans.
In the alternative, Judge Goffe found that, even assuming
that the test case petitioners had established that the primary
loans represented genuine debt, the test case petitioners had
nevertheless failed to show that they actually paid primary loan
interest within the meaning of section 163(a). Specifically,
Judge Goffe concluded that the test case petitioners had not paid
primary loan interest by virtue of Mr. Kersting's waltz of
leverage loan funds (the funds used to pay primary loan interest)
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underlying the stock subscription plan, and the apparent waltz
of (1) first-year subscription interest under the leasing
corporation plan, (2) distribution checks under the leasing
corporation plan, and (3) leverage loan funds in each of the
stock subscription, stock purchase, and leasing corporation
plans.
In sum, considering Judge Goffe's copious list of factors
in support of his conclusion that Mr. Kersting and program
participants had an understanding regarding the stock surrender
policy, as well as Judge Goffe's alternative analyses in support
of his holding that primary loans did not constitute genuine debt
and that interest on primary loans was not paid within the
meaning of section 163, we are convinced that Mr. Thompson's
testimony was not material to the outcome in Dixon II.
Judge Goffe also determined that leverage loans did not
represent genuine debt because of several factors, including the
waltzing of funds, backdating of documents, substance not
following form, and mutual expectations of no personal liability.
Again, given the variety of the factors cited by Judge Goffe, we
are convinced that Mr. Thompson's testimony was not material to
Judge Goffe's holding that leverage loans did not represent
genuine debt.
iii. Additions to Tax
Judge Goffe sustained respondent's determinations that the
Thompsons were liable for interest computed at the increased rate
prescribed in section 6621(c) for 1981, and that the Youngs and
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the DuFresnes were liable for such increased interest for the
taxable years 1982 and 1983. In short, Judge Goffe sustained
these determinations on the ground that the Court had already
determined that the test case petitioners' underpayments were
attributable to sham transactions. Consistent with our finding
that Mr. Thompson's testimony was not material to Judge Goffe's
conclusion that the Kersting transactions were shams, we are
convinced that Mr. Thompson's testimony was not material to Judge
Goffe's decision to sustain respondent's determinations
respecting increased interest.
Although Judge Goffe also sustained respondent's
determinations that the Thompsons were liable for an addition to
tax for late filing under section 6651(a)(1) for 1981 and
additions to tax for negligence for the taxable years 1979 and
1981, these holdings have no bearing on nontest case petitioners.
In particular, nontest case petitioners who signed 1985 piggyback
agreements did not agree to be bound by the Court's holdings
regarding additions to tax. Further, while nontest case
petitioners who signed post-1985 piggyback agreements agreed to
be bound by the Court's holding regarding test case petitioners'
liability for increased interest under section 6621(c), they did
not agree to be bound by the Court's holding regarding test case
petitioners' liability for additions to tax under section 6651(a)
and they were to be relieved of liability for additions to tax
for negligence for years before 1982.
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3. Mr. Alexander
We have found that Mr. McWade and Mr. Alexander had an
understanding before the trial of the test cases that the
Alexanders' tax liabilities would be reduced in exchange for
Mr. Alexander's informal assistance to Mr. McWade during the
trial. We have also found that Mr. McWade allowed Mr. Alexander
to present misleading testimony to the Court during the trial
of the test cases in response to Mr. Izen's question whether
Mr. Alexander had an agreement with Mr. McWade for the reduction
of his tax liabilities. Although Judge Goffe was aware that Mr.
Alexander was hostile towards Mr. Kersting and that Mr. Alexander
had offered an affidavit to Mr. McWade regarding the Kersting
programs, Judge Goffe, had he been informed of Mr. Alexander's
understanding with Mr. McWade, might have precluded Mr. Alexander
from testifying at the trial of the test cases or at least taken
that understanding into account in weighing Mr. Alexander's
credibility. Consequently, we must consider whether
Mr. Alexander's testimony was material to the outcome in Dixon
II.
Mr. Alexander was called to testify in part to rebut
Mr. Kersting's testimony regarding the First Savings transaction.
Indeed, Mr. Alexander directly contradicted Mr. Kersting as to
whether Federal regulators ever approved Investors Financial as a
holding company for First Savings. While Judge Goffe concluded
that Mr. Kersting was not a credible witness, our review of Dixon
II convinces us that Mr. Kersting's lack of credibility was by
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and large attributable to Mr. Kersting's lack of candor as
demonstrated by both inherent contradictions and inconsistencies
with the written record. We are convinced that Mr. Alexander's
testimony was not material to Judge Goffe's findings respecting
Mr. Kersting's lack of credibility.
Like Mr. Thompson, Mr. Alexander testified that Mr. Kersting
had represented to him that stock subscription plan promissory
notes would not be enforced and would be returned or destroyed
upon the termination of the plan. Although Judge Goffe concluded
that there was a pervasive stock surrender policy in the Kersting
programs, we note that Judge Goffe did not list Mr. Alexander's
testimony among the nine items listed in support of his
conclusion on the point. In any event, assuming that Judge Goffe
took Mr. Alexander's testimony into account, we are satisfied
that Mr. Alexander's testimony was not material to Judge Goffe's
holdings that there was a pervasive stock surrender policy within
the Kersting programs or that Kersting promissory notes did not
constitute genuine debt. As previously discussed in our analysis
of the lack of materiality of Mr. Thompson's testimony on this
same subject, Judge Goffe relied upon a long list of items in
support of these holdings. Considering all the evidence in
support of Judge Goffe's holdings, we are convinced that Judge
Goffe would have reached the same conclusions without Mr.
Alexander's testimony on the subject. Moreover, even assuming
for the sake of argument that Mr. Alexander's testimony was
material to Judge Goffe's holding respecting a pervasive stock
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surrender policy, Judge Goffe's reliance upon alternative bases
to support the conclusion that Kersting promissory notes did not
constitute genuine debt convinces us that Mr. Alexander's
testimony was not material to the outcome in Dixon II.
4. Summary
We hold that the Government misconduct in the trial of the
test cases in Dixon II resulted in harmless error in the trial of
the test cases insofar as the Court concluded that: (1) The
Kersting transactions were shams; (2) the Kersting promissory
notes did not constitute genuine debt; and (3) interest on
Kersting loans was not paid within the meaning of section 163(a).
In so holding, we reject Messrs. Izen's and Jones'
contention that, by virtue of the totality of the Government's
misconduct, their clients were denied due process.
We likewise reject Mr. Sticht's contention that his
clients--nontest case petitioners--were denied due process on the
ground that Judge Goffe effectively was precluded from
supervising the trial of the test cases. Although Judge Goffe
might have removed the Thompson and Cravens cases from the test
case array and struck Mr. Alexander's testimony if he had been
informed of the Thompson and Cravens settlements and the
Alexander understanding, we are convinced that the outcome in the
trial of the test cases would not have changed.
Consistent with the preceding discussion, we are convinced
that the test case and nontest case petitioners enjoyed a fair
trial, encompassing "not only fair notice and an adequate
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opportunity to be heard before the appropriate tribunal, but also
an orderly presentation of evidence and a rational application of
the law thereto". Traynor, "The Riddle of Harmless Error", at 80
(1970). Having placed the burden of proof by clear and
convincing evidence on respondent, we are left with the definite
and firm conviction that the Government misconduct had no effect
on the decisions in the test cases whose petitioners were
represented by Mr. Izen.
IV. Fraud, Misrepresentation, and Misconduct
Mr. Izen contends that the Court should not reinstate
its decisions in Dixon II on the ground that the Government
misconduct in the trial of the test cases amounted to fraud,
misrepresentation, or misconduct under rule 60(b)(3) of the
Federal Rules of Civil Procedure. Mr. Izen's contention is akin
to a motion for reconsideration of the Court's Dixon II opinion
under Rule 161 or a motion to vacate a decision under Rule 162.
Relief under either of these Rules may be granted in the Court's
discretion to prevent injustice. See Chao v. Commissioner, 92
T.C. 1141, 1144-1145 (1989); see also Adams v. Commissioner, 85
T.C. at 375.
Rule 60(b)(3) of the Federal Rules of Civil Procedure states
in pertinent part:
On motion and upon such terms as are just, the
court may relieve a party or a party's legal
representative from a final judgment, order, or
proceeding for the following reasons: * * * (3) fraud
(whether heretofore denominated intrinsic or
extrinsic), misrepresentation, or other misconduct of
an adverse party * * *.
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In sum, District Courts are vested with discretion to relieve a
party from a final judgment where the adverse party has committed
a fraud, misrepresentation, or other misconduct. See Atchison,
Topeka & Santa Fe R.R. Co. v. Barrett, 246 F.2d 846, 849 (9th
Cir. 1957).
Although the decisions in these cases are not final, the
parties seem to agree that these proceedings may be analogized to
proceedings under rule 60(b)(3) of the Federal Rules of Civil
Procedure. We will assume for present purposes that the analogy
is valid in light of the apparent agreement of the parties.
A judgment may be set aside under rule 60(b)(3) of the
Federal Rules of Civil Procedure where fraud, misrepresentation,
or misconduct prevents a party from fully and fairly presenting
his or her case at trial. See In re M/V Peacock, 809 F.2d 1403,
1405 (9th Cir. 1987); Simons v. Gorsuch, 715 F.2d 1248, 1253 (7th
Cir. 1983); Bunch v. United States, 680 F.2d at 1283; Atchison,
Topeka & Santa Fe Ry. Co. v. Barrett, supra at 849. Relief does
not depend on whether the judgment is incorrect, only on whether
the judgment was obtained unfairly. See Lonsdorf v. Seefeldt, 47
F.3d 893, 897 (7th Cir. 1995); Anderson v. Cryovac, Inc., 862
F.2d at 924 n.10.
Some courts have held that the willful presentation of
perjured testimony is grounds for granting the innocent party a
new trial pursuant to rule 60(b)(3) of the Federal Rules of Civil
Procedure. See Diaz v. Methodist Hosp., 46 F.3d 492, 497 (5th
Cir. 1995). However, it has been said that
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The very purpose of a trial is to test the truthfulness
of testimony and other evidence proffered by the
parties. Examining the possibility that testimony is
perjurious is one of the principal functions of cross-
examination. * * * Rule 60(b) should not reward the
lazy litigant who did not adequately investigate his or
her case, or who did not vigorously cross-examine a
witness. [Fn. refs. omitted.]
12 Moore, Moore's Federal Practice, sec. 60.43[1][c], at 60-131
to 60-132 (3d ed. 1998). In this regard, courts have denied
relief under rule 60(b)(3) of the Federal Rules of Civil
Procedure where the moving party had a full and fair opportunity
to uncover the alleged fraud or perjury at trial. See Bunch v.
United States, supra at 1283.
We have already described the Government misconduct in these
cases supra pp. 218-225. Arguably, Messrs. McWade's and Sims'
failure to disclose the Thompson and Cravens settlements and the
Alexander understanding to the Court constitute fraud,
misrepresentation, or misconduct within the meaning of rule
60(b)(3) of the Federal Rules of Civil Procedure. However, as
discussed above, fraud, misrepresentation, or misconduct alone is
not sufficient to require or justify relief under rule 60(b) of
the Federal Rules of Civil Procedure. To the contrary, relief
under rule 60(b) of the Federal Rules of Civil Procedure is
warranted only where the fraud, misrepresentation, or misconduct
has prevented the adversely affected party from fully and fairly
presenting his or her case at trial. In re M/V Peacock, supra.
We are convinced that the Government misconduct did not
prevent the remaining test case petitioners from fully and fairly
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presenting their cases at trial. In particular, our review of
the record convinces us that Mr. Izen, who represented
petitioners in six of the eight test cases, was not impeded in
any sense by the Government misconduct in presenting his cases to
the Court. Because Mr. Izen was aware before the trial that the
Government intended to rely on the so-called comfort letters at
the trial of the test cases, we are satisfied that Mr. Izen was
not unduly surprised by Messrs. Thompson's and Alexander's
testimony that Mr. Kersting had assured them that they could
exchange their Kersting corporation stock certificates for the
cancellation of their promissory notes.113 Further, Mr. Izen was
prepared and permitted to cross-examine Messrs. Thompson,
Cravens, and Alexander and to probe and expose the bases of
Messrs. Thompson's and Alexander's hostility towards Mr.
Kersting. Considering all the facts and circumstances, we
conclude that petitioners are not entitled to relief under rule
60(b) of the Federal Rules of Civil Procedure or Rule 161 or 162.
113
Mr. Izen testified at the evidentiary hearing that he
was aware of the comfort letters because some of them were
part of the stipulated record. Further, Mr. Izen informed
Mr. DeCastro before the trial of the test cases that he would
offer evidence of collection actions brought by various Kersting
companies against Kersting program participants to counter
respondent's reliance on the comfort letters. However,
Mr. McWade was aware of collection litigation before the trial
because Mr. Kersting had encouraged certain program participants
to raise the point with Mr. McWade during pretrial settlement
discussions.
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V. Fraud on the Court
Although rule 60(b) of the Federal Rules of Civil Procedure
provides a list of the grounds upon which a court may relieve a
party or a party's legal representative from a final judgment,
the rule also includes a so-called saving clause which states:
"This rule does not limit the power of a court * * * to set aside
a judgment for fraud upon the court." It is well settled that
the Tax Court may reopen and set aside a decision on the basis of
fraud on the Court. See Toscano v. Commissioner, 441 F.2d 930
(9th Cir. 1971) (fraud on the court properly raised where the
taxpayer asserted that the Court's decision sustaining the
Commissioner's determination of joint deficiencies was based on
tax returns on which the taxpayer's signature was either forged
or made under duress), vacating 52 T.C. 295 (1969).
A. Case Law Survey
Hazel-Atlas Glass Co. v. Hartford-Empire Co., 322 U.S. 238
(1944), overruled on other grounds Standard Oil v. United
States, 429 U.S. 17, 18 (1976), is the leading case considering
fraud on the court. In Hazel-Atlas Glass, certain officials and
attorneys representing Hartford Empire Co. (Hartford)
fraudulently prepared and published an article in a trade
publication that Hartford subsequently used to support its
pending application for a patent before the Patent Office. After
obtaining the patent, Hartford sued Hazel-Atlas Glass Co. (Hazel)
for infringement in a District Court. The District Court
dismissed the case on the ground that no infringement had been
- 272 -
proved. In response, Hartford filed an appeal with the Court of
Appeals for the Third Circuit and specifically directed the
court's attention to the fraudulent article. Relying in part on
the fraudulent article, the Court of Appeals for Third Circuit
reversed the District Court and held that the patent had been
infringed. Nine years later, Hazel returned to the Court of
Appeals seeking relief on the ground that the Hartford article
was fraudulent. However, the Court of Appeals declined to set
aside the District Court decree on the grounds that: (1) the
fraud was not newly discovered; (2) the fraudulent article was
not the primary basis for its earlier decision, and (3) the Court
of Appeals lacked the power to set aside the District Court
decree because of the expiration of the term during which its
decision had been rendered.
Upon review of the matter, the Supreme Court held that the
Court of Appeals had equitable power to set aside the District
Court decree despite the fact that the decree was otherwise
final. See id. at 244-245. The Supreme Court explained its
holding as follows:
Every element of the fraud here disclosed demands
the exercise of the historic power of equity to set
aside fraudulently begotten judgments. This is not
simply a case of a judgment obtained with the aid of a
witness who, on the basis of after-discovered evidence,
is believed possibly to have been guilty of perjury.
Here, even if we consider nothing but Hartford's sworn
admissions, we find a deliberately planned and
carefully executed scheme to defraud not only the
Patent Office but the Circuit Court of Appeals. Cf.
Marshall v. Holmes, [141 U.S. 589 (1891]. Proof of the
scheme, and of its complete success up to date, is
conclusive. * * *
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Id. at 245-246.
The Supreme Court further rejected the argument that alleged
lack of diligence by Hazel in discovering the fraud should serve
to bar relief. Observing that the fraud in question did not
concern only private parties or a single litigant, the Supreme
Court stated:
There are issues of great moment to the public in a
patent suit. Mercoid Corporation v. Mid-Continent
Investment Co., 320 U.S. 661 * * *; Morton Salt Co. v.
G.S. Suppiger Co., 314 U.S. 488 * * *. Furthermore,
tampering with the administration of justice in the
manner indisputably shown here involves far more than
an injury to a single litigant. It is a wrong against
the institutions set up to protect and safeguard the
public, institutions in which fraud cannot complacently
be tolerated consistently with the good order of
society. Surely it cannot be that preservation of the
integrity of the judicial process must always wait upon
the diligence of litigants. * * *
Id. at 246.
Finally, the Supreme Court rejected the assertion that
relief should be denied on the ground that the fraudulent article
was not "basic" to the Court of Appeals' decision. In short, the
Supreme Court held that an appraisal of the influence of the
fraudulent article on the Court of Appeals' decision was not
necessary insofar as Hartford had considered the article material
and relied upon the article in obtaining a decision in its favor
from the Court of Appeals. See id. at 246-247.
Some courts hold that the term “fraud on the court” should
be construed consistently with the policy of preserving the
finality of judgments. See Drobny v. Commissioner, 113 F.3d at
- 274 -
677-678;114 Broyhill Furniture Indus., Inc. v. Craftmaster
Furniture Corp., 12 F.3d 1080, 1085 (Fed. Cir. 1993); Toscano v.
Commissioner, supra at 934. In this regard, not all fraudulent
or deceptive acts constitute fraud on the Court. It has been
said that fraud on the court concerns egregious conduct affecting
the ability of the court to function impartially. See Broyhill
Furniture Indus., Inc. v. Craftmaster Furniture Corp., supra at
1085-1086, and cases cited therein.
Since the Supreme Court's decision in Hazel-Atlas Glass Co.
v. Hartford-Empire Co., supra, a number of courts, including the
Court of Appeals for the Ninth Circuit, have relied upon or
adopted the definition of fraud on the court set forth in
12 Moore, Moore's Federal Practice, par. 60.21[4][a], at 60-52
(3d ed. 1998), which states:
"Fraud on the court" is defined in terms of its
effect on the judicial process, not in terms of the
content of a particular misrepresentation or
concealment. Fraud on the court must involve more than
injury to a single litigant; it is limited to fraud
that "seriously" affects the integrity of the normal
process of adjudication. Fraud on the court is limited
to fraud that does, or at least attempts to, "defile
the court itself" or that is perpetrated by officers of
the court "so that the judicial machinery can not
perform in the usual manner its impartial task of
adjudging cases". [Fn. refs. omitted.]
114
In Drobny v. Commissioner, 113 F.3d 670, 678 (7th Cir.
1997), affg. T.C. Memo. 1995-209, the Court of Appeals for the
Seventh Circuit held that the taxpayers were required to
demonstrate "not only that the respondent engaged in conduct that
was intended to mislead the court, but--of paramount importance--
that the actual conduct affected the outcome of their case."
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See Drobny v. Commissioner, supra at 677-678 (citing Kenner v.
Commissioner, 387 F.2d 689 (7th Cir. 1968)); Broyhill Furniture
Indus., Inc. v. Craftmaster Furniture Corp., supra at 1085; In re
Intermagnetics Am., Inc., 926 F.2d 912, 916 (9th Cir. 1991)
(citing Alexander v. Robertson, 882 F.2d 421, 424 (9th Cir.
1989)); Senate Realty Corp. v. Commissioner, 511 F.2d 929, 931
(2d Cir. 1975).
The Court of Appeals for the Ninth Circuit has addressed
the issue of fraud on the court in a number of cases. Before
proceeding with our analysis, we will glean these cases for the
insights they yield on the views of the Court of Appeals.
In Toscano v. Commissioner, 441 F.2d 930 (9th Cir. 1971),
the taxpayer, Josephine Zelasko (Zelasko), asserted that the Tax
Court had erred in failing to vacate a decision entered against
Zelasko and her purported husband, John Toscano. Zelasko argued
that the decision should be vacated on the ground of fraud on the
Court because she was never married to Toscano, her signatures
were placed on joint tax returns with Toscano either by forgery
or under duress, and she was completely unaware that Toscano had
filed a joint petition for redetermination with the Tax Court.
After concluding that the Tax Court had the authority to set
aside a final decision on the ground of fraud on the court, the
Court of Appeals vacated this Court's decision against Zelasko
after finding that she had alleged sufficient facts in support of
her claim of fraud on the court to justify an evidentiary hearing
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in the Tax Court. More specifically, the Court of Appeals
concluded:
When a deficiency was assessed, and Toscano
petitioned the Tax Court for redetermination, he
carried the fraud into the Tax Court. Thus he was
continuing to defraud the Commissioner, and he was
continuing to attempt to subject Miss Zelasko to a
liability that was not hers. But he was doing more; he
was also perpetrating a fraud upon the Tax Court, which
culminated in a determination of joint deficiencies
against Miss Zelasko as well as himself. This, we
think, was as much a fraud on the court as was the use
of the spurious article in the Court of Appeals in
Hazel-Atlas.
Id. at 935.
In Abatti v. Commissioner, 859 F.2d 115 (9th Cir. 1988),
affg. 86 T.C. 1319 (1986), the taxpayers argued that the Tax
Court had erred in failing to vacate final decisions against them
that were consistent with their agreements to be bound by certain
test cases. In particular, after the Tax Court had granted
summary judgment in favor of the Commissioner in the test cases,
decisions were entered against the taxpayers in both the test
cases and the piggyback cases. Although two test case taxpayers
and a number of the taxpayers who had signed piggyback agreements
filed timely appeals and persuaded the Court of Appeals to
reverse the Tax Court's decisions, the remaining taxpayers in the
test cases and piggyback cases did not file appeals. Following
the remand of the appealed cases to the Tax Court for further
proceedings, the taxpayers who had not filed appeals argued
unsuccessfully in the Tax Court that the otherwise final
decisions entered against them should be vacated pursuant to
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their piggyback agreements, which provided that all taxpayers
would be afforded the outcome of the test cases.
The Court of Appeals rejected the taxpayers' contention that
the Commissioner's position regarding entry of decision under the
piggyback agreements constituted fraud on the court.
Specifically, the Court of Appeals observed that, while fraud on
the court may occur when the acts of a party prevent his
adversary from fully and fairly presenting his case or defense,
it was the taxpayers' misunderstanding of the piggyback
agreements, rather than the Commissioner's fraud, that had caused
their misfortune. See id. at 118-119.
In Alexander v. Robertson, supra, the Court of Appeals
considered whether the entry of appearance at trial by counsel
who was not a licensed attorney in the jurisdiction constituted
fraud on the court in the following circumstances. Alexander
sued Robertson in the District Court for the Northern District of
California for failing to make required payments under a contract
to purchase a boat. Robertson in turn cross-claimed against
Fraser, Inc. (Fraser), the broker who had arranged for the sale
of the boat.
Following a trial, the District Court sustained Alexander's
claim against Robertson and rejected Robertson's cross-claims
against Fraser. However, Robertson subsequently learned that
David Warren (Warren), counsel for Fraser, had not been licensed
to practice law in the State of California at the time of the
trial. Robertson thereupon moved the District Court to vacate
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the judgment, relying on Warren's alleged fraud on the Court.
The District Court denied Robertson's motion.
On appeal, the Court of Appeals, citing Moore's definition
of fraud on the court, observed that relief from a judgment for
fraud on the court does not necessarily require the moving party
to show that he was prejudiced by the misconduct. Quoting Hazel-
Atlas Glass Co. v. Hartford-Empire Co., 322 U.S. at 246, the
Court of Appeals stated: "The Supreme Court, for example, has
explained this provision of the Rule not so much in terms of
whether the alleged misconduct prejudiced the opposing party but
more in terms of whether the alleged misconduct 'harms' the
integrity of the judicial process". Alexander v. Robertson,
supra at 424; see In re Intermagnetics Am., Inc., 882 F.2d at
916-917.
Reading Hazel-Atlas Glass in conjunction with Moore's
definition of fraud upon the court, the Court of Appeals further
observed that Robertson's assertion that Warren's misconduct had
subverted the integrity of the judicial process seemed to fit
with the proposition that relief may be granted pursuant to rule
60(b) of the Federal Rules of Civil Procedure for fraud upon the
court where there is an extraordinary harm to the public. See
Alexander v. Robertson, supra at 424.
Nevertheless, the Court of Appeals sustained the District
Court's denial of Robertson's motion to vacate the judgment on
the grounds that: (1) There was no showing that Warren's
misconduct was designed to improperly influence the court in its
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decision; (2) setting aside the judgment pursuant to rule 60(b)
of the Federal Rules of Civil Procedure would be a "fruitless"
gesture, inasmuch as Robertson could not prevail on his cross-
claims against Fraser in any event; and (3) other remedies, such
as disciplinary proceedings, were available to protect the
judicial system from the harm arising from Warren's misconduct.
See id. at 425; see also Chao v. Commissioner, 92 T.C. at 1144-
1145 (where the Court declined to set aside a final judgment for
alleged fraud on the Court where the taxpayers could not show
that the Court's decision would be different).
The final case in the survey, Pumphrey v. K.W. Thompson Tool
Co., 62 F.3d 1128 (9th Cir. 1995), held that in-house counsel for
a defendant/gun manufacturer had committed fraud on the court in
a products liability action by failing to disclose an
incriminating videotape of a product test. Melvin Sparks
(Sparks) had dropped a handgun manufactured by defendant K.W.
Thompson Tool Co. (Thompson) and was killed when the gun
discharged. In a wrongful death action by Sparks' heirs,
Thompson introduced a videotape of drop tests of the handgun, and
relied upon the testimony of its expert witness who had conducted
the tests, to support its contention that the gun had never fired
in a drop test. The jury held that the plaintiffs had suffered
$100,000 in damages, but that Sparks was 80 percent
contributorily negligent.
Following entry of judgment in the case, the plaintiffs
learned that Thompson possessed a videotape, made the same day as
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the videotape offered at trial, which showed that the handgun in
question had in fact fired during a drop test. On the basis of
this evidence, the District Court granted the plaintiff's motion
to set aside the verdict and ordered a new trial.
On appeal, the Court of Appeals affirmed the District
Court's decision ordering a new trial. The Court of Appeals
first held that Thompson's general counsel was an officer of the
court, even though he had not entered his appearance at trial,
because he had significantly participated in the case by
attending the trial, gathering information to respond to
discovery requests, and participating in the videotaping of the
drop tests. See id. at 1130-1131.
The Court of Appeals further defined fraud on the court to
include both attempts to subvert the integrity of the court and
fraud by an officer of the court, involving an unconscionable
plan or scheme designed to influence the court improperly in its
decision. See id. at 1131. In concluding that Thompson's
general counsel had engaged in a scheme to defraud the court, the
Court of Appeals cited the general counsel's role in providing
misleading and incomplete responses to discovery, as well as his
participation in the presentation of fraudulent evidence and his
failure to correct the false impression created by the testimony
of Thompson's expert witness. See id. at 1132.
The Court of Appeals went on to reject Thompson's contention
that there was no fraud on the court because the videotape was
not material to the issues in the trial. Although questioning
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Thompson's assertion that the videotape was not material, the
Court of Appeals observed that "Rule 60(b) focuses not so much in
terms of whether the alleged fraud prejudiced the opposing party
but more in terms of whether the alleged fraud harms the
integrity of the judicial process." Id. at 1133.
B. Discussion
With the preceding review as background, we address whether
the Government misconduct in these cases constitutes fraud on the
Court.
By entering into secret settlements with the Thompsons and
Cravenses, Messrs. McWade and Sims frustrated the Court's and the
public's expectations that all litigants before the Court would
be adversaries in the full sense of the word. Such expectations
were particularly heightened in these cases, which affect more
than a thousand other taxpayers.
Notwithstanding the Government misconduct in these cases, we
are convinced, for the reasons set forth below, that the Court's
deficiency determinations in Dixon II should be reinstated over
petitioners' claims of fraud on the Court.
The misconduct in these cases is not typical of the
fraudulent acts committed in cases in which other courts have
overturned decisions for fraud on the court. In particular,
although Messrs. Sims, McWade, and DeCastro misled the Court
regarding the status of the Thompson and Cravens cases, there was
no attempt to present fraudulent evidence to the Court that had
any bearing on the substantive issues concerning the transactions
- 282 -
that the Court was called upon to review in the trial of the test
cases.
We also observe that, upon discovery of Messrs. McWade's and
Sims' misconduct, respondent promptly reported the matter to the
Court. Respondent's actions upon discovery of the misconduct and
respondent's overall conduct in these proceedings exhibit
respondent's institutional good faith.
Further, we are not convinced that justice would be served
if we were to adopt the extraordinary remedy, after the
evidentiary hearing and our review of the record, of renouncing
the Court's deficiency determinations in Dixon II. Consistent
with the views stated earlier in this opinion, we are convinced
that the test case petitioners were afforded a fair trial,
despite the Government misconduct, and that the Government
misconduct was not material to the outcome in Dixon II. We are
firmly convinced that the outcome of the retrial of the test
cases would be the same if we were to order a new trial.
Moreover, more discriminating remedies are available both to
punish the offenders and to deter similar conduct in the future,
see Alexander v. Robertson, 882 F.2d at 425. Considering all the
facts and circumstances, we will--with the exceptions discussed
below--reinstate the decisions entered in the test cases
remaining before the Court.
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VI. Mr. Izen's Allegations That Mr. DeCastro Was a "Mole"
Mr. Izen created the strong impression, in oral argument
before the Court of Appeals for the Ninth Circuit in the DuFresne
appeal, that Mr. DeCastro had acted as a "mole" or "plant" for
the Internal Revenue Service before and during the trial of the
test cases. Mr. Izen returned to this subject in his opening
brief following the evidentiary hearing, which argues:
Any advantage gained by the Commissioner in
utilizing DeCastro to "infiltrate" the test case
Petitioners' camp is grounds for a new trial, standing
alone. This would be so, in the civil, as well as a
criminal context. Sims and McWade unlawfully paid
DeCastro's attorney's fees in a successful effort to
subvert the test cases. They inserted DeCastro into
the Petitioners' camp. They converted what should have
been a taxpayer's advocate into a government operative.
All of the Petitioners' interests were harmed by this
infiltration, since it prevented the cases from being
"fairly" tried. [Citations omitted.]
Although we agree that it was improper for the Government to
use Mr. Thompson as a conduit to pay Mr. DeCastro's attorney's
fees, there is no credible evidence in the record that Mr.
DeCastro acted as a Government "mole" during the trial of the
test cases or that Mr. DeCastro conveyed any of Mr. Izen's
trial strategies or confidential information to the Government.
Accordingly, we reject Mr. Izen's argument that Mr. DeCastro's
misconduct, standing alone, or in conjunction with the misconduct
of Messrs. McWade and Sims, warrants a new trial of the test
cases, or a trial of any other cases in the Kersting project
group on the issues that were tried on the test cases, for that
matter.
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VII. Enforceability of Piggyback Agreements
Petitioners contend that the piggyback agreements executed
by nontest case petitioners should be set aside on the ground
that Messrs. Sims and McWade fraudulently induced nontest case
petitioners to execute piggyback agreements by misrepresenting
the status of the Thompson and Cravens cases.115 In the
alternative, petitioners contend that the piggyback agreements
should be set aside on the ground that Messrs. Sims' and McWade's
failure to disclose the Thompson and Cravens settlements before
the trial of the test cases resulted in a breach of contract.
Mr. Sticht contends that enforcement of the piggyback agreements
would result in manifest injustice on the ground that Messrs.
Sims and McWade used the piggyback agreements as a means to
proceed to trial under what Mr. Sticht calls the "sporting theory
of justice".
Mr. Sticht raised additional contract arguments in posttrial
Motions for Release From Piggyback Agreement that he filed on
behalf of nontest case petitioners Richard B. and Donna G.
Rogers, Anthony E. and Carol A. Eggers, and John L. and Terry E.
115
Nontest case petitioners Ronald L. and Mattie L.
Alverson executed their piggyback agreement in June 1985--well
before Mr. McWade had negotiated the Thompson and Cravens
settlements. Nontest case petitioners Anthony E. and Carol A.
Eggers, John L. and Terry E. Huber, Stanley C. and Sharon A.
Titcomb, and Richard B. and Donna G. Rogers executed piggyback
agreements in late November 1986--about the time that Mr. McWade
began settlement discussions with Messrs. Thompson and Cravens.
Nontest case petitioners Norman W. and Barbara L. Adair executed
their piggyback agreement in March 1987--well after Mr. McWade
had negotiated the Thompson and Cravens settlements.
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Huber. Mr. Sticht contends that Mr. Seery's apparent conflict of
interest, at a time when Mr. Seery represented nontest case
petitioners Rogers, Eggers, and Huber, provides a basis for
releasing nontest case petitioners from their piggyback
agreements.
Respondent contends that Messrs. Sims' and McWade's failure
to disclose the Thompson and Cravens settlements did not rise to
the level of failure to perform a contractual duty owed to the
nontest case petitioners. Respondent further contends that the
piggyback agreements should be enforced on the ground that the
nontest case petitioners were not prejudiced by Messrs. Sims' and
McWade's misconduct.116
Respondent also filed objections to Mr. Sticht's Motions for
Release From Piggyback Agreement. In short, respondent contends
that the validity of the piggyback agreements is not adversely
affected by either Mr. Seery's alleged conflict of interest or
the events occurring during the trial of the test cases.
A. Principles of Contract Law
Although the piggyback agreements in dispute are titled
"Stipulation of Settlement For Tax Shelter Adjustments", we have
noted that such agreements do not reflect a settlement or
116
Respondent did not address the enforceability of the
piggyback agreements in respondent's opening brief in the belief
that it was premature to address the question pending the Court's
decision whether the Government misconduct in the trial of the
test cases constituted a structural defect. By order dated
Feb. 27, 1998, the Court directed respondent to address the
question in respondent's reply brief, and respondent did so.
- 286 -
compromise of the taxpayer's case but merely prescribe the
procedure for the adjudication of the case. See Adams v.
Commissioner, 85 T.C. at 369. Nevertheless, we have relied
upon general principles of contract law in construing piggyback
agreements and settlement agreements alike. See Gridley v.
Commissioner, T.C. Memo. 1997-210; see also Saigh v.
Commissioner, 26 T.C. 171, 177 (1956); Fisher v. Commissioner,
T.C. Memo. 1994-434; Applestein v. Commissioner, T.C. Memo.
1989-42.
Mr. Izen contends that the piggyback agreements constitute
public contracts that are governed by the Federal common law of
contracts. Neither respondent nor the other petitioners have
addressed the question.117 In any event, as in Fisher v.
Commissioner, supra, we see no consequential choice of law
problem in the cases at hand. We are satisfied that the general
contract principles relied upon herein are consistent with the
principles applied by State courts.
Petitioners argue that the piggyback agreements may be set
aside because of Messrs. Sims' and McWade's failure to disclose
the true status of the Thompson and Cravens cases at the time
nontest case petitioners executed the agreements. Every contract
117
For a detailed discussion whether Federal or State law
governs the validity of a purported joint return that is impugned
on the ground of duress, reviewing the matter under 1
Restatement, Contracts 2d (1981), and New Jersey common law, see
Berger v. Commissioner, T.C. Memo. 1996-76. The Berger opinion
concludes that the result would be same under the State law and
the putative Federal common law.
- 287 -
imposes upon the parties thereto an implied duty of good faith
and fair dealing. See San Jose Prod. Credit Association v. Old
Republic Life Ins. Co., 723 F.2d 700, 703 (9th Cir. 1984); Smith
v. Empire Sanitary Dist., 127 Cal. App. 2d 63, 71, 273 P.2d 37,
43 (1954); 3A Corbin on Contracts, sec. 654A, at 86 (1998 Supp.).
A contract generally is voidable if one party's assent to the
agreement is induced by a fraudulent or material
misrepresentation by the other party to the contract. See
Dorchester Indus. Inc. v. Commissioner, 108 T.C. 320, 335 (1997);
1 Restatement, supra sec. 164(1). A party's nondisclosure of a
fact known to him is treated as an assertion that the fact does
not exist where he knows that the disclosure of the fact would
correct a mistake of the other party as to a basic assumption
on which that party relies in making the contract. See 1
Restatement, supra sec. 161(b). The nondisclosure of a fact
known to a party to a contract may be considered a fraudulent
misrepresentation if the party intends the nondisclosure to
mislead the other party. See id. sec. 162(1)(a). The Court has
held that a settlement stipulation may be set aside for
excusable, damaging reliance upon a false or untrue
representation of the other party. See Saigh v. Commissioner,
supra at 180; Fisher v. Commissioner, supra.
Although a contract may be voidable because of a fraudulent
or material misrepresentation, the right to avoid the contract
may lapse if the effect of the misrepresentation is cured or the
substance of the performance promised has been delivered before
- 288 -
the affected party gives notice of his intent to avoid the
contract. See Ice v. Benedict Nuclear Pharms., Inc., 797 P.2d
757, 759 (Colo. Ct. App. 1990); 1 Restatement, supra sec. 165.
Petitioners also contend that Messrs. Sims' and McWade's
failure to disclose the Thompson and Cravens settlements before
the trial of the test cases constitutes a breach of contract.
The conditions and obligations underlying a contract may be
implied from the terms or nature of the agreement, particularly
where the matter is presumed to have been perfectly obvious to
the parties. See Sacramento Navigation Co. v. Salz, 273 U.S.
326, 328-329 (1927) (contract for the transportation of barley on
a barge (which lacked a power source) implied that the barge
would be used with a steamer or tug); see also Hudson Canal Co.
v. Pennsylvania Coal Co., 75 U.S. (8 Wall.) 276 (1868) (contract
between coal producer and canal company for transportation of
coal by way of canal, under which coal company constructed
railroad from its mine to the canal and canal company enlarged
its canal, did not imply that coal company would use the canal as
sole means for transporting its coal).
A contract may be avoided or rescinded where a party fails
to satisfy a material or essential term or condition of the
agreement. See First Interstate Bank v. SBA, 868 F.2d 340, 343-
344 (9th Cir. 1989), and cases cited therein. A material breach
of contract is one that substantially defeats its purpose so that
the injured party is justified in treating the matter as at an
end. See 4 Corbin on Contracts, supra sec. 946, at 809. The
- 289 -
materiality of a breach generally is considered a question of
fact to be decided on the basis of all the facts and
circumstances. See Smith v. Empire Sanitary Dist., supra, and
cases cited therein. In First Interstate Bank v. SBA, supra at
343-344, the Court of Appeals for the Ninth Circuit stated that
the test of whether a breach of a Federal contract is material is
an "all-the-circumstances-test" and that the Court of Appeals
considers the five factors listed under 1 Restatement, supra sec.
241, as significant in applying the test.118
118
1 Restatement, Contracts 2d, sec. 241 (1981), states as
follows:
In determining whether a failure to render or to offer
performance is material, the following circumstances
are significant:
(a) the extent to which the injured party will be
deprived of the benefit which he reasonably expected;
(b) the extent to which the injured party can be
adequately compensated for the part of that benefit of
which he will be deprived;
(c) the extent to which the party failing to
perform or to offer to perform will suffer forfeiture;
(d) the likelihood that the party failing to
perform or to offer to perform will cure his failure,
taking account of all of the circumstances including
any reasonable assurances;
(e) the extent to which the behavior of the party
failing to perform or to offer to perform comports with
standards of good faith and fair dealing.
- 290 -
B. Discussion
1. Benefit of the Bargain
The piggyback agreements executed in these cases reflect a
bargained-for exchange: Nontest case petitioners who executed
piggyback agreements surrendered their rights to have their own
cases tried on the merits of the Kersting adjustments in exchange
for respondent's agreement that their deficiencies would be
redetermined in accordance with the outcome of the trial on the
merits of the test cases. Both respondent and nontest case
petitioners expected to benefit under the piggyback agreements by
avoiding the expenses of a trial on the merits.
It is apparent that nontest case petitioners who signed
piggyback agreements did so with the assumption, shared by the
Court, that the trial of the test cases would not include cases
that had been settled before the trial. That the trial of the
test cases would not include settled cases is a matter that we
presume to have been perfectly obvious to the parties and an
implied term of the piggyback agreements.
We now know that Messrs. Sims and McWade misled the Court,
the remaining test case petitioners, and the nontest case
petitioners who signed piggyback agreements by entering into--and
not disclosing--settlements with Messrs. Thompson and Cravens.
Under the circumstances, we are persuaded that nontest case
petitioners who executed their piggyback agreements after the
Thompson and Cravens settlements were negotiated, were partially
induced to execute the piggyback agreements by Messrs. Sims' and
- 291 -
McWade's failures to disclose the true status of all the test
cases. Moreover, we conclude that Messrs. Sims and McWade
violated an implied term of the piggyback agreements by allowing
the trial of the test cases to proceed without disclosing the
Thompson and Cravens settlements.
Notwithstanding the foregoing, we are obliged to consider,
under either of petitioners' theories for relief, whether
petitioners' received the substance of the performance promised
under the piggyback agreements; i.e., whether petitioners
received the benefit of the bargain. See Ice v. Benedict Nuclear
Pharms., Inc., supra; 1 Restatement, supra sec. 165. Stated
differently, we must determine whether Messrs. Sims and McWade
violated a material or essential term or condition of the
piggyback agreements before we can declare the piggyback
agreements invalid. See First Interstate Bank v. Small Bus.
Admin., supra.
We begin with the observation that Messrs. Sims' and
McWade's misconduct did not deprive petitioners of the benefit
that they reasonably expected under the piggyback agreements. As
previously discussed, petitioners expected that their cases would
be decided in accordance with the Court's opinion following a
trial of test cases that would be representative of the various
Kersting programs in dispute in their cases. The piggyback
agreements imply an understanding that the trial of the test
cases would be an adversarial proceeding (and that the trial
would not include test cases that had been settled). Although
- 292 -
the Thompson and Cravens settlements were contrary to
petitioners' assumption or expectation that none of the test
cases would be settled before the trial, the record shows that
the trial of the cases of the six test case petitioners
represented by Mr. Izen remained fully adversarial. Further, we
have already observed that Mr. Izen was not prevented or
inhibited from fully and fairly presenting his cases to the Court
and that the testimony and evidence associated with the Thompson
and Cravens cases did not affect the outcome in Dixon II.
Considering that the cases of the six test case petitioners
presented by Mr. Izen were representative of the various Kersting
programs in dispute, see table setting forth test case array
supra pp. 38-41, we conclude that petitioners were not deprived
of the benefit that they reasonably expected under the piggyback
agreements.
We balance the fact that petitioners were not deprived of
the benefit of their bargain under the piggyback agreements
against Messrs. Sims' and McWade's misconduct in failing to
disclose the Thompson and Cravens settlements before the trial of
the test cases, as well as the indirect damages that petitioners
have suffered as a result of Messrs. Sims' and McWade's
misconduct. As a consequence of Messrs. Sims' and McWade's
violation of an implied term of the piggyback agreements, some
petitioners undoubtedly have suffered consequential damages such
as accrual of additional statutory interest under section 6601
- 293 -
and/or attorney's fees incurred for representation at the
evidentiary hearing.119
We note that Messrs. Sims and McWade are not solely
responsible for the accrual of additional statutory interest in
these cases. Petitioners have always had the ability to stop the
accrual of additional interest by remitting a payment in the
nature of a cash bond. See sec. 6213(b)(4). However,
Mr. Kersting advised program participants that they should not
remit any amount to the Internal Revenue Service until their
liability was determined in court, and many of the nontest case
petitioners appear to have relied upon that advice. We further
observe that Mr. Kersting's interference in the Chicoine and
Hallett settlement negotiations, and his recommendation that
program participants reject the 20-percent settlement offer, can
be viewed as indirect causes of the accrual of additional
interest in many of these cases that would have otherwise
settled.
On balance, we conclude that Messrs. Sims' and McWade's
misconduct in failing to disclose the Thompson and Cravens
settlements to nontest case petitioners who signed piggyback
agreements, and in violating an implied term of the piggyback
agreements, does not rise to the level of materiality that would
119
We observe that a number of petitioners, including the
Thompsons and the Cravenses, paid their deficiencies and interest
in late 1986 in order to stop the running of interest and to
obtain the full benefit of deductions for interest that would
have been subject to phaseout if paid in later years.
- 294 -
justify setting aside the piggyback agreements. Accordingly, we
will decline to avoid or rescind the piggyback agreements.
Even if we were to conclude that Messrs. Sims' and McWade's
failure to disclose the Thompson and Cravens settlements
constituted a breach of the piggyback agreements that would
justify their rescission or cancellation, petitioners would not
be entitled to a new trial. In due course, petitioners would be
ordered to show cause why their cases should not be decided
consistently with Dixon II. See, e.g., Krause v. Commissioner,
99 T.C. 132 (1992); Acierno v. Commissioner, T.C. Memo. 1997-441;
Karlsson v. Commissioner, T.C. Memo. 1997-432; Bokum v.
Commissioner, T.C. Memo. 1990-21, affd. 992 F.2d 1136 (11th Cir.
1993). Considering the entire record in these cases, we are
convinced that nontest case petitioners inevitably would be bound
by the Court's opinion in Dixon II.
2. Mr. Seery's Purported Conflict of Interest
We likewise reject Mr. Sticht's contention that the
piggyback agreements should be set aside on the ground that
Mr. Seery had a conflict of interest when he executed the
piggyback agreements. The short answer to Mr. Sticht's
contention is that Judge Goffe did not find that Mr. Seery had a
conflict of interest. Judge Goffe merely indicated that Mr.
Seery's motion to change the place of trial, filed November 7,
1986, gave rise to the possible inference that Mr. Seery was
engaged in dual representation of both Mr. Kersting and Kersting
program participants. Similarly, Mr. Seery's motions to withdraw
- 295 -
as counsel stated that Mr. Seery felt obliged to withdraw because
the Court had raised an issue of his possible conflict of
interest.
The record in these cases does not reflect that Mr. Seery
had a conflict of interest as the result of his possible dual
representation of Mr. Kersting and Kersting program participants.
Mr. Seery negotiated the modified 7-percent settlement offer with
Mr. McWade and arranged to have it disseminated to Kersting
program participants, notwithstanding Mr. Kersting's disapproval
of the offer as inadequate. Equally important, because Mr. Seery
revealed in his motions to withdraw as counsel that he felt
obliged to withdraw because the Court had raised an issue of his
possible conflict of interest, Mr. Sticht's clients had ample
opportunity at that time to move to have their piggyback
agreements set aside.
Finally, even assuming for the sake of argument that
Mr. Seery had a conflict of interest, petitioners have failed to
show that they were prejudiced by his actions. See Adams v.
Commissioner, 85 T.C. at 375-376. Accordingly, we will deny Mr.
Sticht's Motions for Release From Piggyback Agreement filed on
behalf of nontest case petitioners Richard B. and Donna G.
Rogers, Anthony E. and Carol A. Eggers, and John L. and Terry E.
Huber.120
120
Mr. Sticht included as an attachment to the Rogers
motion a copy of a piggyback agreement executed by Mr. Seery (on
the Rogerses' behalf) and by Mr. McWade. Mr. Sticht contends
(continued...)
- 296 -
3. Rejection of Mr. Izen's Argument for Entry of Decision
on the Basis of Thompson Decisions
Mr. Izen contends that, pursuant to the piggyback
agreements, petitioners are entitled to entry of decision
consistent with the decisions entered in the Thompson cases. In
Gridley v. Commissioner, T.C. Memo. 1997-210, we rejected this
argument on the ground that nontest cases petitioners who signed
piggyback agreements agreed to be bound by the Court's opinion in
Dixon II as opposed to a specific decision entered in a
particular test case. Consistent with our analysis in Gridley v.
Commissioner, supra, we reject Mr. Izen's argument.
VIII. Mary Carter Agreements
At common law, a plaintiff had only one cause of action
against joint tort-feasors; therefore a plaintiff's release of
one joint tort-feasor would release all the joint tort-feasors.121
120
(...continued)
that the Rogerses may rescind this piggyback agreement on the
ground that it was never filed with the Court. We reject
Mr. Sticht's argument as contrary to this Court's recent holding
in Dorchester Indus., Inc. v. Commissioner, 108 T.C. 320 (1997)
(settlement agreement is binding even though it has not been
filed as a stipulation with the Court). Moreover, we are
satisfied that the Rogerses are bound by a piggyback agreement
executed by Mr. Seery and Mr. McWade and filed with the Court in
Aaronson v. Commissioner, docket No. 17445-82, on Dec. 1, 1986,
at a time when the Rogerses were parties to that consolidated
docket.
121
See Note, "The Mary Carter Agreement--Solving the
Problems of Collusive Settlements in Joint Tort Actions", 47 S.
Cal. L. Rev. 1393, 1395-1396 (1974). This note is referenced in
d'Hedouville v. Pioneer Hotel Co., 552 F.2d 886, 895 (9th Cir.
1977), one of the few cases in which the Court of Appeals for the
Ninth Circuit has addressed Mary Carter Agreements (MCA's),
thereby meriting special attention.
- 297 -
In order to avoid this result and encourage partial settlements
of cases, a number of legal devices were developed to circumvent
the common law rule. One of these devices is known as the Mary
Carter agreement (MCA),122 taking its name from Booth v. Mary
Carter Paint Co., 202 So. 2d 8 (Fla. Dist. Ct. App. 1967),
overruled by Ward v. Ochoa, 284 So. 2d 385 (Fla. 1973).
As in Mary Carter Paint Co., MCA's typically consist of four
elements: (1) The plaintiff enters into an agreement with some
but not all the defendants not to enforce the court's judgment
against the settling defendants; (2) the settling defendants
agree to pay the plaintiff a guaranteed minimum payment, thereby
placing a limit on their liability to the plaintiff; (3) the
settling defendants agree to remain parties to the action until a
verdict has been rendered or until they have been released by the
court or the plaintiff; and (4) the parties agree to keep the
agreement secret from the court and the nonsettling defendants.
Usually, the defendant's guaranteed minimum payment is reduced or
extinguished if the plaintiff recovers against the nonsettling
defendants in an amount greater than the guaranteed minimum
payment (hereinafter the Sliding Scale Clause), thereby giving
122
But see Note, "It's a Mistake to Tolerate the Mary
Carter Agreement", 87 Colum. L. Rev. 368, 379 (1987), arguing
that MCA's actually encourage litigation, rather than promote
settlement of disputes, because the agreement requires continued
litigation against the nonsettling defendants. The Supreme
Courts of Texas and Florida, in declaring MCA's void as against
public policy, have done so for a variety of reasons, one of them
being that MCA's, rather than encouraging settlements, actually
promote litigation. See Dosdurian v. Carsten, 624 So. 2d 241
(Fla. 1993); Elbaor v. Smith, 845 S.W.2d 240 (Tex. 1992).
- 298 -
the settling defendant a direct financial stake in the outcome of
the case that is adverse to that of the nonsettling defendants.
MCA's that include a Sliding Scale Clause generally are
considered invalid or void because such agreements leave the
finder of fact with the false impression that there is adversity
between the plaintiff and all of the defendants while in reality
there is adversity between the settling defendants and
nonsettling defendants. See Dosdourian v. Cartsen, 624 So. 2d
241 (Fla. 1993); Fullenkamp v. Newcomer, 508 N.E.2d 37 (Ind. Ct.
App. 1987); General Motors Corp. v. Lahocki, 410 A.2d 1039 (Md.
1980); Lum v. Stinnett, 488 P.2d 347 (Nev. 1971); Cox v. Kelsey-
Hayes Co., 594 P.2d 354 (Okla. 1978).123 However, some courts
have declined to invalidate such agreements, depending upon the
particular facts and circumstances of the case. See Hoops v.
Watermelon City Trucking, Inc., 846 F.2d 637 (10th Cir. 1988);
d'Hedouville v. Pioneer Hotel Co., 552 F.2d 886 (9th Cir. 1977);
Slusher v. Ospital, 777 P.2d 437 (Utah 1989).
123
See Note, "It's a Mistake to Tolerate the Mary Carter
Agreement", 87 Colum. L. Rev. 368, 370 (1987); see also Cox v.
Kelsey-Hayes Co., 594 P.2d 354, 359 (Okla. 1978), where the court
stated:
Courts and commentators, recognizing the
substantial prejudice to the non-agreeing defendants,
are nearly unanimous in their belief the agreements
must be disclosed prior to trial and if the agreeing
defendant's maximum liability will be reduced by
increasing the liability of his codefendant, the jury
must be informed of the contents of the agreement
* * *.
- 299 -
Although the Thompson and Cravens settlement agreements
contain the basic elements of an MCA, the tax liabilities of the
Thompsons and the Cravenses were not tied to a Sliding Scale
Clause. Rather than having a direct financial stake in the
outcome of the case adverse to that of the remaining test case
petitioners, the Thompsons and Cravenses had their tax
liabilities capped, and those liabilities would have been further
reduced or eliminated if the test case petitioners had prevailed
at trial. Although the Thompsons' and Cravenses' adversarial
posture toward respondent had been diluted, they remained
adversaries of respondent in some residual sense.
Even more important, the Thompson and Cravens settlement
agreements did not realign their interests so as to justify the
conclusion that they had become adversaries of the remaining test
case petitioners. The record shows that Mr. Cravens appeared at
the trial of the test cases and testified in support of the test
case petitioners' position. Although Mr. Thompson did not have a
direct interest in a decision against the remaining test case
petitioners, the record indicates that Mr. Thompson may have
viewed the trial of the test cases as an opportunity to gain
some advantage against Mr. Kersting's threats to enforce Mr.
Thompson's promissory notes.124 While it might be argued that the
Thompsons expected or received some benefit from the Court's
124
Of course, Judge Goffe was aware that Mr. Thompson
was hostile towards Mr. Kersting and was able to assess
Mr. Thompson's credibility from that standpoint.
- 300 -
holding in Dixon II that the disputed promissory notes did not
create genuine indebtedness for tax purposes, it was not a direct
financial benefit in the sense that Judge Goffe's opinion is not
dispositive of the question whether Mr. Thompson's notes are
enforceable against him for State law purposes. Unlike MCA's
with Sliding Scale Clauses that provide settling defendants with
an immediate financial reward for large verdicts against
nonsettling defendants, Mr. Thompson's reward was a moral victory
at best. Any financial stake the Thompsons did have in the
outcome of the test cases is at least one long step removed from
the distinct and immediate financial stake a settling defendant
normally has under a Sliding Scale Clause in an MCA.
Considering all the facts and circumstances, we hold that
the family resemblances between Mary Carter agreements and the
Thompson and Cravens settlements do not bar the Court from
reinstating its decisions in the test cases.
IX. Mr. Sticht's Motion To Sever Case and for Entry of Decision
or Alternatively To Sever Case and Set for Trial
On June 9, 1998, Mr. Sticht filed a Motion to Sever Case and
for Entry of Decision; Or Alternatively to Sever Case and Set for
Trial on behalf of Joe A. and JoAnne Rinaldi in docket No. 7205-
94. The Rinaldis' case at docket No. 7205-94 concerns the
Rinaldis' tax liabilities for 1990 and 1991 and is based upon a
notice of deficiency that was issued after the disclosure of the
misconduct in the trial of the test cases. Because the Rinaldis
did not sign a piggyback agreement in docket No. 7205-94, Mr.
- 301 -
Sticht contends that the Court's opinion in Dixon II is not
binding on the Rinaldis.125 Mr. Sticht relies upon the misconduct
in the trial of the test cases to contend that the Court should
either enter a decision in the Rinaldis' favor or sever the
Rinaldis' case from the consolidated cases and set the case for
trial. Mr. Sticht contends that the Court's opinion in Dixon II
has no effect in the Rinaldis' dockets in which they did not
execute piggyback agreements.
Respondent contends that Mr. Sticht's motion should be
denied on the grounds that: (1) The record does not support
entry of decision in the Rinaldis' favor; and (2) the Rinaldis'
motion amounts to a premature attempt to avoid a "show cause"
proceeding. Respondent further contends that, if the Court's
opinion in Dixon II should be reinstated, it provides an
appropriate basis for resolving any deductions claimed by the
Rinaldis with respect to Kersting programs in dispute in Dixon
II.126
Consistent with our holdings that the Government misconduct
did not cause a structural defect in the trial of the test cases
125
The Rinaldis have seven cases docketed with the Court
assigned docket Nos. 31065-83, 21615-87, 6981-89, 11439-90,
27556-90, 14907-93, and 7205-94. The Rinaldis executed piggyback
agreements in each of the dockets listed above except docket Nos.
14907-93 and 7205-94.
126
Respondent states that the Rinaldis may have
participated in Mr. Kersting's Bauspar program during some of the
years for which they have filed petitions with the Court.
Respondent acknowledges that, because the Bauspar program was not
litigated in Dixon II, the Court's opinion would not dispose of
Bauspar deductions claimed by the Rinaldis or others.
- 302 -
and that the misconduct resulted in harmless error, we see no
basis or justification for entry of decision in favor of the
Rinaldis. Nor will we sever the Rinaldis' case from the
consolidated group and/or set the case for trial at this time.
To the contrary, because we will reinstate our opinion in Dixon
II and enter decisions in the remaining original test cases, we
will abide the outcome of any appeal that follows the issuance of
this opinion. If affirmed by the Court of Appeals, we will, upon
respondent's motion, issue an Order to Show Cause in due course
directing the Rinaldis to show cause why the resolution of the
substantive tax issues in their case should not be controlled by
our opinion in Dixon II. See Krause v. Commissioner, 99 T.C. 132
(1992); Acierno v. Commissioner, T.C. Memo. 1997-441; Karlsson v.
Commissioner, T.C. Memo. 1997-432; Bokum v. Commissioner, T.C.
Memo. 1990-21.
X. Protective Orders
As previously discussed, the Court issued protective orders
in these cases dated June 10 and 26, 1996, with respect to
documents produced by Mr. Thompson. By order dated August 27,
1998, the Court directed the parties, particularly Messrs.
Huestis and Sticht, to file reports with the Court stating in
detail any objection to the lifting of the Court's protective
orders. Mr. Huestis filed a report with the Court objecting to
the lifting of the Court's protective orders on the ground that
Mr. Kersting might use the records in question to harass the
Thompsons. Mr. Sticht and respondent filed separate reports with
- 303 -
the Court indicating no objection to the lifting of the
protective orders.
Section 7458, which governs hearings before the Tax Court,
provides that such hearings shall be open to the public. In
addition, section 7461, entitled "Publicity of Proceedings",
provides in pertinent part:
SEC. 7461(a). General Rule.--Except as provided in
subsection (b), all reports of the Tax Court and all
evidence received by the Tax Court and its divisions,
including a transcript of the stenographic report of
the hearings, shall be public records open to the
inspection of the public.
(b) Exceptions.--
(1) Trade Secrets or Other Confidential
Information.--The Tax Court may make any provision
which is necessary to prevent the disclosure of trade
secrets or other confidential information, including a
provision that any document or information be placed
under seal to be opened only as directed by the court.
Rule 103 provides that upon motion by a party or other
affected person, and upon good cause shown, the Court may make
any order which justice requires to protect a party or other
person from annoyance, embarrassment, oppression, or undue burden
or expense.
Sections 7458 and 7461 reflect the well-established
principle that official proceedings and records of all courts,
including the Tax Court, generally shall be open and available to
the public. See Nixon v. Warner Communications, Inc., 435 U.S.
589, 597 (1978); Willie Nelson Music Co. v. Commissioner, 85 T.C.
914, 917 (1985). However, section 7461 and Rule 103 provide that
the Court has the discretionary authority to order all or part of
- 304 -
a record to be sealed where such action is necessary to protect
trade secrets and confidential information or to avoid annoyance,
embarrassment, oppression, or undue burden or expense. See
Willie Nelson Music Co. v. Commissioner, supra at 918-919, and
cases cited thereat.
In resolving whether a permanent protective order sealing a
portion of the evidentiary record is warranted in these cases, we
must weigh the public's interest in free and open access to Tax
Court proceedings against the individual interests advanced in
these cases. See Nixon v. Warner Communications, Inc., supra at
602. The public's interest in open judicial proceedings is
presumed to be paramount to the interests of an individual
seeking to close the proceedings in that open proceedings allow
the public an opportunity to understand the underlying dispute
and its disposition, thereby enhancing public confidence in our
system of taxation. See Willie Nelson Music Co. v. Commissioner,
supra at 919.
The Court is of the view that its protective orders sealing
the documents described above have served their purpose and that
the public's interest in open proceedings outweighs any
continuing individual interests at stake in these cases.
Mr. Huestis has not persuaded us otherwise. We note that there
is no indication that Mr. Kersting has initiated litigation
against the Thompsons, nor any imminent threat of any such
litigation. We do not believe that unsealing the documents in
question would increase the likelihood of any such threat.
- 305 -
Moreover, the Court has disclosed the contents of a number of the
disputed documents in this opinion. Considering all the facts
and circumstances, we will lift the protective orders dated
June 10 and 26, 1996.
XI. Sanctions
The Court has inherent power "to protect our own process
from abuse, oppression, and injustice." Griffith v.
Commissioner, T.C. Memo. 1988-123 (citing Gumbel v. Pitkin, 124
U.S. 131, 145-146 (1888), and Eash v. Riggins Trucking Inc., 757
F.2d 557 (3d Cir. 1985) (en banc)).
Messrs. Sims' and McWade's misconduct in the trial of the
test cases has caused a substantial delay in the resolution of
Kersting project cases. Considering the unique circumstances of
these cases, and the harm resulting from the Government
misconduct in the trial of the test cases, we consider this is an
appropriate occasion for the Court to impose limited sanctions
against respondent under Rule 123(a). See Vermouth v.
Commissioner, 88 T.C. 1488 (1987) (discussing and relying on
United States v. Sumitomo Marine & Fire Ins. Co., 617 F.2d 1365
(9th Cir. 1980)); see also Betz v. Commissioner, 90 T.C. 816, 823
(1988).
Respondent determined that Kersting program participants are
liable for additions to tax for negligence under section 6653.
For the taxable years 1981 through 1985, section 6653(a)(2)
provides that the addition to tax for negligence includes a
component equal to 50 percent of the interest due on the
- 306 -
deficiency. For the taxable years 1986 and 1987, the interest
component of the addition to tax for negligence is codified under
section 6653(a)(1)(B).
Respondent also determined that Kersting program
participants are liable for interest computed at the increased
rate prescribed under section 6621(c). Section 6621(c) provides
that interest on a deficiency shall be computed at an increased
rate with respect to any substantial underpayment attributable to
a tax-motivated transaction.
The interest component of the addition to tax for negligence
and interest computed at the increased rate prescribed under
section 6621(c) are time-sensitive provisions whose impact will
be amplified in these cases as a consequence of the delay
occasioned in large part by the Government misconduct described
herein. With a view to promoting basic fairness and justice in
the Kersting project cases, and to discourage future acts of
Government misconduct, we hold that Kersting program participants
who either have not had decisions entered in their cases or whose
decisions are not yet final are not liable for the interest
component of the addition to tax for negligence under sections
6653(a)(2) and 6653(a)(1)(B) or interest computed at the
increased rate prescribed in section 6621(c).127
127
As previously mentioned, see supra pp. 44-47, there is
an inconsistency between the 1985 piggyback agreements and the
post-1985 piggyback agreements concerning additions to tax: the
1985 piggyback agreements are silent about additions to tax,
while the post-1985 piggyback agreements provide that Kersting
(continued...)
- 307 -
Conclusion
Consistent with all the foregoing, we will issue an order
reinstating the Court's opinion in Dixon v. Commissioner, T.C.
Memo. 1991-614, excepting the portions sustaining respondent's
determinations that test case petitioners were liable for
additions to tax for negligence under sections 6653(a)(2) and
6653(a)(1)(B) and increased interest under section 6621(c), and
directing the parties, where appropriate, to file stipulated
decisions with the Court.
An appropriate order will be issued
and decisions will be entered in docket
Nos. 9382-83, 4201-84, 15907-84, 40159-84,
22783-85, 30010-85, 30979-85, and 29643-86.
An appropriate order will be issued in
docket Nos. 17646-83, 7323-84, 20119-84,
35608-86, 19464-92, 621-94, 7205-94,
9532-94, 17992-95, and 17993-95.
127
(...continued)
program participants are not liable for additions to tax for
negligence for taxable years before 1982. We have surmised that
respondent limited this concession to taxable years before 1982
on the ground that the Court’s May 1982 release of its opinion in
Pike v. Commissioner, 78 T.C. 822 (1982), put prospective
Kersting program participants on notice that the Kersting
programs did not generate legitimate interest deductions. See
supra note 26. The record does not disclose whether respondent
intends to extend the same relief across the board to all
participants in the Kersting programs whose cases have not been
the subject of a final determination. We observe that extending
such relief would promote the consistency in treatment among
similarly situated taxpayers that piggyback agreements and the
test case procedure are intended to promote.