A federal appeals court has ruled against the founder of Buy.com in a case involving a tax shelter set up for him by KPMG.

The case involved Scott Blum, who appealed a U.S. Tax Court decision. The Tax Court had upheld the Internal Revenue Service commissioner’s determination to invalidate a financial transaction of Blum’s on the joint tax return he and his wife had filed as lacking economic substance and imposing two accuracy-related penalties for underpayment of taxes.

The appeals court agreed with the Tax Court. “The intricacies of this offshore financial transaction and the fog of plausible deniability surrounding it cannot make up for the clarity of the big picture: this was a transaction designed to produce nothing more than tax advantages, and the Tax Court was right to uphold the Commissioner’s actions,” the U.S. Court of Appeals for the Tenth Circuit ruled last week.

Blum founded Buy.com in 1998, an Internet e-commerce pioneer that quickly set records as the fastest-growing company in U.S. history.

“This achievement undoubtedly springs from Mr. Blum’s drive and business acumen,” the court noted. “Mr. Blum’s success, it should be noted, was not necessarily the result of formal education or expertise. As he points out in his brief, he never graduated from college, nor does he have special expertise in the areas of federal income tax law, accounting, or stock market investment. Rather he is a business development expert, and he generally relies on others to counsel him on matters like tax and investment.”

Blum hired KPMG in 1996 for accounting services after his father vouched for the firm’s reputation and also hired some former KPMG employees.

“It was, by all accounts, a good and fruitful relationship,” said the court. “In August 1998, Mr. Blum made two sales of Buy.com stock resulting in $45 million in capital gains. A KPMG accountant who previously worked on Mr. Blum’s tax returns was aware of Mr. Blum’s possible capital gains and referred him to Carl Hasting of KPMG’s Capital-Transaction Group. Mr. Hasting met with Mr. Blum twice. At these meetings, Mr. Hasting pitched a transaction called OPIS (Offshore Portfolio Investment Strategy) to Mr. Blum. The transaction, it is now widely acknowledged, is a tax shelter. However, KPMG recommended the transaction to Mr. Blum before IRS and Congressional investigations revealed this information to the public. Mr. Blum claims he saw an investment opportunity; the Commissioner claims Mr. Blum saw a tax evasion opportunity.”

The OPIS tax shelter is designed to create large, artificial losses for taxpayers by allowing them to claim a large basis in certain assets, the court explained. These artificial losses offset the actual capital gains, reducing the tax liability of the taxpayer.

Blum claimed he never discussed the tax effects of the transaction with Hasting, and he also could not remember discussing OPIS with any of his other advisors, the court noted. But after a second meeting with Hasting, Blum signed an engagement letter with KPMG that indicated the firm would receive a fee of $687,500 in exchange for serving as a tax advisor to Blum on the transaction. Blum said he did not recall reading the engagement letter.

Blum apparently left the management of his OPIS investments to KPMG, the court observed, and as a result, he claimed $45 million in losses on his 1998 income tax returns. He filed those returns on April 15, 1999. The following month, KPMG provided him with an opinion letter explaining the legal justification for the OPIS transactions and concluded that the IRS would “more likely than not” view the transactions as legitimate.

KPMG had no immediate comment on the case.

Basis-shifting transactions such as OPIS, which created paper losses for clients, caught the IRS’s attention in 2001, and according to the Government Accountability Office, abusive tax shelters such as OPIS cost the U.S. Treasury between $11 billion and $15 billion a year during the 1990s before they were made illegal.

“Extensive investigation by the IRS and U.S. Senate revealed a widespread practice of using basis-shifting to create paper losses for clients, thereby reducing their tax bills,” said the court. “The investigation revealed that even within KPMG there was concern about the potential illegality of these transactions. One memorandum went so far as to call the economic substance of these deals ‘smoke and mirrors.’ … The Senate Report concluded that KPMG might have bullied or misled clients into signing off on certain factual representations underlying the transactions. For example, the Senate Report observes that in certain cases, “KPMG alone, apparently without any client input, wrote the client’s representations and then demanded that each client attest to them by returning a signed letter to the accounting firm.”

The IRS formally disallowed OPIS and similar transactions in 2001, but instead of individually prosecuting each OPIS scheme, the IRS settled with over 90 percent of the OPIS purchasers in 2003, the court noted.

In 2005, the IRS sent a deficiency notice to Blum regarding his 1998 and 1999 federal income tax returns, disallowing the losses he had claimed in connection with OPIS, and imposing penalties for a gross valuation misstatement and negligent underpayment.

Blum challenged the notice in Tax Court in February 2006, but the Tax Court rejected his challenge, concluding that the IRS was correct to disallow the claimed losses under the economic substance doctrine, and that both the gross undervaluation and negligence penalties were appropriate.

Blum also filed a civil suit against KPMG for fraudulent misrepresentation in the Central District of California in 2011. But after the Tax Court approved the negligent underpayment penalty, the District Court ruled that he was “collaterally estopped,” that is, he could no longer argue that he had relied on KPMG’s advice that OPIS was a legitimate investment strategy.

In his appeal, Blum argued that the Tax Court had erred when it disallowed the OPIS losses under the economic substance rule and also when it imposed a penalty for a gross valuation misstatement after concluding the underlying transaction lacked economic substance. He also argued that the Tax Court had erred by imposing penalties for negligent underpayment, because Blum had relied in good faith on KPMG’s representations. The IRS, for its part, continued to maintain that the transaction lacked economic substance, and that the gross valuation misstatement and negligence penalties were warranted.

The appeals court affirmed the opinion of the Tax Court, but also noted that the question of whether Blum was “collaterally estopped” from arguing that he had reasonably relied on KPMG’s advice was not before the appeals court.

“Quixotically, Blum maintains that the OPIS transaction presented a reasonable probability of generating a profit,” the court wrote. “It follows, he argues, that the Commissioner was wrong to disallow the losses he claimed as a result of the transaction, and the Tax Court was wrong to validate the Commissioner’s action. In a nutshell, Mr. Blum argues that the Tax Court applied the wrong test to determine whether the transaction lacked economic substance, that it improperly ignored the testimony of one of two dueling expert witnesses, and that it committed clear error by finding that Mr. Blum lacked the subjective motivation to generate a profit from OPIS. We are unconvinced and find ourselves arriving at the same conclusion arrived at by the IRS, the U.S. Senate Committee on Governmental Affairs, and the Tax Court. The OPIS transaction in this case was a sham designed to reduce Mr. Blum’s tax liability, and it lacked any reasonable probability of generating a profit.”

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