Former Sprint executives who participated in EY tax shelter can’t sue IRS for concealing investigation

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A federal court has barred a lawsuit against the Internal Revenue Service by two former top executives at Sprint over tax shelters promoted by Ernst & Young because the suit failed to qualify for a waiver under the Federal Tort Claims Act.

The Federal Tort Claims Act allows lawsuits against the government in certain circumstances by waiving sovereign immunity. However, there are exceptions to this waiver, one of which applied here, preventing the two former Sprint executives from going forward with their action.

The District Court for the Southern District of New York dismissed the suit last week by former Sprint CEO William Esrey and former Sprint COO Ronald LeMay. The plaintiffs, Esrey and LeMay, alleged wrongdoing by the IRS for not informing them of a criminal investigation of EY’s promotion of certain tax shelters, which prevented them from adequately defending themselves to the Sprint board. EY was the tax advisor and financial planner for both Esprey and LeMay and was also Sprint’s auditing firm while the plaintiffs were employed by the telecommunications company.

On EY’s advice, the plaintiffs engaged in two transactions, a Contingent Deferred Swap and a CDS Add-On transaction. In 2002, the IRS initiated an audit of EY’s promotion of certain tax shelters and also began to audit taxpayers who had participated in those tax shelters. EY represented the plaintiffs before the IRS.

In June 2003, the IRS agents involved in the promoter audit informed EY that the IRS Criminal Investigation Division was investigating the conduct of certain EY employees and the audit team was sharing its documents with the CID. The investigations by the IRS, the CID, and the U.S. Attorney for the Southern District of New York created a conflict of interest between EY and the plaintiffs.

As a result of the conflict of interest, the Sprint board required the plaintiffs to certify every quarter that they had no intention to sue EY. As a solution, the plaintiffs recommended that Sprint stop using EY as its auditor in order to resolve the potential conflict of interest between EY and the plaintiffs. The Sprint board agreed with the plaintiffs that the conflict of interest was too great, but decided that firing EY would result in negative publicity, and as a result, asked for plaintiffs’ resignations instead. They resigned in 2003, but didn’t learn of the criminal investigation of EY until 2004.

The plaintiffs claimed the IRS and EY hid information from them, and they were therefore unable to defend themselves before the Sprint board, leading to their forced resignations from Sprint in 2003.

The court analyzed the claim under the Federal Tort Claims Act. Although the FTCA waives sovereign immunity, and thus authorizes claims for damages against the United States, where federal employees commit torts while acting within the scope of their employment, the waiver does not extend to this case, according to the court. An exception to the waiver exists where the claim arises out of misrepresentation or deceit. Although the plaintiffs styled their complaint as arising from the government’s participation in EY’s breach of fiduciary duties and not based on any misrepresentation, the court concluded that the claim did, in fact, rest on allegations of concealment.

“Because plaintiffs’ claim rests on allegations of concealment, it falls squarely within the section [28 U.S. C.] 2680(h) exception to the FTCA,” the court concluded. Therefore, it granted the government’s motion to dismiss.

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