TaxProf Blog

Editor: Paul L. Caron, Dean
Pepperdine University School of Law

Monday, September 28, 2009

Tax Lawyers Sued for Botched Tax Shelter

National Law Journal, First Client Files Suit, Now Insurer Says No:

Tax lawyers Jonathon Moore and Charles Bruce already had their hands full defending themselves from allegations that they botched a client's matter, resulting in millions of dollars in IRS back taxes and penalties. Now the lawyers' insurance company has come forward saying it no longer wants to cover the malpractice case.

The two lawyers, name partners in Washington-based Moore & Bruce, are being sued, along with their firm, in the U.S. District Court for the District of Columbia. The complaint, filed in May 2008 by cellphone entrepreneur James De May, claims the firm made mistakes while setting up a tax shelter, such as sending certain forms to the IRS late, that cost De May $7.5 million. All the while, the firm was racking up excessive fees, the complaint alleges. De May is seeking $10 million in damages.

This month, Moore & Bruce's malpractice insurer filed its own suit, arguing that the firm's $2 million policy does not cover the De May litigation because the lawyers did not warn the insurer about problems with the De May matter when they applied for coverage. ...

According to court documents, the two lawyers met De May in the summer of 1995. An American-born mathematician and physicist, De May had pioneered critical software used in cellphone networks. But his company, Optimay GmbH, had run into a financial dead end: He needed to find new investors or sell it.

De May hired Moore & Bruce and incorporated Optimay in Delaware. By 1996, he began preparing to find a buyer. Meanwhile, Moore & Bruce devised a way to offset the U.S. taxes such a sale would generate. They created two offshore trusts, as well as a nonprofit foundation, into which De May transferred his own Optimay stock. When it came time for a deal, the trusts and the foundation would be the ones to sell the stock, theoretically reducing De May's tax burden, while directing assets to be distributed among his family members down the line.

In 1998, a subsidiary of Lucent Technologies Inc. bought Optimay for $65 million. De May's share was roughly $20 million. But according to the complaint, there was a hitch: Bruce purportedly tried to alter the legal status of two of the trusts, from "grantor" to "nongrantor" status, just a week before the sale was finalized. Ultimately, the last-minute change would not meet with IRS approval.

In 1999, the IRS informed De May that it planned to audit his finances. Three years later, it issued the first of five position statements concluding that De May owed back taxes on the Optimay sale. ... In a lengthy 2004 advisory memo, the IRS Office of Chief Counsel identified several problems with the De May trusts. Among other things, the IRS said Bruce had tried to change their status too late and had not succeeded in eliminating all the U.S. beneficiaries, a crucial step in making sure that De May would not need to pay taxes on the trusts' capital gains. Bruce also waited until 1999, well after the Optimay sale, to file the form requesting tax-exempt status for the nonprofit foundation.

The final figure, including penalties, came to $12 million in income tax and $3 million in gift tax. By 2005, De May opted to settle the case for $6 million. The family has yet to pay off the debt, which has grown to $7.5 million. ...

The IRS' findings serve as the basis for much of De May's malpractice suit. But the suit also accuses Bruce of breaching his fiduciary duty as trustee of two trusts. The complaint alleges that Bruce was making "decisions which benefitted himself, his law firm and his business colleagues, and harmed beneficiaries" — in particular by approving "unnecessary" and "excessive" fees for himself and his colleagues. ...

In court papers, Moore & Bruce argued it was not responsible for De May's debt to the IRS, because he still would have owed the taxes had they never tried to set up the tax shelters.

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