How Tax Specialists Rescued a Business from its Attorney (and the IRS)

“I plead the fifth.”

This phrase and its meaning has become all too familiar to the American public down through the years.  In fact, it has become a perennial punch line.  Your wife wants to know why you were late coming home last night?  Plead the fifth.  The boss wants to know why your work isn’t finished.  Plead the fifth.  Hilarious, right?

For a construction company at war with the Internal Revenue Service, this phrase was not funny at all.  In fact, it almost cost them $17 million dollars.  And it was uttered by–of all people–its attorney.  In the end, the company’s saving grace was a team of specialists who understood the (entirely legal) moves that the company had initially made.

The Problem

In 2010, a successful construction company in California found itself in United States Tax Court, doing battle with the dreaded IRS.  An accountant’s mistake led to an audit and allegations of fraud.  The IRS became suspicious of an LLC entity set up to purchase the construction company’s management company through a private annuity.  During the audit, the IRS determined that the LLC was a sham, and therefore, the private annuity was denied as not an ordinary and necessary business expense.  As a result, the IRS assessed a fraud penalty of $17 million against the construction company.

The Solution

The construction company began a frantic search for new representation, and decided on Garza & Harris Ltd, a specialty tax firm, to litigate the case in U.S. Tax Court.  Fortunately, because the company had performed due diligence in setting up the management company, the Garza attorneys were able to build their defense strategy around full disclosure, sharing all documents and expertise about the transaction in order to defend it.  Garza & Harris brought on the Roberts Law Firm[i] to assist in the litigation, and Attorney Kyle Coleman took the helm.  Ultimately, it came to light that the problem was not the transaction itself, but that the IRS did not understand how it worked.  After a showing that the transaction was valid, which included providing an expert witness to explain it to the very bureaucrats whose job it is to oversee it, the construction company’s attorneys were successful in reducing the fraud penalty to zero.

“Normally, we don’t make our expert witness available for an interview with the IRS attorneys,” Coleman said.  “But in this case, I couldn’t wait to turn Cameron Harris loose on them.  We had a three-hour meeting with the front line attorneys.  By the end of the meeting, they were calling him Professor Cameron.”

In the end, the government settled for payment of the $600,000 accounting error that had landed everyone in court in the first place.

The taxpayer ultimately prevails.  All’s well that ends well.

Perhaps, but this disastrous situation illustrates a much larger problem.

The Bigger Issue

The IRS representatives weren’t the only clueless participants in this case.  Most unfortunately, the construction company’s representative didn’t get it either.  Not only is it the attorney’s job to understand what’s happening, but it’s also his duty to find out before, for example, intimating criminal activity (if there truly is any) in the midst of a government probe.  The attorney in this case inexplicably breached a fundamental ethical obligation, which plunged his client into further litigation, and nearly cost millions of dollars more for an unnecessary penalty, not to mention its priceless reputation, while implicating himself in the process.  This is an indefensible error in judgment.

Attorney Joe B. Garza, attorney and chief partner at Garza & Harris, was shocked by the handling of the case before his firm took over.  “It is hard to stress how important it is for all parties involved with complex estate plans to have at least a fundamental understanding of how the plan is implemented and executed,” Garza explained.  “This case could have gone very differently if [the construction company] had retained other representation that was unfamiliar with the intricacies of plans like this one.  It is the responsibility of every attorney to perform due diligence in order to fully understand the conditions surrounding each client’s case.”

The California courts agree and have recognized that an attorney has a duty to consult a specialist if a reasonably careful and skillful practitioner would do so.[ii]  The construction company’s attorney may be excused for not having the ability to understand a tax maneuver that the IRS itself had trouble grasping.  However, he may not be excused for going so far as to imply criminal liability by his client rather than seeking the advice of a specialist, or even of the attorney who initially handled the transaction.  Far past mere irresponsibility and negligence, such an action almost certainly constitutes legal malpractice.

The Takeaway

Just as expert witnesses assist juries in understanding technical or specialized information, legal specialists can assist attorneys in explaining complex issues.  This expertise is especially crucial in an area such as tax law, where the stakes are high and the cost of a violation can be devastating.  It is irresponsible and dangerous to make the government feel as if the wool is being pulled over its eyes, rather than use experts to defend a client which is conducting itself responsibly and legally.

In other words, due diligence means never having to say, “I plead the fifth.”

[i] The Roberts Law Firm is now known as Coleman, Anastopulous & Jackson.

[ii] Horne v. Peckham, 97 Cal. App. 3d 404 (Cal. Ct. App. 1979).

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