IN THE UNITED STATES DISTRICT COURT FOR THE NORTHERN...

IN THE UNITED STATES DISTRICT COURT FOR THENORTHERN DISTRICT OF TEXAS

LUBBOCK DIVISION

SALTY BRINE I, LTD. by and through,SALTY BRINE, Inc., Tax Matters Ptr.,

Plaintiff,

vs.

UNITED STATES OF AMERICA,

Defendant.

§§§§§§§§§§

Case No.: 5:10-cv-00108-C (Consolidated)

UNITED STATES OF AMERICA’S POST-TRIAL BRIEF

Respectfully submitted,

KATHRYN M. KENEALLYAssistant Attorney General

GROVER HARTT, III Tex. Bar No. 09174500 CHRISTOPHER R. EGAN Tex. Bar. No. 24036516 JOSHUA D. SMELTZER (Maryland Bar – No ID) Attorneys, Tax Division Department of Justice 717 N. Harwood St., Suite 400 Dallas, Texas 75201 Phone: (214) 880-9721 Fax: (214) 880-9741 [email protected] [email protected] [email protected]

SARAH SALDANA United States Attorney

April 17, 2013

Case 5:10-cv-00108-C Document 167 Filed 04/17/13 of 108 PageID 10211

mailto:[email protected]



TABLE OF CONTENTS

QUESTIONS PRESENTED. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2FACTUAL AND PROCEDURAL BACKGROUND.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2I. The Business Protection Policies. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3

A. Thomas and Kidd First Learned About BPP Transactions Through a Presentation Given to Their Accountant. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4

B. Thomas and Kidd Began Purchasing Cash Value Life Insurance Policies in Early 2002. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5

C. Thomas and Kidd Purchased Cash-Value Life Insurance Policies to Receive the Anticipated Profits from Their Investment in BPP. . . . . . . . . . . . . . . . . . . . . . 7

D. The BPP Transaction Used Five Steps to Funnel Cash Payments from the Thomas and Kidd Businesses to the Thomas and Kidd Life Insurance Policies.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 101. Step One - The Thomas and Kidd Businesses Transfer $4.5 Million

to KOFS Group. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 112. Step Two - KOFS Group Transfers $4.5 Million to Fidelity and

Citadel. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 113. Step Three - Fidelity and Citadel Execute Reinsurance Agreements

with Yield Enhancement Company. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 114. Step Four - Yield Enhancement Executes "Subscription" Agreements

with the Thomas and Kidd Life Insurance Segregated Accounts. . . . . . . 125. Step Five - Fidelity and Citadel Transfer $3.86 Million to the

Segregated Accounts. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 136. Step Six - Thomas and Kidd Withdraw the BPP Proceeds as Policy

Loans. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14II. The Royalty Transfer. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15

1. Step One - Thomas and Kidd Create Two Limited Liability Companies. . . . . . . 162. Step Two - Overriding Royalty Income Interests are Carved Out of

Thomas & Kidd Oil Production and Assigned to Thomas & Kidd Royalty-Nevada. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17

3. Step Three - Thomas & Kidd Royalty Nevada is Transferred to Thomas & Kidd Royalty Nevis. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17

4. Step Four - Thomas & Kidd Royalty Nevis is Transferred to the LifeInsurance Segregated Accounts. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17

III. Legal Opinions and Warnings. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21A. Thomas and Kidd's Tax Advisors Have Suffered from Financial Conflicts,

Refused to Update BPP Opinions, and Have Withdrawn BPP Opinions. . . . . . . 211. Theodore Lustig and Glenn Henderson suffered from financial

conflicts. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 212. Brian Casey Withdrew His Tax Opinion Based on Factual

Misrepresentations. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 233. Jenkens and Gilchrist Refused to Issue a BPP Opinion for the 2006

Tax Year.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 254. Martin Van Brauman Based His 2006 BPP Opinion on Three Key

Assumptions.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25B. In Addition to Withdrawing Lawyers, Thomas and Kidd's Personal Lawyer

Received Other Warnings Related to the BPP Transaction. . . . . . . . . . . . . . . . . . 26

i


ARGUMENT and AUTHORITIES.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27BPP Tax Shelter . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 29Royalty Transfer Tax Shelter. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 29A. The BPP Premiums Do Not Qualify as Business Expenses Under 26 U.S.C. § 162. . . . 30

1. Thomas and Kidd Executed the BPP Transaction for Tax and Estate Planning Purposes, Not for Carrying on a Trade or Business. . . . . . . . . . . . . . . . 31

2. The BPP Payments Were Distributions, Not Expenses. . . . . . . . . . . . . . . . . . . . . 353. The BPP Payments Were Unnecessary. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 42

a) The BPP Policies Did Not Cover Risks.. . . . . . . . . . . . . . . . . . . . . . . . . . 42b) The BPP Policies Did Not Shift Risks.. . . . . . . . . . . . . . . . . . . . . . . . . . . 50

I. The Guarantee Agreements Ensured that Fidelity and Citadel Retained No Risk of Loss. . . . . . . . . . . . . . . . . . . . . . . . . 52

ii. The Operation and Characteristics of the Business Protection Policies Show that No Risk was Transferred to Fidelity or Citadel. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 55

iii. The BPP Transactions Do Not Constitute Captive Insurance. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 58

c) The BPP Policies Did Not Distribute Risks.. . . . . . . . . . . . . . . . . . . . . . . 59d) The BPP Policies Were Not Ordinary. . . . . . . . . . . . . . . . . . . . . . . . . . . . 67

B. Income from the Transferred Royalty Interests Should be Assigned to Thomas & Kidd Oil Production . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 691. Plaintiffs Retained Beneficial Ownership of the Royalty Interests. . . . . . . . . . . . 712. Plaintiffs Retained Control over Activities Generating Royalty Income.. . . . . . . 74

C. The BPP and Royalty Transactions Lack Economic Substance. . . . . . . . . . . . . . . . . . . . 80D. The 20 Percent Penalty Applies. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 86

1. Both the Accuracy Related Penalty for Substantial Understatement and the Penalty for Negligence or Disregard of Rules and Regulations Apply. . . . . . 88

2. The Reasonable Cause Defense to Penalties is Inapplicable. . . . . . . . . . . . . . . . . 93CONCLUSION. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 102

Cases:

ACM P'ship v. Commissioner, 157 F.3d 231 (3d Cir. 1998). . . . . . . . . . . . . . . . . . . . . . . 81Apollo Fuel Oil v. United States, 195 F.3d 74 (2nd Cir. 1999) . . . . . . . . . . . . . . . . . . . . 96Applestein Est. v. Comr., 80 T.C. 331 (1983). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 72ASA Investerings P'ship v. Commissioner, 201 F.3d 505 (D.C. Cir. 2000).. . . . . . . . 81-82Beech Aircraft Corp. v. United States, 797 F.2d 920 (10th Cir. 1986). . . . . . . . . . . . 42, 50Benningfield v. Comr., 81 T.C. 408 (1983). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 72Black & Decker Corp. v. United States, 436 F.3d 431 (4th Cir. 2006). . . . . . . . . . . . . . . 81Burns v. U.S., 65-1 USTC Para. 9385 (N.D. Tex. 1965). . . . . . . . . . . . . . . . . . . . . . . . . . 71Canal Ins v. Montello, Inc., No. 10-CV-411-JHP-TLW, 2012 WL 4891699

(N.D. Okla. Oct. 15, 2012).. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 45Chase v. Comr., 59 T.C.M. 261 (1990), aff'd, 926 F.2d 737 (8th Cir. 1991). . . . . . . . . . 72Chemtech Royalty Associates, L.P. v. United States, 2013 WL 704037

(M. D. La. 2013). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 83, 86-87Chu v. Comr., 72 T.C.M. (CCH) 1519, *9 (1996).. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 71Clougherty Packing Co. v. Comm'r, 811 F.2d 1297 (9th Cir. 1987). . . . . . . . . . . . . . 50, 59CM Holdings, In re, 301 F.3d 96 (3d Cir. 2002). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 81

ii


C.M. Thibodaux Co., Ltd. v. U.S., 915 F.2d 992 (5th Cir. 1990), aff'g 723 F. Supp. 367 (E.D. La. 1989). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 74

Coltec Indus., Inc. v. United States, 454 F.3d 1340 (Fed.Cir. 2006). . . . . . . . . . . . . . 81-82Comm'r v. Lincoln Sav. & Loan Assoc., 403 U.S. 345 (1971).. . . . . . . . . . . . . . . . . . . . . 31Curcio v. Comm'r., 689 F.3d 217 (2d Cir. 2012).. . . . . . . . . . . . . . . . . . . . . . . . . . . . 31, 36Dewees v. Commissioner, 870 F.2d 21 (1st Cir. 1989). . . . . . . . . . . . . . . . . . . . . . . . . . . 81Dow Chemical Corp. v. United States, 435 F.3d 594 (6th Cir. 2006). . . . . . . . . . . . . . . . 81Frank Lyon Co. v. United States, 435 U.S. 561 (1978). . . . . . . . . . . . . . . . . . . . . . . . . . . 81F.W. Services, Inc. v. Comm'r, 459 Fed. Appx. 389 (5th Cir. 2012). . . . . . . . . . . . . . . . . 50Gilman v. Commissioner, 933 F.2d 143 (2d Cir. 1991).. . . . . . . . . . . . . . . . . . . . . . . . . . 81Green v. Comm'r, 507 F.3d 857 (5th Cir. 2007). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31Greensboro Pathology Assocs., P.A. v. United States, 698 F.2d 1196 (Fed. Cir.

1982). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 36Gregory v. Helvering, 293 U.S. 465 (1935).. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 81Gulf Oil Corp. v. Comm'r, 914 F.2d 396 (3d Cir. 1990). . . . . . . . . . . . . . . . . . . . . . . . . . 58Hang v. Comr., 95 T.C. 74 (1990). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 71Harper Group and Includible Subs. v. Comm'r, 96 T.C. 45 (1991). . . . . . . . . . . . . . . . . 58Helvering v. Le Gierse, 312 U.S. 531 (1941). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 42H.J. Heinz Co. v. United States, 76 Fed. Cl. 570 (Fed. Cl. 2007). . . . . . . . . . . . . . . . 82-83Hook v. Comr., 58 T.C. 267 (1972). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 71Ideal Tool and Die Co. v. Comr., T.C. Memo 1960-96.. . . . . . . . . . . . . . . . . . . . . . . . . . 72Illes v. Commissioner, 982 F.2d 163 (6th Cir. 1992).. . . . . . . . . . . . . . . . . . . . . . . . . . . . 93INDOPCO, Inc. v. Comm'r, 503 U.S. 79 (1992). . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30, 42Keeler v. Commissioner, 243 F.3d 1212 (10th Cir. 2001). . . . . . . . . . . . . . . . . . . . . . . . . 81Klamath Strategic Fund v. United States, 568 F.3d 537 (5th Cir. 2009).. . . . . . . . . . 81-83Leuhsler v. Comm'r, 963 F.2d 907 (6th Cir. 1992). . . . . . . . . . . . . . . . . . . . . . . . . . . 92, 95Long Term Capital Holdings, 330 F.Supp.2d 122 (D. Conn. 2004). . . . . . . . . . . . . . . . . 93Lucas v. Earl, 281 U.S. 111 (1930). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 71, 79Marcello v. Commissioner, 380 F.2d 499 (5th Cir. 1967), aff'g 43 T.C. 168 (1964). . . . 89Moore v. Thomas, 145 F.2d 813 (5th Cir. 1944), aff'g 44-1 USTC Para. 9274

(N.D. Tex. 1944). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 71MURFAM Farms, LLC v. United States, 94 Fed. Cl. 235 (2010). . . . . . . . . . . . . . . . . . . 96National Lead Co. v. Comr., 336 F.2d 134 (2d Cir. 1964), cert. denied,

380 U.S. 908 (1965), aff'g 40 T.C. 282 (1963). . . . . . . . . . . . . . . . . . . . . . . . . . . 71Nealy v. Commissioner, 85 T.C. 934 (1985). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 89Neonatology Associates, P.A. v. Commissioner, 299 F.3d 221 (3d Cir. 2002). . . . . . . . . 89New Colonial Ice Co. v. Helvering, 292 U.S. 435 (1934). . . . . . . . . . . . . . . . . . . . . . . . . 30Pasternak v. Commissioner, 990 F.2d 893 (6th Cir. 1993). . . . . . . . . . . . . . . 90-91, 93, 95R & T Developers, Inc. v. Comr., T.C. Memo 1973-128.. . . . . . . . . . . . . . . . . . . . . . . . . 71Rybak v. Comm'r, 91 T.C. 524 (1988). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 95Sather v. Commissioner, 251 F.3d 1168 (8th Cir. 2001). . . . . . . . . . . . . . . . . . . . . . . . . . 81Serianni v. Comr., 80 T.C. 1090 (1983), aff'd, 765 F.2d 1051 (11th Cir. 1985). . . . . . . . 71Skeen v. Comm'r, 864 F.2d 93 (9th Cir. 1989).. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 92Sochin v. Commissioner, 843 F.2d 351 (9th Cir. 1988).. . . . . . . . . . . . . . . . . . . . . . . . . . 81Southgate Master Fund, LLC v. United States, 659 F.3d 466 (5th Cir. 2011). . . . . . . . . 82Steere Tank Lines, Inc. v. United States, 577 F.2d 279 (5th Cir. 1978).. . . . . . . . 32, 42, 50Steere Tank Lines, Inc. v. United States, 1976 WL 1066 (N.D. Tex. June 15,

1976), aff'd, 577 F.2d 279 (5th Cir. 1978). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31Tulia Feedlot, Inc. v. United States, 513 F.2d 800 (5th Cir. 1975). . . . . . . . . . . . . . . 31, 67

iii


United Parcel Serv. of Am., Inc. v. Commissioner, 254 F.3d 1014 (11th Cir. 2001). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 81

Van Scoten v. Commissioner, 439 F.3d 1243 (10th Cir. 2006). . . . . . . . . . . . . . . . . . . . . 89V.R. DeAngelis M.D.P.C. v. Commissioner, 94 T.C. Memo. 2007-360, aff'd,

574 F.3d 789 (2d Cir. July 21, 2009). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 36Welch v. Helvering, 290 U.S. 111 (1933). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31Winn-Dixie Stores, Inc. v. Commissioner, 254 F.3d 1313 (11th Cir. 2001). . . . . . . . 81-82Yeoham Est. v. Comr., T.C. Memo 1986-431, *12, aff'd, 826 F.2d 11 (5th Cir. 1987).. . 72Yosha v. Commissioner, 861 F.2d 494 (7th Cir. 1988). . . . . . . . . . . . . . . . . . . . . . . . . . . 81Zmuda v. Comr., 731 F.2d 1417 (9th Cir. 1984), aff'g 79 T.C. 714 (1982).. . . . . . . . . . . 72

Statutes:

Internal Revenue Code (Title 26, U.S.C.):

§ 162.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2, 80§ 162(a). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30§ 6662.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2, 30-31§ 6662(a). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30, 87§ 6662 (b)(1). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 87§ 6662 (b)(2). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 87§ 6662(c). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 87-89§ 6664(c). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 93§ 6664(c)(1). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 93§ 6662(d). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 87§ 6662(d)(1). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 88§ 6662(d)(2). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 88§ 6662(d)(2)(B). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 87§ 6662(d)(2)(C)(I). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 87§ 6662(d)(2)(C)(ii). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 87-88§ 6664.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21, 87

. Miscellaneous:

Restatement (Second) of Agency §§9(3), 268, 272, 275 (1958) .. . . . . . . . . . . . . . . . . . . 96Treas. Reg. (26 C.F.R.):

§ 1.6662-2(c). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 87§ 1.6662-3(b)(1). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 88§ 1.6662-3(b)(1)(ii). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 89§ 1.6662-3(b)(2). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 89§ 1.6664-4(b)(1). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 93§ 1.6664-4(c)(1)(I). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 94§ 1.6664-4(c)(1)(ii). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 94

iv


IN THE UNITED STATES DISTRICT COURT FOR THE NORTHERN DISTRICT OF TEXAS

LUBBOCK DIVISION

SALTY BRINE I, LTD. by and through, SALTY BRINE, Inc., Tax Matters Ptr., Plaintiff, vs. UNITED STATES OF AMERICA, Defendant.

§ § § § § § § § § §

Case No.: 5:10-cv-00108-C (Consolidated)

UNITED STATES OF AMERICA’S POST-TRIAL BRIEF

From start to finish, the transactions at issue in this case were designed to deceive.

The entities used to facilitate the transactions have impressive sounding names like

Fidelity, Citadel, AXA, and Vanguard, but none of those entities are related to the

established, multi-national companies that bear the same names.1 The business

protection policies reference authentic-sounding coverages like tax audit legal defense,

criminal defense, and key supplier, but the plaintiffs have produced no evidence that the

Thomas and Kidd businesses needed those coverages, much less attempted to quantify

any real risks they may have faced. Formal-sounding Insurance Guaranty Agreements

purport to establish Fidelity and Citadel’s retention of risk, but the agreement’s plain

accomplishes the opposite; it ensured that Fidelity and Citadel always made a profit.

Another set of Subscription Agreements purport to pool risk through a partnership named

Yield Enhancement, but none of the plaintiffs’ witnesses have ever seen Yield

Enhancement’s partnership agreement, accounting records, or general partner. More

1 See www.fidelity.com; www.citadelgroup.com; www.axa.com; and https://investor.vanguard.com.


2

importantly, the actual flow of money in this case shows that pooling was impossible.

Deferential-sounding Letters of Wishes give the impression that the plaintiffs were

beholden to an offshore trustee, but documents and testimony show that these letters were

designed to serve the plaintiffs’ wishes, not check them. Finally, a transfer of royalty

interests was designed to look like an arm’s length sale, but the transfer process and

ownership structures evidence an insider sale designed to move taxable income offshore.

Placed under the bright light of trial, all of the above deceptions have been exposed as

empty complications executed only to avoid taxes on the substantial income earned by

the Thomas and Kidd businesses.

QUESTIONS PRESENTED

1. Whether contributions to personal cash-value life insurance policies are deductible as

ordinary and necessary business expenses under 26 U.S.C. § 162?

2. Whether income from overriding royalty interests should be assigned to the entity that

controls and benefits from them: Thomas & Kidd Oil Production, Ltd.?

3. Whether the BPP and royalty transactions should be disregarded because they lack

economic substance?

4. Whether the penalties imposed under 26 U.S.C. § 6662 for the underpayment of taxes

should be sustained?

FACTUAL AND PROCEDURAL BACKGROUND

On the surface, the ownership structures and transactions encountered in this case

seem as complicated as plaintiffs intended. When boiled down to their essence, however,


3

the ownership and transactions are simple: John Thomas and Lee Kidd owned and

controlled the assets at issue in this case before and after the transactions.

I. The Business Protection Policies

The primary transactions at issue in this case relate to what the plaintiffs call

Business Protection Policies (BPP). These policies were issued by Fidelity Insurance

Company and Citadel Insurance Company. Both companies were based offshore in the

British West Indies.2 They were part of a larger group of entities affiliated with Alliance

Holding Company, Ltd. In addition to the insurance entity, the Alliance group included a

trust company named First Fidelity Trust, a U.S.-based administrative entity named

Offshore Trust Services, and a marketing firm named Foster & Dunhill.3 Duane

Crithfield was Director of the Alliance Group, and was involved in the management of

every entity except the marketing entity, Foster & Dunhill.4 Foster was controlled by

Stephen Donaldson.5

Although the names of these companies are similar to established financial

institutions based in the United States, these offshore entities have no relationship to

U.S.-based institutions.6 Other entities used in this case’s transaction also use names

similar to established U.S.-based firms: AXA Offshore Management, Ltd.; Vanguard

2 Jnt. Ex. 58 (offshore structure chart). 3 Jnt. Ex. 58; Supp. Jnt. Stip. at ¶ 1 (Dkt. No. 119). 4 Jnt. Ex. 58 (director of holding company); Trial Tr. at 285:8-15 (involved in formation). 5 Supp. Jnt. Stip. at ¶ 2. 6 See, e.g., https://www.fidelity.com/; www.axa.com; http://www.citadelgroup.com/; https://investor.vanguard.com.


4

Capital, LLC; Windham Capital, LLC.7

A. Thomas and Kidd First Learned About BPP Transactions Through a Presentation Given to Their Accountant

The ultimate taxpayers in this case, John Thomas and Lee Kidd, first learned

about Business Protection Policies through their accountant, H. Glenn Henderson, who in

turn was introduced to the tax shelters in 2000 through a meeting with Stephen

Donaldson.8 Mr. Donaldson marketed Fidelity’s products.9 Mr. Henderson was

immediately interested in the cash-value life insurance products because Fidelity and

Citadel offered their clients investment options not offered by domestic insurance

companies.10

Within a year, Mr. Henderson met with Mr. Donaldson again. This meeting

focused on Business Protection Policies. Mr. Donaldson presented a Power Point

describing BPP goals and transaction steps.11 The “strategic goals” presented included tax

reduction and protection of assets from creditors:12

“Reduce Business/Personal Income Tax;”

“Reduce Capital Gains Tax;”

“Provide Asset Protection;”

“Create Tax Free Retirement Income.”

7 The remarkable similarities between the names of the offshore entities in this case and unconnected, mainstream companies onshore are illustrative of efforts made to disguise the transactions. See Trial Tr. 558:1 – 559:9 (Crithfield testimony). 8 Trial Tr. at 1404:2-10. 9 Jnt. Ex. 58 (offshore structure chart). 10 Trial Tr. at 1320:9-24. 11 Gov. Ex. 267 (BPP Power Point). 12 Id. at IRSPROD03_063963.


5

To achieve these goals, the presentation included a number of steps that must be

completed. First, the client settles an offshore “asset protection trust.”13 Second, the

client purchases cash-value life insurance policies.14 Next, the cash value of that life

policy is allocated to “Separate Asset” accounts, which are invested in accordance with

the client’s instructions.15 Finally, the client purchases a BPP policy.16 BPP risk is

covered by the life policy’s separate asset accounts, and, at the end of the BPP policy’s

one-year term, 85 percent of the BPP premium, plus a nominal amount of interest earned

at Certificate of Deposit rates, is transferred to the account.17 The presentation stresses

that the BPP risks are not pooled with other clients:18

Although the Separate Asset Accounts are pooled investments and have a common manager, the reinsurance risks are not. Therefore, as a safety feature, the profitability of each life policy’s reinsurance business is tied to that client’s company’s non-life policies and to none other.

In other words, a client’s separate asset accounts were responsible only for BPP claims

filed by that client’s business. No third party business has access to the client’s accounts.

B. Thomas and Kidd Began Purchasing Cash Value Life Insurance Policies in early 2002

Consistent with Donaldson’s power point presentation, the transactions at issue in

this case began and ended with cash value life insurance policies. Messrs. Thomas and

Kidd began purchasing cash-value policies from Fidelity in early 2002. Thomas and

13 Id. at IRSPROD03_063966. 14 Id. at IRSPROD03_063967. 15 Id. at IRSPROD03_063968. 16 Id. at IRSPROD03_063969. 17 Id. at IRSPROD03_063971. 18 Id. at IRSPROD03_063972 (emphasis added)).


6

Kidd did not own these policies directly. Instead, they formed offshore limited liability

companies to directly own the policies: L&E Kidd LLC and J. Thomas LLC.19 Both of

these LLCs were formed in December of 2001 under the laws of Nevis, British West

Indies.20 By 2006, the LLCs owned seven cash-value life policies.21 The offshore LLCs

were owned by two investment partnerships, Kiddel, Ltd. and JTOM, Ltd. Those

partnerships are owned by the Kidd Irrevocable Trust and the Thomas Irrevocable Trust.

Thomas and Kidd are trustees of the trusts and their children are beneficiaries.22 The

following chart shows the ownership structure:23

19 Jnt. Ex. 156-158; 20-24 (insurance policies with applications). 20 Jnt. Ex. 254 (Thomas LLC operating agreement); Jnt. Ex. 252 (Kidd LLC operating agreement). 21 Supp. Jnt. Stip. at ¶ 6-9. 22 Jnt. Ex. 607 (Kidd Trust Agreement); Pl. Ex. 187 (Thomas Trust Agreement). 23 Supp. Jnt. Stip. at ¶ 6-9; 13-19 (describing ownership structure for life policies).


7

The investments of each of these cash-value life policies were held in separate or

“segregated” accounts.24 The assets of these accounts were set aside and accounted for

separately from other insurance policies.25 The owners of the other insurance policies and

the creditors of the insurance companies had no access or right to the assets in these

segregated accounts. These accounts are sometimes referred to as “separate” or “sole”

accounts.26 The following chart shows the structure of the segregated accounts and life

policies:

As discussed in the next section, the trusts and investment partnerships that own

the cash-value life policies also own the Thomas and Kidd businesses.

C. Thomas and Kidd Purchased Cash-Value Life Insurance Policies to Receive the Anticipated Profits from Their Investment in BPP

As explained in the Foster & Dunhill promotional materials, a party desiring to

buy Fidelity Insurance Company’s BPP also had to purchase either cash-value life

insurance or a variable rate annuity. These policies were a necessary part of the tax

shelter scheme because they were to receive the “earnings” or profits from the BPP

investment (premiums paid less Fidelity’s 15% fee) at the end of the policy year. Messrs

24 Supp. Jnt. Stip. ¶ 20; Jnt. Ex. 288 (L&E Kidd LLC 2006 financial report showing assets of policies 145, 144, 513, 514, 521); Jnt. Ex. 291 (J Thomas LLC 2006 financial report showing assets of policies 182, 157 513, 514, 521). 25 Supp. Jnt. Stip. at ¶ 20. 26 Id.


8

Thomas and Kidd followed the plan and purchased cash-value life policies that were in

place by early in 2002.

They made their first BPP purchases late in 2001 and began funneling their

earnings into the life insurance policies at the end of the policy year in December 2002,

but for a number of legal reasons, the only year at issue in this case is 2006. The 2006

policies purportedly protected seven businesses owned and operated by Thomas and

Kidd: Thomas & Kidd Oil Production, Ltd.; Salty Brine, Ltd.; Delta Oil & Gas, Inc.; Del-

Tex Hydrocarbons, Inc.; K&T Farm, Ltd.; Five Star Consolidated, Ltd.; and Wasson

Solid Waste Disposal, Ltd. (the Thomas & Kidd Businesses).27 These businesses

operated oil and gas properties and provided a number of services related to the oil and

gas industry.28

As with the life insurance policies, Messrs. Thomas and Kidd did not own their

businesses directly. They were owned through the same trusts and investment

partnerships that owned the life policies.

All of the Thomas and Kidd businesses except Thomas & Kidd Oil Production

were owned by the Kidd Irrevocable Trust and the Thomas Irrevocable Trust.29 As with

the life policies, the trusts owned the businesses through the investment partnerships,

Kiddle and JTOM. The Kidd Trust owned 98.03 percent of Kiddle and the Thomas Trust

owns 97.54 percent of JTOM.30 Mr. Thomas and Mr. Kidd managed JTOM and Kiddle

through grantor trusts named the Kidd Management Trust and the Thomas Management

27 Joint Ex. 10-16. 28 Supp. Jnt. Stip. at ¶ 29. 29 30Supp. Jnt. Stip. at ¶ 16 (JTOM); 18 (Kiddel).


9

Trust.31 As the following chart shows, Kiddel and JTOM directly owned a combined

majority interest in all of the businesses except for Thomas & Kidd Oil Production:32

The exact ownership percentages varied for each business, and some of the businesses’

ownership structures included minority interest holders. Five Star, for example had a

minority partner named M&H Well Service. Ownership percentages for all of the entities

are detailed in the Supplemental Joint Stipulation (Dkt. 119) at paragraphs 30-35, and in

ownership charts attached as Demonstratives C-H.

31 Id. 32 Supp. Jnt. Stip. at ¶ 30-34; Jnt. Ex. 337-339; 447-449 (business tax returns). Tellingly, Delta Oil & Gas’s Form 1120 shows that John Thomas and Lee Kidd directly owned Delta Oil’s shares, but Glenn Henderson testified that Messrs. Thomas and Kidd indirectly owned those shares through the investment partnerships and management trusts. Trial Tr. at 1392:9 – 1393:12. As explained later, this substantive reporting reveals that, the despite the layers of partnerships and trust, John Thomas and Lee Kidd maintained control of the businesses.


10

Messrs. Thomas and Kidd owned the remaining business, Thomas & Kidd Oil

Production, Ltd., through two grantor trusts and two additional investment partnerships.

The grantor trusts are named Kidd Living Trust and Thomas Living Trust. The

intermediary investment partnerships are named Kiddel II, Ltd. and JTOM II, Ltd. The

following chart shows this second ownership structure:33

A more-detailed ownership structure for Thomas & Kidd Oil Production is described at

Supp. Jnt. Stip. ¶35-39 and diagramed at Demonstrative G.

D. The BPP Transaction Used Five Steps to Funnel Cash Payments from

the Thomas and Kidd Businesses to the Thomas and Kidd Life Insurance Policies

On the surface, the BPP policies appear to protect the Thomas and Kidd businesses

from various risks. A closer look reveals, however, that these policies were merely a

33 Supp. Jnt. Stip. at 35-39.


11

conduit used to funnel income from those businesses to offshore entities in a scheme to

avoid paying taxes due on that income. Messrs. Thomas and Kidd used these policies to

funnel cash into their cash-value life policies. In his expert report and during his

testimony, Expert Bruce Dubinsky described the following six steps:34

1. Step One – The Thomas and Kidd Businesses Transfer $4.5 Million to KOFS Group

The 2006 BPP transaction began with yet another intermediary entity—KOFS

Group.35 Instead of transferring the BPP “premiums” directly to Fidelity and Citadel, the

plaintiff businesses transferred $4.5 million of premiums to KOFS Group.36

2. Step Two – KOFS Group Transfers $4.5 Million to Fidelity and Citadel

Immediately after receiving the total $4.5 million for all the BPP premiums from

the Thomas and Kidd businesses, KOFS Group transferred that $4.5 million to Fidelity

and Citadel.37 Fidelity and Citadel accepted that payment as “premiums” for separate

BPP policies providing the Thomas and Kidd businesses with various sorts of coverage

against remote and implausible risks. The following chart shows these initial transfers:

3. Step Three – Fidelity and Citadel Execute Reinsurance Agreements with Yield Enhancement Company

Fidelity and Citadel then executed “reinsurance” agreements with an entity named

Yield Enhancement Co.38 These agreements purported to transfer responsibility for a

34 Gov. Ex. 630 at 11-20 (Dubinsky Expert Report). 35 Jnt. Ex. 9 (KOFS operating agreement)). 36 Jnt. Ex. 11-16 (BPP Policies); Jnt. Ex. 1-2, 4-7; Gov. Ex 3 (BPP letters of wishes). The ownership percentages in KOFS Group matched the percentage that each company invested in BPP. Trial Tr. at 1792:11 – 1798:12 (Dubinsky description of KOFS role). 37 Id. 38 Jnt. Ex. 18 (Fidelity reinsurance agreement)); Jnt. Ex. 17 (Citadel reinsurance agreement).


12

portion of the BPP coverage amounts. Yield Enhancement was yet another of the

Alliance Holding Group of entities. Fidelity’s agreement provided that Yield

Enhancement would assume responsibility for 85% of BPP policy coverage. In return,

Yield Enhancement would receive consideration equal to 85% of all BPP premiums

minus “any claim” paid by Fidelity:39

Consideration is equal to 85% of the gross premium received by Reinsurer with respect to the Business Protection Policy for which a guaranty is obtained less a USD$250.OO administrative fee for each policy, less any Claim Amount paid by FIC, plus any interest earnings on such premiums during the term of the Agreement.

Claim Amount is defined by the agreement as “all amounts paid by FIC on claims made

under the policy.”40

Citadel’s agreement with Yield Enhancement was identical to Fidelity’s

agreement except that 85% is replaced with 83%.41 Fidelty retained 15% of the

premiums paid and Citadel 17% as their fees.

4. Step Four – Yield Enhancement Executes “Subscription” Agreements with the Thomas and Kidd Life Insurance Segregated Accounts

After Fidelity and Citadel executed reinsurance agreements with Yield

Enhancement, Yield Enhancement immediately executed “subscription agreements” with

the segregated accounts, which held the cash value of the Thomas and Kidd life insurance

policies.42 In return for access to the segregated accounts’ assets to pay BPP claims,

Yield Enhancement agreed to give the accounts all remaining BPP premiums after

payment of claims and administrative fees.

39 Jnt. Ex. 18 at IRSPROD01_038709 (emphasis added). 40 Jnt. Ex. 18 at IRSPROD01_038709 (emphasis added). 41 Jnt. Ex. 17. 42 Jnt. Ex. 29-33 (subscription agreements).


13

5. Step Five – Fidelity and Citadel Transfer $3.86 Million to the Segregated Accounts

At the end of the BPP policies’ one-year term, Fidelity and Citadel issued cash

notices to all of the life policy segregated accounts.43 These notices stated that a total of

$3.86 million of the original $4.5 million of BPP payments was to be transferred to the

segregated accounts. Despite the execution of reinsurance agreements with Yield

Enhancement, no evidence has ever been produced to establish that any money was

actually transferred to an entity named Yield Enhancement. Instead, the cash notices in

December 2007 indicate that the BPP payments were transferred directly from Fidelity

and Citadel to J. Thomas LLC and L&E Kidd LLC, with a direct correlation between the

premium each company paid and the interest earned after deducing the 15% or 17% fee

imposed by Fidelity or Citadel.44 These transfers were made without even bothering to

detour through Yield Enhancement. Although the cash notices each referred to several

segregated accounts, Messrs. Thomas and Kidd, with their advisors, had to allocate the

earnings from the seven BPP policies to their five segregated accounts after they had

received the money from the insurance companies.45

Included in each of the cash notices was a request for instructions on how each

segregated account’s share of the proceeds should be invested. The remaining $730,000

of the original $4.5 million of BPP payments was withheld by Fidelity and Citadel as fee

payments, i.e., their respective 15% and 17% of the premiums paid. These fees were

much smaller than the tax benefit derived from deducting the BPP payments as insurance

43 Jnt. Ex. 35-41 (cash notices). 44 See Demonstrative J and discussion below of BPP payment flow in Arguments and Authorities, Part A(3)(b). 45 Jnt. Ex. 19.


14

expenses, i.e., the deduction of the $4.5 million in premiums paid as “ordinary and

necessary business expenses.”46 Accordingly, $730,000 was spent to acquire a $4.5

million reduction in otherwise taxable income in the United States and to funnel the

remaining $3.86 million ($3.77 million plus interest) into offshore life insurance policies.

6. Step Six – Thomas and Kidd Withdraw the BPP Proceeds as Policy Loans

Within a day after the $3.86 million of BPP premiums was transferred in to the

segregated accounts, Messrs. Thomas and Kidd withdrew the premiums as policy loans.

They issued a letter with detailed instructions to withdraw all the BPP payments as

loans.47 The letter further detailed particular Bear Stearns accounts to which that the loan

proceeds were to be transferred. Plaintiffs claim that $2.8 million of the proceeds were

transferred to accounts that supported a new “insurance” product, and the remaining

$1.06 million of proceeds was transferred to a business account that supported Thomas &

Kidd Oil Production’s drilling operations.48 The flow of money through these BPP steps

is shown in the following diagram:49

46 Jnt. Ex. 337-339; Jnt. Ex. 447-449 (business tax returns). 47Jnt. Ex. 19 (allocation letter). 48 Jnt. Ex. 19 (letter allocates $1.06 million to “Kiddel JTOM Joint Venture”); Gov. Ex. 279 (Henderson predicts $1 million left for “drilling reserve”); Trial Tr. at 1465:12 –1465:12 (Henderson description of drilling funds). 49 Gov. Ex. 630 at 11-20.


15

II. The Royalty Transfer

The BPP transactions were not the only method Messrs. Thomas and Kidd used to

avoid paying taxes.50 They also used a transaction involving oil and gas royalty interests.

As with the BPP transactions, the royalty transactions seem complicated on the surface.

A closer look reveals a simple transfer similar to the BPP transfer. The royalty interests

were transferred from Thomas & Kidd Oil Production to cash value insurance policies.

50 In Gov. Ex. 442, Glenn Henderson explains that the “income tax and estate tax savings” provided by the royalty transaction “dwarf the costs.”).


16

The royalty transaction involves overriding royalty interests. In 2006, Thomas &

Kidd Oil Production, Ltd. owned a number of working interests in oil and gas

properties.51 As part of the royalty transaction, overriding royalty interests were carved

out of these working interests and transferred to the segregated accounts owned by the

Thomas and Kidd life insurance policies. A small portion of the royalty income was

eventually brought back on shore via annuity payments to Messrs. Thomas and Kidd, but

only after a three-year deferral while no taxes were paid on this income. The greater

portion of the income shifted off-shore was not taxed and continued to accumulate and be

available for tax-free policy loans. Note: Unlike the BPP transaction which affects only

the 2006 year in this case, the impact of the assignment of income resulting from then

royalty transfer continues to occur in subsequent tax years and will be controlled by this

Court’s disposition of the issue for 2006.

As described in the report and testimony provided by Bruce Dubinsky, executing

the royalty transaction included four steps.52

1. Step One – Thomas and Kidd Create Two Limited Liability Companies

The royalty transaction began with the creation of more entities. In January of

2006, Messrs. Thomas and Kidd created two limited liability companies: Thomas & Kidd

Royalty-Nevada LLC and Thomas & Kidd Royalty-Nevis LLC.53 Both of these LLCs

were owned by Kiddel II and JTOM II—the same entities that owned Thomas & Kidd

51 Supp. Jnt. Stip. at ¶ 42. 52 Gov. Ex. 630 at 26-28 (Dubinsky Expert Report). 53 Jnt. Ex. 253 (Nevis operating agreement); Jnt. Ex. 295 (letter describing royalty LLC creation); Supp. Jnt. Stip. at ¶ 44-45.


17

Oil Production, Ltd.54 Kiddel II and JTOM II directly owned 100 percent of the Nevis

entity, and the Nevis entity directly owned 100 percent of the Nevada entity.55 The Nevis

LLC acted only as a foreign intermediary.

2. Step Two – Overriding Royalty Income Interests are Carved Out of Thomas & Kidd Oil Production and Assigned to Thomas & Kidd Royalty-Nevada

Immediately after creating the royalty LLCs, Thomas & Kidd Oil Production

assigned overriding royalty income interests to Thomas & Kidd Royalty-Nevada.56 This

assignment gave Royalty-Nevada the right to receive just over 31 percent of the income

generated by the oil and gas working interests owned by Thomas & Kidd Oil

Production.57

3. Step Three – Thomas & Kidd Royalty Nevada is Transferred to Thomas & Kidd Royalty Nevis

This meaningless step meant that the Nevis LLC indirectly now owned the

overriding royalties which were its only asset.58

4. Step Four – Thomas & Kidd Royalty Nevis is Transferred to the Life Insurance Segregated Accounts

Kiddel II and JTOM II then transferred Thomas & Kidd Royalty Nevis – and the

royalties it owned through the Nevada LLC – to the life insurance segregated accounts in

54 Supp. Jnt. Stip. at ¶ 46. 55 Id. 56 Jnt. Ex. 351-355 (assignments); Jnt. Ex. 45-49 (memos of assignment); Supp. Jnt. Stip. at ¶ 47. 57 Supp. Jnt. Stip. at ¶ 47. 58 Supp. Jnt. Stip. at ¶ 48.


18

return for two annuities, one annuity for Kiddel II and one annuity for JTOM II.59 The

Kiddel II annuity paid $192,810 per year for the remainder of Lee Kidd’s life; and the

JTOM II annuity paid $178,579 per year for the remainder of John Thomas’s life.60 But

the annuity payments were deferred. Payments did not begin until January of 2009.61 The

following chart shows this exchange of royalty interests for annuities:

The value of the exchanged royalty interests is unclear. Thomas and Kidd’s

accountant, Glenn Henderson, valued one-half of the royalty interests, i.e., half of the

59 Jnt. Ex. 54-55 (agreements to transfer Royalty Nevada for annuities); Jnt. Ex. 53 (consent to transfer Royalty Nevis to segregated accounts); Supp. Jnt. Stip. at ¶ 49. 60 Jnt. Ex. 54 (Kidd annuity agreement); Jnt. Ex. 55 (Thomas annuity agreement); Supp. Jnt. Stip. at ¶ 49. 61 Supp. Jnt. Stip. at ¶ 49.


19

total value for Mr. Thomas and half for Mr. Kidd, at $1,261,500,62 by applying certain

“discounts” to the initial value of the production supplied to him by the plaintiffs

themselves. Subsequently, but the plaintiffs’ experts in this case, Mr. Harris of Forrest

Garb, and Peter Phalon of Waterview, valued the same half interests in the same royalties

at $1,001,00063—a 26 percent difference. [$1,261,500 less $1,001,000 = $260,500;

$260,500 ÷ $1,001,000 = .26] Our oil and gas expert, Greg Scheig, found this gaping

disparity between plaintiffs’ two valuation experts to be puzzling.

Nevertheless, only Glenn Henderson’s valuation was used for the exchange in

2006. The plaintiffs have gone to great lengths to present the royalty transaction as an

arm’s length exchange between unrelated parties, but nothing about Glenn Henderson’s

valuation can be described as arm’s length. Mr. Henderson served both sides of the

royalty transaction. On one side of the transaction, he was the long-time accountant for

John Thomas, Lee Kidd, and Thomas & Kidd Oil Production. On the other side of the

transaction, he was the “Manager” for the LLCs that owned the life insurance policies.64

Other evidence shows that he was also investment manager for the segregated accounts

that allegedly purchased the royalty interests. A resolution from L&E Kidd LLC

appoints Glen Henderson’s company, IBS, as “Investment Manager” of the CDA

150502.65 A similar resolution from J. Thomas LLC appoints IBS as “Investment

Manager” of CDA 150503.66 Mr. Henderson signed both resolutions.67 When asked

62 Jnt. Ex. 603 (Henderson valuation report); Supp. Jnt. Stip. at ¶ 50. 63 Pl. Ex. 119 (Phalen Expert Report); Supp. Jnt. Stip. at ¶ 51. 64 Jnt. Ex. 19 (signing for IBS, as manger); Trial Tr. at 1422:24 - 1423:5 (confirming ownership of IBS). 65 Gov. Ex. 801. 66 Gov. Ex. 802.


20

which side of the transaction he represented, Mr. Henderson cited neither Thomas &

Kidd Oil Production nor the offshore LLCs. Tellingly, he testified that he represented

John Thomas and Lee Kidd.68

Despite the royalty transfer, nothing about the operation of the underlying oil and

gas interests changed. During his deposition, Mr. Thomas confirmed that he supervised

the Thomas and Kidd drilling and production operations.69 He explained that Thomas &

Kidd Oil Production owned the working oil and gas interests and Delta Oil & Gas,

another of their companies, operated the interests. When asked whether anything about

the drilling operations changed after the royalty income interests were transferred

offshore, Mr. Thomas unequivocally said no: “It didn’t make them any difference.”70

When viewed alongside the BPP transaction, the similarity of the BPP transaction

and royalty transaction becomes clear. Both transactions accomplish a transfer of assets

into cash-value life insurance policies. Both transactions represent an internal shifting of

assets from one set of entities owned and controlled by Thomas and Kidd to another set

of entities owned and controlled by Thomas and Kidd. The tax benefits sought in this

case require arms-length transfers to third parties, but no third parties exist on either end

of the BPP or Royalty transactions. The chart attached as Demonstrative A shows the

BPP transaction and the royalty transaction side-by-side.

67 Trial. Tr. at 1430:8-20; 1431:22 – 1432:8. 68 Trial Tr. at 1480:16 – 1481:17. 69 Trial Tr. at 1541:12 – 1542:1. 70 Trial Tr. at 1593:12-18.


21

III. Legal Opinions and Warnings

During the early BPP presentation given to Glenn Henderson, Stephen Donaldson

discussed obtaining a “Substantial Authority Tax Opinion.”71 Consistent with that

presentation, Messrs. Thomas and Kidd have obtained multiple tax opinion letters from

multiple lawyers. These letters were obtained for use as a defense to tax penalties that

the IRS might impose.72 Ironically, the process for obtaining those opinions provided

Messrs. Thomas and Kidd with multiple warnings about the legality of their transactions.

These warnings were particularly noteworthy since Messrs. Thomas and Kidd had never

paid for tax opinions regarding the legitimacy of their purchase of real insurance through

their long-time insurance agent in Texas.

A. Thomas and Kidd’s Tax Advisors Have Suffered from Financial Conflicts, Refused to Update BPP Opinions, and Have Withdrawn BPP Opinions

The professionals that Messrs. Thomas and Kidd allegedly relied upon for tax

advice provided multiple warnings about the legality of BPP transactions: two suffered

from financial conflicts and one withdrew his opinion, citing misrepresented facts.

1. Theodore Lustig and Glenn Henderson suffered from financial conflicts Through all of the years that Messrs. Thomas and Kidd executed offshore

transactions, they were advised by their accountant, Glenn Henderson, and their lawyer,

Theodore Lustig. Mr. Henderson and Mr. Lustig coordinated the creation of offshore

entities, the execution of offshore transfers, and the investment of offshore funds. But

their compensation for that coordination did not come from their clients. Instead, it came

71 Gov. Ex. 267 (BPP power point). 72 See reasonable cause defense to penalties at 26 U.S.C. § 6664.


22

from Fidelity and Citadel. To promote their offshore transactions, Fidelity and Citadel

used an entity named Foster & Dunhill.73 Fidelity and Citadel paid Foster a commission

percentage of all funds that Foster clients contributed into Fidelity and Citadel products.74

Foster paid part of its commission to various client representatives.

Mr. Henderson and Mr. Lustig received those Foster commissions. Theodore

Lustig, for example, received a commission equal to 3 percent of all BPP premiums paid

by his clients, including the Thomas & Kidd businesses.75 His commission for Flexible

Premiums Variable Annuity policies equaled over 2.5 percent. Mr. Lustig’s

compensation records show that, for 2006 alone, he received $490,000 of commissions

from Foster & Dunhill.76 Between 2002-2007, Mr. Lustig received over $2.5 million in

commissions from Foster & Dunhill.77 All of Mr. Lustig’s commissions between 2002

and 2007 are shown on Gov. Ex. 635 and Demonstrative B, which summarizes Gov. Ex.

635. Before he received fees from Foster & Dunhill, Mr. Lustig disclosed his Foster &

Dunhill fee agreement to John Thomas and Lee Kidd.78

Glenn Henderson received similar commissions. Mr. Henderson did not produce

his Foster & Dunhill fee agreement, but he remembers receiving about 2.25 percent of all

premiums paid by his clients for business protection policies and life insurance policies.79

73 Jnt. Ex. 58; Gov. Ex. 267; Trial Tr. 273:15-19; 74 See Gov. Ex. 255, 636 (LustigT Advisor Agreement). 75 Gov. Ex. 255 at IRS-SW000818 (¶ 6.1), IRS-SW000822 (total Foster percentage), IRS-SW000823 (Lustig share of percentage); Trial Tr. at 209:12-19. 76 Gov. Ex. 635; Demonstrative B (summary of Gov. Ex. 635). 77 Gov. Ex. 635; Demonstrative B; Trial Tr. at 212:14-20. 78 Trial Tr. at 213:1-5. 79 Trial Tr. at 1484:25 – 1485:21.


23

Mr. Henderson’s compensation records show that, between 2002-2009, he received over

$2.5 million in commissions from Foster & Dunhill.80 He disclosed all of these

commissions to John Thomas and Lee Kidd.81 Mr. Henderson also sold various contact

names and Power Point templates to Foster & Dunhill for $50,000.82 Some of those

Power Point templates related to business protection policies.

2. Brian Casey Withdrew His Tax Opinion Based on Factual Misrepresentations

For the 2002 tax year, a lawyer named Brian Casey issued a tax opinion on the

BPP transaction to John Thomas and Lee Kidd. By 2003, however, Mr. Casey had

moved his law practice to Lord Bissell & Brook. His new law firm required opinions on

transactions like the BPP transaction to be reviewed by a committee of other lawyers.83

Emails between Mr. Casey and Duane Crithfield show that Lord Bissell had many

questions about the BPP transaction that Mr. Crithfield could not answer. For example,

the review committee questioned the “apparent disincentive for BPP insureds to file

claims for losses that are covered by the BPP.”84 Another member of the committee

questioned why Fidelity’s financial statements reflected inventory accounting principles

instead of insurance accounting principles.85 Unable to obtain answers to his questions

80 Gov. Ex. 610 (Henderson compensation records). 81 Trial Tr. at 1484:25 – 1485:21. 82 Trial Tr. 1485:25 – 1486:11. 83 Trial Tran. at 436:15 – 437:15. 84 Gov. Ex. 658 at DJC-001030; see also Gov. Ex. 657 (questioning lack of claims). 85 Gov. Ex. 666.


24

about claims and risk, Mr. Casey questioned the accuracy of assumptions and

representations that he relied upon for his first BPP opinion.86

On September 12, 2003, Mr. Casey withdrew his 2002 BPP opinion.87 He sent a

letter directly to Messrs. Thomas and Kidd stating that material facts about the BPP

policies were misrepresented to him:88

There are a number of respects in which material facts regarding the BP Policy and the related reinsurance and guarantee structure are not as they have been represented to us. Most importantly, perhaps, it was represented to us that the Company retained all liability for the first five percent (5%) of any losses under the BP Policy, and that an independent third party reinsurer (the "Reinsurer") retained all liability for twenty percent (20%) of any losses in excess of the first five percent (5%). As we now understand it, these representations were not true – all or nearly all losses under the BP Policy were intended to be funded by the limited liability companies (the "LLCs") in which insurance premiums paid for the Select Investment Plus Variable Life Insurance Policies (the "Life Policies) issued by the Company to J. Thomas, LLC and L&E Kidd, LLC were invested. This circumstance provides the Taxpayer with an incentive not to file claims for losses covered under the BP Policy, with the result that BP Policy lacks sufficient substance to support the Opinion. When asked about his reaction to the Casey’s withdrawal letter, Mr. Kidd stated

that it did not concern him because he could always find another lawyer:89

1 Q. Did it concern you at all that an attorney from 2 Lord Bissell and Brook was withdrawing his tax opinion 3 on the business protection plan? 4 A. There's another one down the street, good 5 attorneys. 6 Q. So no, it didn't concern you? 7 A. No.

86 Gov. Ex. 658. 87 Gov. Ex. 341 (withdrawal letter). Mr. Casey also withdrew the BPP opinion he provided to Fidelity. See Trial Tr. 436:15-16; 440:25 – 441:11. 88 Gov. Ex. 341 (Casey withdrawal letter) (emphasis added). 89 Trial Tr. 1531:6-11 (emphasis added).


25

3. Jenkens and Gilchrist Refused to Issue a BPP Opinion for the 2006 Tax

Year

Messrs. Thomas and Kidd found their next lawyers at the now-defunct law firm of

Jenkens & Gilchrist. Jenkens attorneys Jason Flaherty and Michael Cook prepared BPP

opinions for the 2003-2005 tax years. They did not issue an opinion on the BPP

transaction for 2006—the tax year at issue in this suit.

Jenkens’ failure to issue a BPP opinion for the 2006 tax year relates to concerns

raised by Jenkens lawyer Jason Flaherty. In an email to Theodore Lustig, Flaherty aired

concerns he had about informal “linkage” between clients’ BPP policies and life

policies.90 It appears that Flaherty was concerned that risk was not distributed via the

subscription agreements with Yield Enhancement. Ultimately, Jenkens advised Fidelity

and Citadel about the risk distribution issue and decided that it had become a material

advisor that could no longer issue opinions on the BPP transaction.91

4. Martin Van Brauman Based His 2006 BPP Opinion on Three Key Assumptions

For their 2006 tax year, Messrs. Thomas and Kidd turned to yet another lawyer—

Martin Van Brauman. Mr. Van Brauman issued them an opinion on the BPP transaction

for the 2006 tax year. Mr. Van Brauman’s opinion relies upon three key factual

assumptions:92

90 Gov. Ex. 498 (Flaherty email); Flaherty Dep Trans. at 25:3-18. In accordance with this linkage, funds from the Thomas & Kidd life policies could be used to pay claims only of the Thomas & Kidd businesses. See below for discussion of linkage in Part A(3)(c) of the Arguments and Authorities. 91 Flaherty Dep. Trans. at 22:13 – 24:5. 92 Pl. Ex. 104 at IRSPROD01_038292 - IRSPROD01_038293 (paragraphs 11, 19, and 20).


26

“Each of the risks covered by the Business Risk Policies issued to KOFS Group, LLC are genuine and material risks of the businesses;”

“The is no arrangement plan, contract, or agreement that exists between the owners of any insurance policy and Citadel or Fidelity linking reserves of any particular Business Risk Policy and Citadel and Fidelity, in their sole discretion, can use any reserves in the Guaranty Fund to cover losses on the Business Risk Policies;”

“The coverages under the Business Risk Policies are similar to policies of insurance that are currently available from other insurers, the premiums are determined under valid and proper actuarial principles, and the premiums are determined at arm’s length and are at fair market rates approximately equal to what other insurers would typically charge.”

Crucially, Mr. Van Brauman never made any attempt to verify the accuracy of these

representations. As we shall see, the letter is no better than its assumptions, which in this

case were false.

B. In Addition to Withdrawing Lawyers, Thomas and Kidd’s Personal Lawyer Received Other Warnings Related to the BPP Transaction

In addition to the concerns raised by opinion writers, Messrs. Thomas and Kidd’s

personal lawyer, Theodore Lustig, considered additional red flags about the legality of

BPP.

In November of 2005, Lustig forwarded an email to lawyers with Jenkens and Gilchrist. The article, titled “Stupid Captive Tricks” described illegal tax structures that attempt to create insurance premium deductions through self-insurance arrangements.93 The author provides four words of advice for taxpayers that execute the described transaction: “Don’t drop the soap.” He stressed that the tax scheme was “amazing blatant criminal tax evasion” that is “detached from tax reality.”94

Another article forwarded by Lustig in November of 2005 discusses an illegal tax shelter involving cash-value life insurance policies.95 The marketers of this scheme “promise that the insured can pay a premium to the insurance company,

93 Gov. Ex. 260. 94 Id. at IRSPROD04_064471. 95 Gov. Ex. 377.


27

take a business deduction for it, and then at the end of the policy term recapture the premium inside a cash-value life insurance product.”96 The author warned that the “IRS is examining…some of the more heavily-marketed arrangements and we would not be surprised to see them soon specifically designated as illegal tax shelters.”97

As we shall see, Mr. Lustig’s status as the agent for Messrs. Thomas and Kidd made his

knowledge of the growing concerns in the legal community about the legitimacy of BPP

attributable to his clients/principals. No ostrich defense is available to them.

ARGUMENT and AUTHORITIES

John Thomas, Lee Kidd, Theodore Lustig, and Glenn Henderson met on

December 14, 2006, to discuss the BPP transactions and royalty transfers.98 This meeting

occurred on the same day that John Thomas and Lee Kidd signed letters giving

instructions for the purchase of BPP policies.99 The substance of the transactions at issue

in this case is reflected in the materials that Theodore Lustig prepared for the December

14th meeting. The materials do not discuss insurance protection or the furtherance of any

business activities; they discuss two tax equations.

First, for the BPP transaction, the materials provide an analysis of whether the tax

benefits generated by an “investment” of BPP payments were higher than the fees

charged by Fidelity and Citadel. The actual equation presented shows that the tax

benefits far exceeded the fees:100

96 Id. at IRS-FSC002605. 97 Id. 98 Gov. Ex. 77 (offshore analysis). 99 Jnt. Ex. 1-7 (BPP letters and applications). 100 Gov. Ex. 77 at IRSPROD01_008273 (gain from 2001-2005 BPP investments); IRSPROD01_008273 (anticipated gain from 2006 BPP investment).


28

This equation encouraged high BPP premiums. The higher the premium, the larger the

gain. Thus, the meeting materials provide an analysis of the net income and cash

positions of the Thomas & Kidd businesses.101 Based on that analysis, John Thomas and

Lee Kidd ultimately decided that the most they could afford to invest in BPP was $4.5

million.

For the transfer of royalty interests, the materials did not discuss sales

negotiations or fair market values. Instead, the materials analyze tax deferrals. The

materials show that transferring the royalty interests offshore, where they would not be

subject to U.S. taxation, would avoid over $1.1 million of tax in 2006 and 2007 alone:102

It does not require a detailed legal analysis to determine that the BPP and royalty

transactions were not executed for business purposes. They were executed for tax

purposes. As explained in the following sections, the substance of the BPP and royalty

transactions follows those tax purposes. Nothing about the BPP transaction insures the

101 Gov. Ex. 77 at IRSPROD01_008279 (chart showing net income and cash). 102 Gov. Ex. 77 at IRSPROD01_008277.

Investment

(BPP payments) Gain

(4,500,000)$ + 4,500,000$ X 87% + 4,500,000$ X 35% = 990,000$

*The actual fee vaired by company due to excise taxes. Citadel's fee equaled 17%;Fidelity's fee equaled 15%.

Return Net of Fees* Tax Benefits

(cash notices) (deductions)

2006 2006 2006 Tax

Royalties Tax Rate Deferral

1,352,185$ X 35% = 473,265$

2007 2007 2007 Tax

Royalties Tax Rate Deferral

2,000,000$ X 35% = 700,000$


29

Thomas & Kidd businesses against business risk. And nothing about the royalty

transactions resembles an arm’s length transfer for fair market value. The transactions at

issue in this case fail to meet both the specific requirements of the Internal Revenue Code

and the broader requirements of the economic substance doctrine, which provides a

separate and independent basis for invalidating these transactions.

The full impact of the tax avoidance at issue in this case can be explained as

follows:

BPP Tax Shelter

Begin with $4,500,000 of business income transferred off-shore as BPP premiums and never taxed. This provided an estimated tax benefit of $1,575,000 ($4,500,000 x 35%).

Add $93,886 of interest earned on the net $3,771,000 of BPP payments during the year it was held by the insurance companies. See analysis of cash notices at Demonstrative J. This interest was also not taxed, resulting in an additional estimated tax benefit of $32,860 ($93,886 x 35%).

So, the total amount of income that escaped taxation by use of the BPP tax shelter

in 2006 was at least $4,593,886.103

Royalty Transfer Tax Shelter

Begin with $856,003.62 of Thomas & Kidd Oil Production, Ltd. income

transferred off-shore to each of the Thomas and Kidd Annuities in 2006 for a total of $1,712,007.24 ($856,003.62 x 2).104

Then add $947,587.65 of TKOP income transferred off-shore to each of the

Thomas and Kidd Annuities for 2007 for a total of $1,895,175.30 ($947,587.65 x

103 This calculation does not account for any part of this amount that would be treated as a taxable distribution to partners or shareholders. 104 Tr. Tran. 1867:3-25 (Dubinsky testimony on income); Jnt. Ex. 291 at MC001-DOJ0013536, MC001-DOJ0013549 (J. Thomas 2007 Financial Report); Jnt. Ex. 288 at MC001-DOJ0013146, MC001-DOJ0013159 (L&E Kidd 2006 Financial Report).


30

2).105

Next, add the conservative estimate of TKOP income transferred off-shore to each of the Thomas and Kidd Annuities in 2008 used by Mr. Dubinsky for a total $1,800,000 ($900,000 x 2).106 At this point, the total TKOP income transferred off-shore for each of the three years and never taxed is conservatively $5,407,182.54.

Then, in 2009, first add another conservative estimate of the TKOP income

transferred off-shore for that year, or another $1,800,000 for a new untaxed total, less interest earned, of $7,207,182.54.

Finally, subtract the first two annuity payments made $178,579 (Thomas) and

$192,810 (Kidd), or a total of $381,389, for a new total of untaxed TKOP income of $6,835,793.54, but remember that, as Mr. Dubinsky explained and the two private annuity agreements make clear (Jnt. Ex. 54 and 55, Exs. B), only about half of the annuity payments are taxed as ordinary income.

Accordingly, Messrs. Thomas and Kidd begin to receive handsome payments in

2009 taxed at very favorable rates while they have accumulated over $6.8 million available for use as tax-free loans or to be left to accumulate still greater

amounts for their heirs. A. The BPP Premiums Do Not Qualify as Business Expenses Under 26

U.S.C § 162

Deductions are a matter of legislative grace, and taxpayers bear the burden of

proving their entitlement to them.107 The taxpayers in this case seek to deduct the BPP

“premiums” they transferred off-shore, but they cannot prove that the payments qualify

as deductions under any statute.

Plaintiffs claim that the BPP payments are business expenses, but the payments

do not meet the requirement of 26 U.S.C. § 162. Section 162(a) allows businesses to

105 Tr. Tran. 1867:3-25 (Dubinsky testimony on income); Jnt. Ex. 292 at MC001-DOJ0013690, MC001-DOJ0013715 (J. Thomas 2007 Fin. Rpt.); Jnt. Ex. 289 at MC001-DOJ0013292, MC001-DOJ0013317 (L&E Kidd LLC 2007 Fin. Rpt.). 106 Tr. Tran. 1871:14 – 1873:16. 107INDOPCO, Inc. v. Comm’r, 503 U.S. 79, 84 (1992); New Colonial Ice Co. v. Helvering, 292 U.S. 435, 440 (1934).


31

deduct “all the ordinary and necessary expenses paid or incurred during the taxable year

in carrying on any trade or business.” Courts generally recognize five requirements in

section 162. The expense must be (1) paid or incurred during the taxable year; (2) be for

carrying on a trade or business; (3) be an expense; (4) be a necessary expense; and (5) be

an ‘ordinary’ expense.108 The BPP payments fail at least four of those five requirements –

any one of them would be lethal to their deductibility.

1. Thomas and Kidd Executed the BPP Transaction for Tax and Estate Planning Purposes, Not for Carrying on a Trade or Business

The Fifth Circuit explained in Green v. Commissioner that “[e]xpenditures may

only be deducted under § 162 “if the facts and the circumstances indicate that the

taxpayer made them primarily in furtherance of a bona fide profit objective independent

of tax consequences.”109 Payments made to further an owner’s personal estate and tax

planning do not qualify as payments made for carrying on a trade or business.

In Steere Tank Lines, Inc. v. United States, for example, the Fifth Circuit affirmed

the trial court’s holding that alleged insurance payments were not deductible under

section 162.110 The taxpayer in that case, Steere Tank Lines, paid over $200,000 into a

“premium contract account” as part of an alleged insurance policy. Claims against the

policy would be paid from that account. The premium account was managed by an entity

owned by two trusts. Those trusts were established for the benefit of the children of

108 Comm’r v. Lincoln Sav. & Loan Assoc., 403 U.S. 345, 352 (1971); Welch v. Helvering, 290 U.S. 111, 115 (1933); Tulia Feedlot, Inc. v. United States, 513 F.2d 800, 804 (5th Cir. 1975); Curcio v. C.I.R., 689 F.3d 217, 223 (2d Cir. 2012). 109Green v. Comm’r, 507 F.3d 857, 871 (5th Cir. 2007). 110 Steere Tank Lines, Inc. v. United States, 1976 WL 1066 (N.D. Tex. June 15, 1976), aff’d, 577 F.2d 279 (5th Cir. 1978).


32

Bruce and David Steere—the owners of Steere Tank Lines. Any amount left in the

premium account after six years would be returned to Steere Tank Lines.

The trial court in the Northern District of Texas rejected this alleged insurance

arrangement as personal estate planning: “In truth, the plan more closely approximates a

clever estate planning device.”111 The Fifth Circuit agreed, holding that the arrangement

was not a “true insurance contract.”112

As in Steere, the BPP arrangement in this case is not true insurance; it is disguised

tax and estate planning. Undisputed evidence shows that the BPP payments were not

paid to a third-party insurer; they were funneled to cash-value life policies purchased by

Messrs. Thomas and Kidd through their LLCs. Those policies, as in Steere, were owned

by trusts that benefited the Thomas and Kidd children. Messrs. Thomas and Kidd did not

further their businesses by shifting business risks to a third-party insurer; they contributed

cash to personal life policies. From those policies, they accessed the contributed cash

through policy loans. Taxes were never paid on this money which was income to the

Thomas and Kidd businesses. The following evidence supports the conclusion that the

BPP transactions were executed for personal reasons, not business reasons:

Lack of Underwriting – The plaintiffs have produced no documentation showing an analysis or quantification of risks faced by the Thomas & Kidd businesses. The plaintiffs’ insurance expert, Robert Hughes, testified about the underwriting activities he would have performed to determine risks faced by the businesses. Trial Tr. at 1232:18 – 1235:18. And Prof. David Babbel testified about the underwriting activities that he would expect to see. Trial Tr. at 1710:12 – 1711:8.

Businesses Covered – Despite Greg Thomas’s extensive testimony about the risks he considered, the only business covered during 2001-2004, Thomas & Kidd Oil Production, was an investment holding company that did not face most of those

111 Id. at *2. 112 Steere Tank Lines, Inc. v. United States, 577 F.2d 279, 280 (5th Cir. 1978).


33

risks. See Trial Tr. 866:1-16; 1307:1-10 (business of Thomas & Kidd Oil Production); Jnt. Ex. 330, 333, 334 (2001, 2002, 2004 BPP Policies).

BPP Presentations (Gov. Ex. 267, 612) – Foster & Dunhill BPP Power Points focus on tax benefits and gains. They do not discuss the management of business risks.

Offshore Analysis (Gov. Ex. 77) – An “Offshore Analysis” prepared by Theodore Lustig shows a BPP “Investment Analysis” at IRSPROD01_008273 and IRSPROD01_008278. It also shows an income and cash chart used to determine BPP premiums at IRSPROD01_008279. See also Trial Tr. at 1441:17 – 1443:3.

Premiums Determined by Available Funds Instead of Costs for Coverage Needed

– Lee Kidd testified that he determined BPP premium amounts by looking in his pocket to determine how much the businesses had to spend. Trial Tr. at 1526:8-16. Expert Bruce Dubinsky determined that BPP premiums were determined by looking at how much income and cash the entities possessed. Trial Tr. at 1802:17 – 1804:4. During all of his years as a CPA advising businesses, Mr. Dubinsky has never seen business insurance determined that way. In his experience, businesses first determine what risks the business face and how much it will cost to cover those risks. Id. Our insurance expert, Professor David Babbel agreed. Trial Tr. at 1724:8-24.

Manipulation of Premiums (Jnt. Ex. 1-2, 4-7; Gov. Ex. 3) – The 2006 applications for BPP policies show an unexplained manipulation of 2006 premium amounts for each business. Nevertheless, the original budget amounts and amended budget amounts both total $4.5 million.

Ashton Tiffany Underwriting Files (Gov. Ex. 222-231) – Ashton Tiffany

underwriting files for prior-years’ BPP policies show that premium amounts for each coverage were calculated after the premiums were paid. They also show a manipulation of coverages and deductibles to meet budget amounts:

o Gov. Ex. 222 (memo includes ideas to increase premiums to budget amount at ASHTON-03376);

o Gov. Ex. 223 (reference to reworking coverage to match amount "paid" at ASHTON-05286);

o Gov. Ex. 224 (reference to reworking coverage to increase premium to budget amount at ASHTON-06433);

o Gov. Ex. 225 (reference to reworking coverage to increase premium to paid budget amount at ASHTON-06544);


34

o Gov. Ex. 226 (reference to adjusting coverage to meet a paid premium amount at ASHTON-06703; additional reference to adjusting limits to meet premium amount at ASHTON-06709);

o Gov. Ex. 227 (reference to calculation being close enough to "client's premium" at ASHTON-06893; reference to eliminating deductible to come within budget at ASHTON-06905);

o Gov. Ex. 228 (reference to adjusting limits and eliminating covers to come within budget at ASHTON-07195);

o Gov. Ex. 229 (suggesting adding kidnap/ransome while eliminating disability to meet budget at ASHTON-01373); and

o Gov. Ex. 230 (suggesting Bankruptcy Legal Expense coverage to meet "target" at ASHTON-02213).

Nothing demonstrates the tax-focused nature of the BPP transaction better than

the economics of that transaction. Deductions are supposed to represent economic

expenditures, but the BPP payments represented economic gains. At the December 14th

meeting described above, the plaintiffs considered whether the “investment” of BPP

premiums would provide them with a gain from tax benefits.113 They did not consider

the risks faced by their businesses or the coverages provided by business protection

policies.

Greg Thomas114 testified that, as early as 2001, he considered risks from

regulatory investigations, the loss of key suppliers, and the loss of key customers.115 But

113 Gov. Ex. 77 at IRSPROD01_008273 (gain from 2001-2005 BPP investments); IRSPROD01_008273 (anticipated gain from 2006 BPP investment). 114 Greg Thomas testified that, during 2006, he managed operations at Thomas & Kidd Oil Production, Delta Oil & Gas, and Del-Tex. All of the important documents in this case, however, are signed by John Thomas and Lee Kidd. See, e.g., Jnt. Ex. 1-7 (BPP letters and applications), 19 (BPP proceeds allocation letter), 337 (T&K Form 1065), 339 (Delta Form 1120); Pl. Ex. 88C (June 2007 claim letter), 89C (Feb. 2008 claim letter). The United States does not contest Greg Thomas’s involvement in the business


35

the plaintiffs have produced no documentation showing an analysis of these risks. The

plaintiffs can point to no documents, for example, showing a calculation or other analysis

of how much it would cost to change suppliers. Likewise, the plaintiffs can cite to no

insurance professionals that analyzed these risks.

More importantly, the one business covered by BPP from 2001-2004 did not face

the risks that Greg alleges he considered. From 2001-2004, the only business covered by

BPP was Thomas & Kidd Oil Production. That business was essentially an investment

partnership. It owned working interests in oil and gas properties, but it did not perform

any drilling or other operations.116 Delta Oil & Gas performed those operations. Thus,

Thomas & Kidd Oil Production did not have customers, suppliers, or drilling operations.

It did not face the risks that Greg alleges he considered. Nevertheless, Thomas & Kidd

Oil Production was the only business covered by BPP from 2001-2004.117

This decision to cover the one business facing the least amount of risk shows that

the plaintiffs did not purchase BPP to further their business interests. Tax purposes drove

the decision to purchase BPP, not business purposes.

2. The BPP Payments Were Distributions, Not Expenses

The economics of the BPP transaction leads to another reason the BPP payments

do not qualify as business deductions: the BPP payments were distributions, not

expenses. In addition to the payment being made to further a business, the payment must

qualify as an expense. In other words, the business must actually spend money.

operations, but it is clear that John Thomas and Lee Kidd still controlled the businesses and offshore entities. 115 Trial Tr. at 1351:20 – 1353:25. 116 Trial Tr. at 866:1-16; 1307:1-10. 117 Jnt. Ex. 330, 333, 334 (2001, 2003, 2004 BPP Policies).


36

Distributions to company executives do not qualify.118

For example, in Curcio v. Commissioner, the Second Circuit held that alleged

insurance expenses were not deductible expenses under section 162.119 Instead, they

were disguised contributions to personal cash-value life policies. The taxpayers in that

case owned four small businesses. Those businesses enrolled in purported life insurance

plans for their employees. Under the plan, the businesses would pay the premiums of

cash-value life insurance policies that covered the businesses employees. Only the

owners, however, were covered by the plans.

The businesses deducted the life insurance premiums as business expenses, but

the Second Circuit held that the premium payments did not qualify under section 162.

Instead of business expenses, the payments were cash distributions to the businesses’

owners:120

The contributions were a mechanism by which petitioners could divert company profits, tax-free, to themselves, under the guise of cash-laden insurance policies that were purportedly for the benefit of the businesses, but were actually for petitioners' personal gain. Just like the payments in Curcio, the BPP payments in this case were not business

expenses; they were “a mechanism by which [Thomas and Kidd] could divert company

profits, tax-free, to themselves, under the guise of cash-laden insurance policies.”

Nothing demonstrates this fact more dramatically than the undisputed flow of BPP

118 V.R. DeAngelis M.D.P.C. v. Commissioner, 94 T.C. Memo. 2007-360, aff’d, 574 F.3d 789 (2d Cir. July 21, 2009); Greensboro Pathology Assocs., P.A. v. United States, 698 F.2d 1196, 1201 (Fed. Cir. 1982) (“Of course, in any instance where a company maintains total control of and retains all rights to the plan's funds, no deduction is allowed because the company has not in reality spent this money.”). 119 Curcio v. Comm’r., 689 F.3d 217 (2d Cir. 2012). 120 Id. at 226.


37

premiums from the Thomas and Kidd businesses to the Thomas and Kidd life insurance

policies, which Messrs. Thomas and Kidd readily accessed through policy loans.121

The plaintiffs allege that they did not own or control funds deposited in the life

policy segregated accounts, but the following evidence exposes that deception:

Dubinsky Description of Payment Flow (Gov. Ex. 630, Trial Tr. 1789:14 – 1842:8 ) – The testimony and expert report of Bruce Dubinsky describes the flow of BPP payments from the Thomas & Kidd businesses to the Thomas & Kidd cash-value life policies. Mr. Dubinsky concluded that the BPP transactions were “a series of pre-planned and integrated steps of a single transaction designed to produce a tax deduction on the front-end while allowing for tax free access to the same monies at the back end.” Gov. Ex. 630 at DOJ-000124.

Letter of Wishes Approval Process (Pl. Ex. 13) – The Letters of Wishes approval process was designed to protect client assets from third-party creditors: “The purpose of this procedure is to ensure that distributions are made in accordance with the client’s wishes and to prevent unauthorized distributions to third parties.”122 The process provided no substantive check on a client’s control.

Giordani Testimony on Segregated Account Investment Manager – Plaintiffs’

expert Leslie Giordani testified that the segregated accounts were “controlled by discretionary investment managers.”123

L&E Kidd Resolution (Gov. Ex. 801) – A resolution from L&E Kidd LLC appoints Glenn Henderson’s company, IBS, as “Investment Manager” of the CDA 150502. Lee Kidd, Theodore Lustig, and Glen Henderson signed this resolution on March 5, 2007.124 Prior to that date, the resolution states that Theodore Lustig’s company, TLTG Planners, was the investment manager.

J. Thomas Resolution (Gov. Ex. 802) – A similar resolution from J. Thomas LLC appoints IBS as “Investment Manager” of CDA 150503.125 John Thomas and

121 Gov. Ex. 630 at DOJ-000133 - DOJ-000145 (Dubinsky expert report). 122 Pl. Ex. 3 at page 2 of the “FFT Draft Procedures” under “Distribution Requests.” (emphasis added). 123 Trial Tr. at 669:21 – 700:6. 124 Mr. Henderson could not remember the resolution, but he did identify his signature. Trial Tr. at 1430:8-20. 125 Gov. Ex. 802.


38

Glenn Henderson signed this resolution on March 5, 2007.126 Prior to that date, the resolution states that Theodore Lustig’s company, TLTG Planners, was the investment manager.

Investment Manager Letter of Wishes (Jnt. Ex. 303) – Lee and Edith Kidd issued a letter on October 31, 2006, directing the appointment of IBS as “Investment Manager” over segregated accounts named Vanguard Capital and Windham Capital.

Investment Manager Letter of Wishes (Jnt. Ex. 308) – John Thomas issued a letter on October 31, 2006, directing the appointment of IBS as investment manager of the segregated account named Castleford Capital.

Investment Manager Agreement (Gov. Ex. 34) – An unsigned signed copy of a “Segregated Accounts Investment Manager Agreement” appoints IBS as investment manager of the segregated accounts named Castleford Capital, Vanguard Capital, and Windham Capital.

Emails Documenting Transfer to Bear Stearns (Gov. Ex. 280-281) – Emails from Glenn Henderson to John Thomas and Lee Kidd document the decision to move segregated account investments to Bear Stearns.

Letter of Wishes Signed by Glenn Henderson as Manager (Jnt. Ex. 19) – A letter of wishes dated December 20, 2007, directs the allocation of BPP premiums into the segregated accounts and the immediate distribution of those funds via policy loans. Glenn Henderson signed that letter as “Manager” of L&E Kidd LLC and J. Thomas, LLC.

Theodore Lustig Testimony about Protection of Investments – Theodore Lustig testified that the protection offered by segregated accounts led him to recommend Fidelity. Trial Tr. at 56:5-19.

Glenn Henderson Testimony About Investment Options – Glenn Henderson testified that “investment selection” was an attractive attribute of the Fidelity cash-value life policies. Tr. Tran. at 1320:9-24. As long as the investment manager was willing to sign an agreement with Fidelity, life policy clients “could use an independent manager of their choosing to manage those investments.” Id.

Greg Thomas Testimony on Segregated Accounts Protecting Investments – During his testimony, Greg Thomas stated that he liked the idea of segregated accounts because they protected the families’ investments: “To me, it added more protection, and I thought that was--that was what-- You know, you don't want to put your money somewhere and have something happen to it, and I think, you

126 Again, Mr. Henderson could not remember the resolution, but he did identify his signature. Trial. Tr. at 1431:22 – 1432:8.


39

know, having it outside of the general account of the insurance agency in a protected segregated account just makes sense.” Trial Tr. 902:25 – 903:11 (emphasis added). Greg also testified that he was attracted to the Fidelity cash-value life policies because they “had a large cash value that you could use if you needed it.” Trial Tr. 899:17 – 900:4.

More than anything, the plaintiffs cite the letter-of-wishes process to support their

control allegations. John Thomas and Lee Kidd gave instructions related to the

segregated accounts through letters of wishes.127 The plaintiffs assert that a “trustee” in

Nevis had to approve those letters of wishes, but letter-of-wishes procedures produced by

Duane Crithfield show that the approval process was designed to protect a policyholder’s

assets from third party creditors. They were not designed to check a policyholder’s

wishes. The procedures for “Distribution Requests” states this asset protection

purpose:128

The purpose of this procedure is to ensure that distributions are made in accordance with the client’s wishes and to prevent unauthorized distributions to third parties. Thus, the letters of wishes operated more like letters for wishes. By design, the

“trustee” approval process was used to ensure that the client’s wishes were honored. If it

appeared that a third party creditor was forcing a client to request assets, the trustee could

refuse the request. In theory, a client could maintain control of their assets without

having to honor judgments awarded to third-party creditors. This “asset protection”

purpose is highlighted in Foster & Dunhill’s marketing materials.129 Duane Crithfield

127 E.g., Jnt. Ex. 19. 128 Pl. Ex. 13 (email with letters of wishes procedure) (emphasis added); see also Trial Tr. 374:8 – 377:3 (CrithfieldD description of approval process). 129 Gov. Ex. 267 at IRSPROD03_063963 (“asset protection”); Gov. Ex. 612 at DJC-000251 (“Protect your assets from litigation”), DJC-000294 (asset protection).


40

testified that he and Stephen Donaldson formed Foster & Dunhill to implement structures

that would protect clients’ assets from “frivolous lawsuits.”130 The plaintiffs own estate

planning expert, Leslie Giordani, testified about this asset protection goal.131

The plaintiffs also cite the presence of an “investment manager” that must

approve segregated account investment decisions. Plaintiffs’ expert Leslie Giordani

testified that the segregated accounts were “controlled by discretionary investment

managers.”132 The investment manager for the segregated accounts at issue in this case

was John Thomas and Lee Kidd’s accountant, Glenn Henderson. Messrs. Thomas and

Kidd controlled the segregated accounts through Mr. Henderson. Resolutions and letters

signed by John Thomas, Lee Kidd, Glenn Henderson, and Theodore Lustig, evidence Mr.

Henderson’s appointment as investment manager.133 Prior to Mr. Henderson, Mr. Lustig,

was investment manager.134

Glenn Henderson’s role as investment manager—and John Thomas and Lee

Kidd’s control over Henderson—is shown through a transfer of the segregated account

assets to a broker with Bear Stearns. On June 27, 2006, Glenn Henderson sent an email

to John Thomas and Lee Kidd with the Subject of “Selection of Money Management

Firm.”135 This email described a decision between Bear Stearns, Raymond James, and

Stanford Group. Mr. Henderson stressed that the decision was one that “only the two of

130 Trial Tr. at 264:17 – 265:6. 131 Trial Tr. 686:3-12; 692:12 – 693:14 (“Wealthy families take steps to protect assets from third-party creditors…”). 132 Trial Tr. at 669:21 – 700:6. 133 Jnt. Ex. 303, 308; Gov. Ex. 34, 801, 802. 134 Id. 135 Gov. Ex. 280.


41

you can make,” referring to John Thomas and Lee Kidd.136 The email provides a

spreadsheet of factors for Messrs. Thomas and Kidd to consider when making their

decision.

Ultimately, Messrs. Thomas and Kidd choose Bear Stearns. A follow up email

sent by Glenn Henderson on July 18th refers to the “Transition of Accounts to Bear

Stearns.”137 Mr. Henderson references “account application packages” that “Lee and

John” had to “get to Dallas to sign.”138 He also states that “We will work through First

Fidelity Trust to transfer the offshore accounts from Fidelity to Bear Stearns.”139 A few

months later, John Thomas and Lee Kidd executed letters of wishes directing Fidelity

Management Limited to appoint Bear Stearns as the “Custodian” of the segregated

accounts named Vanguard, Windham, and Castleford.140

Mr. Henderson testified that he did not remember his transfer emails relating to

the segregated accounts,141 but the documentary evidence conflicts with his memory.

The June 27th email stresses that all three potential managers “can perform with

international accounts.”142 The follow up email dated July 18th refers to working with

“First Fidelity Trust to transfer the offshore accounts from Fidelity to Bear Stearns.”143

And Mr. Henderson confirmed that Mr. Thomas and Mr. Kidd did in fact choose Bear

136 Trial. Tr. at 1436:1-13. 137 Gov. Ex. 281. 138 Gov. Ex. 281; Trial Tr. at 1440:8 – 1441:2. 139 Gov. Ex. 281. 140 Gov. Ex. 303 (Vanguard and Windham); 308 (Castleford). 141 Trial Tr. at 1435:18-25. 142 Gov. Ex. 280 at IRSPROD01_020983. 143 Gov. Ex. 281.


42

Stearns.144 Asserting that it is just a coincidence that the segregated account investments

were transferred to Bear Stearns during the same time period defies reality. The transfer

to Bear Stearns shows that John Thomas and Lee Kidd had effective control over the

segregated account assets. As Glen Henderson stated in his email, transferring the

segregated account assets to Bear Stearns was a decision that only the two of them could

make.

3. The BPP Payments Were Unnecessary

Even if the BPP payments were expenses, plaintiffs have not shown that the

expenditures were necessary. A necessary expense is “appropriate and helpful” for the

development of the taxpayer's business.145 Courts have held that insurance premiums can

be necessary business expenses, but the BPP program in this case does not qualify as

insurance. To qualify as insurance, a transaction must include three elements: (1) risk;

(2) shifting of risk; and (2) distribution of risk.146 The Thomas and Kidd BPP program

satisfies none of those elements.

a) The BPP Policies Did Not Cover Risks

First, there is no evidence that the Thomas and Kidd businesses faced the risks

allegedly covered by the BPP policies. The following evidence shows that the choice of

BPP premiums and coverages was driven by maximizing tax deductions, not protecting

against risk:

144 Trial Tr. 1438: 25 – 1439:5. 145 Id. at 223 (2d Cir. 2012) (quoting INDOPCO, Inc. v. Comm'r, 503 U.S. 79, 85, (1992)). 146 Helvering v. Le Gierse, 312 U.S. 531, 539 (1941); Beech Aircraft Corp. v. United States, 797 F.2d 920, 922 (10th Cir. 1986); Steere Tank Lines, Inc. v. United States, 577 F.2d 279, 280 (5th Cir. 1978) (Risk shifting or risk distribution is one of the requisites of a true insurance contract).


43

Lack of Underwriting – The plaintiffs have produced no documentation showing an analysis or quantification of risks faced by the Thomas & Kidd businesses. The plaintiffs’ insurance expert, Robert Hughes, testified about the underwriting activities he would have performed to determine risks faced by the businesses. Trial Tr. at 1232:18 – 1235:18. And Prof. David Babbel testified about the underwriting activities that he would expect to see. Trial Tr. at 1710:12 – 1711:8.

Businesses Covered – Despite Greg Thomas’s extensive testimony about the risks

he considered, the only business covered during 2001-2004, Thomas & Kidd Oil Production, was an investment holding company that did not face most of those risks. See Trial Tr. 866:1-16; 1307:1-10 (business of Thomas & Kidd Oil Production); Jnt. Ex. 330, 333, 334 (2001, 2002, 2004 BPP Policies).

Scheig Analysis of Coverages (Gov. Ex. 632) – Oil and gas expert Gregory Scheig found no business reason for the BPP coverages. He concluded that the business protection policies did not “serve the Plaintiffs business in any significant way.” Gov. Ex. 632 at DOJ-000313. He also concluded that the business protection policies were not “commonly used in the oil and gas industry.” Id.; see alsoTrial Tr. at 1625:11-22.

Offshore Analysis Presentation (Gov. Ex. 77) – An “Offshore Analysis” prepared

by Theodore Lustig shows an income and cash chart used to determine BPP premiums at IRSPROD01_008279. See also Trial Tr. at 1441:17 – 1443:3.

Premiums Determined by Budget – Lee Kidd testified that he determined BPP premium amounts by looking in his pocket to determine how much the businesses had to spend Trial Tr. at 1526:8-16. Expert Bruce Dubinsky determined that BPP premiums were determined by looking at how much income and cash the entities possessed. Trial Tr. at 1802:17 – 1804:4. During all of his years as a CPA advising businesses, Mr. Dubinsky has never seen business insurance determined that way. In his experience, businesses first determine what risks the business face and how much it will cost to cover those risks. Id. Professor David Babbel agreed. Trial Tr. at 1724:8-24.

Ashton Tiffany Underwriting Files (Gov. Ex. 222-231) – Ashton Tiffany underwriting files for prior-years’ BPP policies show that premium amounts for each coverage were calculated after the premiums were paid. They also show a manipulation of coverages and deductibles to meet budget amounts:

o Gov. Ex. 222 (memo includes ideas to increase premiums to budget amount at ASHTON-03376);

o Gov. Ex. 223 (reference to reworking coverage to match amount "paid" at ASHTON-05286);


44

o Gov. Ex. 224 (reference to reworking coverage to increase premium to budget amount at ASHTON-06433);

o Gov. Ex. 225 (reference to reworking coverage to increase premium to paid budget amount at ASHTON-06544);

o Gov. Ex. 226 (reference to adjusting coverage to meet a paid premium amount at ASHTON-06703; additional reference to adjusting limits to meet premium amount at ASHTON-06709);

o Gov. Ex. 227 (reference to calculation being close enough to "client's premium" at ASHTON-06893; reference to eliminating deductible to come within budget at ASHTON-06905);

o Gov. Ex. 228 (reference to adjusting limits and eliminating covers to come within budget at ASHTON-07195);

o Gov. Ex. 229 (suggesting adding kidnap/ransome while eliminating disability to meet budget at ASHTON-01373);

o Gov. Ex. 230 (suggesting Bankruptcy Legal Expense coverage to meet "target" at ASHTON-02213);

Charts Showing Legitimate Insurance (Gov. Ex. 265, 266, 274) – Glenn Henderson prepared charts showing the legitimate insurance policy premiums for Delta, Del-Tex, and Thomas & Kidd Oil Production. This legitimate insurance covered the businesses’ real risks. See, e.g., Trial Tr. 1518:1-22 (describing coverage of accident). As discussed above, Greg Thomas testified about business risks that were of

concern to him. The plaintiffs, however, have produced no documented analysis or other

quantification of those risks. Professor David Babbel testified about the importance of

“careful underwriting” by professionals.147 In this case, he would have expected to see

evidence that insurance professionals were “on-site” evaluating the businesses risks.

Testimony from the plaintiffs’ insurance expert, Robert Hughes, supports professor

147 Trial Tr. at 1710:12 – 1711:8.


45

Babbel’s conclusions. If Mr. Hughes148 were called upon to determine risks faced by oil

& gas related businesses, he agreed that he would have wanted to visit the businesses

operations, inspect their equipment, speak with their employees, and review their

contracts.149 Nevertheless, the plaintiffs have produced no evidence that any of those

activities were ever conducted.150 The plaintiffs may assert that Greg Thomas or Glenn

Henderson could have performed those underwriting activities, but Professor Babbel

explained why the entities being insured are not qualified to underwrite their own

risks:151

It's like a fox tending the henhouse. What you need is someone independent, without potential biases or willingness to hide risks or otherwise distort the picture. You need to have outside people assessing the risk. Professor Babbel also found that “the premiums charged for the BPPs had no

documented relation to the risks purportedly insured under the policies.”152 In other

words, Professor Babbel found no actuarial support or other claims data supporting the

large BPP premiums at issue in this case. Even for new coverages, claims data should

emerge after a few years. In this case, that data has never emerged. Tom Monier testified

that, even after five years, Fidelity and Citadel provided Ashton & Tiffany with no

significant loss data.153 Mr. Monier cited that as a reason he believes Ashton & Tiffany

148 Recall that at least one United States District Court was quite vocal in rejecting Mr. Hughes as an expert. Canal Ins v. Montello, Inc., No. 10-CV-411-JHP-TLW, 2012 WL 4891699 (N.D. Okla. Oct. 15, 2012) (striking Robert Hughes’ expert report). 149 Trial Tr. at 1232:18 – 1232:18. 150 Trial Tr. at 1711:5-8 (Prof. Babbel found no evidence of underwriting). 151 Trial. Tr. at 1710:24 – 1711:4. 152 Gov. Ex. 631 at DOJ-000014 (Babbel report). 153 Monier Dep. Tr. at 24:2-18.


46

terminated its contract with Fidelity.154 In this context, recall the similar concerns of the

Lord Bissell Brook opinion review committee about the lack of claims that lead to the

eventual withdrawal of that firm’s opinion letters.155

Instead of a risk analysis, the evidence shows that the BPP premiums were based

on a cash analysis. The BPP premiums were based on arbitrarily determined budgets, not

on genuine risks. Each application listed a budget amount. Even though the coverages

purchased by particular Thomas and Kidd business entities were adjusted—often

dramatically with some increasing while others decreased—the amended combined

premium paid by all of the entities conveniently matched the original combined

premium—$4.5 million in 2006:156

Greg Thomas referred to this as a coincidence.157

154 Monier Dep. Tr. at 22:17 – 24:18. 155 Gov. Ex. 657. 156 Jnt. Ex. 1-2, 4-7; Gov. Ex. 3. 157 Trial Tr. at 1001:8-24.

Original Budget Final Budget

T&K Oil Prod 1,500,000$ 1,300,000$

Delta Oil 1,000,000$ 100,000$

Del‐Tex 650,000$ 800,000$

K&T Farm 60,000$ 100,000$

Five Star 1,000,000$ 1,400,000$

Wasson 200,000$ 400,000$

Salty Brine 90,000$ 400,000$

Total 4,500,000$ 4,500,000$


47

When asked how the Thomas and Kidd businesses determined each budget,

Thomas and Kidd referred to available cash flow—not protection against risks. Kidd

used his pockets to explain:158

15 Q. (BY MR. EGAN) How did the Thomas and Kidd 16 businesses determine how much to pay for business 17 protection insurance? 18 A. John and I always talk about it, everything. 19 We felt like we would spend that much money to be put in 20 each year. 21 Q. How did you determine you could spend that much 22 money? 23 A. Just reached down in your pocket and see what 24 you had, get a ballpark. 25 Q. Are you saying you made the determination based 97 1 on how much cash was on hand? 2 A. How much cash, what all we had to do at the 3 time, how far we thought we'd go, what our monthly 4 income was on each business. This available cash approach led to coverages driven by a predetermined

premium, not a premium driven by predetermined coverages. In other words, Fidelity

and Citadel tailored the coverages to meet the amount Thomas and Kidd wanted to

contribute to their cash-value policies. The total premiums equaled the total funds they

wanted to transfer offshore; protection against risks was not part of the equation.

Files produced by Fidelity’s insurance consultant, Ashton Tiffany, demonstrate

this upside down process. In one memo, Ashton notes that the requested coverages

produced a premium that is lower than the predetermined budget.159 Instead of accepting

that as a client benefit, the memo suggests adding disability and international travel 158 Trial Tr. 1526:8-16 (emphasis added)). See also Trial. Tr. at 1571:7-12 (John Thomas referring to “what money we had that we felt like we could release without putting us in a bind on operation and drilling.”). 159Gov. Ex. 222 at ASHTON-03376.


48

coverage to increase the premium to meet the client’s budget, i.e., the targeted amount to

be transferred. In another email, someone working for Fidelity asks Ashton to “rework”

a client’s coverage.160 The client had “paid” a $300,000 premium, but Ashton had

calculated only a $254,000 premium. Although Ashton was not familiar with any of the

businesses that purchased BPP policies,161 it was asked to “make suggestions for

coverage, so that the client can meet his 300K premium.”162 Another email similarly

requests a higher premium to meet a prepaid amount. That email explains that Ashton

had calculated a premium of only $60,000, but the client had prepaid a premium of

$100,000.163 The email asks Ashton to “rework this case with suggestions of coverages

where the client can meet his 100K premium.”164

This backward approach was not only contrary to how real insurance was

purchased, but it also resulted in some odd coverages for Thomas and Kidd’s businesses.

Some of the policies include, for example, “International Kidnap/Ransom Indemnity and

Investigation.”165 All of Thomas and Kidd’s businesses is conducted in Texas and New

Mexico. Another policy covers “Key Customer Loss Expense Reimbursement” for

Wasson Solid Waste.166 Wasson’s largest key customer is listed as another Thomas and

160Gov. Ex. 224 at ASHTON-06433. 161Monier Dep. Trans. at 102:18 – 103:5 (explaining that Ashton received no client information other than the applications). 162Gov. Ex. 224 at ASHTON-06433 (emphasis added). 163Gov. Ex. 225 at ASHTON-06532. 164 Id. 165 See, e.g., Gov. Ex. 11 at IRSPROD01_039018. 166 Jnt. Ex. 14.


49

Kidd entity, Five Star Consolidated.167 There is no plausible reason why one Thomas and

Kidd business needed to cover the risk that another Thomas and Kidd business would no

longer purchase its services. Greg Thomas testified about his knowledge of injunctions

imposed by environmental enforcement agencies, but Josh Parker168 testified that

Wasson, a waste disposal business, never purchased BPP injunction coverage.169

Professor David Babbel reviewed the process used to determine BPP coverages,

and he determined that it was the strangest process he had ever seen:170

this is the weirdest--the weirdest underwriting I have ever seen. They pay for the insurance beforehand, before they even know that the coverages are, what the deductibles are, and some guy takes a spreadsheet and tries to figure out, how can I make all these coverages and deductibles and other factors fit so that it exhausts the premium. That's not typically why people buy insurance. They have real risks. They want to cover them. The Thomas and Kidd businesses did face real risks, but those real risks were

covered by real insurance policies. Thomas and Kidd’s accountant, Glenn Henderson

confirmed that he examined the businesses’ insurance in the mid-1990s and ensured that

the proper policies were purchased.171 Charts showing those legitimate insurance policy

premiums for Delta, Del-Tex, and Thomas & Kidd Oil Production are shown at Gov. Ex.

265, 266, and 274. This legitimate insurance covered the businesses’ real risks. Mr.

167 Jnt. Ex. 6 at IRSPROD01_034868. 168 Glen Henderson testified that Josh Parker helped manage the Denver City businesses in 2006, but “Lee Kidd would have still been…primarily involved in running those companies.” Trial Tr. 1312:4-17. 169 Trial Tr. at 1279:21 – 1282:10. Mr. Parker also testified that Five Star waited five years after a fatal accident to purchase criminal defense coverage. 170 Trial Tr. 1724:8 – 24. 171 Trial Tr. 1351:20 – 1353:25 (Henderson review); Trial Tr. 1518:1-22 (example of prior accident covered by legitimate insurance).


50

Kidd, for example, testified about insurance from Travelers Insurance Company that

covered the businesses’ liability from an accident.172 Tellingly, the premiums for

traditional business insurance policies are much lower than the BPP policy premiums.

b) The BPP Policies Did Not Shift Risks

Even if the BPP policies covered real risks, those risks must be transferred to a

third party for the insurance to be real. Self-insurance does not qualify as a deductible

expense under section 162.173 The Fifth Circuit cited risk shifting in Steere Tank Lines,

supra.174 Steere’s insurance arrangement amounted to self-insurance, the Fifth Circuit

held, because the “premium contract account could be used only to pay losses suffered by

Steere or its owner-lessors.” In effect, “Steere’s losses were to be paid only out of a fund

made up of premiums Steere had paid.”175 Just last year, and 34 years after Steere, the

Fifth Circuit promptly disposed of another attempt to manipulate Section 162 to deduct

supposed insurance premiums as an ordinary and necessary business expense. Finding

that no risk had been shifted, the Fifth Circuit affirmed denial of the deduction.176

All of the potential losses of the Thomas and Kidd businesses, like those in

Steere, were covered by Messrs. Thomas and Kidd’s own funds. Through the

reinsurance agreement and subscription agreements, all risk of loss was transferred to the

172 Trial Tr. 1518:1-22. 173Clougherty Packing Co. v. Comm’r, 811 F.2d 1297, 1300 (9th Cir. 1987); Beech Aircraft Corp. v. United States, 797 F.2d 920, 922 (10th Cir. 1986) (“funds set aside as reserves against contingent losses, as a plan of ‘self-insurance,’…are therefore not deductible as an ordinary business expense.”); Steere Tank Lines, Inc. v. United States, 577 F.2d 279, 280 (5th Cir. 1978). 174Steere Tank Lines, 577 F.2d at 280. 175 Id. 176 F.W. Services, Inc. v. Comm’r, 459 Fed. Appx. 389 (5th Cir. 2012).


51

segregated accounts, which were in turn owned or controlled by them or their children.

Even if the BPP policies covered real risks, the following evidence shows that those risks

were self-insured:

Dubinsky Description Payment Flow (Gov. Ex. 630, Trial Tr. 1789:14 – 1842:8 – The testimony and expert report of Bruce Dubinsky describes the flow of BPP payments from the Thomas & Kidd businesses to the Thomas & Kidd cash-value life policies. Mr. Dubinsky concluded that the BPP transaction was “a series of pre-planned and integrated steps of a single transaction designed to produce a tax deduction on the front-end while allowing for tax free access to the same monies at the back end.” Gov. Ex. 630 at DOJ-000124.

Reinsurance Agreements (Jnt. Ex. 17-18) – The definition of “consideration” in the reinsurance agreements executed by the Fidelity, Citadel, and Yield Enhancement shows that Fidelity and Citadel were guaranteed to receive 15 percent and 17 percent of the premiums.

BPP Cancelation Provision (Jnt. Ex. 10-16) – Every policy contained a cancellation clause on page 2 that allowed Fidelity or Citadel to “cancel” the policy for a “Loss of the reinsurance applicable to the risk insured against resulting from termination of treaty or facultative reinsurance initiated by our reinsurer or reinsures.” (E.g., Jnt. Ex. 10 at IRSPROD01_038805, ¶ 4(f)). Professor Babbel discussed this provision during his testimony. Trial Tr. at 1720:17 – 1721:2.

McNamee Email (Gov. Ex. 166) – The president of Fidelity Insurance Company, David M. McNamee, stated in an email that BPP policyholders were “self-insuring, in effect.”177

Babbel Opinion (Gov. Ex. 631; Trial. Tr. 1701:16 – 1721:1) – In his report and during his testimony insurance expert Professor David Babbel described the many factors leading to his conclusion that the BPP transactions “resulted in no transfer of business risk from the Thomas & Kidd business entities to Citadel or Fidelity.” Gov. Ex. 631 at DOJ-000013. These factors included:

o the language in the guarantee agreements;

o an “extraordinarily low” loss history;

o no documented relationship between the risks covered and the premiums charged; and

177 In an article written by Duane Crithfield, he appears to assert that Fidelity’s business protection policies “essentially” provide self-insurance. Trial Tr. 625:8 – 629:22.


52

o evidence showing a link between the premiums paid and the life policy

segregated accounts.

i. The Guarantee Agreements Ensured that Fidelity and Citadel Retained No Risk of Loss

The plain language of the reinsurance agreements shows that Fidelity and Citadel

retained no risk of loss. Fidelity’s reinsurance agreement, for example, provided that

Yield Enhancement would assume responsibility for 85% of BPP policy coverage. In

return, Yield Enhancement would receive 85% of all BPP premiums “less any Claim

Amount paid by FID.”178 “Claim amount” is explicitly defined in the agreement as “all

amounts paid by FIC on claims made under the policy.”179 Professor Babbel explained

in his report that these provisions meant that any claims paid by Fidelity would be

subtracted from the consideration paid to Yield Enhancement.180 In other words, the

reinsurance agreement gave Fidelity the right to use all of the insurance premiums to pay

its share of claims. Fidelity never had to use its own funds to pay claims. During trial,

Professor Babbel even offered to prove mathematically for plaintiffs’ counsel that the

definition of consideration under the guarantee agreement ensured that no risk was

transferred to Fidelity or Citadel.181 Plaintiffs’ counsel did not accept Professor Babbel’s

offer, but a calculation of consideration paid for reinsuring Delta Oil & Gas’s business

178Jnt. Ex. 18 at IRSPROD01_038709). 179 Id. (emphasis added). 180 Gov. Ex. 631 at DOJ-000084; see also Trial Tr. at 1759:9 – 1760:8 (Professor Babbel offering to prove mathematically that no risk is transferred to Fidelity or Citadel). 181 Trial Tr. at 1759:9 – 1760:8.


53

protection policy makes Professor Babbel’s point. The following calculations assume

that maximum claims are paid on Delta’s BPP:182

As shown by the above calculation, Fidelity received its 15 percent fee even when

maximum claims are paid. Citadel’s agreement’s with Yield Enhancement was identical

except 15 percent is replaced with 17 percent. A calculation of consideration paid for

reinsuring Thomas & Kidd Oil Production’s BPP shows the same result:

In addition, the business protection policies gave Fidelity and Citadel the right to

cancel the BPP coverage if Yield Enhancement failed. Every policy contained a

cancellation clause that allowed Fidelity or Citadel to “cancel” the policy for a “Loss of

the reinsurance applicable to the risk insured against resulting from termination of treaty

182 See Jnt. Ex. 12 at IRSPROD01_038729 for policy assumptions and Jnt. Ex. 18 for Guarantee Agreement assumptions.

Total Claims Retained

Fidelity Portion of Claims 300,000$ multiplied by 15% equals 45,000$


YEC Portion of Claims 300,000$ multiplied by 85% equals 255,000$

85% of Prem Fidelity Pmt

Consideration to YEC 85,000$ minus 45,000$ equals 40,000$

Premiums Fidelity Pmt Pmt to YEC 15%

Profit to Fidelity 100,000$ minus 45,000$ minus 40,000$ equals 15,000$


Citadel Portion of Claims 5,000,000$ multiplied by 17% equals 850,000$


YEC Portion of Claims 5,000,000$ multiplied by 83% equals 4,150,000$

83% of Prem Citadel Pmt

Consideration to YEC 1,079,000$ minus 850,000$ equals 229,000$

Premiums Citadel Pmt Pmt to YEC 17%

Profit to Citadel 1,300,000$ minus 850,000$ minus 229,000$ equals 221,000$


54

or facultative reinsurance initiated by our reinsurer or reinsures.”183 The plaintiffs’

insurance expert, Robert Hughes, concluded that his opinion did not depend on the

existence of Yield Enhancement,184 but it is clear that the business protection policies did.

Fidelity and Citadel were not required to honor the business protection policies if Yield

Enhancement failed. Mr. Hughes claimed in his report that the risk “resides with the

primary insurers, Fidelity and Citadel,”185 but the BPP cancellation provision shows that

Fidelity and Citadel had effectively shifted that primary risk to plaintiffs’ segregated

accounts, which reinsured the BPP policies. As Professor Babbel testified, “The insurer

isn't standing behind its own policy. It can cancel it whenever the reinsurer walks

away.”186

In short, the complicated BPP structure boils down to self-insurance. Only

Thomas and Kidd’s BPP premiums and segregated accounts could be used to pay

Thomas and Kidd’s BPP claims. No risk was shifted to Fidelity, Citadel, or any other

third party.

No one knew this better than the president of Fidelity Insurance Company, David

M. McNamee. In response to an actuarial study of the BPP transaction, Mr. McNamee

indicated that the BPP premiums amounts were unimportant because BPP coverage

amounted to self-insurance:187

183 E.g., Jnt. Ex. 10 at IRSPROD01_038805, ¶ 4(f). 184 Pl. Ex. 143 at 14-15. Prior to Yield Enhancement, Fidelity used “Federation Re” for reinsurance. Duane Crithfield testified that Fidelity switched to YEC because of the concern that there was linkage. Trial Trans. at 514:11-20. 185 Pl. Ex. 143 at 15. 186 Trial Tr. at 1720:17 – 1721:2. 187 Gov. Ex. 166.


55

These people are self-insuring, in effect. Why do we want to give them lower rates or rebates? What are we going to do, take money out of their segregated accounts and send it back to the company? lol [laughing out loud]

ii. The Operation and Characteristics of the Business Protection Policies Show that No Risk was Transferred to Fidelity or Citadel

In addition, to the formal guarantee structure, the substantive operation of the BPP

policies shows that no risk was transferred. At trial, Professor Babbel cited three

additional reasons for his conclusion that no risk was transferred to Fidelity or Citadel:

(a) an “extraordinarily low” loss history; (b) no documented relationship between the

risks covered and the premiums charged; and (c) a link between the premiums paid and

the life policy segregated accounts.188

On the loss history, Professor Babbel explained that the BPP coverages were

extraordinarily broad and laden with moral hazard, morale hazard, and adverse

selection.189 Those attributes are detailed in Professor Babbel’s report and testimony.190

In short, those attributes attract risky policy holders and encourage policyholders to make

claims. Thus, Professor Babbel expected to see a high number of BPP claims.191 He did

not. For the coverage period of December of 2001 through December of 2007, Professor

Babbel found evidence of only three claims for all of the BPP policies issued by Fidelity

and Citadel. Other witnesses testified that there may have been as many as five total

claims for all BPP policies – for the entire six-year period (2001-2006) they were sold by

188 Trial Tr. at 1701:16 – 1702:12; see also Gov. Ex. 631 at DOJ-000013-14 (Babbel report). 189 Trial Tr. at 1702:21 – 1706:22. 190 Gov. Ex. 631 (Babbel Rpt.); Trial Tr. at 1703:6 – 1704:7. 191 Trial Tr. at 1702:21 – 1703:5.


56

Fidelity and Citadel.192 No evidence of those other claims has been produced. The three

claims that the plaintiffs have produced evidence of are shown on the following timeline:

Although one or more of the Thomas & Kidd entities purchased BPP policies

every year from 2001-2006, and they paid over $11,746,054 in BPP premiums,193 the

Thomas & Kidd entities made only three BPP claims totaling $128,057. Thomas & Kidd

Oil Production made the first claim in December of 2005 for $10,789 of IRS audit

expenses.194 Thomas & Kidd made two more claims for IRS audit expenses in June of

2007 for $37,700 and February of 2008 for $79,568.195 The timing and substance of

192 Trial Tr. at 430:16 – 431:4 (Crithfield). 193 See Gov. Ex. 77 at IRSPROD01_008273 (prior years BPP premiums); Trial Tr. at 177:23 – 178:12 (Lustig testimony on prior-year’s BPP premiums); Gov. Ex. 10-16 (2006 BPP Policies). 194 Pl. Ex. 38. 195 Pl. Ex. 88C (June 2007); 89C (Feb. 2008).


57

these last claims led Professor Babbel to question their authenticity.196 First, both claims

were made after a grand jury subpoena was issued to the Alliance Group and its affiliates

in connection with an investigation of the BPP policies.197 Glenn Henderson notified

John Thomas and Lee Kidd of that investigation in May of 2007.198 Because the last two

claims came after the grand jury subpoena, Professor Babbel questioned whether the

claims were manufactured to make the BPP policies look authentic.199 The last claim

raised more suspicions. The BPP policies are “claims made” policies.200 In other words,

claims may only be made during the coverage period.201 Claims made after the coverage

period are invalid. The coverage period for Thomas & Kidd Oil Production ended on

December 31, 2007202—almost two months before the third claim was made.

Nevertheless, the third claim was approved on the tenuous ground that it was

“supplemental” to the 2007 claim.

The substance of the last two claims further affirms Professor Babbel’s

suspicions. Both claims were made under the “audit” expense coverage. That coverage

triggers only when a government agency examines or verifies the covered company’s

“tax return.” Glenn Henderson testified, however, that Thomas & Kidd Oil Production’s

tax returns were not examined during the BPP coverage period of December 2006

196 Trial Tr. at 1707:18 – 1708:19. 197 Gov. Ex. 438, 430 (grand jury letters); Trial Tr. at 1472:24 – 1475:17 (Henderson testimony about grand jury letters). Theodore Lustig had also read articles that questioned the legality of transactions similar to BPP. Gov. Ex. 260, 377. 198 Gov. Ex. 438, 440; Trial Tr. 1472:25 – 1474:22. 199 Trial Tr. 1707:18-22. 200 Trial Tr. 1707:23 – 1708:19; Jnt. Ex. 11 at IRSPROD01_039014. 201 Id. 202 Jnt. Ex. 11 at IRSPROD01_039016.


58

through December 2007.203 Thus, the last two claims do not qualify for coverage.

Nevertheless, Citadel granted them. The approval of these two claims which were

beyond the coverage provided by the tax audit policy was a transparent attempt to “paper

the file” once the IRS had served its search warrant.

iii. The BPP Transactions Do Not Constitute Captive Insurance

To escape the obvious self-insurance present in this case, plaintiffs may assert that

they shifted risk to a “captive insurance company.” In a captive arrangement, the

taxpayer owns the insuring entity. Captive insurance can be legitimate, but the captive

company must operate as a legitimate insurance company. In other words, it must insure

real risk, shift real risk, and distribute real risk.204 For example, risk must be

underwritten, premiums must be negotiated at arm’s length, the captive must possess

adequate capital to cover risk, and some percentage of the captive’s customers must be

unrelated to the captive’s owner. In other words, a captive insurance company must

operate as a legitimate insurance company. Professor Babbel testified that captive

insurance companies “look like regular insurance companies in a lot of ways.”205

In this case, the captive argument fails before it starts. Plaintiffs do not even

allege that they owned an insurance company. To the contrary, they assert that they

shifted risk to Fidelity and Citadel—two companies in which they had no ownership

interest. Further, the above analysis explains that risks faced by the Thomas & Kidd

businesses were not underwritten, and the BPP premiums were based on available cash

203 Trial Tr. at 1474:23 – 1475:17. 204 E.g., Gulf Oil Corp. v. Comm’r, 914 F.2d 396, 411-412 (3d Cir. 1990); Harper Group and Includible Subs. v. Comm’r, 96 T.C. 45, 58 (1991). 205 Trial Tr. 1721:12-24.


59

budgets instead of a customary arm’s length negotiation to determine a premium related

to a real risk. Professor Babbel also noted that the loss experience of the BPP policies

indicates that the BPP policies do not operate like a legitimate captive insurance

arrangement.206

c) The BPP Policies Did Not Distribute Risks

Even if risk had been shifted, plaintiffs must show also that risk was distributed

among a group of separate parties. As the Ninth Circuit explained in Clougherty Packing

Co. v. Commissioner, “[d]istributing risk allows the insurer to reduce the possibility that a

single costly claim will exceed the amount taken in as a premium and set aside for the

payment of such a claim.”207 No such distribution occurred in this case. To the extent

risk existed, it started with Thomas and Kidd and ended with Thomas and Kidd.

In an attempt to satisfy this requirement, plaintiffs look to the subscription

agreements with Yield Enhancement Company. Risk was distributed, plaintiffs argue,

through the subscription agreements that the segregated accounts executed with Yield

Enhancement. The following evidence—or lack of evidence—exposes this story as

another deception:

No Limited Partnership Agreement – Despite the reference to Yield Enhancement’s partnership agreement in the subscription agreements,208 that partnership agreement has never been produced. No witness has ever even seen a copy of that agreement.

No Supporting Accounting or Other Financial Records – No records showing the capital accounts of partners in Yield Enhancement or any apportionment of Yield Enhancement earnings has ever been produced. No witness has ever seen these records.

206 Trial Tr. at 1721:3 – 1723:7. 207 Clougherty Packing Co. v. Comm’r, 811 F.2d 1297, 1300 (9th Cir. 1987). 208 E.g., Jnt. Ex. 29 at IRSPROD01_000811.


60

Dubinsky Testimony on Yield Enhancement (Trial Tr. 1807:1 – 1835:8) – Expert

Bruce Dubinsky testified about his attempt to locate evidence supporting the existence and operation of Yield Enhancement. The only evidence he found indicated that Yield Enhancement, if it existed, was an empty shell used to funnel BPP payments into cash value life policies.

YEC Bank Records (Pl. Ex. 122, 123, 127-129) – The incredibly sparse bank

records produced by Duane Crithfield support Bruce Dubinsky’s conclusion that Yield Enhancement operated like an empty shell instead of a pool. These records show payments transferring into to an account for Yield Enhancement and immediately being transferred back out.

Cash Notices (Jnt. Ex. 35-41) – Fidelity and Citadel issued cash notices that purport to show earnings from Yield Enhancement. Although only five segregated accounts “invested” in Yield Enhancement, seven cash notices were issued—one for each Thomas & Kidd business that purchased BPP in 2006. More importantly, each amount shown in the cash notice equals 85 or 87 percent of the BPP premiums plus about 2.5 percent interest. See demonstrative below.

Flaherty Email (Gov. Ex. 498) – An email from Jason Flaherty concludes that risks were not distributed through Yield Enhancement. Instead, the BPP risks of a particular “investor” were informally linked to the cash-value policies owned by that investor.

Other than the reinsurance and subscription agreements, the plaintiffs have

produced no evidence supporting the existence of Yield Enhancement. In our opening

statement, we described YEC as an HOAX, and the evidence has proved that point. They

have produced no formation documents and have identified no executives. In addition,

they have produced no accounting documents or other records showing how and when

funds were pooled. The subscription agreements reference a limited partnership

agreement that governs the distribution of profits,209 but plaintiffs have not produced that

agreement. In addition, no witness at trial could ever remember seeing the partnership

agreement or any other accounting documents related to Yield Enhancement. Theodore

209 E.g., Jnt. Ex. 29 at IRSPROD01_000811.


61

Lustig and Glenn Henderson testified that they had never seen the partnership agreement

or any accounting of Yield Enhancement’s capital accounts.210

Plaintiffs have the burden of proving that the words in the subscription actually

carried into reality. Without the partnership agreement and other accounting records,

they cannot meet their burden. The partnership agreement is crucial because the

subscription agreement states that the partnership agreement governs the crediting of

gains and the debiting of losses from the alleged reinsurance of BPP policies: “gains or

income shall be credited and losses, expenses and distributions shall be debited, all in

accordance with the terms of the Fund’s limited partnership agreement.”211 Without the

agreement, the plaintiffs cannot describe how BPP premiums were pooled and

distributed.

Accounting records for Yield Enhancement’s capital accounts are equally

important. All of the subscription agreements list initial capital contributions equal to

zero.212 Thus, the agreements do not show each segregated account’s interest in the

Yield Enhancement partnership. Without that information, it is impossible to know how

a pool of funds would have been distributed to the segregated accounts. The plaintiffs

claim that Yield Enhancement profits were distributed on a pro rata basis, but they have

produced no evidence showing how a pro rata calculation could have been made. It is a

mathematical impossibility to determine each limited partner’s pro rata share in whatever

distributions Yield Enhancement was purportedly going to make without knowing the

contribution each limited partner made, i.e., each partner’s individual contribution must

210 Trial Tr. at 181:1 – 182:11 (Lustig); 1445:17 – 1448:12 (Henderson). 211 Jnt. Ex. 29 at IRSPROD01_000811. 212 E.g., Jnt. Ex. 29 at IRSPROD01_000815.


62

be added up to determine a total of all of the contributions which becomes the

denominator and the individual contribution will become that partner’s numerator. These

figures undoubtedly never existed, but, in any case, they were never produced in this trial.

An email from Jenkins & Gilchrist lawyer Jason Flaherty indicates that, even if

the Yield Enhancement partnership agreement existed, the agreement did not control

distributions of BPP premiums. Mr. Flaherty prepared one of the legal opinions relied

upon by the plaintiffs for a prior tax year’s BPP. As part of his role, he had access to

many BPP documents and executives. Based on those documents and discussions, he

determined that there was informal, but unmistakable, linkage between a client’s

segregated accounts and that client’s BPP policies:213

If a claim is made on a BPP, then all of the investors in the guaranty fund don’t pay. Instead, only the investor that is related to the insurance under the BPP pays. If that is the case, then it is much harder to conclude that there is risk distribution.

In other words, the segregated accounts attached to the Thomas and Kidd life

insurance policies were not pooled with other clients’ segregated accounts. The Thomas

and Kidd accounts could be used only to pay BPP claims from the Thomas and Kidd BPP

policies. No risks were distributed.

The actual flow of BPP payments confirms Mr. Flaherty’s conclusions. Fidelity

and Citadel issued cash notices that purport to show earnings from Yield

Enhancement.214 Although only five segregated accounts “invested” in Yield

Enhancement, seven cash notices were issued—one for each Thomas & Kidd business.

213 Gov. Ex. 498; Flaherty Dep Trans. at 25:3-18. 214 Jnt. Ex. 35-41.


63

The notices listed the “Insured” as John Thomas and Lee Kidd,” and the “Account

Owner” as each of the businesses:215

More importantly, each amount shown in the cash notice equals 85 or 87 percent

of the BPP premiums plus about 2.5 percent interest:216

215 E.g., Jnt. Ex. 35. Duane Crithfield testified that the “Account Owner” label was caused by a software error. The error, he testified, related to earlier BPP policies that linked the business policies with particular cash value life policies. Trial Tr. 427:21 – 429:8. He claimed that linkage no longer occurred in 2006, but his testimony conflicts with the evidence. As discussed at length in this section, the evidence shows that the YEC distribution pool was a hoax. Further, Mr. Crithfield could not explain why the alleged error remained two years after YEC emerged. Trial Tr. 584:17 – 596:6. 216 Jnt. Ex. 10-16 (BPP Premiums); 35-41 (Cash Notices).

BPP Premium Net Premium Cash Notice Difference

T&K Oil Prod 1,300,000$ minus 17% 1,079,000$ 1,105,943.49$ 2.50%

Delta Oil 100,000$ minus 15% 85,000$ 86,921.72$ 2.26%

Del‐Tex 800,000$ minus 15% 680,000$ 697,168.59$ 2.52%

K&T Farm 100,000$ minus 15% 85,000$ 86,904.06$ 2.24%

Five Star 1,400,000$ minus 17% 1,162,000$ 1,191,035.78$ 2.50%

Wasson 400,000$ minus 15% 340,000$ 348,456.09$ 2.49%

Salty Brine 400,000$ minus 15% 340,000$ 348,456.09$ 2.49%

Total 4,500,000$ 3,771,000$ 3,864,885.82$ 2.49%


64

The above numbers show that the BPP payments were never pooled. If a pool existed,

one would expect to see each of the net BPP premiums deposited into a pool with net

premiums from other BPP policies. That pool would then be divided up among all of

Yield Enhancement’s partners—the subscribing segregated account LLCs—in

accordance with the proportion of each partner’s capital account to total capital.

Thus, one would expect to see over fifty cash notices dividing up the total net

BPP premiums and making a pro rata allocation to each of the segregated accounts, five

of which would gone to the Thomas and Kidd related segregated accounts. Instead,

Fidelity and Citadel issued one cash notice for each BPP policy. Those cash notices did

not divide the net premiums for each Thomas & Kidd business among over fifty

segregated accounts, or even between their own five segregated accounts. Although the

cash notices referenced several Thomas and Kidd segregated accounts, they never made

an allocation to any of them. Instead, it remained for Messrs. Thomas and Kidd, acting in

concert with the advisors, to make those allocations subsequently in the letter of wishes

dated December 20, 2007217

When given an opportunity to explain the above numbers, none of the plaintiffs’

witnesses could.218 No witness could explain why seven cash notices were issued for

each business instead of five cash notices for each segregated account. No witness could

explain why net BPP premiums for Thomas & Kidd business were issued only to the

segregated accounts for Thomas & Kidd life policies. Glenn Henderson, in particular,

could not explain why, almost five months before the BPP coverage periods ended, he

217 Jnt. Ex. 19. 218 E.g., Trial Tr. at 582:19 – 595:16 (Crithfield); 1452:4 – 1456:5 (Henderson).


65

was able to predict the final Yield Enhancement distribution amounts without ever having

seen Yield Enhancement’s partnership agreement, capital accounts, or any other

accounting records.219 The plaintiffs allege that the BPP premiums were deposited into a

pool with premiums from other BPP policies, but they can produce no evidence

supporting that pool’s existence. They can only produce empty agreements and vague

testimony that is thoroughly contradicted by the facts proved at trial.

One way plaintiffs attempted to shore-up the absence of the numerous documents

needed to sustain their burden of proof was through calling Duane Crithfield as their

witness. Plaintiffs refer Mr. Crithfield to as the “forefather” of the offshore insurance

operations and the person in charge of all of their operations.220 On this point, we agree

with plaintiffs. Mr. Crithfield sat at the apex of Alliance Holdings and all of its related

entities – both offshore and onshore, including Fidelity Insurance Company, Citadel

Insurance Company, and Offshore Trust Services, Inc.

That said, the cross-examination of Mr. Crithfield established that he was not a

credible witness. Not only did he testify untruthfully about the reasons for his dismissal

from Fortune Savings Bank,221 but he was revealed as having falsely portrayed himself as

having a Masters of Business Administration, or MBA, over an extended period of time

as part of the marketing campaign for his BPP products.222 In between, he made in

numerous conflicting and implausible statements as he attempted to explain his way out

of one contradiction after another. During our opening statement, we advised the Court

219 Gov. Ex. 435. 220 Trial Tr. 1598:6-13; Plaintiffs’ Motion in Limine and Incorporated Brief to Exclude Deposition Designations of David McNamee and Kasey Klem, Dkt. No. 122, at p. 3. 221 Trial Tr. 472:16-477:5. 222 Trial Tr. 632:21-638:3.


66

that deception would be a central theme of this trial and that the evidence would establish

a pervasive attempt to make things appear to be something other than what they truly

were. Duane Crithfield personifies that deception.

Therefore, it is highly significant that Mr. Crithfield was the only witness called

to substantiate the reality of YEC and the validity of its operations. He did neither. We

have already explained that the documents to show a limited partnership named Yield

Enhancement Company really did exist and how it could make pro rata distributions to its

limited partners were not produced. We have also reviewed the only monthly bank

statements for YEC that were produced – a total of four – and explained how their sparse

entries not only do fail to reflect pro rata distributions to YEC’s limited partners, but that

they actually contradict such a story. In this regard, recall the testimony of Mr. Dubinsky

exposing the flaws in this story.223

For the sake of completeness, we should also examine the audited financial

statements Mr. Crithfield produced as part of his effort to establish the legitimacy of his

operations. During his direct testimony, he stated that audited financial statements were

required by regulatory authorities and that his companies complied with these

requirements. However, during his cross-examination, he was unable to explain the

many lengthy delays in submitting those audited financial statements or the

contradictions between one after another of them.224 Mr. Dubinsky reviewed the same

financial statements and found numerous inconsistencies and red flags in them.225

223 Trial Tr. 1879:17-1883:13. 224 Trial Tr. 607:16-621:23. 225 Trial Tr. 1883:14-1893:16.


67

d) The BPP Policies Were Not Ordinary

Finally, there was nothing ordinary about the BPP payments at issue in this case.

The Fifth Circuit explained in Tulia Feedlot, Inc. v. United States, that, to qualify as a

Section 162 deduction, payments “must be ordinary, not in the sense that they are

habitually or normally made by a single taxpayer, but in the sense that they are of a

known type and commonly made, in some circumstances, by persons in the type of

business carried on by the taxpayer.”226 The BPP program in this case was neither known

nor common in any business, let alone the oil and gas business.

The insurance consulting firm that initially advised Fidelity immediately

recognized that BPP was unknown and uncommon. Fidelity asked Ashton to sign a letter

stating that the method it used to calculate the BPP premiums was comparable to methods

used by other insurance companies, but Ashton stated that it could not sign a letter with

that statement. Ashton could not compare its method for calculating BPP premiums with

other insurance companies because it knew of no other insurance company that offered a

policy similar to BPP:227

Not many, if any, insurance companies offer this type of policy and coverages. It is very unique. For us to speculate on how another insurance company would develop an underwriting model for this policy is not something we can do. If we were to make this statement and then were asked to name which insurance companies would use a method similar to ours, we could not do it.

Professor Babbel likewise concluded that the BPP policies were “neither common

nor customary in the business insurance industry.”228 As part of his analysis on this point,

226 Tulia Feedlot, Inc. v. United States, 513 F.2d 800, 804 (5th Cir. Tex. 1975). 227Gov. Ex. 204. 228 Gov. Ex. 631 at DOJ-000013; Trial Tr. at 1691:5-9.


68

he compared the BPP premiums to the other expenses of the Thomas & Kidd businesses.

The ratios he found were higher than any he had ever seen:229

T&K Oil Production (COGS) Salty Brine (COGS)

BPP Premium $ 1,300,000 BPP Premium $ 400,000

Cost of Labor $ 150,000 Utilities $ 96,871

Insurance (Not BPP) $ 35,829 Intangible Drilling Costs $ 232,269

Production Taxes $ 875,409 Labor $ 77,086

Depreciation from O&G $ 352,432 Contract Labor $ 40,103

Lease Expenses $ 42,416 Repairs & Maintenance $ 45,322

Legal & Professional Fees $ 317,326

Operating from O&G $ 4,525,766

Delta and Del‐Tex (Consolidated) K&T Farm (Farm Expenses)

BPP Premium $ 900,000 BPP Premium $ 100,000

Insurance (Not BPP) $ 85,467 Fertilizer $ 1,055

Lease Operating $ 855,799 Seed and Plants $ 6,995

Statutory Depletion $ 422,456 Feed $ 2,965

Intangible Drilling $ 321,317 Depreciation $ 4,936

Production Taxes $ 185,220 Supplies $ 7,772

Management Fees $ 1,200,000 Utilities $ 2,432

Salaries and Wages $ 903,557 Taxes $ 16,951

Five Star Consolidated (COGS) Wasson Solid Waste Disposal (COGS)

BPP Premium $ 1,400,000 BPP Premium $ 400,000

Cost of Labor $ 7,454,513 Contract Labor $ 346,427

Purchases $ 2,061,148 Management Fees $ 196,000

Insurance (Not BPP) $ 568,467 Operating from O&G $ 458,910

Workers Comp $ 478,229 Other from O&G $ 121,493

Safety Expenses $ 115,107

Repairs and Maint ‐ Trucks $ 712,787

Repairs and Maint ‐ Equip $ 376,107

Payroll Taxes $ 713,165

Vehicle Registration $ 117,531

Freight Charges $ 378,877

Water Disposal‐Landfill $ 2,059,626

229 Trial Tr. at 1698:10 – 1701:15.


69

Fuel and Oil Charges $ 1,640,776

Professor Babbel questioned how a business with such high insurance expenses could

compete:230

In fact, they're so high, I don't know how you could compete. If other companies aren't buying these policies and if this is legitimate insurance, these companies are incurring somewhere between 5 1/2 and 36 percent extra costs for their--relative to their revenues. How are they going to compete?

B. Income from the Transferred Royalty Interests Should be Assigned to Thomas & Kidd Oil Production

After five years of transferring substantial funds offshore through their BPP tax

shelter, Messrs. Thomas and Kidd decided to raise the stakes in 2006. Not only did they

increase the amount of funds transferred for BPP from $3 million in 2005 to $4.5 million

in 2006, but they also embarked upon a new tax shelter arrangement to transfer

substantial additional sums offshore for 2006 and each succeeding year. This second tax

shelter involved a purported assignment of 17 overriding royalty interests from Thomas

& Kidd Oil Production, Ltd, one of the plaintiffs in these consolidated cases, in exchange

for private annuities that were ostensibly paid from two of the five segregated accounts

controlled by Messrs. Thomas and Kidd – CDA 150502 and CDA 150503.

The annuity agreements permitted the entire amount of the overriding royalties

transferred offshore to accumulate without paying any taxes for three years. Jnt. Exs. 54

& 55. Although plaintiffs never produced bank records reflecting the money coming into

and going out of the relevant bank accounts, one of our expert witnesses, Bruce

Dubinsky, the forensic account, was able to take the two known amounts transferred –

230 Trial Tr. at 1701:2-15.


70

$856,003.62 for 2006 and $947,587.65 for 2007 – and conservatively project (assuming

just $900,000 was transferred in 2008) that a total of $2,700,000 was transferred offshore

for those three years. Trial Tr. 1867:9-1872:2 Of course, that $2.7 million figure was for

each of the two interests in the overriding royalties created by Messrs. Thomas and Kidd;

so, a total of $5.4 million of income from Thomas & Kidd Oil Production. Ltd. was

NEVER TAXED.

Recall that Mr. Dubinsky was able to link this untaxed money to the projections

made for the plaintiffs by Mr. Henderson at their annual meeting in Dallas in December

2006 where he forecast a “tax savings” of $2 million for 2007 resulting from the royalty

transfer. Gov’t Ex. 77, Trial Tr. 1867:20-1869:5. Whatever may said of Mr. Henderson,

his number crunching was remarkably accurate; he predicted that $2 million would

escape taxation and the accrual figure for 2007 was $1.9 million. When plaintiffs tell the

Court that this was a taxable transaction, the truth of the matter relates to the taxes they

began paying in 2009 when the distributions to the annuitants – JTOM II (John Thomas )

and Kiddel II (Lee Kidd) (Gov’t Ex. 442) -- began to be made. However, as Mr.

Dubinsky pointed out, the private annuity agreements provide that only about half of the

$178,579 paid to John Thomas and the $192,810 paid to Lee Kidd three years later

would actually be taxed as ordinary income while the balance would be taxed at more

favorable capital gains rates or not taxed at all. Trial Tr. 1869:23-1871:10. Accordingly,

only a small fraction of the vast sums transferred offshore was ever taxed, and even then

only after a three-year deferral while no taxes were paid.

The assignment of income doctrine applies to income from property which the

taxpayer unsuccessfully attempts to transfer to a different taxpayer, or at least a


71

theoretically different taxpayer.231 The assignment of income doctrine exists to prevent a

taxpayer from avoiding tax on income it earned by transferring the right to receive such

income to another taxpayer—typically a taxpayer that would pay less or even no tax on

the assigned income.232 If the transfer is a bona fide transfer of property, without

retention of control by the transferor, the assignment of income doctrine does not

apply.233 But if the transfer is unsuccessful or invalid, the income would continue to be

included in the transferor’s, not the purported transferee's, gross income.

1. Plaintiffs Retained Beneficial Ownership of the Royalty Interests. To determine the true owner of income-producing property, it is necessary to

identify the person with “beneficial ownership rather than mere legal title”,234 which is

the person with the ability to command the property or enjoy its economic benefits.235

Transactions structured as purported sales but which do not shift ownership rights and

ones in which the transferor retains substantial dominion and control are not treated as

valid transfers.236 When all of the entities involved are directly or indirectly controlled

231 See Moore v. Thomas, 145 F.2d 813 (5th Cir. 1944), aff'g 44-1 USTC Para. 9274 (N.D. Tex. 1944). 232 See Lucas v. Earl, 281 U.S. 111, 115 (1930)(holding that “tax could not be escaped by anticipatory arrangements and contracts however skillfully devised” to prevent income from vesting in the taxpayer who earned it). 233 See R & T Developers, Inc. v. Comr., T.C. Memo 1973-128; Burns v. U.S., 65-1 USTC Para. 9385 (N.D. Tex. 1965). 234 Chu v. Comr., 72 T.C.M. (CCH) 1519, *9 (1996); Serianni v. Comr., 80 T.C. 1090 (1983), aff'd, 765 F.2d 1051 (11th Cir. 1985); Hook v. Comr., 58 T.C. 267 (1972). 235 Chu v. Comr., supra (citing Hang v. Comr., 95 T.C. 74 (1990)). 236 National Lead Co. v. Comr., 336 F.2d 134, 140-141 (2d Cir. 1964), cert. denied, 380 U.S. 908 (1965), aff'g 40 T.C. 282 (1963).


72

by the taxpayers, as they are here, the courts “closely scrutinize all transactions in order

to determine their substance.”237

To be a valid transfer of property, there must be a significant change in the

economic relationship of the taxpayer to the property.238 There is no significant change

in the taxpayer's economic relationship to the property if the “documents purportedly

creating the organizations left the taxpayers in exactly the same relationship to the

properties after the ‘transfers’ that they were in prior to such transfers.”239 The

assignment of income doctrine applies if, despite the taxpayer's purported assignment, the

income nonetheless wends its way to the taxpayer through any number of intermediary

assignees.240 Retention by the taxpayer of risk of loss and full control of the property,

such as discretion over the distribution or investment of the assets, obviates any effective

transfer.241

The evidence presented at trial proves that the royalty transaction is merely a

variation on the BPP scheme designed to transfer assets between related entities in order

to retain control but reap large tax benefits. Specifically, the evidence at trial describing

the transaction between related entities established the following points:

The overriding royalty interests were transferred from only one of the multiple plaintiffs in these consolidated cases, Thomas & Kidd Oil

237 Yeoham Est. v. Comr., T.C. Memo 1986-431, *12, aff'd, 826 F.2d 11 (5th Cir. 1987). 238 See Zmuda v. Comr., 731 F.2d 1417, 1421 (9th Cir. 1984), aff'g 79 T.C. 714 (1982); see also, Ideal Tool and Die Co. v. Comr., T.C. Memo 1960-96. 239 Yeoham Est, T.C. Memo 1986-431 at *13; see also, Chase v. Comr., 59 T.C.M. 261 (1990), aff'd, 926 F.2d 737 (8th Cir. 1991). 240 See Benningfield v. Comr., 81 T.C. 408, 418-419 (1983). 241 Applestein Est. v. Comr., 80 T.C. 331, 346-347, 349-350 (1983).


73

Production, Ltd., to the same cash-value life insurance policies that receive the business protection premiums.242

Mr. Dubinsky noted that the same very precise 31.82 percentage interest in each of the working interests was used to create all of the overriding royalty interests and opined that there appeared to be some “reverse engineering” involved that negated the existence of any valid business purpose for the transaction. Instead, it appeared that the transaction had been designed to “suck out” a predetermined amount of money from the business. Trial Tr. 1861:22-1863:2. In this regard, consider his previously discussed conclusion about how Mr. Henderson was able to forecast in December 2006 that the “tax savings” for 2007 would be $2 million

To accomplish what could have been a straightforward transfer, the

owners of Thomas & Kidd Oil Production, Ltd. (JTOM II and Kiddel II – two LLCs owned by Messrs. Thomas and Kidd, respectively) transferred the overriding royalty interests to Thomas & Kidd Royalty – Nevada, LLC.243 Then, they transferred ownership of their Nevada LLC to Thomas & Kidd Royalty - Nevis, LLC so that it effectively owned the overriding royalties through its ownership of the Nevada LLC.244 Next, they transferred JTOM II’s and Kiddel II’s interests in Thomas & Kidd Royalty - Nevis, LLC to CDA150502 and CDA 150503 in exchange for life annuities.245

CDA150502 exchanged a life annuity on Kidd with Kiddel II for 50% interest in the Nevis LLC, and CDA150503 made the same exchange of a life annuity on Thomas with JTOM II for the remaining 50% interest in the Nevis LLC.246

Of course, CDA150502 and CDA 150503 were owned and controlled by

L&E Kidd, LLC and J. Thomas, LLC through three life insurance

242 Pre-Trial Order (Dkt. #110) at 10 ¶¶1-3, Dkt#110 at 14 ¶35; Supplemental Joint Stipulation (Dkt. #119) at 4 ¶23. 243 Dkt. #110 at 14 ¶¶32-35; Jnt Exs. 351-355, 45-49. Recall that Mr. Dubinsky testified that there was no apparent reason for adding the Nevada LLC to the chain of related entities through which the royalty interests traveled during the complex transaction structured by Glenn Henderson. He also found nothing in the record to substantial the rationalization offered for the Nevada, LLC, i.e., that it was somehow needed to satisfy an offshore banking requirement. Trial Tr. 1860:9-25. 244 Id. 245 Dkt. #119 at 4 ¶¶26-27; Dkt. #119 at 8 ¶¶43, 46, 49; Jnt Exs. 50-51, 53-55. 246 Dkt. #119 at 8 ¶¶ 46, 49.


74

policies also owned and controlled by Thomas and Kidd.247 The use of these life insurance policies as, essentially, a line of credit created a “readily realizable economic value” retained by the plaintiffs and the owners of these entities – Thomas and Kidd. This series of complex transactions is shown above in Part II of the Factual and Procedural Background.

The economic relationship of plaintiffs, and Messrs. Thomas and Kidd, was

identical at the beginning and the end of the transaction. JTOM II and Kiddel II owned

the working interests from which the overriding royalty interests were created. Trial Tr.

1851:18-1851:9. After all of the transfers from Thomas and Kidd Oil Production through

all of the entities, the private annuities were payable to the same entities that owned

Thomas and Kidd Oil Production – JTOM II and Kiddel II. Trial Tr. 1859:3-15. The

transfer merely removes income from one pocket and puts it into another. The economic

benefits of the royalty interests did not change with the alleged assignment, and the

transfer should not be allowed to transfer taxable income away from plaintiffs.

2. Plaintiffs Retained Control over Activities Generating Royalty Income. The assignment of income doctrine applies if the taxpayer continues to exercise

significant control over the activities generating the income and thus precludes the

nominal assignee from exercising the control.248 Even when the assignment constitutes a

property transfer under state law, if the taxpayer retains significant control over the assets

generating those payments, then the income remains with the transferor.249 Greg Scheig,

our expert witness on transactions and insurance needs involving oil and gas companies,

247 Trial Tr. 1863:21-1864:18 248 See C.M. Thibodaux Co., Ltd. v. U.S., 915 F.2d 992, 994-995 (5th Cir. 1990), aff'g 723 F. Supp. 367 (E.D. La. 1989). 249 See C.M. Thibodaux, 915 F.2d at 996.


75

explained that the entity with actual legal title to the overriding royalties was not material

because “control” over them was crucial. Trial Tr. 1678:20-1679:5. In his opinion, the

assorted carve outs and transfers resulted in no “substantive change” because the same

collection of family members and family entities remained in control of the production

and the income from it both before and after the transaction. Trial Tr. 1637:24-1638:14.

As described above, the alleged transaction involved a variety of transfers among entities

owned and controlled by Messrs. Thomas and Kidd ending with cash-value life insurance

policies also under their control. Once the income was in those life policies, they

continued to control how the royalty income was used and invested through the letters of

wishes.

Specifically, the evidence at trial establishing the claims of indirect ownership

resulting in effective control of the income producing asset and the royalty interests

themselves is as follows:

John Thomas admits that the royalty transaction was done for estate planning purposes and that operation of the properties did not change after assignment of the royalty interests.250 An email from Glenn Henderson, the taxpayers’ advisor and accountant, explained that the “income tax and estate tax savings” provided by the royalty transaction “dwarf the cost” of participating in the transaction.251

Glenn Henderson also determined the fair market value for a 50% membership interest in Royalty-Nevis at $1,261,500.00.252 Plaintiffs’ experts have subsequently valued the underlying royalties transferred as January 19, 2006, at $3,062, 477.00, and valued a 50% membership interest in Royalty-Nevis on that same date at $1,001,000.00 – a 26 percent difference.253 Notwithstanding attempts to inject vagueness about “ranges” of values, plaintiff’s experts confirmed these values when they testified at trial.254

250 Trial Tr. 1588:1-24. 251 See Gov. Ex. 442. 252 Dkt. #119 at 9 ¶50; Joint Ex. 603. 253 Dkt. #119 at 9 ¶51. 254 Trial Tr. 231:22 – 233:2, 253:6-23.


76

Mr. Scheig, who has made over 1,000 valuations (Trial Tr. 1619:25-1620:9) and

valued between 25 and 30 overriding royalties (Trial Tr. 1637:21-23) found a discrepancy of this magnitude – 26% – odd. Trial Tr. 1642:16-1643:5.

Mr. Scheig also opined that it was peculiar for an alleged third party granting an annuity in exchange for an interest in oil and gas production, as distinguished from cash or marketable securities, to be willing to accept the valuation of the offeror without some independent analysis. Trial Tr. 1645:1-1646:5. Of course, if the same parties were on all sides of the transaction, as they are here, the interest in independent analysis would not arise.

Although Mr. Scheig was not asked to value the overriding royalty interests in this case, he did opine that it appeared to him that the even the divergent values determined by the taxpayers’ accountant Mr. Henderson and their trial experts were both low. Trial Tr. 1642:3-22. When Mr. Dubinsky added his perspective as a forensic accountant to Mr. Scheig’s opinion as an oil and gas expert, the motivation for a low value became clear. The low value for the property exchanged for the annuities permitted more money to be transferred offshore and accumulate without the necessity of a distribution that would have been at least partially taxable. A higher value would have meant a higher annuity payment would have been required. Trial Tr. 1874:2-23.

Ms. Giordani used the Henderson appraisal as part of her evaluation of the transaction.255 (Because her work was done at the same time as plaintiffs’ other experts, she would have been unaware that two of them, Messrs. Harris and Phalon, determined a substantially different value from Mr. Henderson.) Although she unequivocally testified in her deposition that if the transaction was not arm’s-length then “it would cease to be a private annuity as I’ve defined it in this report, yes,” she equivocated about the definition of arm’s-length when asked the same question at trial.256 The Court will have to make its own evaluation on the reluctance of an experienced estate planning attorney to use a common term like “arm’s length” and her remarkable attempt to recant her unequivocal testimony on that subject given in her deposition.

Ms. Giordani claimed, on re-direct, that her confusion was caused by the fact that her definition of arm’s-length at trial is any private annuity transaction with parties – related or unrelated.257 Plaintiff’s counsel did, however, ask Ms. Giordani on re-direct whether, if the valuation of the annuity were “too low” or

255 Trial Tr. 716:17-24. 256 Trial Tr. 717:4 – 718:4. 257 Trial Tr. 731:24 – 732:5, 732:15-17, 732:21- 733:20.


77

“too high,” it would still be an annuity - indicating that plaintiffs recognized a value component to the definition of arm’s length even if their expert did not.258

Ms. Giordani’s report and her testimony at trial claim that the “structure” involved in this case meets and met many traditional non-income tax goals of high net worth families.259 The vagueness of this generalization is revealed by her other testimony that, in her practice, she only recommends estate planning techniques only after understanding the particular circumstances of specific clients.260 In this case, however, Ms. Giordani never met Thomas or Kidd, never did any work for any of their entities, and was never even provided with a description of what the estate planning goals were.261

Ms. Giordani testified that estate planning can affect income taxes, but admits that her opinions do not address any tax impact associated with the structure she evaluated.262 Of course, the issue in this case concerns the income taxes that were not paid by virtue of the royalty transfer.

After flatly changing her testimony about the necessity of an arm’s length relationship for a valid private annuity at trial, Ms. Giordani was clear that her trial opinion (as distinguished from her deposition opinion) was based on the necessity of an investment manager having “independence, nonrelation to the policy owner, and operating under a discretionary investment mandate.”263 Ms. Giordani did not, however, review any letters of wishes for her opinion and only rebutted the opinion of the United States’ expert.264 Crucially, Ms. Giordani was NEVER asked about the identity of the investment manager in this case whose “independence, nonrelation to the policy owner, and discretionary mandate” would be necessary to create a valid annuity.

Subsequently, the identity of this investment manager for the segregated accounts related to the royalty transaction was revealed. The Court will recall that after a series of evasive answers, in which he refused to identify himself as the investment manager, Glenn Henderson finally admitted that,he had executed the documents through which his entity, IBS, LLC, acted as the investment manager.265 Glenn Henderson was also signing the letters of wishes on behalf of

258 Trial Tr.732:6-14. 259 Pl. Ex. 117. 260 Trial Tr.710:5-21. 261 Trial Tr.710:22 – 711:6. 262 Trial Tr. 713:5-17. 263 Trial Tr.729:5-22. 264 Trial Tr.726:8-18. 265 TR 1429:9 – 1432:24; Gov. Exs. 801, 802.


78

segregated accounts, adding still more questions regarding his purported independence and discretionary mandate.266 In no way can Mr. Henderson be called “independent.” His professional responsibilities to his long-time clients, Messrs. Thomas and Kidd and the substantial fees they paid him deprive him of any plausible authority to act independently of what they instructed him to do.

Plaintiff, Thomas & Kidd Oil Production, Ltd (the nominal transferor), and

Messrs. Thomas and Kidd individually, were in exactly the same position both before and

after the alleged transfer of royalty interests with respect to both the economics and the

operation and control of the income producing properties. JTOM II and Kiddel II both

owned TKOP and they were the beneficiaries of the private annuities granted in exchange

for the overriding royalty interests in the TKOP properties. The alleged sale was not an

arms-length transaction and was, instead, just one step in a coordinated scheme to avoid

taxes on the TKOP income.

Plaintiff’s own expert on the royalty transaction said that it would cease to be a

private annuity if not at arm’s length and stressed the necessity of an independent

investment manager. The disturbing attempt by plaintiff’s expert to recant her testimony

regarding an arm’s length transaction must also be weighed against the unequivocal

testimony of our expert, Mr. Dubinsky. When asked whether the transactions were at

arm’s length, he replied: “Not in my opinion.” Trial Tr. 1916:22-1917:2

The investment manager in this transaction was not independent, it was the

plaintiffs’ own accountant – Glenn Henderson. Therefore, the income from the royalty

interests should remain with plaintiff and not the alleged transferees who neither received

the benefits of the income or control over its production. It would be improper to

266 Joint Ex. 19 at 3.


79

condone a transaction “by which the fruits are attributed to a different tree from that on

which they grew.”267

The evidence adduced at trial on this issue provides another revealing insight.

Plaintiffs’ witness, Duane Crithfield, who—near the end of the discovery period in this

case—decided to return to the United States and to forego his earlier intention to assert

his Fifth Amendment privilege, testified at length about his involvement in the

negotiations between plaintiffs’ entities and the purported third party, Citadel Insurance

Company, related to the transfer of the overriding royalties. His testimony included

remarks on the importance of an accurate fair market value for the assets exchanged for

the annuity benefits. Trial Tr. 461:4-465:13.

Mr. Crithfield’s new found volubility on these topics when he testified at trial

(March 16, 2013) must be weighed against his completely contradictory responses just

one month earlier at his deposition in Miami (February 6, 2013). There he told a starkly

different story. Trial Tr. 630:24-632:19. During his deposition, Mr. Crithfield was

asked:

Q. [Mr. Hartt] Were you involved in the negotiations that were associated with the transaction here for this assignment of royalties? A. [Mr. Crithfield] No, I was not.

Q. Do you know who was? Do you know who was? A. No, I do not – I do not know who was.

Trial Tr. 631:21-632:1. Plaintiffs’ willingness to offer such testimony reveals their

desperation and their witness’ dishonesty. Mr. Crithfield’s subsequent attempt to

rationalize his changed story is so implausible that it does merit further response.

267 Lucas, 281 U.S. at 115.


80

Recall Mr. Dubinsky’s chart outlining the flow of money resulting from the BPP

and the royalty transfer transactions in this case. Demonstrative A. Although the

plaintiffs have the burden of proof in this case, the evidence at trial has established that

the money from the production on the 17 Thomas & Kidd Oil Production, Ltd. properties

that was funneled offshore without being subject to income tax remained under the

control of Messrs. Thomas and Kidd – notwithstanding the contrived and circuitous path

it may have traveled. This is an income tax case, not an estate planning case. If Messrs.

Thomas and Kidd want to make arrangements to transfer their substantial income and the

assets that produce it to their heirs, that is a decision for them to make. For purposes of

this case, however, the crucial point is that they must first pay the tax owed on that

income before they decide what to do with the remaining amount of that money that is

properly theirs.

C. The BPP and Royalty Transactions Lack Economic Substance

In addition to failing section 162 and assignment of income principles, the

transactions at issue in this case lack economic substance. Under the economic substance

doctrine, transactions that are invented to create tax deductions and otherwise have no

economic substance, even though formally complying with the letter of the Internal

Revenue Code, will not be recognized. The judicially created doctrine requiring genuine

economic substance before a transaction that may literally comply with the relevant

statute will be recognized as valid for tax purposes provides an important safety valve in

tax administration. It should be understood as a second, independent ground for denying

the abusive results sought by the plaintiffs in this case, even though it rests upon the same

evidence. This principle, which has been recognized and applied by every circuit,


81

originates in the Supreme Court’s holding in Gregory v. Helvering, 293 U.S. 465

(1935).268 Later, in Frank Lyon Co. v. United States, 435 U.S. 561, 583-84 (1978), the

Supreme Court recognized two areas of inquiry to determine whether a transaction should

be respected for tax purposes: first, whether the taxpayer was motivated by any business

purpose other than obtaining tax benefits, and second, whether the transaction lacked

economic substance. In more recent cases, however, several circuits have held that a lack

of economic substance alone is sufficient to disqualify a transaction without proof that

the taxpayer’s sole motivation is tax avoidance.269 These decisions by multiple courts of

appeals further hold that a sole tax avoidance motive is sufficient to disregard a

transaction even if it has economic substance. Id.

The Fifth Circuit in Klamath Strategic Fund v. United States, 568 F.3d 537, 545

(5th Cir. 2009), adopted a rigorous test for economic substance in this circuit that a

taxpayer must satisfy before its transaction will be respected. The Court adopted the

majority view, relying on “a multi-factor test for when a transaction must be honored as

legitimate for tax purposes, with factors including whether the transaction (1) has

economic substance compelled by business or regulatory realities, (2) is imbued with

268 See Dewees v. Commissioner, 870 F.2d 21 (1st Cir. 1989); Gilman v. Commissioner, 933 F.2d 143, 147 (2d Cir. 1991); ACM P’ship v. Commissioner, 157 F.3d 231 (3d Cir. 1998); In re CM Holdings, 301 F.3d 96, 102-07 (3d Cir. 2002); Black & Decker Corp. v. United States, 436 F.3d 431, 440-43 (4th Cir. 2006); Dow Chemical Corp. v. United States, 435 F.3d 594, 601-02 (6th Cir. 2006); Yosha v. Commissioner, 861 F.2d 494, 498-99 (7th Cir. 1988); Sather v. Commissioner, 251 F.3d 1168, 1173 (8th Cir. 2001); Sochin v. Commissioner, 843 F.2d 351, 353-54 (9th Cir. 1988); Keeler v. Commissioner, 243 F.3d 1212, 1217-20 (10th Cir. 2001); Winn-Dixie Stores, Inc. v. Commissioner, 254 F.3d 1313 (11th Cir. 2001); ASA Investerings P’ship v. Commissioner, 201 F.3d 505, 512-17 (D.C. Cir. 2000); and Coltec Indus., Inc. v. United States, 454 F.3d 1340, 1352 (Fed.Cir. 2006). 269 See, e.g., Coltec Indus., Inc. v. United States, 454 F.3d 1340, 1355 (Fed. Cir. 2006); Dow Chemical Co. v. United States, 435 F.3d 594, 599 (6th Cir. 2006); United Parcel Serv. Of Am., Inc. v. Commissioner, 254 F.3d 1014, 1018 (11th Cir. 2001).


82

independent tax consideration, and (3) is not shaped totally by tax avoidance features.

Importantly although ‘these factors are phrased in the conjunctive, meaning that the

absence of any one of them will render the transaction void for tax purposes,’ there is a

near total overlap between the latter two factors.” Southgate Master Fund, LLC v. United

States, 659 F.3d 466, 480 (5th Cir. 2011). “To say that a transaction is shaped totally by

tax-avoidance features is, in essence, to say that the transaction is imbued solely with tax-

dependent considerations.” Id. at 480, n. 40. The Fifth Circuit further emphasized “that

when applying the economic substance doctrine, the proper focus is on the

particular transaction that gives rise to the tax benefit, not collateral transactions

that do not produce tax benefits.” Klamath, 586 F.3d 545 (emphasis added).

In Coltec Indus., Inc. v. United States, 454 F.3d 1340, 1355 (Fed. Cir. 2006), a

case embraced by the Fifth Circuit in Klamath, the Federal Circuit held that a lack of

objective economic substance is sufficient by itself to disqualify a transaction without

proof that the taxpayer's sole motive is tax avoidance. The Federal Circuit emphasized,

however, that a transaction can also be disregarded as an economic sham “if the

taxpayer’s sole subjective motivation is tax avoidance even if the transaction has

economic substance . . . .” Id. See also, Winn-Dixie Stores, Inc. v. Commissioner, 254

F.3d 1313, 1316 (11th Cir. 2001) (the economic-substance doctrine provides that a

transaction is not entitled to tax respect if it lacks economic effects or substance other

than the generation of tax benefits, or if the transaction serves no business purpose); ASA

Investerings P'ship v. Comm'r, 201 F.3d 505, 511-12 (D.C. Cir. 2000) (“the absence of a

nontax business purpose is fatal”); H.J. Heinz Co. v. United States, 76 Fed. Cl. 570, 585


83

(Fed. Cl. 2007) (the plaintiff has the burden of proving both a business purpose and

objective economic substance).

Just recently, a district court in this circuit had occasion to consider the economic

substance doctrine in light of Klamath. In another tax shelter involving “arrangements *

* * * enormously complicated in their construction and operation,” the court held that the

case turned upon the application of judicial doctrines that were developed by the courts

for more than “three-quarters of a century,” including the economic substance doctrine.270

The court was compelled to sift through a very complex record before making its

conclusions of law, but its description of the economic substance doctrine and its

operation is clear and consistent with our presentation of it in this case.271 As noted by

that court in its preface to the discussion of economic substance, “[W]hen no legitimate

business activity accompanies the goal of tax avoidance, a transaction or other business

engagement may be disregarded for tax purposes.”272

In this case, the BPP transaction and royalty transfers both fail to satisfy the

factors of the Fifth Circuit’s economic substance test and both should “be disregarded for

tax purposes. Back in 2001, the purposes for BPP transactions in general were discussed

at a meeting between Stephen Donaldson and Glenn Henderson.273 The “strategic goals”

presented at that meeting included tax reduction and protection of assets from

270 Chemtech Royalty Associates, L.P. v. United States, 2013 WL 704037 (M. D. La. 2013). 271 Id., at **20-23. 272 Id., at * 19. 273 Gov. Ex. 267 (BPP Power Point); Trial Tr. at 1466:13 – 1469:11.


84

creditors.274 From the beginning of Fidelity’s BPP tax shelter, business risk was not part

of the 2001 presentation, and it never entered the picture later.

The purposes of the particular BPP and royalty transactions at issue in this case

were discussed at the December 14, 2006 meeting between John Thomas, Lee Kidd,

Glenn Henderson, and Theodore Lustig.275 The materials prepared by Mr. Lustig for that

meeting the materials focus exclusively on the tax purposes for those transactions. For

the BPP transaction, the materials show that the fees paid to Fidelity and Citadel are

much smaller than the tax benefits generated by BPP premium deductions. The

protection of the Thomas & Kidd businesses is discussed nowhere in the materials. For

the royalty transaction, the materials show the tax benefits generated by moving the

royalty income offshore, where the income would not be subject to taxation.276 The

materials contain no discussion of estate planning purposes or arm’s length sales.

The substance of the BPP and royalty transactions is described above in sections

A and B. The BPP transaction bears no resemblance to real insurance. The plaintiffs

have produced no documentary evidence that the risks of the Thomas & Kidd businesses

were ever analyzed or quantified. The process for determining BPP premiums focused on

budgets instead of risks. The flow of BPP premiums into segregated accounts reflects

investments, not expenditures. Recall the extraordinary spectacle of plaintiffs’ long-time

trusted attorney, Mr. Lustig, spending so much time during his direct examination

274 Id. at APP 1478 (IRSPROD03_063963.) 275 Gov. Ex. 77 (offshore analysis). See above for a more though discussion of the December 14th meeting. 276 Emails from Glenn Henderson in 2007 were fully consistent with the tax avoidance opportunities resulting from the royalty transfer as being the motivation for the transaction. Gov. Ex. 442.


85

attempting to explain away his references in 2006 and 2007 to BPP “earnings” as being

“inartful” language.277 Unlike some of his testimony about what he told the opinion

writers, Mr. Lustig was telling the truth when referred to BPP earnings. The taxpayers

certainly understood what he meant.

The YEC reinsurance gambit is a further example of the lack of economic

substance in the BPP tax shelter. The evidence establishes that no one ever saw the YEC

limited partnership agreement, no one could identify YEC’s mysterious general partner –

IMNIHAAB, and no one could provide the capital contributions made by the limited

partners that would be essential before any pro rata payments could be made. YEC’s

tardy and inconsistent financial statements were highly suspicious, and the few bank

statements that were produced were inconsistent with any pro rata payments to limited

partners being made. At best, the BPP arrangement provided nothing more than self-

insurance and is not deductible under applicable law, as we explained in section A.

Likewise, nothing about royalty transaction resembles an arm’s length transfer of

assets for fair value. All of the evidence points to an insider transfer for tax purposes

only, i.e., taking money out of one pocket and putting into another. As reflected by the

evidence, JTOM II and Kiddel II owned the production interests carved out to create the

overriding royalties and they owned the annuities that were created from them. Messrs.

Thomas and Kidd, the individuals controlled the cash flow at the beginning of the

transaction and they continued to do so after it was complete. Neither the control nor the

benefits of the royalty interests were ever transferred. Duane Crithfield’s diametrically

contradictory testimony at his deposition on February 5-6, 2013 and his testimony at trial

277 E.g., Trial Tr. 116:23 – 117:2.


86

on March 15-16, 2013 is just another example of the contrived and spurious nature of this

transaction that deprives it of economic substance.

D. The 20 Percent Penalty Applies

Penalties under the Internal Revenue Code exist to discourage abusive behavior

that serves no purpose beyond avoiding tax obligations. Without the imposition of

penalties, taxpayers could report any frivolous position and then pay the amount they

owed all along, plus interest due, if and when they were caught. In essence, they would

just be repaying a loan they had made to themselves of the Treasury’s money. This

willingness to accept the risk of simply paying what was owed all along if the IRS

eventually discovers the abusive behavior is sometimes referred to as playing “the audit

lottery.” Penalties are needed to ensure the integrity of a self-reporting system of tax

administration; there must be a consequence that deters irresponsible and abusive

behavior. The prospect of penalties for those inclined to game the system promotes the

voluntary compliance essential to its success.278

278 The necessary role played by penalties in our system of tax administration was recently considered in Chemtech Royalty Associates, L.P. v. United States, 2013 WL 704037 (M. D. La. 2013). In a thoughtful opinion, the court explained,

Congress designed accuracy-related penalties in order to provide a “downside risk” to tax avoidance schemes.FN127 Without accuracy-related penalties FN127. S.Rep. No. 97–494, at 272–73 (1982).

[T]axpayers are not exposed to any downside risk in taking highly questionable positions on their tax returns since even resolution of the issues against the taxpayer will require only payment of the tax that should have been paid in the first instance with interest to reflect the cost of the ‘borrowing.’ ... Thus, in the event that the questionable position is not detected, the taxpayer will have achieved an absolute reduction in tax without cost or risk.FN128

FN 128 Id.


87

The IRS may impose a percent penalty equal to 20 percent of the unpaid tax for

either a substantial understatement of income tax or for negligence or disregard of rules

or regulations.279 In the cases before this Court, the IRS determined that the twenty

percent substantial understatement penalty and, in the alternative, the twenty percent

penalty for negligence or disregard of rules and regulations applied. (Dkt. #1 at 23.)

There is no “stacking” of penalties, however; so the maximum penalty is 20 percent of

the underpayment of tax, even if an underpayment is attributable to more than one type of

misconduct, i.e. either the substantial understatement of the tax due or negligence.280

There are special rules in cases like this one involving tax shelters, which are

defined under the Internal Revenue Code as "(I) a partnership or other entity, (II) any

investment plan or arrangement, or (III) any other plan or arrangement, if a significant

purpose of such partnership, entity, plan, or arrangement is the avoidance or evasion of

Federal income tax."281 If a tax shelter is involved in a case, then neither the substantial

authority or the adequate disclosure/reasonable basis exceptions under Section

6662(d)(2)(B) applies.282 However, the reasonable cause exception under Section 6664

may still apply.

As described previously, the entire structure of both the BPP transaction and

alleged transfer of royalty interests to off-shore entities indicates that the purpose of these

Chemtech at 2013 WL * 26. 279 26 U.S.C. §6662(a), §6662 (b)(1)-(2), §6662(c), and §6662(d). Chemtech, supra, at ** 26-29. 280 See Treas. Reg. § 1.6662-2(c). 281 26 U.S.C. § 6662(d)(2)(C)(ii); Chemtech, supra, at * 29. 282 26 U.S.C. § 6662(d)(2)(C)(i); Chemtech, supra, at * 29.


88

transactions was “the avoidance or evasion of Federal income tax.”283 Therefore, both of

these transactions are tax shelters and the only available defense to the penalties assessed

is a showing of “reasonable cause.” The evidence produced at trial establishes that the

plaintiffs’ aggressive pursuit of schemes to avoid paying the taxes due on their substantial

income undermines and overwhelms any reasonable cause defense.

1. Both the Accuracy Related Penalty for Substantial Understatement and the Penalty for Negligence or Disregard of Rules and Regulations Apply.

Simply put, an “understatement” is the excess of the amount required to be shown

on the return over the amount shown as tax on the return.284 A "substantial

understatement of income tax", for a corporate taxpayer, occurs if the amount of

understatement exceeds greater of (i) 10 percent of the tax required to be shown on the

return or (ii) $5,000.285 There is no dispute that the amounts of unpaid taxes in these

consolidated cases are more than sufficient to trigger the substantial understatement

penaltyAccordingly, since the understatement of tax is “substantial,” the only issue

remaining with regard to the applicability of the penalties imposed by the IRS is whether

plaintiffs can prove that their conduct was justified by the reasonable cause defense.

Negligence "includes any failure to make a reasonable attempt to comply with the

provisions of [the Internal Revenue Code]" or to exercise ordinary and reasonable care in

preparing a tax return.286 According to the regulations, "[n]egligence is strongly

indicated where . . . a taxpayer fails to make a reasonable attempt to ascertain the

283 26 U.S.C. § 6662(d)(2)(C)(ii). 284 26 U.S.C. §6662(d)(2). 285 26 U.S.C. § 6662(d)(1). As we have already seen, the substantial authority and adequate disclosure defenses are not available in the case of tax shelters. 286 See 26 U.S.C. § 6662(c); Treas. Reg. § 1.6662-3(b)(1).


89

correctness of a deduction, credit or exclusion on a return which would seem to a

reasonable and prudent person to be 'too good to be true' under the circumstances[.]"287

Disregard of rules and regulations includes any careless, reckless, or intentional disregard

of the rules and regulations relating to the Internal Revenue Code.288 The Fifth Circuit

defines “negligence” as the failure to do what a reasonable and ordinarily prudent person

would do under the circumstances.289 The Third Circuit found that when “a taxpayer is

presented with what would appear to be a fabulous opportunity to avoid tax obligations,

he should recognize that he proceeds at his own peril.”290 This caution is sometimes

referred to as avoiding a transaction that is obviously “too good to be true.”

The evidence in this case goes far beyond proving NO reasonable attempt to

comply with the provisions of the Internal Revenue Code or to ascertain the correctness

of claiming BPP deductions and excluding the royalty interests on the return. What the

evidence establishes is a course of conduct that cannot be condoned or dismissed as

“negligence.” What the evidence establishes is a pervasive and persistent plan to shift

millions of dollars of taxable income offshore while honest taxpayers in this country were

paying every cent of what they owed. Specifically, the evidence conclusively proving a

substantial understatement and negligence is as follows:

Through all of the years that Messrs. Thomas and Kidd executed offshore transactions, they were advised by their accountant, Glenn Henderson, and

287 Treas. Reg. § 1.6662-3(b)(1)(ii). 288 See I.R.C. § 6662(c); Treas. Reg. § 1.6662-3(b)(2). 289 Marcello v. Commissioner, 380 F.2d 499, 506 (5th Cir. 1967), aff’g 43 T.C. 168 (1964); Nealy v. Commissioner, 85 T.C. 934, 947 (1985). 290 Neonatology Associates, P.A. v. Commissioner, 299 F.3d 221, 234 (3d Cir. 2002); see also, Van Scoten v. Commissioner, 439 F.3d 1243, 1260 (10th Cir. 2006)(upholding negligence-related penalties where the plaintiffs’ actions in relation to their investment and the tax claims were objectively unreasonable).


90

their lawyer, Theodore Lustig.291 Reliance on advice is only considered “reasonable” if the professional does not manifest a conflict-of-interest, and, given the taxpayer’s knowledge and experience, the transactions are “too good to be true”.292

Messrs. Henderson and Lustig were both receiving commissions from the promoters of the BPP insurance scheme through Foster and Dunhill, totaling over $2 million each.293

Messrs. Henderson and Lustig testified that these fees were disclosed to Thomas and Kidd so they were aware that the advice provided to them by Henderson and Lustig, and that Henderson and Lustig provided to the tax opinion writers, was not independent.294

In addition to their awareness that any advice they were receiving from their

“long-time trusted advisers,” Messrs. Henderson and Lustig, was irretrievably

compromised and not independent by those advisers’ dual roles representing the interests

of the tax shelter promoters, Messrs. Thomas and Kidd consciously disregarded obvious

warning signs. The following items were “red flags” taxpayers were aware of and chose

to ignore.

The 2001 tax year opinion writer (Arthur Boelter) refused to issue an opinion on BPP in subsequent years.295

The 2002 tax year opinion writer (Brian Casey) for BPP refused to issue an opinion for the 2003 tax year and withdrew his 2002 opinion stating that material facts were misrepresented.296

The 2003 through 2005 tax opinions for the BPP transaction came from the now defunct law firm of Jenkens & Gilchrist297, but even that firm

291Trial Tr. 1508:25 – 1509:10, 1535:7-12, 1535:24 – 1536:9. 292 See, e.g., Pasternak v. Commissioner, 990 F.2d 893, 903 (6th Cir. 1993). 293 Trial Tr. 212:13 – 213:5; 1483:24 – 1490:6. 294 Id. 295 Trial Tr. 127:19-25. 296 Gov. Ex. 341. 297 Trial Tr. 1133:3-9,


91

refused to provide an opinion for BPP in 2006 although it agreed to opine on the royalty transaction for that year.298

Lustig was also forwarding multiple emails of articles questioning these types of transactions and was aware of the risks that the transaction was being treated as improper in other cases.299

The 2006 tax opinion writer for the BPP transaction, Martin Van Brauman, testified that he only met Thomas and Kidd after completing the tax opinion in a ten-minute meeting where the taxpayers asked no questions.300

Further, despite receiving multiple tax opinions by several advisers, John Thomas, Lee Kidd, and Greg Thomas never even read the tax opinions they allegedly rely on to show that they made a reasonable attempt to comply with the Internal Revenue Code.301

Taxpayers in this case point to their reliance on tax advisers as the defense against

both the substantial understatement and negligence penalties. But, as we have pointed

out already, the advisers, Messrs. Lustig and Henderson, were not independent because

they received substantial fees from the promoter of the tax shelter.302 This lack of

independence had another corrosive effect. Permitting these two biased advisers in

control of the information provided to the allegedly independent tax opinion writers

ensured that truly independent advice would never be received. Messrs. Henderson and

298 Trial Tr. 1154:18 – 1155:4. 299 Trial Tr. 198:11 – 204:16. 300 Trial Tr. 1070:22 – 1071:10. 301 Trial Tr. 848:21 – 849:13, 862:22 – 863:1, 968:12 – 969:4. Josh Parker also testified at trial; however, the testimony indicated that in the 2006 tax year Lee Kidd was still making the decisions for the Denver City companies. See Trial Tr. 1508:2-13, 1510:6-19, 1511:13 – 1512:1; 1527:7-12. 302 See, e.g., Pasternak v. Commissioner, 990 F.2d 893, 903 (6th Cir. 1993); Rybak v. Comm’r, 91 T.C. 524, 565 (1988)(upholding a negligence penalty because of reliance on advisors who “held a financial stake in the shelters” which amounted to inquiring “of the promoter if the investment was sound” without investigating “the projects on their own” or “obtain[ing] independent appraisals for any of the investments”).


92

Lustig were far deeply involved advising their clients and simultaneously being paid by

the tax shelter promoters whose products they were recommending to run any risk of

providing complete and accurate information to permit an attorney objectively to review

the transactions they structured and then return with a “thumbs down” opinion.

Thomas and Kidd are successful businessmen capable of recognizing the red flags

presented by this transaction. By 2006, they had worked together for 35 years and created

a collection of highly successful businesses. Notwithstanding the considerable business

acumen they required to achieve that success, even unsophisticated investors cannot

escape a negligence penalty by claiming reliance on the advice of professionals who are

not competent investment counselors.303 Reliance on professional advice must be

reasonable under the circumstances and failure to investigate “in any meaningful way

prior to participating” and only focusing on “the incredible tax benefits possible” is

unreasonable.304 Turning a blind eye to information that would expose the true nature of

an abusive tax ploy is no defense to penalties.

The evidence admitted at trial, and explained by the United States’ experts Dr.

Babbel and Bruce Dubinsky, proves that the structures employed in these transactions are

blatant in creating tax benefits without any of the business reasons or risks that would

exist in legitimate insurance or royalty interest transactions. As tax opinion writers

refused to issue subsequent opinions, and even withdrew previous opinions, the taxpayers

ignored the warning signs instead of taking reasonable steps to verify correct tax

treatment. Therefore, the 20 percent penalty applies.

303 See, e.g. Leuhsler v. Comm’r,963 F.2d 907, 910 (6th Cir. 1992). 304 See Skeen v. Comm’r, 864 F.2d 93, 96 (9th Cir. 1989); Leuhsler v. Comm’r, 963 F.2d at 910.


93

2. The Reasonable Cause Defense to Penalties is Inapplicable. The defense of “reasonable cause” under Section 6664(c) provides an affirmative

defense to the accuracy-related penalties for taxpayers who can show there was

reasonable cause for their underpayment, and that they acted in good faith.305 The

determination of a taxpayer’s reasonable cause and good faith is made on a case-by-case

basis, taking into account all pertinent facts and circumstances.306 Significantly,

reasonable reliance is not available where a tax opinion is prepared as part of a litigation

strategy.307 Moreover, concealment of the tax benefits generated through transactions or

entities which are disregarded for tax purposes, e.g., the numerous limited liability

companies, or “LLCs,” and needlessly complicated transactions employed in this case,

proves a complete lack of good faith.308

Relevant case law makes clear that “reasonable reliance” on professional advice

exists only when (1) the advice itself is reasonable (in that it is based upon accurate

information and representations supplied by the taxpayer, reflects reasonable

investigation into the transactions, and does not make unreasonable or unsupported

assumptions)309, and (2) the taxpayer’s reliance thereon is reasonable (in that the

professional does not manifest a conflict-of-interest, and, given the taxpayer’s knowledge

and experience, the transactions are “too good to be true”).310

305 26 U.S.C. §6664(c)(1). 306 Treas. Reg. § 1.6664-4(b)(1). 307 See Long Term Capital Holdings, 330 F.Supp.2d 122, 208 (D. Conn. 2004). 308 Id. at 211. 309 See Illes v. Commissioner, 982 F.2d 163, 164-66 (6th Cir. 1992). 310 See, e.g., Pasternak v. Commissioner, 990 F.2d 893, 903 (6th Cir. 1993).


94

Plaintiffs rely on tax opinions provided for both the BPP transaction and the

transfer of royalty interests. Reliance on a legal opinion cannot be reasonable and in

good faith if the taxpayer fails to disclose a fact that it knows, or reasonably should know,

to be relevant to the proper tax treatment of an item, or if the opinion is based on

unreasonable factual and legal assumptions or unreasonably relies on the representations,

statements, finding, or agreements of the taxpayer or any other person.311

One source of factual representations made to the attorneys who were hired to

provide the opinion letters, which the taxpayers kept in reserve as a penalty defense in

case they were audited by the IRS, was the collection of entities that promoted and

administered the BPP tax shelter and acted as the nominal party granting the annuities in

exchange for the overriding royalties. Letters from Fidelity and Citadel regarding BPP

were sent to Mr. Van Brauman, and a single letter from Citadel regarding the royalty

transaction was sent to Mr. Cook.312 At trial, plaintiffs called Duane Crithfield as their

witness to establish the accuracy and truthfulness of these representations, even though

he was not the author of any of them. The author of the two Citadel letters was David

McNamee, the then president of that company. It is undisputed that he invoked his

privilege against self-incrimination and refused to testify when we attempted to take his

deposition. The Fidelity letter of representations regarding its BPP products was signed

by William Duncombe, a resident of the Bahamas who we were unable to depose and

who did not appear at trial.

311 Treas. Reg. § 1.6664-4(c)(1)(i), (ii). 312 The Fidelity and Citadel letters regarding BPP were sent to Mr. Van Brauman on January 10, 2007 (Pl. Exs. 70 & 71), and the Citadel letter regarding the royalty transfer was sent to Mr. Cook on March 27, 2007 (Jnt. Ex. 117).


95

That brings us back to Mr. Crithfield, the man plaintiffs refer to as the “forefather” of the

offshore insurance operations and the person in charge of all of their operations. Trial Tr.

1598:6-13. As we established during his cross-examination at trial, Duane Crithfield is

not a credible witness. He is also a biased witness. Trial Tr. 466:10-470:16. His self-

serving affirmations that the letters signed by Messrs. McNamee and Duncombe are

truthful and accurate are (1) hearsay and (2) vulnerable to his lack of credibility. 641:7-

16. Reliance upon Duane Crithfield’s testimony to establish the truth and accuracy of the

factual representations made by Fidelity and Citadel cannot sustain plaintiffs’ burden of

proof. Plaintiffs also rely on the advice of their accountant, Glenn Henderson, and their

attorney, Theodore Lustig. As discussed above, both Henderson and Lustig were

receiving substantial fees from the promoter of the scheme and disclosed these fees to the

taxpayers. The advice of professionals who are either promoters themselves or agents of

the promoters cannot be considered independent.313 There is another very important

factor related to the plaintiffs’ reliance on Messrs. Henderson and Lustig. As

professionals rendering accounting and legal advice to the plaintiffs, these two

individuals became their agents when they selected the other attorneys who provided

opinion letters, and they were acting as plaintiffs’ agents when they made the disclosures

313 See Pasternak, 990 F.2d at 903; Leuhsler v. Comm’r,963 F.2d 907, 910 (6th Cir. 1992) (finding “no difficulty” affirming the Tax Court’s finding of negligence because the taxpayer failed to investigate the matter “in any meaningful or substantial way…[a]pparently cognizant only of the incredible tax benefits…”); Rybak v. Comm’r, 91 T.C. 524, 565 (1988)(upholding a negligence penalty because of reliance on advisors who “held a financial stake in the shelters” which amounted to inquiring “of the promoter if the investment was sound” without investigating “the projects on their own” or “obtain[ing] independent appraisals for any of the investments”).


96

and representations to those opinion writers that became the basis for their opinions.314

Accordingly, the failure of these two agents to make complete and truthful

representations to the opinion writers is directly attributable to their principals – the

plaintiffs themselves. The plaintiffs have no defense to the incomplete and untruthful

representations made to their opinion writers.

The evidence presented at trial negates even so much as inference of a desire to

determine tax treatment in a conscientious manner. Instead, the history of the tax

opinions obtained in this case is in reality, not a search for independent advice and

counsel but a quest for a rubber stamp for the aggressive tax schemes proposed by

Messrs. Henderson and Lustig and by Stephen Donaldson and Duane Crithfield. As

compliant opinion writers began to have second thoughts, Mr. Kidd candidly admitted at

trial that the easy solution was move on to, “the next lawyer down the street.”

Specifically, the evidence at trial supporting denial of any reasonable cause defense is as

follows:

Messrs. Henderson and Lustig were the primary sources for information, especially the representations, used to generate tax opinions provided on the transactions.315

As noted above, regarding negligence, Messrs. Henderson and Lustig were both receiving commissions from the promoters of the BPP insurance scheme through Foster and Dunhill, totaling over $2 million each.316

314 See e.g. Apollo Fuel Oil v. United States, 195 F.3d 74, 76 (2nd Cir. 1999) (citing Restatement (Second) of Agency §§9(3), 268, 272, 275 (1958) for the proposition that “when an agent is employed to perform certain duties for his principal and acquires knowledge material to those duties, the agent’s knowledge is imputed to the principal”); see also MURFAM Farms, LLC v. United States, 94 Fed. Cl. 235, 246-247 (2010)(imputing the knowledge of an agent to the principal taxpayers). 315 TR 1069:17 – 1070:18, 1135:20 – 1136:8. 316 TR 212:13 – 213:5; 1483:24 – 1490:6.


97

Messrs. Henderson and Lustig testified that these fees were disclosed to the plaintiffsso they were aware that the advice provided to them and their tax opinion writers was not independent.317 The financial interests of their advisors in the promoter and disclosure of that interest to the taxpayers also negates any reasonable cause defense to penalties.

Mr. Lustig was also forwarding multiple emails of articles questioning these types of transactions and was aware of the risks that the transaction was being treated as improper in other cases.318 In addition to being a red flag, as noted above, this knowledge is imputed to the taxpayer since Mr. Lustig was their agent for this transaction.319

The 2003 through 2005 tax opinions for the BPP transaction came from the now defunct law firm of Jenkens & Gilchrist320, but even that firm refused to provide an opinion for BPP in 2006 although it agreed to opine on the royalty transaction for that year.321

Mr. Cook also testified that despite representations that there was “no arrangement, plan, contract, or agreement…linking the reserves of any particular business risk policy” and linkage being contrary to the agreements they assumed “arguendo” that linkage occurred.322 The primary position of the opinion was no linkage, but Jason Flaherty (the associate spear-heading due diligence) confirmed that linkage did in fact occur.323 Therefore, Jason Flaherty concluded that risk was not distributed among a pool of clients, which would place the deductibility of BPP payments in question.324

Mike Cook, the lead counsel at Jenkens, testified that the due diligence on their BPP opinions included review of the Lord Bissell tax opinion drafted by Brian Casey but they were not provided a copy of the letter withdrawing that opinion.325 Mr. Cook testified that Mr. Lustig’s testimony that he was provided the letter while drafting the BPP opinions

317 Id. 318 Trial Tr. 198:11 – 204:16. 319 See supra fn. 32. 320 Trial Tr. 1133:3-9, 321 Trial Tr. 1154:18 – 1155:4. 322 Trial Tr. 1149:16 – 1154:9. 323 Gov. Ex. 498. 324 Gov. Ex. 498; Trial Tr. 1149:16 – 1154:9. 325 Gov. Ex. 341; Trial Tr. 1141:21 – 1143:5.


98

was “untrue.”326 Despite Mr. Lustig’s attorney “probing” him to admit he’d seen it, Mr. Cook confirmed in his deposition he had not seen it prior to issuing his opinion.327

Martin Van Brauman, the fourth attorney hired to provide a BPP defense, had never seen this insurance setup before328 and was never provided with any of the previous tax opinions on BPP - including the withdrawn opinion of Lord Bissell alleging misrepresentations.329 Mr. Lustig’s testimony that Mr. Van Brauman was aware of previous tax opinions, but specifically asked not to see them, was untrue.330

The only tax opinions reviewed by Mr. Van Brauman were opinions issued to the insurance companies by Handler, Thayer, and Duggan.331 However, Mr. Van Brauman was unaware (1) that Mr. Handler, the attorney whose name was first in the firm’s name and who purchased his own BPP transaction332, (2) that Messrs. Handler, Thayer, and Duggan had been on the faculty of the off-shore conferences for the promoter Foster & Dunhill333, and (3) did not remember seeing the disclaimer in bold font at the top of that firm’s opinion that “the tax advice provided herein was written to support the promotion or marketing of the matters addressed herein.”334 Mike Cook, who generated the previous BPP tax opinions and the tax opinion on the royalty transaction, testified he was also unaware of Handler, Thayer, and Duggan’s close affiliation with the BPP transaction and its promoter.335

Mr.Van Brauman was also never shown any substantive letter of wishes and did not know how many were involved, how many were honored, or how many were denied.336 Because he was never provided with copies of

326 Compare Trial Tr. 138:11 – 139:5 with Trial Tr. 1144:22 – 1145:18. 327 TR 1141:21 – 1144:21. 328 TR. 1069:9-14. 329 Trial Tr. 1086:12 – 1088:14; Gov. Ex. 341. 330 Compare Trial Tr. 162:19 – 163:15 with Trial Tr. 1074:18 – 1075:5, 1075:13-24. 331 Trial Tr. 1072:2-10. 332 Trial Tr. 1072:21-25. 333 Trial Tr. 1073:1-5. 334 Pl. Ex. 54; Trial Tr. 1073:6-11, 1073:25 – 1074:10. 335 Trial Tr. 1136:9 – 1137:11. 336 Trial Tr. 1079:18 – 1080:11.


99

the letters of wishes, he just assumed they were nothing more than meaningless “letters to Santa Claus.”337

Mr. Van Brauman’s tax opinion is conditioned upon the accuracy of the representations he received, but he did not make any independent investigation into the representations on which his opinion relies.338 Instead, he merely took the assertions of the insurance companies and Theodore Lustig as truthful.339 Since the representations were untruthful, the opinion based upon them is worthless and provides no defense to penalties.

Mr. Van Brauman assumed, in his opinion, that BPP risks were “genuine and material” but did not know the claims history and testified that he would just “assume they were lucky” even if no claims were made.340 He evidently did not consider the impact of the absence of claims that so concerned the opinion review committee at Lord Bissell Brook and eventually led that firm to withdraw its BPP opinion for an earlier year.341 Of course, the concern Lord Bissell Brook had about the lack of claims in 2003 would have been only more acute by 2006, the year of Mr. Van Brauman’s opinion.

Mr. Van Brauman assumed, in his opinion, that there was “no arrangement, plan, contract, or agreement exists” between owners of policies and the insurance companies requiring certain investments despite, as noted above, no review of the letters of wishes.342 Mr. Cook testified that the previous tax opinions on BPP contained similar representations.343

Mr. Van Brauman assumed, in his opinion, that the BPP policies were “determined at arm’s length and are at fair market rates approximately equal to what other insurers would typically charge,” but he did admit that he was not qualified to make that determination and had to rely solely on the insurance company representations.344 The evidence at trial, of course, contradicts any plausible belief in his assumptions.

337 Trial Tr. 1081:23 – 1082:4. 338 Trial Tr. 1076:12-15, 1076:24 – 1078:7. 339 Trial Tr. 1076:24 – 1077:17. 340 Trial Tr. 1078:14 – 1079:10. 341 Gov. Exs 657, 658, and 341. 342 Trial Tr. 1079:18 – 1081:22. 343 Trial Tr. 1147:25 – 1149:14. 344 Trial Tr. 1084:14 – 1085:13.


100

Mike Cook, the opinion writer for earlier BPP tax years and the royalty transaction for the 2006 tax year, testified that the due diligence process of all the tax opinions they produced was the same.345 Mr. Cook also testified that the opinions are conditioned on the stated facts and representations being true.346 He further testified, that they “do not go behind” the representations and develop their own due diligence, and they instead merely “rely on the representation made” by the client.347 Accordingly, opinions prepared in this manner are no better than the validity of the representations relied upon by their authors.

Indeed, Mr. Cook testified that his tax opinion was “dependent on the accuracy” of the specific representations that there was “no arrangement, plan, contract, or agreement” between the owners of life insurance policies and the insurance company regarding requiring acquisition or retention of investments and that “all decisions regarding investments” were made by Citadel or an investment manager selected by Citadel.348 He also confirmed that the only basis for these statements is the representations from the insurance companies and taxpayers.349

Mr. Cook testified further that, as stated in his opinion, if there was too much investor control then the income would be attributed to the policyholder.350 However, similar to Mr. Van Brauman, he testified that they never saw any letters of wishes to determine whether control of the royalty interests and the income they produced remained firmly with Messrs. Thomas and Kidd.351 In addition, Mr. Cook confirmed that they did not do “any investigation into the possible adverse facts” involved in this transaction.352

When considering the reasonable cause defense, the inescapable conclusion is that

it was unreasonable, particularly for experienced businessmen like Messrs. Thomas and

Kidd, in the face of so much opposition to the transaction – of which they had actual

345 Trial Tr. 1137:12-19. 346 Trial Tr. 1137:20 – 1138:23 347 Trial Tr. 1138:24 – 1139:11. 348 Trial Tr. 1155:9-1158:1. 349 Trial Tr. 1156:18-22. 350 Trial Tr. 1158:2-15. 351 Trial Tr. 1158:16-1159:10. 352 Trial Tr. 1141:17-20.


101

knowledge or of which the actual knowledge of their agents is attributable to them – to

assume that the tax treatment advertised by the promoter of the BPP tax shelter was

accurate and likely to be upheld by the IRS. Multiple advisors refused to provide

subsequent opinions and one had deliberately withdrawn his opinion in a letter to Messrs.

Thomas and Kidd stating that facts were misrepresented by the insurance companies

involved. Those events would each have been huge red flags to any conscientious

taxpayer trying to comply with the law, but Messrs. Thomas and Kidd were not deterred

from pursuit of their tax avoidance schemes.

Further, they were aware of Messrs. Lustig and Henderson’s financial stake in

fees being received from the promoter of the transaction but enlisted them to be the

primary communication and distributor of relevant facts to the allegedly independent tax

opinion writers. Mr. Lustig deliberately withheld the withdrawal letter from the previous

BPP tax opinion writer and then gave what must be described as false testimony to this

Court about providing the withdrawal letter to Messrs. Cook and Van Brauman; and he

gave additional false testimony when he testified that Mr. Van Brauman specifically

asked to be kept in the dark about previous tax opinions.353 For both the BPP and royalty

transaction tax opinions, Messrs. Lustig and Henderson chose not to provide a single

letter or wishes so that the opinion writers could weigh the control being exercised

against representation and investor control requirements.

Accordingly, there is no reasonable cause defense to either the penalties for

substantial understatement or negligence, and they should be sustained. A single 20

percent penalty should be imposed.

353 Compare Trial Tr. 162:19 – 163:15 with Trial Tr. 1074:18 – 1075:5, 1075:13-24.


102

CONCLUSION

The undisputed facts show a complicated set of transactions that boil down to a

simple sleight of hand. The BPP premiums and the royalty interests started with Thomas

and Kidd and ended with Thomas and Kidd. These transfers from one hand to the other

are not the sort of third party transactions that warrant the tax benefits claimed. The

United States asks the court to dismiss the plaintiffs’ complaints with prejudice.

/s/ Christopher R. Egan GROVER HARTT, III Tex. Bar No. 09174500 CHRISTOPHER R. EGAN Tex. Bar. No. 24036516 JOSHUA D. SMELTZER (Maryland Bar – No ID) Attorneys, Tax Division Department of Justice 717 N. Harwood St., Suite 400 Dallas, Texas 75201 Phone: (214) 880-9721 Fax: (214) 880-9741 [email protected] [email protected] [email protected]

SARAH SALDANA UNITED STATES ATTORNEY

ATTORNEYS FOR THE UNITED STATES


103

CERTIFICATE OF SERVICE

On April 17, 2013, I electronically filed the attached document with the Clerk of

the Court using the ECF system, which will send a filing notification to the following

individuals:

Josh O. Ungerman [email protected]

Anthony P. Daddino [email protected]

Mary Elizabeth Wood [email protected]

Todd A. Kraft [email protected]

/s/ Christopher R. Egan CHRISTOPHER R. EGAN


IN THE UNITED STATES DISTRICT COURT FOR THE NORTHERN...

Documents

Transcript of IN THE UNITED STATES DISTRICT COURT FOR THE NORTHERN...