Case Number: SC114716 Hearing Date: April 08, 2014 Dept: M

Preliminary Ruling
Regis and Hein v. Sanders, Kalvin, McMillan & Carter LLP
SC114716

Plaintiffs, Joseph C. Regis and William Hein (“Regis and Hein”) filed this case against Defendant Sanders, Kalvin, McMillan & Carter, LLP (“SKMC”) alleging professional negligence relating to the creation of a business structure that the Franchise Tax Board (“FTB”) deemed to be an abusive tax shelter. The FTB described the subject tax shelter as follows:
“. . . a loss-shifting/loss duplication transaction” that is an abusive tax avoidance transaction, . . . under the sham transaction doctrine, and alternatively under several arguments including substance over form, step transaction doctrine, ….”

The FTB’s audit suggested:

1. The use of transitory entities created by SKMC with no business purpose other than tax avoidance; and

2. The returns filed by SKMC reported an asset sales agreement the year before the transaction actually closed. Upon discovery of the actual facts, the FTB concluded that the scheme created an abusive tax shelter designed to transfer losses suffered by a third party to Hein and Regis.

As a preliminary matter, the Court received “emotional distress” testimony from the Plaintiffs, subject to a motion to strike. At this time, the Court sees no relevance to that testimony and strikes it as requested by the Defendant. In addition, the Plaintiffs highlight two transcription errors in their “Post Trial Reply Brief” at footnote 42, page 12. The Court agrees with the Plaintiffs that the transcript is inaccurate and should be corrected as suggested.

The Court, preliminarily, issued the following tentative ruling. However, the Court had some additional questions and permitted additional briefing by counsel. Having received the additional briefing, upon hearing all of the evidence submitted and received, including exhibits, and considering the well-reasoned and thoughtful arguments of counsel for the respective sides, the Court finds for the Plaintiffs and agrees with the analysis of the FTB that the scheme devised by the Defendant’s agent, Mr. Engel, was an “abusive tax shelter” (the Court does not by this comment mean to suggest that the factual findings of the FTB were received for the truth of the matters asserted therein. In addition, the Court is not suggesting that the extraordinarily punitive approach taken by the FTB was appropriate. However, due to circumstances described later in this ruling, financial constraints and Amnesty, the Court accepts the business decision made by the Plaintiffs that was thrust upon them by the Negligence of the Defendant.).

The Plaintiffs, Hein and Regis, were successful record executives who recognized their limitations, one of which was limited tax expertise. In 1991, the Plaintiffs formed and became equal owners of Restless Corporation, a company that acquired rights, including copyrights, from recording artists and released recordings throughout the United States and the world (hereafter referred to as the “Restless Music Business Assets.”) In March 1997, Hein and Regis exchanged their stock of Restless Corporation, for stock of Monarchy, the ultimate parent company of New Regency Productions (The parties agreed to refer to Monarchy/New Regency as “Regency”, and the Court will adopt that approach.) Regis and Hein’s acquisition of Regency stock was achieved utilizing a tax-free Reorganization. They received no cash. Restless Corporation continued to operate under the auspices of Regency. Hein and Regis continued to work for Restless Corporation as employees. Hein left in 1999, but Regis continued working until 2002.

SKMC had been Hein’s accountant and SKMC became Regis’ accountant in the 1990s. SKMC provided accounting services to Restless Corporation prior to its acquisition by Regency, and assisted Regis and Hein with their 1997 stock for stock, tax-free exchange. Regis and Louis Santor, a Regency executive, testified that under Regency’s watch Restless Corporation lost tens of millions of dollars leading Regency to, ultimately, lose interest in the music business. Thus, in early 2001, Santor and Regis discussed an unwinding of the 1997 stock transaction meaning Regency would return the “Restless Music Business Assets” in exchange for all of the Regency stock held by Regis and Hein. Negotiations ensued ultimately resulting in a transaction structured by Morris Engel, an SKMC partner (deceased). In a nutshell, Hein and Regis gave up their Regency stock in return for $1,500,000 cash and the return of the “Restless Music Business Assets.” However, instead of a direct transfer to Hein and Regis, the “Restless Music Business Assets” were contributed to a transitory limited liability company Restless Records LLC (not to be confused with Restless Corporation), the membership interests of which were assigned to Hein and Regis for a total of $1 on August 29, 2002. Briefly, Engel directed Santor, and, thereby, Regency, to structure the deal in that manner to allow Plaintiffs to exploit losses sustained by Regency before the transfer. The following is a brief outline of the structure which the FTB properly found and this Court finds to be a sham:

1. Restless Corporation (99.99% member) and Restless (USA), LLC (.01% member formed on June 6, 2002)) were transitory members in Restless Records LLC (formed on June 6, 2002, and creating a partnership for income tax purposes and not as “single member LLC”), all established by Regency at the direction of Engel (SKMC sought to deflect the blame for this structure on others, but the evidence was simply unavailing.); and

2. Restless Corp., on July 18, 2002, contributed its assets which included the “Restless Music Business Assets” and losses (approximately $10,000,000+) carried on its books.

The Court finds that Restless Corporation and Restless (USA), LLC did not intend to join together in the present conduct of the enterprise. In fact, they essentially came together to immediately abandon the interests. The Court finds that there was a complete absence of a nontax business purpose. The purpose of the structure of this arrangement was to allow the new transitory entity to assist the Plaintiffs if they sought to exploit some of the losses sustained by Regency prior to the transfer or assignment, and there simply was no credible evidence to support the contention that Restless Records LLC was engaged in business activity for a purpose, a substantive business related economic purpose, other than tax avoidance. To close the circle, Hein’s and Regis’ basis in Restless Records LLC was $1, whereas the basis of the “Restless Music Business Assets” within the Restless Records LLC had a cost basis of approximately $10,000,000+ resulting in a transfer of basis that had the built-in loss.

Almost immediately after Hein and Regis acquired the ability to exploit the “Restless Music Business Assets,” Ryko, a distributor, made an outright offer to purchase the “Restless Music Business Assets.” Negotiations began in 2002 and the Ryko contract was finally signed in February 2003, even though the Ryko agreement was dated as of August 1, 2002. Ryko agreed to pay $3,200,000 in cash and $500,000 in stock; however, the cash payments were to be installments made over several years with the first installment due and paid in 2003. The 2002 tax returns prepared by SKMC for Restless Records LLC, Hein and Regis reported the sale to Ryko as a transaction that closed, for tax purposes in 2002. SKMC treated the entire $3,700,000 of the Ryko purchase as a gain in 2002, but showed no taxable gain on the Restless Records LLC’s 2002 returns because of ostensible loss carry-overs created by the very scheme this Court finds to be a sham. In addition, there was no evidence presented that Hein and Regis were driven by a desire to avoid legitimate and appropriate taxes. In fact, Regis paid all California and Federal taxes in the years that he received money from the Ryko deal. Hein, a Vermont resident, paid all Vermont and Federal taxes in the years that he received money from the Ryko deal. Neither one sought to or attempted to exploit the losses that were at the heart of the Engel scheme.

Upon uncovering the sham transactions, the FTB’s draconian reaction was twofold:

1. It assessed significant penalties on Hein and Regis; and

1. It imposed onerous reporting limitations on Hein and Regis. Hein and Regis were required to amend their 2002 tax returns to recognize a $3,700,000 gain in 2002 (the Ryko deal), even though the money was actually paid in installments over a span of years and even though the full $3,700,000 was never received (due to a subsequent dispute, and litigation that resulted in a settlement that generated less in proceeds for Hein and Regis than the contract price of $3,700,000). Hein and Regis were also burdened with the assessment of “phantom income” for 2002, and the FTB denied otherwise legitimate deductions. In 2011, Hein was required to pay 2002 California taxes, and accumulated interest, even though he paid Vermont taxes on the same gain (Hein testified, without objection or evidence to the contrary, that he was unable to amend his Vermont taxes due to the statute of limitations, and that Vermont State taxes were higher or greater than California State taxes.).

Fortunately for all concerned, in March 2011, the State of California enacted an “Amnesty Initiative.” In essence, if Hein and Regis agreed to amend their 2002 returns in the manner demanded by the FTB and pay the taxes arising from the recast 2002 returns, all penalties would be forgiven. To avoid the substantial penalties, which were incurring interest, and the risk and costs of further litigation, and due to their inability to front the money necessary to contest the FTB findings in court, Hein and Regis applied for “Amnesty”. In short, the huge penalties were cancelled, but Hein and Regis were forced to comply with the strict reporting requirements imposed by the FTB, which meant, among other things, that they had to report, recognize and pay tax on income as if it were received in 2002 when it was actually received and had been reported in later years, all based upon elections made in their 2002 tax returns prepared by SKMC. Stated another way, the statutory penalties that were imposed because of SKMC’s “loss-shifting/loss-duplication tax shelter” were forgiven, but the practical penalty arising from the FTB’s draconian reporting requirements was left unabated.

Accountants have been recognized as a skilled professional class subject generally to the same rules of liability for negligence in the practice of their profession as are members of other skilled professions. Lindner v. Barlow, Davis & Wood (1962) 210 CA 2d 660, 665, citing Gagne v. Bertran (1954) 43 C 2d 481, 489. Both experts, Gantman for the Plaintiff and Dellinger for the Defense, testified that the standard according to the American Institute of Certified Public Accountants (“AICPA”) Statements on Standards for Tax Services (SSTS) is recognized as the standard of care for accountants in tax practice. In the Statements on Standards for Tax Services for the period 2001 through 2003, SSTS No. 1 sets forth the applicable standards for members when recommending tax return positions. That standard is that a return preparer should not recommend a tax return position unless the return preparer has a good faith belief that the position has a realistic possibility of being sustained on its merits if challenged. That standard is interpreted as a one in three chance of being sustained on its merits. In addition, SSTS No. 7 sets the standards for members providing tax advice to taxpayers. That advice does not have to be provided in any standard format but members should exercise professional judgment in deciding on what form the advice should take. Both experts agree that the foregoing summary is the appropriate standard of care to be applied in this case.

Notwithstanding the standard being somewhat lower than one would expect of a “skilled professional class”, and the incentive thereby created for misbehavior by such a standard, the Court accepts this standard and will apply it in the case at bar. Both experts agreed that if the Court found the transaction to be a “sham”, the Defendant created the scheme and the Defendant failed to properly advise the client, then the conduct was below the standard of care. The Court finds that the Defendant, through its agent, Mr. Engel, created and directed a tax scheme that was audacious and arrogant. The Plaintiffs went along without understanding the true nature of the series of transactions, the reasons for them or the precarious nature of their position if reviewed by the taxing authority. Engel’s letter on October 13, 2003 (exhibit 65), purportedly advising the clients of the risks inherent in the scheme he devised is viewed by the Court as an “after the fact” ‘CYA’ letter that, more than anything, shows the prescient nature of the analysis of the FTB (without the benefit of the letters and e-mails generated at the time that make the sham/scheme abundantly clear – despite the lack of such clarity on the 2002 returns), and the ineffectiveness of the Engel approach to his clients who had no interest in investing in real estate where the ultimate benefits of the scheme could be realized. The letter memorializes a tax avoidance scheme that the Court has already defined as being “audacious and arrogant” and falling well below the standard of care of a tax professional who was a member of a “skilled professional class”. The Court does not find, as suggested by the Defendant, that Hein understood the scheme as devised or the risks involved. In addition, the Court does not find, as suggested by the Defendant, that others created the scheme that was ultimately carried out by Engel.

The damages claimed by Hein and Regis were the fees paid to SKMC (adjusted), the costs of the attorneys they hired to deal with the FTB (adjusted), the tax on “phantom income” and accelerated tax (the $1million, and the $3.7 million Ryko deal), and the denied yet otherwise legitimate deductions. Hein suffered additional damages by having to pay both Vermont and California taxes on the Ryko deal (Hein’s uncontroverted testimony was that he could not obtain a Vermont tax credit due to the statute of limitations.)

The Plaintiffs are seeking “Joint Damages” for money paid to SKMC for the negligently structured tax scheme designed by Mr. Engel, and for the fees paid to the Kajan firm to defend them when they were contesting the audit by the FTB. The Plaintiffs have requested $189,371.04 based upon fees paid, and interest, to the Defendant for the services related to the reacquisition of the Restless Business Assets (The Plaintiffs reached this number by taking the total amount paid to the Defendant from 2002 to end of their relationship, by reducing that number by the “estimated” tax preparation services that continued after the reacquisition, and then calculating interest at 7% per annum.) The Plaintiffs have requested $196,469.06 based upon fees paid, and interest, to the Kajan firm for defending them before the FTB (The Plaintiffs reached this number by taking the total amount paid to the Kajan firm and reducing that number for time communicating with Plaintiffs’ trial lawyers in this matter, $12,371.82, and then calculating interest at 7% per annum.)

Defendant contends that Plaintiffs lack standing to recover all of the fees paid by Joe & Bill, LLC, on behalf of the Plaintiffs, to the Defendant or the Kajan firm as described above. Defendant argues that through Exhibits 92 and 96, and the testimony of Hein, Plaintiffs concede that most of the invoices from the Defendant, and all invoices from the Kajan firm defending the Plaintiffs before the FTB were paid by Joe & Bill, LLC. Defendant argues that Joe & Bill LLC is not a party to this action, and there was no evidence that Joe & Bill LLC had assigned to Regis or Hein such rights as it had to seek recoupment of professional fees it paid.

These damages claimed by the Plaintiffs represent the majority of all damages sought in this case. The Court has not found any case which supports Plaintiffs’ proposition that because a Defendant who rendered services to principals of an entity and accepted payment from an LLC or corporation on behalf of the principals of that entity, the principals had standing to sue for the sums paid by the entity. The Court finds the cases cited by the Plaintiff to be unavailing. However, the Court permitted further briefing on this issue.

In the initial ruling, the Court indicated that it agreed “with SKMC’s argument that, under Paclink and other cases, claims for the subject bills belong to the LLC, and must be sought by the LLC – not the individual Plaintiffs, unless the claims were derivative in nature (which has not been alleged here).” In supplemental briefing, the Plaintiffs reiterated their position as did the Defendant. However, in their supplemental brief, attached as Exhibit #1, is evidence of the “revival” of Joe & Bill LLC in the State of Delaware. In addition, Plaintiffs claim that “Hein and Regis, as 100% of the managers of the LLC, confirmed the intent of the LLC and did distribute to its members the right to seek reimbursement for monies paid to SKMC and the Kajan firm. To close the circle, in their “reply supplemental brief”, the Plaintiffs, who still disagree with the Court’s analysis of the LLC being an independent entity, seek leave to amend their complaint to add the LLC as a Plaintiff (the Court assumes based on the lack of evidence of the assignment in the court record). The Defendant has not had an opportunity to respond to this latest request, but responded to the “revival” and distribution of “the right to seek reimbursement for monies paid” to Defendant and the Kajan firm as follows: “The effort by Plaintiffs and their counsel to change the evidence after the Court has made its preliminary ruling would make a mockery of these proceedings.”

Tentatively, the Court believes the appropriate approach to take to this issue would be to grant the Plaintiffs’ request to amend the pleadings, reopen the evidence to establish a proper assignment of rights or add the new party, and permit the Defendant to ameliorate any prejudice the Defendant can reasonably establish to the Court’s satisfaction. The Court’s preliminary thoughts are based on the following:

1. Code of Civil Procedure section 576 provides that after trial commences, a court “in the furtherance of justice, and upon such terms as may be proper, may allow the amendment of any pleading.” This language necessarily implies the trial judge has discretion on whether to permit amendment to pleadings during the course of trial, and scores of cases so hold. City of Stanton v. Cox (1989) 207 CA 3d 1557, 1563, See, e.g., Trafton v. Youngblood (1968) 69 Cal.2d 17, 31; Weingarten v. Block (1980) 102 Cal.App.3d 129, 134; Union Bank v. Wendland (1976) 54 Cal.App.3d 393, 401; Stanley v. Kawakami (1954) 127 Cal.App.2d 277, 279;

2. There is a policy of great liberality in allowing amendments to pleadings at any stage of the proceeding so as to dispose of cases upon their substantial merits where the authorization does not prejudice the substantial rights of others. Board of Trustees of Leland Stanford Jr. University v. Superior Court (2007) 149 CA 4th 1154;

3. The cases on amending pleadings during trial suggest trial courts should be guided by two general principles: (1) whether facts or legal theories are being changed and (2) whether the opposing party will be prejudiced by the proposed amendment. Frequently, each principle represents a different side of the same coin: If new facts are being alleged, prejudice may easily result because of the inability of the other party to investigate the validity of the factual allegations while engaged in trial or to call rebuttal witnesses. If the same set of facts supports merely a different theory – for example, an easement as opposed to a fee – no prejudice can result. As noted by the court in Union Bank v. Wendland, supra, at p. 401: ”[T]he amended pleading must be based upon the same general set of facts as those upon which the cause of action or defense as originally pleaded was grounded.“ (See also Brady v. Elixir Industries (1987) 196 Cal.App.3d 1299, 1303) cited in City of Stanton (supra) at p. 1563; and

4. The Court does not see any new facts being alleged in the case at bar other than establishing to the Court’s satisfaction that the proper party or rights are being rectified based on the funds expended for negligent work, and work generated as the result of said negligence. All parties were well aware that some of the payments to the Defendant and the Kajan firm were made by the LLC, and not the Plaintiffs. For reasons that are unclear to the Court, the Plaintiffs believe there is no distinction between payments made by the LLC and payments the Plaintiffs made directly. The Court simply disagrees. However, being that this matter was tried to the Court, and both sides will be given the opportunity to delve into these issues with greater clarity, if necessary, the Court does not envision substantial prejudice to the Defendant at this time. However, the Court wishes to hear from both sides on this issue before making a final decision. By raising this desire to amend in their reply, the Defendant has been denied their due process right to be heard on the issue and the Court has no intention of ratifying that request without giving Defendant the opportunity to be heard; and

5. The Court will permit additional briefing on this issue, if so desired by the Defendant. The Defendant must file and serve their brief on this issue by April 18, 2014. The Plaintiff is to file its response, if any, by May 2, 2014.

Plaintiffs are seeking damages based upon the California tax payment each made pursuant to the FTB assessment. In essence, the FTB ruled that Hein and Regis were each obligated to recognize a gain on their 2002 California tax return of one half of $3,700,000, the contract sales price, and approximately one half of $838,805 of ordinary income, for which they also purportedly used the improper loss. Regis and Hein each paid taxes on an audit adjustment of $2,244,933 for the year 2002. However, each only received one half of $3,428,374 or $1,714,187 for an audit adjustment difference of $530,746. The reasons outlined by Plaintiffs were the following:

1. Neither Regis nor Hein received any part of the ordinary income paid in 2002;

2. Ryko balked on its payments forcing a lawsuit in New York with a settlement of $3,428,374 rather than $3,700,000; and

3. Regis and Hein were denied deductions for $154,000 in transaction costs.

Plaintiffs Regis and Hein, therefore, contend that they paid California Taxes on money they did not receive at a 9.3% bracket rate or $49,359.00 (Plaintiffs do not discuss this “loss” sustained in the Ryko transaction from the contract price to the settlement agreement, and the tax benefit, if any, the Plaintiffs may have or could derived there from. The Plaintiffs cite the Court to Depalma v. Westland Software House (1990) 225 CA 3d 1534 for the proposition that any claimed “off-set” for federal tax savings is “improper speculation….” Id., at p. 1544-1545). Defendant disputes Regis and Hein’s claim for any tax damage “as he never paid more California taxes than he might have owed, it was just a timing difference with interest.” The Court agrees with the Defendant that income paid in 2002 that would have been paid eventually, does not entitle the Plaintiffs to receive damages sustained for the requirement to pay earlier. However, there is no evidence, in the record, dealing with the alleged $1 million referenced as “ordinary income” in exhibit 78 and Mr. Gantman’s testimony that suggests that the alleged “ordinary income” would have been realized at some other time, or was realized at all. The testimony from the Plaintiffs was that they never received the distribution that is contemplated in the “ordinary income” added to their tax obligations by the FTB to their 2002 taxes. However, the Defendant suggests that there is no dispute that the “fees were income to the LLC for tax year 2002” and that each Plaintiff’s distributed share would have been taxable income to them regardless of the negligence of the Defendant. The Plaintiffs have not convinced the Court that they are entitled to be compensated by the Defendant for the tax treatment of this “ordinary income” that the FTB found improperly benefitted from the tax scheme. There is simply a dearth of information about it, and, without more, the Plaintiffs have not met their burden of proof of establishing the Defendant caused any “harm” regarding the “ordinary income”. In addition, Plaintiffs have abandoned their request for the $154,000.00 lost deduction for transaction costs. Leaving only the loss of the adjustment that should have been available due to the Ryko payment as opposed to the contract price. That difference was $271,626.00 of which each Plaintiff failed to receive 1/2, even though each paid taxes on his 1/2 of the entire contract price. Therefore, each paid taxes on $135,813.00 that he wasn’t paid, at 9.3% would total $12,630.61, plus 7% interest pursuant to CC 3288 from the date of payment which was 8/31/11, for Regis and 10/24/11, for Hein.

Plaintiff Hein is seeking damages based upon the “unnecessary” California taxes paid, $296,341 plus seventeen months interest from November 1, 2011, to the present. The Court agrees with the well-reasoned arguments of the Plaintiff outlined in the Post Trial Reply Brief pages 12-14. In addition, these damages sought by Hein appropriately fall within CC 3287(a) (although the Court could award interest pursuant to CC 3287(a) or CC 3288), so the Court will award interest. There is nothing speculative regarding either the existence of damage or the amount. Hein paid $296,341 to the FTB on October 11, 2011, based upon the finding by the FTB that the scheme devised by the Defendant was an abusive tax shelter. Unlike most of the damages sought in this proceeding, there is, essentially, no dispute between the parties concerning the basis of computation of these damages. The Complaint in this matter was filed on October 31, 2011, so the Defendant was on notice of the claimed damage for dual tax payments to California and Vermont with that filing. Having prepared Hein’s Vermont tax returns for the years in question, the Defendant was well-aware of the double payment, and interest is, therefore, appropriate.
Fortunately for all concerned, the IRS did not impose sanctions on Hein and Regis like the FTB for the tax scheme devised by the Defendant. The IRS simply ignored SKMC’s machinations and Hein and Regis never claimed “potential” loss deductions to reduce their Federal taxes. The Defendant claims that its tax preparation yielded “Special Benefits” that should off-set the tax liability imposed on the Plaintiffs by the FTB, and, thereby, reduces the damages allegedly caused by the Defendant. The Defendant claims that since the IRS did not accelerate the gain from the Ryko deal, like the FTB, the Plaintiffs garnered the “economic benefit of that deferral.” The Defendant argues that it “is axiomatic that if the FTB’s position on tax reporting is correct then the tax reporting for federal tax purposes is incorrect.” The Court disagrees. The Plaintiffs were entitled to the deferral from any one of a number of different methods of reporting the Ryko transaction. The “tax scheme” of the Defendant caused the FTB to impose draconian reporting requirements, despite those requirements being inconsistent with some of the details that have been outlined earlier in this decision. There is simply no evidence that the Plaintiffs obtained any “Special Benefits” because of the “abusive tax shelter” created by Mr. Engel.

The Court will permit further briefing by counsel in this matter, if they choose, but only on the issues suggested by the Court in the body of this decision and by the dates so indicated. The Court will request that counsel use the same method of e-mail and court submission as has been used in the past. The Court requests that each side include an approach to the possible additional evidence that Plaintiff will seek to introduce, if the Court finds that additional evidence will be permitted regarding the “joint damages” including those sums paid by the LLC.

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