A tax preparation firm discovered that its preparation of a tax return ended up being treated as part of a promotion of an illegal tax shelter by its liability insurance carrier, which meant the carrier refused coverage when clients sued the firm when the IRS came after the programs. The Sixth Circuit’s decision in the case of Financial Strategy Group, PLC v. Continental Casualty Company, CA6, Docket No. 14-6296, 2015 TNT 152-16 may prove surprising to some since it turns out the firm did not have the protective net it thought it did against these claims.

The firm in this case prepared LLC returns for two clients who had been convinced by financial advisers with a national accounting firm (which is not the firm in this suit) to enter into a program to buy and sell distressed debt that the national firm advised them would reduce their tax bills. For the year they entered into the program the national firm prepared the LLC tax return for the partnerships through which these investments were held.

However, in the following two years Financial Strategy Group (FSG) prepared the LLCs that held these investments, and then use those returns to prepare the related individual tax returns.

FSG had purchased a policy from Continental Casualty to protect them from professional liability claims. As the opinion noted:

The insurance policy said that Continental would defend FSG against claims arising from its tax-preparation services and, if necessary, pay the claims. But the policy excluded claims “based on, arising out of or in connection with the design, recommendation, referral, sale or promotion" of illegal tax shelters.”

Given the unfavorable result they received when the IRS examined these transactions, the clients decided to seek redress from FSG. FSG, upon receiving the complaints, filed claims with the carrier. FSG, having been engaged to prepare the tax returns, believed that their policy, which insured them against professional liability arising from tax preparation, would provide funds for their defense and, if necessary, any eventual payment that would be made to the clients.

The insurance carrier didn’t see it that way. The clients had alleged that FSG had “conspired with financial, tax and legal advisors to develop, promote, sell and implement illegal tax shelters.” Since the policy excluded coverage for such activities related to illegal tax shelters, the carrier argued it had no responsibility with regard to these claims. FSG then sued the carrier for breach of their agreement.

The District Court agreed with Continental and dismissed FSG’s suit, so FSG appealed to the Sixth Circuit Court of Appeals.

The Sixth Circuit noted that, under applicable Tennessee law:

To determine whether an insurer must defend a policyholder against a lawsuit, we examine the complaint in that lawsuit. Forrest Const., Inc. v. Cincinnati Ins. Co., 703 F.3d 359, 363 (6th Cir. 2013) (applying Tennessee law). If the complaint contains a single claim for which the policy provides coverage, then the insurer must defend the policyholder against the entire lawsuit. Id. We resolve in the policyholder's favor any doubts about whether the policy provides coverage. Travelers Indem. Co. of Am. v. Moore & Associates, Inc., 216 S.W.3d 302, 305 (Tenn. 2007).

At that point things seem to look good for FSG, as they merely need to find a claim in there for which there is coverage and doubt is to resolved in their favor. Since they clearly prepared a tax return, and a national firm had actually designed the shelter, shouldn’t they merely be seen as doing simple compliance work (tax return preparation) for which the insurer had agreed to provide coverage.

Unfortunately for FSG, in the Court’s view that was not the case. The Court dismissed FSG’s argument that it “merely” prepared the tax returns for year 2 and 3 after the shelters had already been designed, marketed and sold by finding they had, implicitly, recommended the shelters (and recommendation of an illegal shelter was one of the things the carrier had not agreed to insure).

The opinion notes:

But a “recommendation” is a piece of advice or a suggestion of how to do something. Oxford English Dictionary (3d ed. 2009). And the Lowry and Kahn clients alleged that FSG “advised” them that they “could properly” claim losses from the illegal tax shelters. Moreover, FSG’s act of including a proposed loss on a tax return was itself a suggestion to claim the loss. Thus, regardless of when the shelters here were sold, FSG’s actions in preparing the LLCs’ returns amounted to a recommendation to proceed with them.

That is, they had “blessed” the transaction because they had agreed to prepare the return in question and then claimed the losses on the individual return.

Viewed from a practical perspective, the Court found that the firm had effectively “endorsed” the program when it prepared the tax returns and did not inform the clients explicitly that this program had issues.

But what about the fact that they clearly had prepared tax returns, a function that is covered by the insurance? The Court outlined four reasons why that would not serve to salvage their coverage.

First, the Court notes, the complaint alleges that the preparation of the return was part of the act of the recommendation noting:

But the Kahn complaint more specifically alleges that FSG instructed the Kahn clients to use illegal tax shelters, that FSG advised the Kahn clients that the shelters were legal, and that FSG proposed tax returns that claimed losses from the shelters. Kahn Complaint ¶¶ 29, 67-69. That conduct amounts to the recommendation of illegal tax shelters, so the exclusion applies to it.

FSG had also signed the returns and gave the clients instruction to do so and then file them as well. The Court notes:

Second, the Kahn complaint alleges that FSG signed the Kahn clients’ tax returns, and “advis[ed]” the Kahn clients “to sign and file the tax returns[.]” Appellant’s Br. 23. As discussed above, however, that advice amounts to a recommendation to proceed with the tax strategies on the return—which is what FSG did as to illegal tax shelters. Thus, FSG recommended illegal tax shelters when it signed tax returns and advised the Kahn clients to file them, which means the exclusion applies.

The Court next looks at applicable professional and legal standards noting:

Third, the Kahn complaint alleges that FSG "[a]dvis[ed]" the Kahn clients "that their tax returns . . . were prepared in accordance with professional standards and pursuant to the IRS guidelines and established legal authorities"—which again FSG contends the policy covers. Appellant's Br. 23. But FSG's advice to the Kahn clients that their tax returns were prepared in accordance with the applicable laws constituted advice that the tax shelters were legal—which again amounts to a recommendation to proceed with illegal tax shelters. So the policy excludes coverage for that advice.

And FSG’s failure to advise the client that the shelters were illegal also was deemed a recommendation of the shelters. As the opinion continues:

Fourth, the Kahn complaint alleges that FSG failed “to advise” the Kahn clients that the tax strategies used on their returns “did not comply with the applicable tax laws”—an omission that FSG contends is not a recommendation. Appellant’s Br. 23. But the Kahn complaint did not allege merely that FSG had failed to act. Rather, the Kahn complaint alleged that FSG said that the tax shelters were legal and then failed to retract that advice. Kahn Complaint ¶¶ 71-72. In context, therefore, the allegation that FSG failed to disclose certain information is no different from the allegation that FSG recommended illegal tax shelters. Thus, the exclusion applies.

FSG’s final argument is that even if there was such advice, the complaint also alleges a harm from the preparation of the return, a covered item. However the Court found “the distinction is illusory” in this case between return preparation and the giving of advice with regard to the shelter. As the Court noted, the tax preparation activities “amount to the recommendation of illegal tax shelters.”

No doubt the firm in this case felt that they were merely preparing a return, most likely for less than the national firm had charged for its return preparation. And, as well, they believed that since the clients’ LLC program had been designed and implemented by the national firm, they were “merely” doing a simple compliance service. Any risk related to the tax results of that shelter should be borne by the national firm that designed it.

However, the firm was not held to that standard. Rather it’s important to note that the firm was found to have “recommended” the shelters mainly because they had never voiced any objection to them and, in fact, were preparing returns necessary for the continued operation of the shelter.

Whenever an adviser prepares a return for a client, the standards under §6694 generally require the adviser to determine if there exists substantial authority for any undisclosed position on a tax return and a reasonable basis for any disclosed position. CPAs will face, in addition, AICPA Statements on Standards for Tax Services No. 1 which also imposes the same standard on the CPA to comply with the standards of the taxing agency in this area. Thus, a failure to raise a red flag about a program the clients brings in may very well be treated, by the Courts and a malpractice carrier, as a recommendation of the program.