KROUPA, Judge:
Respondent determined a $183,458,981 deficiency in petitioner's (Chesapeake) Federal income tax for 1999, the year at issue. Respondent asserts in his amended answer that Chesapeake owes a $36,691,796 substantial understatement of income tax penalty under section 6662(a) for 1999. We must determine whether Chesapeake's subsidiary's contribution of its assets and most of its liabilities to a newly formed limited liability company and the simultaneous receipt of a $755 million distribution should be characterized as a disguised sale, requiring Chesapeake to recognize a $524 million gain in 1999, the year of contribution and distribution. We hold that the transaction was a disguised sale, requiring Chesapeake to recognize the gain. We must also determine whether Chesapeake is liable for the substantial understatement penalty under section 6662(a). We hold Chesapeake is liable for the penalty.
All monetary amounts are rounded to the nearest dollar.
Chesapeake Corporation changed its name to Canal Corporation in June 2009. We refer to the corporation as Chesapeake in this Opinion.
A11 section references are to the Internal Revenue Code (Code), and all Rule references are to the Tax Court Rules of Practice and Procedure, unless otherwise indicated.
FINDINGS OF FACT
Some of the facts have been stipulated and are so found. We incorporate the stipulation of facts and the accompanying exhibits by this reference. Chesapeake's principal place of business at the time it filed the petition was Richmond, Virginia.
Background of Chesapeake and WISCO
Chesapeake is a Virginia corporation organized as a corrugated paper company in 1918. Chesapeake's business has expanded over time into several paper industry segments, including merchandising and specialty packaging, tissue, and forest and land development. Chesapeake eventually became a publicly traded company and served as the common parent of a group of subsidiary corporations filing consolidated Federal income tax returns. Each subsidiary managed its own assets and liabilities. Chesapeake received dividends from the subsidiaries and made loans to the subsidiaries as needed.
Chesapeake's largest subsidiary was Wisconsin Tissue Mills, Inc. (wisco). Chesapeake purchased wisco's stock from Philip Morris in 1985 in a leveraged buyout transaction. wisco manufactured commercial tissue paper products, including napkins, table covers, towels, place mats, wipes, and facial and bathroom tissue, wisco sold its products to commercial and industrial businesses such as restaurants, hotels, schools, offices, hospitals, and airlines, wisco accounted for 46 percent of Chesapeake's sales and 94 percent of Chesapeake's earnings before interest and tax for 1998. Chesapeake and Wisco shared most of the same executive officers.
wisco incurred significant environmental liabilities during the 1950s and 1960s. The Environmental Protection Agency (EPA) determined that a mill wisco operated contaminated the Fox River in Wisconsin with polychlorinated biphenyls (PCBS). The EPA designated the Fox River area as a Superfund site and held five companies, including wisco, involved in the contamination jointly and severally liable for the cleanup costs (Fox River liability). Philip Morris indemnified Chesapeake for any Fox River liability costs up to the purchase price of wisco. Approximately $120 million of the Phillip Morris indemnity remains. Chesapeake also purchased $100 million of environmental remediation insurance to pay costs beyond those covered by the indemnity. Chesapeake's management estimated that Wisco's remaining Fox River liability costs varied between $60 million and $70 million in 1999. In addition to the Fox River liability, WISCO and other Chesapeake subsidiaries also guaranteed a $450 million credit facility enabling Chesapeake to acquire another company in 2000. Tissue Business
Tissue is a capital intensive commodities business, and only the largest companies have the ability to make the investment needed to compete in the industry. In the late 1990s, the tissue business experienced much consolidation. Fort Howard Corporation merged with James River Corporation to form Fort James Corporation. Kimberly-Clark Corporation purchased Scott Paper Company. These consolidations put smaller tissue businesses at a strategic disadvantage.
Chesapeake, through wisco and Chesapeake's Mexican subsidiary, Wisconsin Tissue de Mexico, S.A. de C.V. (WISMEX), was a second tier player in the tissue industry. Chesapeake sold its retail tissue business to the Fonda Group, Inc. in 1995. wisco and WISMEX serviced only commercial accounts and lacked the large timber bases needed to support a retail business. Chesapeake had only two paper mills, one in Wisconsin and one in Arizona, and thus was at a significant logistical disadvantage in servicing the Southeast and Northeast.
Restructuring of Chesapeake
Chesapeake hired Tom Johnson as its chief executive officer and chairman in 1997. Mr. Johnson sought to restructure Chesapeake. He wanted to move Chesapeake away from its historic commodity products business and focus on specialty packaging and merchandising services. Chesapeake's speciality packaging business involved producing high-value custom packaging for such goods as perfume, liquor and pharmaceuticals. To that end, Chesapeake sold certain assets, including a mill, corrugated box plants, a building products business and substantial land. Chesapeake acquired other businesses and assets to further its specialty packaging business.
Commercial tissue did not fit the new specialty packaging strategy. Chesapeake examined several options for the future direction of Wisco's tissue business. Chesapeake considered maintaining the status quo. Management concluded, however, that WISCO would be too small to compete. Management further determined that internal expansion would be too difficult and costly. Management also considered selling Chesapeake and all its subsidiaries. Management surmised that no one would buy all the diverse subsidiary businesses for an acceptable price.
Pete Correll, chief executive officer of Georgia Pacific (GP), made overtures to Mr. Johnson regarding GP purchasing Wisco. GP's primary business was the manufacture and distribution of building products, timber, and paper products. GP also had a small profitable tissue business that accounted for 5 to 6 percent of its total sales. GP wanted to expand its tissue business but questioned whether GP's business could grow internally. GP viewed the purchase of WISCO as a strategic piece in advancing its tissue business.
Chesapeake considered selling WISCO to generate capital for Chesapeake's new specialty packaging business. Given Chesapeake's low tax basis in WISCO, however, the after-tax proceeds would have been low compared to the pre-tax proceeds. This tax differential caused Chesapeake to decide a direct sale of WISCO would not be advantageous.
Chesapeake thereafter engaged Salomon Smith Barney (Salomon) and PricewaterhouseCoopers (PWC) to explore strategic alternatives for the tissue business. Salomon recommended to Chesapeake's management that the best alternative for maximizing shareholder value would be a leveraged partnership structure with GP. The leveraged partnership structure required WISCO to first transfer its tissue business assets to a joint venture. GP would then transfer its tissue business assets to the joint venture. Next, the joint venture would borrow funds from a third party and distribute the proceeds to Chesapeake (special distribution). Chesapeake would guarantee the third-party debt through a subsidiary. WISCO would hold a minority interest in the joint venture after the distribution, and GP would hold a majority interest. Salomon presented the leveraged partnership structure as tax advantageous to Chesapeake because it would allow Chesapeake to get cash out of the business yet still protect Chesapeake from recognizing a gain when the partnership distributed to Chesapeake the proceeds from the third-party loan.
Salomon referred to the leveraged partnership deal as "Project Odyssey" after Homer's "The Odyssey" and identified Chesapeake as "Calypso" and GP as "Zeus."
Chesapeake's board liked the leveraged partnership idea and thought GP seemed like a good fit as a partner. Chesapeake made clear to PWC and Salomon that the asset transfer and special distribution had to be nontaxable for it to approve the transaction. Tax deferral enabled Chesapeake to accept a lower price.
GP's executives accepted the leveraged partnership structure to expand its tissue business. GP did not have any interest in Chesapeake receiving a tax deferral. GP recognized, however, that it was a necessary part of bridging the purchase price gap. Chesapeake agreed to a lower upfront valuation of wisco, $775 million, because of the tax deferral benefit.
Salomon had valued WISCO between $800 and $900 million in 1998.
PWC assisted Salomon in negotiating and structuring the joint venture. PWC examined the transaction from both an accounting and a tax perspective. PWC had served as Chesapeake's auditor and tax preparer for many years. Donald Compton (Mr. Compton), a partner in PWC's Richmond office, managed the Chesapeake account and had given Chesapeake advice on different tax matters in the past. David Miller (Mr. Miller) worked with Mr. Compton on the Chesapeake and GP joint venture. PWC advised that Chesapeake did not need to guarantee the debt but needed only to provide an indemnity to the guarantor to defer tax. PWC also determined that the transaction should be treated as a sale for accounting purposes. Mr. Miller helped structure the indemnity agreement and aided in writing the partnership agreement.
Mr. Miller is a licensed attorney. He practiced law with the law firm Jenkens Gilchrist before joining Coopers Lybrand's, now PWC's, Washington National Tax practice in 1996. He was not a practicing attorney at the time he gave the legal opinion here.
Indemnity Agreement
GP agreed to guarantee the joint venture's debt and did not require Chesapeake to execute an indemnity. Mr. Miller advised Chesapeake, however, that an indemnity was required to defer tax on the transaction. Chesapeake's executives wanted to make the indemnity an obligation of WISCO rather than Chesapeake to limit the economic risk to WISCO's assets, not the assets of Chesapeake. The parties to the transaction agreed that GP would guarantee the joint venture's debt and that wisco would serve as the indemnitor of GP's guaranty.
WISCO attempted to limit the circumstances in which it would be called upon to pay the indemnity. First, the indemnity obligation covered only the principal of the joint venture's debt, due in 30 years, not interest. Next, Chesapeake and GP agreed that GP had to first proceed against the joint venture's assets before demanding indemnification from WISCO. The agreement also provided that wisco would receive a proportionately increased interest in the joint venture if wisco had to make a payment under the indemnity obligation.
No provision of the indemnity obligation mandated that Wisco maintain a certain net worth. Mr. Miller determined that wisco had to maintain a net worth of $151 million to avoid taxation on the transaction. GP was aware that WISCO's assets other than its interest in the joint venture were limited. GP nonetheless accepted the deal and never invoked the indemnity obligation.
Joint Venture Agreement
Chesapeake, wisco, and GP executed the joint venture agreement. The two members (partners) of the joint venture were wisco and GP. The agreement provided that GP would reimburse WISCO for any tax cost WISCO might incur if GP were to buy out WISCO's interest in the joint venture.
We use the terms "partners," "partnership," and "LLC" for narrative convenience only as these are the terms used by the parties to the transaction. No inference should be drawn from our use of such terms regarding any legal status or relationship.
PWC Tax Opinion
Chesapeake hired PWC to issue an opinion on the transaction's Federal tax implications. In fact, Chesapeake conditioned the transaction's closing upon PWC's issuing a "should" tax opinion. Instead of Mr. Compton, the PWC partner with the long-term relationship to Chesapeake, PWC assigned Mr. Miller to write the opinion. In effect, Mr. Miller's job was to review the transaction he helped structure. Mr. Miller considered three issues: (1) whether the joint venture qualified as a partnership for tax purposes, (2) whether WISCO was a partner in the joint venture, and (3) whether the distribution to Chesapeake should be treated as part of a sale or qualifies under the debt-financed distribution exception.
Chesapeake agreed to pay PWC an $800,000 fixed fee for issuing the opinion. The payment did not depend on time spent or expenses incurred by PWC. A letter PWC sent to Chesapeake stated that PWC would bill Chesapeake "at the closing of the joint venture financing." Chesapeake's board informed Mr. Miller that as a condition to closing the transaction PWC would need to issue the opinion that the special distribution should not be currently taxable. A "should" opinion is the highest level of comfort PWC offers to a client regarding whether the position taken by a taxpayer will succeed on the merits.
Mr. Miller and his PWC team reviewed the transaction's structure and approved each item that could affect the tax consequences. Mr. Miller crafted an "all or nothing" test for allocating the joint venture debt. Either all the liability would be allocated to WISCO or none of it would. Mr. Miller reasoned that the transaction would not be characterized as a sale provided the entire liability was allocated to WISCO. Mr. Miller found no legal authority for such a test. He created the test using his own analysis of then existing rulings and procedures.
Mr. Miller based his opinion on WISCO's indemnification of GP's guaranty being respected. Mr. Miller assumed that Wisco had the ultimate legal liability for the full amount of the debt if the joint venture became wholly worthless. Mr. Miller concluded that WISCO could defer gain until it sold its remaining assets, paid off the debt, or sold its partnership interest. Mr. Miller advised that WISCO maintain assets of at least 20 percent of its maximum exposure under the indemnity. Mr. Miller did not have direct authority requiring this percentage. He merely made this determination based on Rev. Proc. 89-12, 1989-1 C.B. 798, which was declared obsolete by Rev. Rul. 2003-99, 2003-2 C.B. 388. Moreover, Rev. Proc. 89-12, supra, makes no reference to allocation of partnership liabilities.
Rev. Proc. 89-12, sec. 4.07, 1989-1 C.B. 798, 801, states that the Internal Revenue Service will generally rule that an organization lacks limited liability if the net worth of the corporate general partners equals at least 10 percent of the total contributions to the limited partnership and is expected to continue to equal at least 10 percent throughout the life of the partnership.
Chesapeake also sought to transfer the assets of WISMEX to the joint venture, PWC informed Chesapeake that neither the United States nor Mexico could tax (1) the transfer of WISMEX'S assets to wisco or (2) the asset transfer from wisco to the joint venture. Chesapeake caused WISMEX to transfer its assets to wisco as advised by PWC
Mr. Miller wrote and signed the "should" opinion before issuing it to Chesapeake. The parties effected the transaction on the same day PWC issued the "should" opinion.
The Transaction
GP and wisco formed Georgia-Pacific Tissue LLC (LLC) as the vehicle for the joint venture. GP and wisco treated the LLC as a partnership for tax purposes. Both partners contributed the assets of their respective tissue businesses to the LLC. GP transferred to the LLC its tissue business assets with an agreed value of $376.4 million in exchange for a 95-percent interest in the LLC. wisco contributed to the LLC all of the assets of its tissue business with an agreed value of $775 million in exchange for a 5-percent interest in the LLC. The LLC borrowed $755.2 million from Bank of America (BOA) on the same day it received the contributions from GP and wisco. The LLC immediately transferred the loan proceeds to Chesapeake's bank account as a special cash distribution. GP guaranteed payment of the BOA loan, and wisco agreed to indemnify GP for any principal payments GP might have to make under its guaranty.
Chesapeake maintained the bank accounts for its subsidiaries.
The value of WISCO's assets contributed ($775 million) less the distribution ($755.2 million) equals the initial value of WISCO's 5-percent LLC interest ($19.8 million).
The LLC had approximately $400 million in net worth based on the parties `combined initial contribution of assets ($1.151 billion) less the BOA loan ($755.2 million), and it had a debt to equity ratio of around 2 to 1. The LLC assumed most of wisco's liabilities but did not assume wisco's Fox River liability. Chesapeake and wisco both indemnified GP and held it harmless for any costs and claims that it might incur with respect to any retained liabilities of wisco, including the Fox River liability.
WISCO used a portion of the funds from the special distribution to repay an intercompany loan to Cary Street, Chesapeake's finance subsidiary, wisco also used portions of the funds to pay a dividend to Chesapeake, repay amounts owed to Chesapeake and lend $151.05 million to Chesapeake in exchange for a note (intercompany note). The intercompany note was a 5-year note with an 8-percent interest rate. Chesapeake used the loan proceeds to repay debt, repurchase stock and purchase additional specialty packaging assets.
WISCO's assets following the transaction included the intercompany note with a face value of $151 million and a corporate jet worth approximately $6 million, wisco had a net worth, excluding its LLC interest, of approximately $157 million. This represented 21 percent of its maximum exposure on the indemnity. WISCO remained subject to the Fox River liability.
Refinancing the Debt
The LLC refinanced the BOA loan in two parts soon after the transaction closed. First, the LLC borrowed approximately $491 million from a GP subsidiary, Georgia-Pacific Finance LLC (GP Finance) to partially retire the BOA loan. This transaction occurred about a month after the closing date. Then the LLC borrowed $263 million from GP Finance the following year to repay the balance on the BOA loan.
The GP Finance loans had terms similar to those of the BOA loans. GP executed a substantially identId. No member of this Court, certainly not the author of that opinion, has ever before suggested that in determining the law we ought to confine ourselves to the decisions that were cited in the district court. We, like all courts, have a duty to find and apply the correct law.
Nor does the fact that Irey will be subject to restrictions and supervised release when he gets out of prison offer any guarantee that he will not commit any crimes. In 2003 alone, for example, 12.8% of all federal offenders on supervised release committed new crimes. Bureau of Justice Statistics, Dep't of Justice, Federal Criminal Justice Trends, 2003, at 37 tbl.29 (2006). Sex offenders often fail to complete their treatment programs. See Loretta J. Stalans, Adult Sex Offenders on Community Supervision: A Review of Recent Assessment Strategies and Treatment, 31 Crim. Just. Behav. 564, 573 (2004) ("Sex offenders have high rates of either dropping out or being expelled from treatment. Termination rates in the United States outpatient treatment programs have ranged from one quarter to more than one half of adult sex offenders. . . ."). Supervised release is revoked for 37.7% of the sex offenders who, like Irey, have a high school diploma but not a college degree. James L. Johnson, Sex Offenders on Federal Community Supervision: Factors that Influence Revocation, Fed. Probation, June 2006, at 18, 19. And the experience of states which have had sex offenders on supervised release, such as probation or parole, shows that it often fails to prevent sex offender recidivism. See Patrick A. Langan et al., Bureau of Justice Statistics, Recidivism of Sex Offenders Released from Prison in 1994, at 14 (2003) ("Of the 4,163 sex offenders rearrested for a new [state] crime, nearly 9 in 10 (87%) were on parole when taken into custody. . . .").
Those studies are informative, but even without them we know that supervised release is no guarantee that a criminal will not commit more crimes when he gets out of prison. Courts of appeals regularly see cases in which serious crimes were committed by those on supervised release. See, e.g., United States v. Wilk, 572 F.3d 1229, 1232 (11th Cir. 2009) (possession of child pornography); United States v. Williams, 322 Fed.Appx. 846, 846 (11th Cir. 2009) (unpublished) (aggravated child molestation and enticing a child for indecent purposes); United States v. Horsfall, 552 F.3d 1275, 1278 (11th Cir. 2008) (viewing child pornography); United States v. Trobee, 551 F.3d 835, 836 (8th Cir. 2009) (possession of child pornography); United States v. Azure, 539 F.3d 904, 905-06 (8th Cir. 2008) (robbery); United States v. Defoor, 535 F.3d 763, 763-64 (8th Cir. 2008) (aggravated assault); United States v. Eirby, 515 F.3d 31, 34 (1st Cir. 2008) (sexual abuse of a minor); United States v. Ralph, 480 F.3d 888, 888-89 (8th Cir. 2007) (child molestation); United States v. Spraglin, 418 F.3d 479, 480 (5th Cir. 2005) (murder); United States v. Martin, 382 F.3d 840, 841 (8th Cir. 2004) (rape); United States v. Marshall, 371 F.3d 42, 44 (2d Cir. 2004) (robbery); see also McNaught v. United States, 646 F.Supp.2d 372, 380 (S.D.N.Y. 2009) (arson).
Unpublished opinions are not precedential, see 11th Cir. R. 36-2, and we do not cite Williams for any legal holding or point of law discussed in that opinion. Instead, we cite it solely as a source of facts about the crime committed while the defendant was on supervised release. See 11th Cir. R. 36-2, IOP 7 ("The court may cite to them . . . to establish the . . . facts of the case.").
By contrast, Judge Tjoflat's separate opinion cites as "precedent" on a point of law two unpublished opinions, Separate Op. of Tjoflat, J., at 1261, which under our rules and our precedent cannot be precedent. See 11th Cir. R. 36-2; see also United States ex rel. Atkins v. McInteer, 470 F.3d 1350, 1358 n. 15 (11th Cir. 2006) (Tjoflat, J.).
Part of the problem may be understaffing and the resulting high case loads of those who have the responsibility of doing the supervising. For example, as of September 30, 2009, there were 14,987 people under post-conviction supervision in the federal probation system in this circuit alone, with 12,216 of them on supervised release. Admin. Office of the United States Courts, 2009 Annual Report of the Director: Judicial Business of the United States Courts, tbl. E-2 (forthcoming spring 2010). And that does not count all of those on pre-trial supervision or the thousands of presentence investigation reports that the federal officers in this circuit have to complete each year. The nationwide situation was summed up by Dr. Berlin (the same one who evaluated Irey for purposes of this case), when he testified before Congress that: "Many of these parole and probation people are stretched very thin. I think we want to be able to have them have smaller case loads." Protecting Our Nation's Children from Sexual Predators and Violent Criminals: What Needs to Be Done?, Hearing Before the Subcomm. on Crime, Terrorism, and Homeland Security of the H. Comm. on the Judiciary, 109th Cong. 30 (2005) (statement of Fred S. Berlin, M.D., Associate Professor, Johns Hopkins University).
Regardless of why so many convicted criminals on supervised release, including sex offenders, commit new crimes, the fact is that they do. Supervised release is better than unsupervised release, but it does not offer society the level of protection from a convicted criminal that incarceration does. Despite that undeniable fact, the district court found that Irey, one of the worst sex offenders ever prosecuted in this circuit, had a low risk of recidivism, or would pose a low risk when released at the end of the reduced sentence it imposed on him.
The government, however, has never attacked that factfinding as clearly erroneous. Instead, it has insisted throughout this appeal that it is not challenging any of the factfindings. As a result, for purposes of this appeal we will assume that at the end of a 17½-year sentence — 15 years and 3 months after it was imposed — Irey would present a low risk of recidivism.
This is another part of our opinion that Judge Tjoflat in his separate opinion has misread. His opinion operates under the erroneous assumption that we have rejected the district court's finding that when Irey is released from the sentence it imposed on him and goes on supervised release he will pose a low risk of recidivism. See Separate Op. of Tjoflat, J., at 1264-65. Although we have pointed out for the benefit of sentencing courts in the future the reasons and decisions indicating that the district court's finding is wrong, because the government has not challenged the factfinding we have expressly accepted the low risk of recidivism finding for purposes of reviewing this sentence.
That does not mean, however, that the sentence the district court imposed will adequately "protect the public from further crimes of the defendant," as § 3553(a)(2)(C) requires. A low risk is not the same as no risk. Adequate protection is a function of two variables: the level of risk that conduct will occur and the level of harm that will be inflicted if that conduct does occur. See United States v. Boyd, 475 F.3d 875, 877-78 (7th Cir. 2007) (upholding a sentencing determination that the defendant's acts created a substantial risk of bodily injury to another person in part because "[d]angerousness is a function of the magnitude of the harm that will occur if danger materializes and the probability that it will materialize"). With child sexual abuse of the kind that we know Irey is capable of and has committed, the harm is enormous and permanent. It can literally destroy lives. Accordingly, even with an assumed low risk of recidivism following release in 15 years and 3 months, imprisonment for that length of time does not afford adequate protection from further crimes by him. The district court imposed not one extra month over the statutory minimum for the purpose of protecting society and its children from further crimes by Irey, stating: "I don't think society needs further protection from him, at least beyond the statutory minimum sentence." Given the magnitude of the harm that will occur if Irey does commit more sexual crimes against children, that was a clear error in judgment.
5. Section 3553(a)(4) (5)
District courts in sentencing, and courts of appeals in reviewing sentences, must also consider the guidelines range and any pertinent policy statements in the guidelines. 18 U.S.C. § 3553(a)(4)-(5). Of course, since Booker the guidelines have been advisory, but they are still to be given respectful consideration. We have not attempted to specify any particular weight that should be given to the guidelines range and will not do so now. Our best discussion of the subject came in United States v. Hunt, 459 F.3d 1180 (11th Cir. 2006), where we rejected "any across-the-board prescription regarding the appropriate deference to give the Guidelines." Id. at 1184. We decided instead that, subject to review for reasonableness, sentencing courts may "determine, on a case-by-case basis, the weight to give the Guidelines, so long as that determination is made with reference to the remaining section 3553(a) factors that the court must also consider in calculating the defendant's sentence." Id. at 1185. In doing so, we recognized that " Booker restored to district courts a measure of discretion that the mandatory Guidelines had removed," id. at 1184, but we added this important caveat: "This discretion is bounded, of course, by Congress's mandate to consider the factors in section 3553(a), one of which, subsection four, is the Sentencing Guidelines." Id.
Section 3553(a)(2)(D) requires consideration of the need "to provide the defendant with needed educational or vocational training, medical care, or other correctional treatment in the most effective manner," and § 3553(a)(3) requires consideration of "the kinds of sentences available." No one suggests that either of those two considerations is relevant to this appeal. Nor has anyone mentioned the § 3553(a)(7) factor, "the need to provide restitution to any victims of the offense."
We stressed in Hunt that consideration of the advisory guidelines range is important, because the guidelines "are an indispensable tool in helping courts achieve Congress's mandate to consider `the need to avoid unwarranted sentence disparities' among similarly situated defendants," id., which is required by 18 U.S.C. § 3553(a)(6). Even though not bound by the guidelines, a sentencing court may not give them so little consideration that it amounts to "not giv[ing] any real weight to the Guidelines range in imposing the sentence." Pugh, 515 F.3d at 1200; see also Booker, 543 U.S. at 264, 125 S.Ct. at 767 ("The district courts, while not bound to apply the Guidelines, must consult those Guidelines and take them into account when sentencing."). See generally Kimbrough, 552 U.S. at 107, 128 S.Ct. at 573-74 ("[I]t is unquestioned that uniformity remains an important goal of sentencing. As we explained in Booker, however, advisory Guidelines combined with appellate review for reasonableness and ongoing revision of the Guidelines in response to sentencing practices will help `to avoid excessive sentencing disparities.'"); Rita, 551 U.S. at 348, 127 S.Ct. at 2463 ("The upshot is that the sentencing statutes envision both the sentencing judge and the Commission as carrying out the same basic § 3553(a) objectives, the one, at retail, the other at wholesale."). In this case, the advisory guidelines range calculated out at life imprisonment and was lowered to thirty years only because that is the statutory maximum based on the way the crime was charged. See supra at 1169-70. In view of all of the facts and circumstances of this case, and given the weakness of the district court's explanation for deviating from the guidelines range, it effectively gave the guidelines range no real weight in imposing the sentence.
In addition to requiring consideration of the guidelines range, the Sentencing Reform Act also requires that district courts consider any pertinent policy statement issued by the Sentencing Commission. 18 U.S.C. § 3553(a)(5). The policy statements in the guidelines that are relevant to this case address when departures are appropriate in calculating the sentencing range. We are not dealing with a guidelines departure decision here, but a § 3553(a) variance decision. Still, even though the policy statements are in no way binding, § 3553(a)(5) requires that they be considered in making decisions about variances. All of the policy statements point in one direction in this case and that is away from a below-the-guidelines sentence.
The guidelines state as a matter of policy that age "is not ordinarily relevant in determining whether a departure is warranted," at least not unless "the defendant is elderly and infirm." U.S.S.G. § 5H1.1. In the present case the district court expressly considered Irey's age at sentencing (50 years) in his favor, even though he was not elderly or infirm.
The guidelines state as a matter of policy that "civic, charitable, or public service . . . and similar prior good works are not ordinarily relevant in determining whether a departure is warranted." Id. § 5H1.11. Yet one of the reasons the district court gave for varying downward was Irey's civic work — that he had been "a good person to his community." The guidelines also advise, as a matter of policy, that aberrant behavior may be used to support a downward departure only if, among other things, "the defendant committed a single criminal occurrence or single criminal transaction" that was "without significant planning" and "was of limited duration." Id. § 5K2.20(b). This case does not fit any of those requirements, yet the district court used what amounted to an aberrant behavior theory as part of the justification for its downward variance, stating: "I think other than the acts of Mr. Irey, there's no indication that he has engaged in any other sort of criminal conduct or conduct representing poor character."
The district court either overlooked the fact that Irey, a married man, had patronized prostitutes on a weekly basis for 15 years, or it thought that doing so does not "represent[] poor character."
The guidelines state as a matter of policy that "[m]ental and emotional conditions are not ordinarily relevant in determining whether a departure is warranted," except in circumstances not present here. Id. § 5H1.3. Yet in deciding to vary downward, the district court placed significant weight on Irey having what it characterized as the "illness" of pedophilia. To the extent that the district court relied on its belief that because he was a pedophile Irey had diminished capacity to resist raping children, or that his criminal behavior was due in substantial part to pedophilia, another policy statement is relevant. The guidelines state that a court should not depart downward based on diminished capacity where "the offense involved actual violence or a serious threat of violence," or where the defendant has been convicted of an offense under Chapter 110 of Title 18, which Irey was. Id. § 5K2.13.
There are also guideline policy statements advising that an upward departure would be appropriate in this case. While Irey's criminal conduct was so extreme that the guideline calculations maxed out at life even without any upward departures, § 3553(a)(2)(5) still expressly requires that those policy statements be considered. As the Presentence Report in this case noted, the comment to § 2G2.1 advises that "[a]n upward departure may be warranted if the offense involved more than 10 minors." Id. § 2G2.1 cmt. n. 6. Irey's criminal conduct involved at least five times more than 10 minors, yet the district court varied downward. The guideline policy statements also call for an upward departure "[i]f the defendant's conduct was unusually heinous, cruel, brutal, or degrading to the victim." Id. § 5K2.8. Everyone agrees that what Irey did fits within that description, yet the district court varied downward.
The cited comment to § 2G2.1 of the guidelines is technically not a policy statement, but the guidelines provide that it is to be treated as one. See U.S.S.G. § 1B1.7 ("Such commentary is to be treated as the legal equivalent of a policy statement."); see also United States v. Smith, 568 F.3d 923, 927 n. 1 (11th Cir. 2009) ("The commentary and application notes of the Sentencing Guidelines are authoritative, unless they are plainly erroneous, inconsistent with the regulation they interpret, or contrary to the Constitution or federal law.").
While not binding on the district court, the policy statements in the guidelines, which it was required by the Sentencing Reform Act to consider, all advise against a sentence below the guidelines range. The district court effectively ignored them all.
With one exception. The district court did impose a lifetime term of supervised release, as the policy statement in U.S.S.G. § 5D1.2(b) advises for all cases where the defendant was convicted of a sex offense against a minor.
6. Section 3553(a)(6)
Section 3553(a) requires that district courts in sentencing, and courts of appeals in reviewing sentences, "consider . . . the need to avoid unwarranted sentence disparities among defendants with similar records who have been found guilty of similar conduct." 18 U.S.C. § 3553(a)(6). This factor is a particularly important one when reviewing the substantive reasonableness of a sentence because one of the primary purposes of appellate review of sentences is to iron out differences in order to avoid undue disparity. Booker, 543 U.S. at 264, 125 S.Ct. at 767.
It is difficult to find a case involving sexual abuse of children that compares to this one. The number of Irey's victims (at least 50), the very young age (four, five, and six years old) of some of them, the extreme nature of the abuse and torture that he inflicted on them, the number of years it went on (four or five), and the massive amount of graphic child pornography that he single-handedly produced and distributed (at least 1,200 photographs or videos showing Irey himself sexually abusing the children) combine to make his criminal behavior the worst of the worst. Yet, the district court gave Irey a major downward variance, resulting in a sentence just above the statutory minimum and more than a decade below the guidelines range. That sentence is seriously out of line with sentences imposed on other defendants whose criminal behavior, while atrocious in some cases, was not as extreme as Irey's or did not involve as many victims. See, e.g., United States v. Frank, 599 F.3d 1221 (11th Cir. 2010) (40-year sentence for defendant who had twice traveled to Cambodia, where he paid three girls who were between the ages of approximately 11 and 15 to engage in sexual acts with him and to take sexually explicit pictures of those acts); United States v. Culver, 598 F.3d 740 (11th Cir. 2010) (60-year sentence for defendant who fell within criminal history category II, had used tranquilizers and a stun gun to render his 13-year-old stepdaughter unconscious, and had produced a pornographic videotape and four pictures depicting the unconscious girl); United States v. Huskey, 349 Fed.Appx. 495 (11th Cir. 2009) (70-year sentence for defendant, who (like Irey) fell within criminal history category I, who engaged in anal, oral, and vaginal sex with his daughter and penetrated her vagina with objects, while she was between the ages of 6 and 9, recorded the abuse in photographs and on videotapes, and traded images of the abuse over the internet for other child pornography); Sarras, 575 F.3d 1191 (100-year sentence for the defendant, who fell within criminal history category I, who engaged in oral and vaginal sex with his 13-year-old step-daughter approximately 23 times during a 4-month period and photographed it on three of those occasions); United States v. Kapordelis, 569 F.3d 1291 (11th Cir. 2009) (35-year sentence for the defendant, who fell within criminal history category I, who over a span of at least 20 years: drugged two boys, aged 11 and 14, on three occasions before photographing their genitalia; traveled abroad, where he molested and took digital videos and pictures of three minors, some of whom he had drugged, and engaged in oral and anal sex with at least one 17-year-old; solicited sex from male prostitutes under the age of 18 while in foreign countries; drugged his 16-year-old second cousin and then videotaped himself having sex with the minor; and possessed approximately 10,580 images and 400 videos of child pornography, some of which featured victims he had personally molested); United States v. Wilcox, 324 Fed.Appx. 805 (11th Cir. 2009) (45-year sentence for the defendant, a 50-year-old diabetic with no prior criminal history, who took and posted on the internet pornographic photographs of himself touching an 11-year-old girl, attempted to gain commercially from the photographs, and possessed approximately 120 child pornography images, including a sadistic picture of a 5-year-old girl wearing a dog collar while being vaginally penetrated by an unidentified male); United States v. Harris, 291 Fed.Appx. 300 (11th Cir. 2008) (30-year sentence for the defendant, who fell within criminal history category I, who filmed and photographed seven 15- and 16-year-old boys, two of whom were his godchildren, engaging in sexual acts with each other in his bedroom, shared videos and photographs depicting those occurrences with others, and on one occasion invited his friend over to watch two underage males engage in sexual activities and then filmed as his friend had sex with one of them); United States v. Carter, 292 Fed.Appx. 16 (11th Cir. 2008) (45-year sentence for the defendant, with no specified criminal history, who possessed approximately 4,800 image, text, and movie files depicting or describing the sexual exploitation, including bondage, of at least eleven different young girls, ages 7 to 14; some of those files were produced and distributed by the defendant himself and depicted him touching the genitalia of two young girls); United States v. Oliver, 281 Fed.Appx. 898 (11th Cir. 2008) (130-year sentence for the defendant, with no criminal record that was mentioned, who produced images of himself molesting a single victim, his 6-year-old granddaughter, and distributed those images over the internet); United States v. Hodnett, 210 Fed.Appx. 949 (11th Cir. 2006) (30-year sentence for the defendant, who fell within criminal history category I, who possessed at least 600 images of child pornography, some of which depicted prepubescent minors engaged in sexual activity, traded images of child pornography over the internet, and had in the past engaged in the following sexual activities with minors: kidnaping and raping a 6-year-old Vietnamese girl in 1969 while serving in Vietnam; molesting and engaging in sexual intercourse with his two stepdaughters in the 1970s; and engaging in oral sex with a 6-year-old girl in 2004); United States v. Foster, 209 Fed.Appx. 942 (11th Cir. 2006) (life imprisonment for the defendant who fell within criminal history category I, and who during a 4-year period engaged in oral and vaginal sex with a single victim who was less than 12 years old when the abuse began); United States v. Johnson, 451 F.3d 1239 (11th Cir. 2006) (140-year sentence for the defendant, who had two prior convictions for lewd acts in front of minors, who sexually abused and photographed three boys between the ages of 8 and 16 over an approximately 6-year period, produced at least 150 pornographic images of the victims, transmitted an unknown number of those images over the internet, and either possessed or transmitted at least 24 videos of children engaging in sexually explicit conduct); United States v. Hersh, 297 F.3d 1233 (11th Cir. 2002) (105-year sentence for the defendant, who fell within criminal history category I, and who traveled to third world countries during a period of 20 years and enticed at least eight boys, between 8 and 17 years old, to engage in sex with him, encouraged them to engage in sex with a fellow pedophile, convinced one Honduran family to allow their minor son to live with him illegally in the United States, and possessed at least 120 images of child pornography).
We include a number of unpublished opinions in this list, citing each one not for any holding but solely for the facts about the crime and the sentence imposed by the district court. See supra at 1215 n. 34.
The defendant in Sarras was sentenced in the same courthouse the same year as Irey but by a different district court judge.
While the criminal conduct of all the defendants in the cited cases ranges from serious to truly depraved, none of it is worse than Irey's criminal conduct, yet he received a sentence far more lenient than they did. The lesser sentence the district court imposed on Irey by means of a major downward variance creates a substantial disparity. The disparity arises not because the defendants in the cited cases were denied a downward variance they should have received and were sentenced too harshly, but because Irey was given a downward variance he should not have received and was sentenced too leniently. The unreasonableness is not in the sentences imposed in the cited cases but in the sentence imposed in this case.
Judge Barkett's dissenting opinion argues that we cannot assess whether Irey is similarly situated to any defendant convicted of sexually abusing children "without the benefit of the entirety of the sentencing records of all [those] defendants." Dissenting Op. of Barkett, J., at 1278 n. 1. The statutory command is to consider "the need to avoid unwarranted sentence disparities among defendants with similar records who have been found guilty of similar conduct." 18 U.S.C. § 3553(a)(6). That information can be discerned from the appellate opinion in most cases, including those that we have cited. See also Kimbrough, 552 U.S. at 108, 128 S.Ct. at 574 (holding that the statute requires consideration of sentences of other courts in order to comply with § 3553(a)(6)'s instruction that the need to avoid unwarranted sentencing disparities be taken into account). Any requirement that the record in other cases be scoured before the sentences in those cases can be considered would render it impossible to comply with the statute, and we will not interpret the statute in a way that effectively renders it a nullity, see, e.g., Hibbs v. Winn, 542 U.S. 88, 101, 124 S.Ct. 2276, 2286, 159 L.Ed.2d 172 (2004), and ignores what the Supreme Court has said about it.
7. What "It Comes Down To"
The district court suggested that these factors weighed in Irey's favor: he was 50 years old; his family still loved him; when he was not consorting with prostitutes in this country or raping, sodomizing, and torturing little girls in Cambodia, he was not such a bad guy; the "illness" of pedophilia rendered his criminal acts "not purely volitional"; and he was a victim of child pornography on the internet. The court discounted the value of general deterrence for sexual crimes against children. It thought that Irey would present a low risk of recidivism once released and, as a result, no time above the statutory minimum was needed to protect society from him. The result the court reached created an unwarranted sentence disparity among defendants who have committed comparable or less egregious offenses involving the sexual abuse of children. Along the way to its final sentencing decision the district court, as we have explained, committed a number of subsidiary errors in judgment, but even if we disregard all of them there remains one overriding clear error in judgment that renders the downward variance sentence substantively unreasonable.
After discussing the other factors, the district court said: "It comes down to my view of what promotes respect for the law and provides just punishment." The district court was right about the importance of the § 3553(a)(2)(A) factor, which requires consideration of the need for the sentence imposed "to reflect the seriousness of the offense, to promote respect for the law, and to provide just punishment for the offense." But the court was wrong, it committed a clear error in judgment, in deciding that those purposes could be served by a major downward variance to a point closer to the statutory minimum sentence than it is to the guidelines range. The district court's leap from the advisory guidelines sentence of 30 years down to a just-above-minimum sentence of 17½ years does not reflect the seriousness of and provide just punishment for Irey's rape, sodomy, and sexual torture of at least fifty children, acts that he committed "many many times" over a four-or five- year period, and his production and distribution of one of the worst series of child pornography on the internet. Nor does it promote respect for the law.
For all of the reasons we have explained, no downward variance from the guidelines range is reasonable in this case. Nothing less than the advisory guidelines sentence of 30 years, which is the maximum available, will serve the sentencing purposes set out in § 3553(a). We are left with the definite and firm conviction that it was substantively unreasonable, a clear error in judgment, an abuse of discretion, for the district court to conclude to the contrary. Were we to hold otherwise, "we would come perilously close to holding that appellate review is limited to procedural irregularity," and that the Supreme Court has "eviscerated appellate review at the same time that it has mandated the appellate courts to continue to review sentences for reasonableness." Pugh, 515 F.3d at 1203-04. That paradoxical holding would throw us back a quarter of a century into the pre-Sentencing Reform Act era, with its "non-system in which every judge is a law unto himself or herself," Frankel, Jail Sentence Reform, at E21, an era that is gone for good.
In reaching this conclusion, we are not, as Judge Tjoflat asserts, usurping the district court's sentencing role. Separate Op. of Tjoflat, J., at 1258-60. Instead, we are performing our sentence review role. Again, the Supreme Court has instructed us that "district judges at times make mistakes that are substantive" and "impose sentences that are unreasonable," and we "exist to correct such mistakes when they occur." Rita, 551 U.S. at 354, 127 S.Ct. at 2466-67. In the course of reviewing this sentence, we have determined that, given the extreme facts in the case, a downward deviation from the guidelines range is not substantively reasonable. We have made that decision after studying the record of the sentence proceedings, which is complete; considering the district court's findings and explanation, which are adequate for the purpose; granting the district court's decision the full measure of deference that it is due; and considering all of the arguments of the parties for and against the reasonableness of the sentence. That is what appellate courts are supposed to do.
Nor are we, as Judge Tjoflat's opinion charges, taking a step toward creating, through judicial decisions, a system of mandatory sentencing ranges "that is identical in all relevant respects to [the pre- Booker] mandatory-Guidelines sentencing range[s]." Separate Op. of Tjoflat, J., at 1267 n. 98. We are simply doing our duty, as prescribed in Rita, to review the substantive reasonableness of the sentence imposed in this case.
Judge Tjoflat's separate opinion goes to great lengths to accuse us of addressing arguments that were not raised and preserved in the district court. See Separate Op. of Tjoflat, J., at 1258-59, 1262-65. Much of that opinion's analysis is based on the faulty premise that the government made only a "simple objection" that Irey's sentence is "unreasonable." Id. at 1259. As we have already explained, however, the government has been arguing for a 30-year sentence ever since it filed the sentencing memorandum in the district court. See supra at 1170. That memorandum emphasized the sheer magnitude and utter depravity of Irey's criminal conduct and urged the court to respect Congress' findings that "departures should be extremely rare in child sex crime cases" because of the seriousness of those crimes. The government specifically argued that a variance would not be justified even if Irey's risk of recidivism was low, his capacity was diminished, his behavior was aberrant, his family ties and responsibilities were significant, and his decisions were clouded by his pedophilia. Indeed, the government said that "any variance under 18 U.S.C. § 3553(a) would be unreasonable because there is nothing unusual about the nature or circumstances of this offense or the defendant's personal characteristics." The government argued in its sentencing memorandum that "[i]f this case is atypical, it is because of aggravating, not mitigating, factors." And it took the same position at the sentence hearing. See supra at 1176-77.
The government's objection that Irey's sentence was substantively unreasonable was sufficient to preserve the specific grounds for the objection that it had already raised in its sentencing memorandum and in its arguments during the sentence proceeding. Especially given the context of the sentence proceedings, the government did not need to regurgitate its arguments in favor of a 30-year sentence after the court had pronounced the sentence; it is enough that the government objected to the downward variance sentence as unreasonable. See United States v. Maurice, 69 F.3d 1553, 1557 (11th Cir. 1995) (holding that a general objection after the sentence was announced is sufficient to preserve supporting arguments made before it was announced where the reasons for the objection are clear); see also United States v. Candelario, 240 F.3d 1300, 1304-05 (11th Cir. 2001) (Tjoflat, J.) (citing, with approval, a circuit court decision "reviewing the defendant's sentence under preserved error review where the defendant argued in his sentencing memorandum that the amount of drugs for which he was to be sentenced had to be pleaded in the indictment and found by the jury beyond a reasonable doubt" (emphasis added) (quotation marks omitted)); see also United States v. Bartlett, 567 F.3d 901, 910 (7th Cir. 2009); United States v. Guthrie, 557 F.3d 243, 255 (6th Cir. 2009); United States v. Curry, 461 F.3d 452, 459 (4th Cir. 2006) (concluding that the government, "by vigorously arguing for a sentence within the Guidelines range throughout the sentencing hearing," had preserved its objection to the sentence even though it did not object at the end of the sentencing colloquy); United States v. Shumard, 120 F.3d 339, 340 (2d Cir. 1997).
We have specifically recognized that so long as the government raises "the crux of its objection to the district court's sentence," it is not required to articulate all the details of its position. United States v. Smith, 39 F.3d 1143, 1146 (11th Cir. 1994); see also United States v. Livesay, 484 F.3d 1324, 1327-29 1330 n. 7 (11th Cir. 2007) (concluding that the government's objection to the extent of the downward departure also preserved an objection "to the reasonableness of the overall sentence"), vacated on other grounds, 552 U.S. 1092, 128 S.Ct. 872, 169 L.Ed.2d 712 (2008); United States v. Arevalo-Juarez, 464 F.3d 1246, 1249-50 (11th Cir. 2006) (stating that even though the district court did not grant a departure the government's argument that a departure was unwarranted was enough to preserve the issue of whether the sentence was otherwise unreasonable); see also United States v. Carlson, 498 F.3d 761, 763 n. 2 (8th Cir. 2007); United States v. Pineiro, 470 F.3d 200, 204-05 (5th Cir. 2006) ("We have never required a party to express its objection in minute detail or ultra-precise terms.").
On a similar point, Judge Tjoflat's opinion accuses us of implicitly overruling United States v. Jones, 899 F.2d 1097 (11th Cir. 1990), overruled on other grounds by United States v. Morrill, 984 F.2d 1136 (11th Cir. 1993) (en banc), by allowing an unexplained objection that a sentence is "substantively unreasonable" to trigger the equivalent of a new sentencing hearing on appeal. See Separate Op. of Tjoflat, J., at 3538-39 n. 90. Our decision, however, is consistent with Jones and its progeny. In United States v. Weir, 51 F.3d 1031 (11th Cir. 1995), we explained that "[i]f the relevant objection is raised after the presentation of the [pre-sentence investigation] report, . . . but before the actual imposition of the sentence, Jones is satisfied." Id. at 1033. Specifically, in Weir, we held that Jones was satisfied because "[t]he district court clearly understood the Government's position and specifically rejected it." Id. Similarly, we held in Maurice that the rationales behind Jones "are served so long as the objection to be preserved and the grounds for the objection are clear to the sentencing court at the conclusion of the hearing." 69 F.3d at 1557. As a result, "a party is not required to reargue a general objection made after sentencing if the argument in support of that objection has previously been presented to the sentencing court and the reasons for the objection remain clear after the sentence is pronounced." Id. The government did enough to preserve all of the arguments in favor of a 30-year sentence here.
This is one of those unusual cases where the top and bottom of the guidelines range are the same; both are 30 years. There can be no upward variance because the statutory maximum is also 30 years. As a result, our holding that no downward variance is reasonable under the totality of the facts and circumstances of this case means that on remand the sentence must be 30 years. There is no other sentence left. When we vacate a district court's judgment and remand, we routinely include in the bottom line of our decision that we are sending the case back for "proceedings consistent with this opinion." Because we have determined that a downward deviation from the guidelines range in this case is unreasonable, it follows that the only action on remand that will be consistent with this opinion is resentencing within the guidelines range, which necessarily means a sentence of 30 years.
Judge Tjoflat's separate opinion points out that in none of the other cases where we have vacated a sentence as unreasonable have we directed the district court to enter a particular sentence. Separate Op. of Tjoflat, J., at 3541 n. 96. That is true, but in none of those four other cases did we have both extreme facts and circumstances rendering any downward variance unreasonable and a pinpoint guidelines range — one where the bottom and top were the same sentence. Because this is an unprecedented situation, it adds nothing to label our decision an "unprecedented step." Id. at 1265. Whatever we do in a situation that has never been before us is, by definition, an unprecedented step one way or the other.
Having determined that no downward variance is reasonable, it would be senseless to remand with instructions that permit the district court to downwardly vary and resentence below the guidelines range again. If the district court on remand resentenced Irey to 20 years, we would have to vacate that sentence and send the case back. If the court then tried out a sentence of 22.5 years, we would have to vacate that sentence and send the case back again. And so on, back and forth the case would go in a pointless ping pong game. To borrow Judge Tjoflat's hyperbolic language, such proceedings would "gobble[] up judicial resources" that could be better spent elsewhere. Separate Op. of Tjoflat, J., at 1270. Doing as he suggests would prevent the first appeal from a sentence from being "the main event" for determining whether a sentence is substantively reasonable and would instead send "the unmistakable message that [the first appeal of a sentence] is nothing but a tryout on the road." Id. at 1268. That would be, to use his term, "shocking." Id. at 1259.
V. CONCLUSION
Because of the substantial deference district courts are due in sentencing, we give their decisions about what is reasonable wide berth and almost always let them pass. There is a difference, though, between recognizing that another usually has the right of way and abandoning one's post. We will not quit the post that we have been ordered to hold in sentencing review and the responsibility that goes with it. The Supreme Court has instructed us that "[i]n sentencing, as in other areas, district judges at times make mistakes that are substantive," and that it is our duty "to correct such mistakes when they occur." Rita, 551 U.S. at 354, 127 S.Ct. at 2466-67.
In this case the district court made a substantive mistake, a clear error in judgment, by unreasonably varying downward from the advisory guidelines sentence when no sentence less than it is sufficient to fulfill the purposes set forth in the Sentencing Reform Act. To do our duty to correct that mistake, we vacate the sentence the district court imposed and remand with instructions that the defendant is to be resentenced within the guidelines range.
VACATED AND REMANDED.
TJOFLAT, Circuit Judge, specially concurring in part and dissenting in part:
I concur with the court's judgment that Irey's sentence must be vacated but dissent as to the instruction that the district court sentence Irey to 30 years' imprisonment. I write separately because in reaching this result, the court asks the wrong question and gives the wrong answer. Today's decision cements this circuit's approach to one of the most difficult questions posed by United States v. Booker, 543 U.S. 404, 125 S.Ct. 738, 160 L.Ed.2d 621 (2005): what is the proper role of the courts of appeals now that the once mandatory Guidelines are only advisory?
The court asks whether Irey's sentence achieves the purposes of 18 U.S.C. § 3553(a). After conducting its own § 3553(a) analysis, the court answers "no," then proceeds to decide what would be an appropriate sentence: 30 years' imprisonment. It orders the district court to impose this sentence on remand. It does so on the basis of new evidence and arguments that the Government never presented to the district court. In short, we have assumed the role of resentencer.
Resentencing defendants on appeal does immense harm to this court's institutional relationship with the district courts by transforming the district court's sentencing proceeding from the "main event" to a "tryout on the road." This, in turn, creates perverse incentives for the parties and the district court, misallocates judicial resources, and creates disrespect for the rule of law.
In my view, the right question for us to ask is whether the district court abused its discretion. The correct answer is "yes" because its factfindings as best I can understand them cannot be reconciled with the sentence it imposed. The correct disposition is to vacate and remand for resentencing. With this approach, we would preserve our traditional function as an appellate court and ensure that the district court is the forum for the main event, which is required by United States v. Booker, 543 U.S. 404, 125 S.Ct. 738, 160 L.Ed.2d 621 (2005).
To understand the roles Booker assigned to the district court, the Sentencing Commission, and the courts of appeals, it is necessary to see the evolution of these roles over time. This opinion is therefore organized as follows: part I describes the sentencing model before and under the Sentencing Reform Act (the "SRA") before Booker, part II sets out the sentencing model after Booker, part III applies abuse of discretion review to the case at bar, and part IV surveys the court's approach and resulting institutional harm. Part V concludes.
Sentencing Reform Act of 1984, Pub.L. No. 88-473, 98 Stat. 1987 (codified, as amended, in scattered sections of 18 and 28 U.S.C.).
I. Pre- Booker A. Pre-SRA
Understanding the sentencing model I apply today requires understanding the deeply rooted purposes of sentencing and their evolution in American criminal law.
Prior to the American Revolution, colonial courts fashioned sentences with three basic purposes in mind: to punish the offender for his crime, thereby satisfying society's desire for retribution ("punishment"); to deter others from committing the same crime by demonstrating its disadvantageous consequences ("general deterrence"); and to incapacitate the wrongdoer, so as to protect society from further criminal activity ("specific deterrence" or "incapacitation").
United States v. Scroggins, 880 F.2d 1204, 1206 (11th Cir. 1989). In the 1800s, penological experts became "dissatisfied with the failure of prisons to rehabilitate inmates," and rehabilitation became a fourth basic purpose of sentencing.
See Arthur W. Campbell,
The Law of Sentencing § 1:2 (2009). The American tradition thus embraced four purposes of sentencing — punishment, general deterrence, specific deterrence, and rehabilitation;
this tradition has continued to the present day.
See United States v. Brown, 381 U.S. 437, 458, 85 S.Ct. 1707, 1720, 14 L.Ed.2d 484 (1965).
An early model of sentencing that combined theseical guaranty in favor of the new lender, and wisco executed a substantially identical indemnity obligation, PWC issued another opinion finding that the refinancing was tax free as well.
Characterization of the Transaction for Tax and Non-Tax Purposes
Chesapeake timely filed a consolidated Federal tax return for 1999. Chesapeake disclosed the transaction on Schedule M of the return and reported $377,092,299 book gain but no corresponding tax gain. Chesapeake treated the special distribution as non-taxable on the theory that it was a debt-financed transfer of consideration, not the proceeds of a sale.
Unlike its treatment for tax purposes, Chesapeake treated the transaction as a sale for financial accounting purposes. Chesapeake did not treat the indemnity obligation as a liability for accounting purposes because Chesapeake determined that there was no more than a remote chance the indemnity would be triggered. Despite Chesapeake's characterization for tax purposes, PWC and Salomon each referred to the transaction as a sale.
Standard Poor's, Moody's and stock analysts also treated the transaction as a sale. Chesapeake executives represented to Standard Poor's and Moody's that the only risk associated with the transaction came not from Wisco's agreement to indemnify GP but from the tax risk. Moody's downgraded Chesapeake after the announced joint venture because of Chesapeake's readjusted focus, the monetization of wisco, and the resulting loss of operating income. Standard Poor's kept its rating of Chesapeake the same because Chesapeake generated significant cash by divesting itself of wisco for $755 million and of its timberlands for $186 million.
End of the Joint Venture
The joint venture operated for only a full year. It ended in 2001 when GP sought to acquire the Fort James Corporation. The Department of Justice required GP to sell its LLC interest for antitrust purposes. GP contacted Svenska Cellulosa Aktiebolaget (SCA), a Swedish company, about purchasing its LLC interest, SCA informed GP that it was interested in purchasing only the entire LLC, not just GP's interest in the LLC. Therefore, GP needed to buy Wisco's interest in the joint venture. WISCO agreed to sell its minority interest in the LLC to GP for $41 million, which represented a gain of $21.2 million from its initial valuation of $19.8 million. GP also paid Chesapeake $196 million to compensate Chesapeake for any loss of tax deferral. WISCO declared a $166,080,510 dividend to Chesapeake payable by cancelling Chesapeake's promissory note in 2001.
Chesapeake reported a $524 million capital gain on its consolidated Federal tax return for 2001. Chesapeake determined that the termination of the indemnity resulted in WISCO receiving a deemed distribution under section 752. Chesapeake also reported the $196 million tax cost payment it received from GP as ordinary income on its consolidated Federal tax return for 2001.
Respondent issued Chesapeake the deficiency notice for 1999. In the deficiency notice, respondent determined the joint venture transaction to be a disguised sale that produced $524 million of capital gain includable in Chesapeake's Consolidated income for 1999. Chesapeake timely filed a petition. Respondent asserted in an amended answer a $36,691,796 accuracy-related penalty under section 6662 for substantial understatement of income tax.
OPINION
We are asked to decide whether the joint venture transaction constituted a taxable sale. Respondent argues that Chesapeake structured the transaction to defer $524 million of capital gain for a period of 30 years or more. Specifically, respondent contends that wisco did not bear any economic risk of loss when it entered the joint venture agreement because the anti-abuse rule disregards wisco's obligation to indemnify GP. See sec. 1.752-2(j), Income Tax Regs. Respondent concludes that the transaction should be treated as a taxable disguised sale.
Chesapeake asserts that the transaction should not be recast as a sale. Instead, Chesapeake argues that the anti-abuse rule does not disregard wisco's indemnity and that the LLC's distribution of cash to wisco comes within the exception for debt-financed transfers. We disagree and begin with the general rules on disguised sales.
I. Disguised Sale Transactions
The Code provides generally that partners may contribute capital to a partnership tax free and may receive a tax free return of previously taxed profits through distributions. See sees. 721, 731. These nonrecognition rules do not apply, however, where the transaction is found to be a disguised sale of property. See sec. 707(a)(2)(B).
Sec. 731 concerns distributions to a partner acting in his capacity as a partner. Neither party asserts that sec. 731 applies in this case. Moreover, sec. 731 does not apply if a partner contributes property to a partnership and the partnership distributes property to the partner within a short period to effect an exchange of property between two or more partners or between the partnership and a partner. Sec. 1.731-1(c)(3), Income Tax Regs. We will not therefore consider the effect of sec. 731 on the transaction. See sec. 1.707-1(a), Income Tax Regs.
Transfers described in sec. 707(a)(2)(B) are treated as occurring between a partnership and a non-partner or partner acting outside his capacity as a member of the partnership. Sec. 707(a)(1), (2)(B).
A disguised sale may occur when a partner contributes property to a partnership and soon thereafter receives a distribution of money or other consideration from the partnership. Id. A transaction may be deemed a sale if, based on all the facts and circumstances, the partnership's distribution of money or other consideration to the partner would not have been made but for the partner's transfer of the property. Sec. 1.707-3(b)(1), Income Tax Regs, (emphasis added). Such contribution and distribution transactions that occur within two years of one another are presumed to effect a sale unless the facts and circumstances clearly establish otherwise (the 2-year presumption). Sec. 1.707-3(c)(1), Income Tax Regs.
Here, wisco transferred its assets with an agreed value of $775 million to the LLC and simultaneously received a cash distribution of $755.2 million. After the transfer and distribution, WISCO had a 5-percent interest in the LLC. Its assets included only its interest in the LLC, the intercompany note and the jet. We therefore view the transactions together and presume a sale under the disguised sale rules unless the facts and circumstances dictate otherwise.
Chesapeake contends that the special distribution was not part of a disguised sale. Instead, it was a debt-financed transfer of consideration, an exception to the disguised sale rules. See sec. 1.707-5(b), Income Tax Regs. Chesapeake argues that the debt-financed transfer of consideration exception to the disguised sale rules limits the applicability of the disguised sale rules and the 2-year presumption in this case.
A. Debt-Financed Transfer of Consideration
We now turn to the debt-financed transfer of consideration exception to the disguised sale rules. The regulations except certain debt-financed distributions in determining whether a partner received "money or other consideration" for disguised sale purposes. See id. A distribution financed from the proceeds of a partnership liability may be taken into account for disguised sale purposes to the extent the distribution exceeds the distributee partner's allocable share of the partnership liability. See sec. 1.707-5(b)(1), Income Tax Regs. Respondent argues that the entire distribution from the LLC to WISCO should be taken into account for purposes of determining a disguised sale because WISCO did not bear any of the allocable share of the LLC's liability to finance the distribution.
A distribution qualifies as a debt-financed transfer if it meets certain requirements. See sec. 1.707-5(b)(1), Income Tax Regs. We consider only the requirements at issue.
We turn now to whether WISCO had any allocable share of the LLC's liability to determine whether the transaction fits within the exception.
B. Partner's Allocable Share of Liability
A partner's allocable share of a partnership's recourse liability equals the partner's share of liability pursuant to sec. 752 and its regulations, multiplied by a fraction of which the numerator is the portion of the liability that is allocable to the distribution under sec. 1.163-8T, Temporary Income Tax Regs., 52 Fed. Reg. 24999 (July 2, 1987), and the denominator is the total amount of the liability. See sees. 1.707-5(b)(2)(i), 1.752-1(a)(1), 1.752-2, Income Tax Regs. The parties agree that the LLC's liability to BOA was recourse. The parties do not dispute that the special distribution to WISCO and the BOA loan were both $755.2 million. We need only determine WISCO's share of the LLC's liability under sec. 752 and its regulations.
In general a partner's share of a recourse partnership liability equals the portion of that liability, if any, for which the partner bears the economic risk of loss. See sec. 1.752-1(a)(1), Income Tax Regs. A partner bears the economic risk of loss to the extent that the partner would be obligated to make an unreimbursable payment to any person (or contribute to the partnership) if the partnership were constructively liquidated and the liability became due and payable. Sec. 1.752-2(b)(1), Income Tax Regs.; see IPO II v. Commissioner, 122 T.C. 295, 300-301 (2004). Chesapeake contends that wisco's indemnity of GP's guaranty imposes on wisco the economic risk of loss for the LLC debt. Respondent concedes that an indemnity agreement generally is recognized as an obligation under the regulations. Respondent asserts, however, that wisco's agreement should be disregarded under the anti-abuse rule for allocation of partnership debt.
C. Anti-Abuse Rule
Chesapeake counters that wisco was legally obligated to indemnify GP under the indemnity agreement and therefore wisco should be allocated the entire economic risk of loss of the LLC's liability. We assume that all partners having an obligation to make payments on a recourse debt actually perform those obligations, irrespective of net worth, to ascertain the economic risk of loss unless the facts and circumstances indicate a plan to circumvent or avoid the obligation. Sec. 1.752-2(b)(6), Income Tax Regs. The anti-abuse rule provides that a partner's obligation to make a payment may be disregarded if (1) the facts and circumstances indicate that a principal purpose of the arrangement between the parties is to eliminate the partner's risk of loss or to create a facade of the partner's bearing the economic risk of loss with respect to the obligation, or (2) the facts and circumstances of the transaction evidence a plan to circumvent or avoid the obligation. See sec. 1.752-2(j)(1), (3), Income Tax Regs. Given these two tests, we must review the facts and circumstances to determine whether WISCO's indemnity agreement may be disregarded as a guise to cloak wisco with an obligation for which it bore no actual economic risk of loss. See IPO II v. Commissioner, supra at 300-301.
1. Purpose of the Indemnity Agreement
We first consider the indemnity agreement. The parties agreed that WISCO would indemnify GP in the event GP made payment on its guaranty of the LLC's $755.2 million debt. GP did not require the indemnity, and no provision of the indemnity mandated that WISCO maintain a certain net worth. WISCO was chosen as the indemnitor, rather than Chesapeake, after PWC advised Chesapeake's executives that WISCO's indemnity would not only allow Chesapeake to defer tax on the transaction, but would also cause the economic risk of loss to be borne only by WiSCO's assets, not Chesapeake's. Moreover, the contractual provisions reduced the likelihood of GP invoking the indemnity against WISCO. The indemnity covered only the loan's principal, not interest. In addition, GP would first have to proceed against the LLC's assets before demanding indemnification from WISCO. In the unlikely event WISCO had to pay on the indemnity, WISCO would receive an increased interest in the LLC proportionate to any payment made under the indemnity. We find compelling that a Chesapeake executive represented to Moody's and Standard Poor's that the only risk associated with the transaction was the tax risk. We are left with no other conclusion than that Chesapeake crafted the indemnity agreement to limit any potential liability to WiSCO's assets.
2. WISCO's Assets and Liabilities
We now focus on whether wisco had sufficient assets to cover the indemnity regardless of how remote the possibility it would have to pay. Chesapeake maintains that WISCO had sufficient assets to cover the indemnity agreement. WISCO contributed almost all of its assets to the LLC and received a special distribution and a 5-percent interest in the LLC. Moreover, Chesapeake contends that wisco did not need to have a net worth covering the full amount of its obligations with respect to the LLC's debt. See sec. 1.752-2(b)(6), Income Tax Regs, wisco's assets after the transfer to the LLC included the $151.05 million intercompany note and the $6 million jet. wisco had a net worth, excluding its LLC interest, of approximately $157 million or 21 percent of the maximum exposure on the indemnity. The value of wisco's LLC interest would have been zero if the indemnity were exercised because the agreement required GP to proceed and exhaust its remedies against the LLC's assets before seeking indemnification from wisco.
We may agree with Chesapeake that no Code or regulation provision requires wisco to have assets covering the full indemnity amount. We note, however, that a partner's obligation may be disregarded if undertaken in an arrangement to create the appearance of the partner's bearing the economic risk of loss when the substance of the arrangement is in fact otherwise. See sec. 1.752-2(j)(1), Income Tax Regs, wisco's principal asset after the transfer was the intercompany note. The indemnity agreement did not require WISCO to retain this note or any other asset. Further, Chesapeake and its management had full and absolute control of wisco. Nothing restricted Chesapeake from canceling the note at its discretion at any time to reduce the asset level of wisco to zero. In fact wisco's board, which included many Chesapeake executives, did cancel the note and issued an intercompany dividend to Chesapeake in 2001. We find Wisco's intercompany note served to create merely the appearance, rather than the reality, of economic risk for a portion of the LLC debt.
In addition, WISCO remained subject to the Fox River liability, and wisco and other Chesapeake subsidiaries guaranteed a $450 million credit line obtained by Chesapeake in 2000. This guaranty and the Fox River liability further reduced wisco's net worth. GP neither asked for nor received any assurances that wisco would not further encumber its assets. We find that wisco's agreement to indemnify GP's guaranty lacked economic substance and afforded no real protection to GP.
3. Anti-Abuse Rule Illustration
Chesapeake seeks to distinguish the transaction in this case from the transaction illustrated in the anti-abuse rule. See sec. 1.752-2(j)(4), Income Tax Regs, (illustrating when payment obligations may be disregarded). The illustration considers a consolidated group of corporations that use a thinly capitalized subsidiary as a partner in a general partnership with a recourse debt payment guaranteed by the other partner. The circumstances are deemed indicative of a plan enabling the corporate group to enjoy the losses generated by the partnership's property while avoiding the subsidiary's obligation to restore any deficit in its capital account. Chesapeake argues wisco was not a newly-created entity, as was the subsidiary in the illustration, but had been in business before the transaction. We find Wisco's preexistence insufficient to distinguish this transaction from the illustration.
A thinly capitalized subsidiary with no business operations and no real assets cannot be used to shield a parent corporation with significant assets from being taxed on a deemed sale. Chesapeake intentionally used WISCO, rather than itself, to limit its exposure under the indemnity agreement. It further limited its exposure only to the assets of wisco. We refuse to interpret the illustration to provide additional protection. Moreover, this appears to be a concerted plan to drain wisco of assets and leave wisco incapable, as a practical matter, of covering more than a small fraction of its obligation to indemnify GP. We find this analogous to the illustration because in both cases the true economic burden of the partnership debt is borne by the other partner as guarantor. Accordingly, we do not find that the anti-abuse rule illustration extricates Chesapeake, but rather it demonstrates what Chesapeake strove to accomplish.
4. Rev. Proc. 89-12 Does Not Apply to Anti-Abuse Rule
Chesapeake also argues that it would be found to bear the economic risk of loss if the Court would apply a 10-percent net worth requirement. In so arguing, Chesapeake relies on Rev. Proc. 89-12, 1989-1 C.B. 798, which stated that a limited partnership would be deemed to lack limited liability for advance ruling purposes if a corporate general partner of the partnership had a net worth equaling 10 percent or more of the total contributions to the partnership. We decline Chesapeake's invitation to extend the 10-percent net worth test. Requirements for advance ruling purposes have no bearing on whether a partner will be treated as bearing the economic risk of loss for a partnership's liability. There are no mechanical tests. The anti-abuse rule mandates that we consider the facts and circumstances. We decline to establish a brightline percentage test to determine whether Wisco bore the economic risk of loss with respect to the LLC's liability.
5. Speculative Fraudulent Conveyance Claims
Chesapeake argues alternatively that wisco bore the economic risk of loss because GP had a right to make fraudulent conveyance claims against Chesapeake and Chesapeake's financial subsidiary Cary Street. Chesapeake contends that such potential claims exposed wisco to a risk of loss in excess of wisco's net worth. This argument is flawed on many points. First, a fraudulent conveyance is simply a cause of action, not an obligation. See La Rue v. Commissioner, 90 T.C. 465, 478-480 (1988); see also Long v. Commissioner, 71 T.C. 1, 7-8 (1978), supplemented by 71 T.C. 724 (1979), aff'd. in part and remanded on other grounds 660 F.2d 416 (10th Cir. 1981). The Court may consider obligations only in allocating recourse liabilities of a partnership. See sec. 1.752-2(b)(3), Income Tax Regs. Next, Chesapeake's fraudulent conveyance argument connotes that Chesapeake engaged in a plan to circumvent or avoid the obligation. This argument completely undercuts and overrides Chesapeake's attempt to create an obligation on behalf of Chesapeake and Cary Street. Finally, we would render the anti-abuse rule meaningless by creating an automatic exception for speculative fraudulent conveyance claims. Accordingly, we reject this argument.
We have carefully considered the facts and circumstances and find that the indemnity agreement should be disregarded because it created no more than a remote possibility that Wisco would actually be liable for payment. Chesapeake used the indemnity to create the appearance that WISCO bore the economic risk of loss for the LLC debt when in substance the risk was borne by GP. We find that WISCO had no economic risk of loss and should not be allocated any part of the debt incurred by the LLC.
Consequently, the distribution of cash to wisco does not fit within the debt-financed transfer exception to the disguised sale rules. Instead, we find Chesapeake has failed to rebut the 2-year presumption. The facts and circumstances evince a disguised sale. Accordingly, we conclude that WISCO sold its business assets to GP in 1999, the year it contributed the assets to the LLC, not the year it liquidated its LLC interest.
II. Whether Chesapeake Is Liable for an Accuracy-Related Penalty Under Section 6662(a)
We now turn to respondent's determination that Chesapeake is liable for the accuracy-related penalty under section 6662(a) and (b)(2) for a substantial understatement of income tax. Respondent bears the burden of proof for a penalty asserted in an amended answer. See Rule 142(a).
A substantial understatement of income tax exists for a corporation if the amount of the understatement exceeds the greater of 10 percent of the tax required to be shown on the return, or $10,000. Sec. 6662(d)(1); sec. 1.6662-4(b)(1), Income Tax Regs. Chesapeake's correct tax for 1999 is $217,576,519, which includes the $183,458,981 deficiency determined in the deficiency notice. Respondent has established the understatement of income tax is substantial as it exceeds both 10 percent of the correct tax ($21,757,651) and $10,000.
The accuracy-related penalty under section 6662(a) does not apply, however, to any portion of an underpayment if a taxpayer shows that there was reasonable cause for, and that the taxpayer acted in good faith with respect to, that portion. Sec. 6664(c)(1); sec. 1.6664-4(a), Income Tax Regs. We consider the pertinent facts and circumstances, including the taxpayer's efforts to assess his or her proper tax liability, the taxpayer's knowledge and experience and the reliance on the advice of a professional in determining whether the taxpayer acted with reasonable cause and in good faith. Sec. 1.6664-4(b)(1), Income Tax Regs. Generally, the most important factor is the extent of the taxpayer's effort to assess the proper tax liability. Id.
Reasonable cause has been found when a taxpayer selects a competent tax adviser, supplies the adviser with all relevant information and, in a manner consistent with ordinary business care and prudence, relies on the adviser's professional judgment as to the taxpayer's tax obligations. Sec. 6664(c); United States v. Boyle, 469 U.S. 241, 250-251 (1985); sec. 1.6664-4(b)(1), Income Tax Regs. A taxpayer may rely on the advice of any tax adviser, lawyer or accountant. United States v. Boyle, supra at 251.
The right to rely on professional tax advice, however, is not unlimited. Neither reliance on the advice of a professional tax adviser nor reliance on facts that, unknown to the tax-payer, are incorrect necessarily demonstrates or indicates reasonable cause or good faith. See Long Term Capital Holdings v. United States, 330 F. Supp. 2d 122, 205-206 (D. Conn. 2004), aff'd. 150 Fed. Appx. 40 (2d Cir. 2005). The advice must not be based on unreasonable factual or legal assumptions and must not unreasonably rely on representations, statements, findings, or agreements of the taxpayer or any other person. Sec. 1.6664-4(c)(1)(ii), Income Tax Regs. Courts have repeatedly held that it is unreasonable for a tax-payer to rely on a tax adviser actively involved in planning the transaction and tainted by an inherent conflict of interest. See, e.g., Mortensen v. Commissioner, 440 F.3d 375, 387 (6th Cir. 2006), affg. T.C. Memo. 2004-279; Pasternak v. Commissioner, 990 F.2d 893 (6th Cir. 1993), affg. Donahue v. Commissioner, T.C. Memo. 1991-181; Neonatology Associates, PA. v. Commissioner, 115 T.C. 43 (2000), aff'd. 299 F.2d 221 (3d Cir. 2002). A professional tax adviser with a stake in the outcome has such a conflict of interest. See Pasternak v. Commissioner, supra at 903.
Chesapeake claims it reasonably relied in good faith on PWC's tax advice and "should" opinion and therefore no penalty should be imposed. Respondent contends that Chesapeake unreasonably relied on an opinion riddled with improper assumptions written by a tax adviser with a conflict of interest. We look to whether PWC'S advice was reasonable and inquire whether PWC'S advice was based on all pertinent facts and circumstances and not on unreasonable factual or legal assumptions. See Long Term Capital Holdings v. United States, supra at 205-206.
A. PWC Based Its Advice on Unreasonable Assumptions.
We now focus on whether PWC'S advice was reasonable. Chesapeake contends that it relied on legal analysis prescribed in PWC's "should" opinion. Chesapeake submitted a draft, not the original, of the "should" opinion into evidence. We therefore look to the draft opinion to determine whether PWC'S advice was reasonable.
Chesapeake paid PWC an $800,000 flat fee for the opinion, not based on time devoted to preparing the opinion. Mr. Miller testified that he and his team spent hours on the opinion. We find this testimony inconsistent with the opinion that was admitted into evidence. The Court questions how much time could have been devoted to the draft opinion because it is littered with typographical errors, disorganized and incomplete. Moreover, Mr. Miller failed to recognize several parts of the opinion. The Court doubts that any firm would have had such a cavalier approach if the firm was being compensated solely for time devoted to rendering the opinion.
In addition, the opinion was riddled with questionable conclusions and unreasonable assumptions. Mr. Miller based his opinion on WISCO maintaining 20 percent of the LLC debt. Mr. Miller had no case law or Code authority to support this percentage, however. He instead relied on an irrelevant revenue procedure as the basis for issuing the "should" opinion. A "should" opinion is the highest level of comfort PWC offers to a client regarding whether the position taken by the client will succeed on the merits. We find it unreasonable that anyone, let alone an attorney, would issue the highest level opinion a firm offers on such dubious legal reasoning.
Mr. Miller testified that tax practitioners render different levels of opinion based on their comfort that the legal conclusions contained in the opinion are correct as a matter of law assuming the factual representations and assumptions set forth in the opinion are also correct. A "reasonable basis" opinion has a 33-percent chance of success on the merits. See sec. 1.6662-3(b)(3), Income Tax Regs. A "substantial authority" opinion has a 40-percent chance of success on the merits. See sec. 1.6662-4(d)(2), Income Tax Regs. A "more likely than not" opinion has a 51-percent chance of success on the merits. See id. Mr. Miller did not give an exact percentage regarding a "should" opinion, but he testified that it is materially higher than that of a "more likely than not" opinion.
We are also nonplused by Mr. Miller's failure to give an understandable response when asked at trial how PWC could issue a "should" opinion if no authority on point existed. He demurred that it was what Chesapeake requested. The only explanation that makes sense to the Court is that no lesser level of comfort would have commanded the $800,000 fixed fee that Chesapeake paid for the opinion.
We are also troubled by the number of times the draft opinion uses "it appears." For example, it states, "[i]n focusing on the language of the 752 regs, it appears that such regulation adopts an all or nothing approach." Mr. Miller had no basis for that position other than his interpretation of the regulations. Further, Mr. Miller assumed that the indemnity would be effective and that Wisco would hold assets sufficient to avoid the anti-abuse rule, PWC assumed away the very crux of whether the transaction would qualify as a nontaxable contribution of assets to a partnership. In so doing PWC failed to consider that the indemnity lacked substance. Neither the joint venture agreement nor the indemnity agreement included provisions requiring wisco to maintain any minimum level of capital or assets, wisco and Chesapeake could also remove wisco's main asset, the intercompany note, from Wisco's books at any time and for any reason. This possibility gutted any substance for the indemnity.
We find that Chesapeake's tax position did not warrant a "should" opinion because of the numerous assumptions and dubious legal conclusions in the haphazard draft opinion that has been admitted into the record. Further, we find it inherently unreasonable for Chesapeake to have relied on an analysis based on the specious legal assumptions.
B. Chesapeake Lacked Good Faith
Moreover, Chesapeake did not act with reasonable cause or in good faith as it relied on Mr. Miller's advice. Chesapeake argues that it had every reason to trust PWC'S judgment because of its long-term relationship with the firm. PWC crossed over the line from trusted adviser for prior accounting purposes to advocate for a position with no authority that was based on an opinion with a high price tag — $800,000.
Any advice Chesapeake received was tainted by an inherent conflict of interest. We would be hard pressed to identify which of his hats Mr. Miller was wearing in rendering that tax opinion. There were too many. Mr. Miller not only researched and drafted the tax opinion, but he also "audited" wisco's and the LLC's assets to make the assumptions in the tax opinion. He made legal assumptions separate from the tax assumptions in the opinion. He reviewed State law to make sure the assumptions were valid regarding whether a partnership was formed. In addition, he was intricately involved in drafting the joint venture agreement, the operating agreement and the indemnity agreement. In essence, Mr. Miller issued an opinion on a transaction he helped plan without the normal give-and-take in negotiating terms with an outside party. We are aware of no terms or conditions that GP required before it would close the transaction. We are aware only of the condition that Chesapeake's board would not close unless it received the "should" opinion. Chesapeake acted unreasonably in relying on the advice of pwc given the inherent and obvious conflict of interest. See New Phoenix Sunrise Corp. Subs. v. Commissioner, 132 T.C. 161, 192-194 (2009) (reliance on opinion by law firm actively involved in developing, structuring and promoting transaction was unreasonable in face of conflict of interest); see also CMA Consol., Inc. v. Commissioner, T.C. Memo. 2005-16 (reliance not reasonable as advice not furnished by disinterested, objective advisers); Stobie Creek Invs., LLC v. United States, 82 Fed. CI. 636, 714-715 (2008), aff'd. 608 Fed. 3d 1366 (Fed. Cir. 2010).
We also find suspect the exorbitant price tag associated with the sole condition of closing. Chesapeake essentially bought an insurance policy as to the taxability of the transaction. PWC received an $800,000 fixed fee for its tax opinion. pwc did not base its fee on an hourly rate plus expenses. The fee was payable and contingent on the closing of the joint venture transaction, PWC would receive payment only if it issued Chesapeake a "should" opinion on the joint venture transaction. PWC therefore had a large stake in making sure the closing occurred.
Considering all the facts and circumstances, PWC's opinion looks more like a quid pro quo arrangement than a true tax advisory opinion. If we were to bless the closeness of the relationship, we would be providing carte blanche to promoters to provide a tax opinion as part and parcel of a promotion. Independence of advisers is sacrosanct to good faith reliance. We find that pwc lacked the independence necessary for Chesapeake to establish good faith reliance. We further find that Chesapeake did not act with reasonable cause or in good faith in relying on PWC's opinion. We sustain respondent's determination that Chesapeake is liable for the accuracy-related penalty under section 6662(b)(2) for 1999.
This holding should not be interpreted as requiring taxpayers to obtain a second tax opinion to qualify for the reasonable reliance exception under sec. 6664(c). Rather, we hold that tax-payers may not reasonably rely on an adviser tainted by an inherent conflict of interest the tax-payer had reason to know of.
We have considered all remaining arguments the parties made and, to the extent not addressed, we find them to be irrelevant, moot, or meritless.
To reflect the foregoing,
Decision will be entered for respondent.