KPMG

Tax Shelter Cases

August 29, 2005: KPMG agreed to pay $456 million in fines, restitution, and penalties. It also agreed to change several business practices as part of a deferred prosecution agreement with federal authorities to prevent a grand jury from indicting the firm for selling tax-shelter strategies designed to help wealthy individuals evade federal income taxes. KPMG was known as a leader in designing tax shelters.

An investigation by the Senate Permanent Subcommittee on Investigations concluded that KPMG “developed and supported an extensive internal infrastructure of offices, programs, and procedures designed to churn out a continuing supply of new generic tax products, unsolicited by a specific client, for marketing to multiple clients.”

“The only purpose of these abusive deals was to further enrich the already wealthy and to line the pockets of KPMG partners,” IRS Commissioner Mark Everson said. KPMG sold the shelters – with names such as OPIS, FLIP, SOS and BLIPS -- to at least 350 wealthy individuals, who used them to create paper losses of up to $20 million. As a result, between 1997 and 2001, the federal government lost an estimated total $2.5 billion in tax revenues, while KPMG earned some $124 million in fees. (Carrie Johnson, “Former KPMG Partners May Be Charged,” Washington Post, August 3, 2005) According to the Justice Department, the IRS collected more than $3.7 billion from taxpayers who volunteered for an amnesty program dubbed “Son of Boss,” which allowed taxpayers to settle what they owed from using the tax shelters.

After years of protecting its lucrative tax practice by refusing to turn over tax shelter documents to the government, the firm's combative disposition suddenly changed. In June 2005, under new leadership, it issued a statement taking “full responsibility for the unlawful conduct by former KPMG partners” involved in the tax-shelter schemes. KPMG's new leadership fired some 30 partners involved in the scheme for cause or pressured them to resign. (Carrie Johnson, “Challenges Just Starting at KPMG,” Washington Post, August 30, 2005)

The same day the firm reached the agreement with the Department of Justice, nine individuals -- including eight former KPMG partners (Jeffrey Stein, John Lanning, Richard Smith, Jeffrey Eischeid, Philip Wiesner, John Larson, Robert Pfaff, and Mark Watson) -- were charged with criminal tax fraud conspiracy. (US Department of Justice, [tp://www.usdoj.gov/opa/pr/2005/August/05_ag_433.html “KPMG to Pay $456 for Criminal Violations in Relation to Largest-Ever Tax Shelter Fraud Case,”] August 29, 2005)

The settlement permanently barred KPMG from providing tax advice to wealthy individuals or selling pre-packaged tax products, and restricted the firm from accepting any fees apart from hourly rates. It also required other changes in the company's professional standards. (US Department of Justice, “KPMG to Pay $456 for Criminal Violations in Relation to Largest-Ever Tax Shelter Fraud Case,” August 29, 2005)

The deferred prosecution agreement was negotiated by lead partner Timothy Flynn, who became KPMG chairman just months before the settlement. His predecessor Eugene D. O'Kelly resigned after announcing he had advanced-stage cancer. Former SEC chair Richard C., Breeden was appointed to monitor KPMG's fulfillment of the conditions of the agreement. (Carrie Johnson, “Challenges Just Starting at KPMG,” Washington Post, August 30, 2005)

Federal prosecutors in New York had previously recommended that KPMG face criminal charges, but Justice Department headquarters officials expressed concerns that the firm would collapse, as Arthur Andersen had after being indictement. (Although the Supreme Court later reversed a lower court decision against Andersen, some industry observers believe Anderson would have collapsed anyway.) Discussions between KPMG and the federal government took place as several key figures were in transition, including the US attorney for the Southern District of New York and the head of Justice's criminal division. Corporate Counsel magazine reported that former U.S. Attorney David Kelley “had convened a grand jury and appeared determined to indict the company as much for its cover-up tactics as for its tax shelters.” But KPMG went over Kelley's head to then Deputy Attorney General James Comey (Kelley's predecessor as U.S. attorney in Manhattan) who ordered Kelley to settle with the firm.

Two months later (October 2005), another ten people were indicted (bringing the total number of KPMG former employees to 16), including Steven Gremminger, KPMG's former associate general counsel. Gremminger was the primary contact in the law deparment for the firm's tax practice, according to the government's indictment and related news reports. Prosecutors claim that Gremminger and other KPMG officials met to discuss the possibility of a criminal investigation of the tax shelters, but decided to continue offering the shelters anyway.

The case against the former partners also drew significant attention to Department of Justice corporate crime policies (established in the “Thompson Memo”). Those policies required a firm to accede to government demands and to help government investigators in order to stave off criminal charges against the business itself. Attorneys for KPMG urged its executives to meet with prosecutors and share information or to risk being dismissed or forced to pay their own mounting legal bills – as some ultimately had to do. White collar crime defense attorneys decried the actions and the Justice Department policy as unconstitutional. They argued that defendants were deprived of the right to an attorney – even though the longtime practice of paying legal fees for employees caught up in federal investigations did not preclude the employees from hiring their own outside counsel.

June 2006: Judge Lewis Kaplan said KPMG's decision to stop paying its former employees' legal fees had been made under intense pressure from the government, which had held a “proverbial gun” to the auditing company's head. (“Judge rebukes DoJ over KPMG,” Financial Times, June 28, 2006) A year later (July 16, 2007), Kaplan tossed out the indictments against 13 of the defendants after an appellate court rejected his proposal to hold a separate proceeding to determine whether the accounting firm was obligated to pay its former employees' legal fees. (David Reilly and Paul Davies, “KPMG Ruling Marks Setback for Prosecutors,” WSJ, 7/17/2007).

Kaplan's ruling came a few days after Rep. Robert C. Scott (D-VA) introduced legislation that would protect executives' communications with their lawyers and bar prosecutors from using legal fees as a weapon against executives who assert their right against self-incrimination. Sen. Arlen Specter (R-PA) introduced a similar bill in the Senate.

One of the firms that used an aggressive KPMG tax-avoidance strategy to reduce state taxes was WorldCom, which continued to use the strategy when it reorganized as MCI. Under the strategy, MCI treated the “foresight of top management” as an asset valued at billions of dollars, licensing the foresight to its subsidiaries in exchange for royalties that the company's subsidiaries then deducted as business expenses on state tax forms. Although the company's board said it was unlikely to sue KPMG, MCI's Chapter 11 bankruptcy-court examiner, former U.S. Attorney General Richard Thornburgh, concluded that KPMG likely rendered negligent and incorrect tax advice to MCI and that MCI would likely prevail if it decided to sue to recover past fees and damages for negligence. Critics also said that KPMG was unable to provide independent auditing services. (Jonathan Weil, “New Issues are Raised Over Independence of Auditor for MCI,” Wall Street Journal, January 28, 2004).