Court Affirms Fraud Award in Tax-Shelter Case

(CN) — Consulting firm Grant Thornton must pay nearly $40 million in damages to a hotel owner for fraud and negligence in its tax advice, the Kentucky Court of Appeals ruled.

William Yung owns a hospitality company called Columbia Sussex Corp. He shares ownership with his wife, Martha, and the family trust.

The Yungs also own a pair of holding corporations that are based in the Cayman Islands: Casuarina Cayman Holdings Ltd. and Wytec Ltd.

Grant Thornton LLP, a Chicago-based public accounting firm, provided tax-related services to the Yung companies.

One of these services was a leveraged distribution 301, or Lev301, transaction, which was designed to transfer funds from the Caymans to the U.S. while minimizing tax liability, according to court records.

Grant Thornton met with the Yungs in 2000 to discuss the Lev301, in which a foreign corporation would borrow money to buy U.S. Treasury notes before transferring the notes to corporate shareholders in the U.S.

After the firm issued an opinion that the IRS would "more likely than not" uphold the non-taxability of the Lev301, the Yungs executed the transactions.

However, the IRS began to question the viability of the Lev301 strategy. Grant Thornton suspended the sale of the product to new customers but advised the Yungs that their transactions would not be affected.

Grant Thornton prepared the Yungs' 2000 tax returns, which did not include the Lev301 transactions. The Yungs' 2001 returns did not mention the repayment of the loans secured by the Treasury notes.

In 2002, the IRS asked Grant Thornton to name its clients that used the Lev301 product. The IRS followed up by auditing the Yungs in 2004.

The audit showed that the Lev301 transactions did not have a non-tax related business purpose, so they were fully taxable.

The Yungs settled with the IRS for $11.8 million in back taxes, $5 million in interest and $1.5 million in penalties.

They sued Grant Thornton for fraud and negligence, and a six-week bench trial was held in the spring of 2012.

In a 211-page opinion, the trial court found that Grant Thornton knew the IRS would mostly likely disallow the Lev301 transactions.

The court awarded the Yungs $19.3 million in compensatory damages, to cover their liability to the IRS and the $900,000 in fees that they paid to the accounting firm.

In addition, the court slammed Grant Thornton with an $80 million punitive damages award.

On appeal, Grant Thornton argued that its predictions and opinions about the IRS were not actionable as fraud. The Kentucky Court of Appeals disagreed in a ruling published Friday.

Judge Irv Maze noted that the IRS had disallowed a similar strategy — the Bond and Option Sales Strategy, or BOSS — in 1999.

"Grant Thornton also represented that Lev301 had survived review by an outside law firm," Maze wrote for a three-judge panel. "However, that firm, Baker & McKenzie, warned Grant Thornton that Lev301 was flawed and could not be used to successfully avoid tax liability."

Maze also did not agree with the firm's argument that the Yungs' award should be offset by the profits they earned in the U.S. from the transactions.

"The trial court simply was not convinced that any profits earned by the Yungs were the result of Grant Thornton's misconduct, instead of the Yungs' own investment skill," he noted.

However, Maze reduced the award of punitive damages from $80 million to $20 million.

"As Grant Thornton points out, the Yungs were not economically vulnerable and suffered only an economic injury," the judge wrote. "The infliction of only economic harm can still merit a substantial penalty, especially when done intentionally through affirmative acts of misconduct. But not all acts which cause economic harm are sufficiently reprehensible to justify a significant sanction in addition to compensatory damages."

Judge Kelly Thompson wrote a dissenting opinion, disagreeing with the reduction of punitive damages.

"After conducting a month-long trial, the trial court made extensive findings of fact regarding the reprehensibility of Grant Thornton's conduct and found Grant Thornton acted with intentional malice, trickery and deceit," he wrote. "I would defer to the trial court's factual finding regarding the degree of reprehensibility of Grant Thornton's conduct."

Late last year, the U.S. Securities and Exchange Commission fined Grant Thornton $3 million and ordered it to forfeit $1.5 million in fees, finding that the firm ignored fraud risks and red flags while auditing two companies in California from 2009 to 2011.

During that same time period, the firm advised the Administrative Office of the Courts in California to continue a $1.9 billion software project that ultimately failed.

"We are pleased that the court greatly reduced the damages in this matter, and will consider our option to further appeal to the Kentucky Supreme Court," said Jon Rucket, Grant Thornton's director of external communications.

George Vinci Jr., the Yungs' attorney, said "the findings in respect to liability were spot-on," but he disagreed with the reduction of punitive damages.

"Our position is that a 4-to-1 ratio is well within due process," he said.

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