Arthur Shealy's letter
about IRS's abusive treatment of Hoyt Partners

Arthur H. Shealy
Attorney at Law
325 Georgia Avenue
North Augusta, SC 29841
(803) 442-6003
AHShealy@worldnet.att.net

February 1, 1999

HON. SENATOR ABCDEF
c/o MR. GHIJKL
RUSSELL SENATE OFFICE BUILDING
WASHINGTON, D.C. 20510

RE: PARTNERS IN HOYT CATTLE RAISING TAX SHELTER

Dear Senator,

Thank you very much for your December 7, 1998, letter that transmits the Internal Revenue Service's response to my clients' concerns. I do appreciate your assistance in extracting a response from the IRS. My letter today is to address certain points in the IRS response and to further request your help in persuading the IRS to undertake an independent review of the Hoyt Tax Shelter Project, removing it from the jurisdiction of the Sacramento Appeals Office. One of the reasons for this mountainous problem is mishandling by the Sacramento Office management.

Ex Parte Contacts Between Exam and Appeals

Specifically management assigned at least one IRS employee, R. M. Spooner, Associate Chief of the Sacramento Appeals Office to negotiate and sign the May 20, 1993 Memorandum of Understanding that gave rise to the taxpayers' liabilities for the years before 1987. He and the Sacramento appeals office is now assigned the task of reviewing appeals regarding this Memorandum of Understanding.⁽¹⁾ Because of similar conduct, Congress recognized the importance of ensuring an independent Appeals Office and enacted a restriction against this practice in The IRS Restructuring and Reform Act of 1998. Specifically, the Act included a provision that provides:

(a) IN GENERAL. - The Commissioner of Internal Revenue shall develop and implement a plan to reorganize the Internal Revenue Service. The plan shall -

…

(4) ensure an independent appeals function within the Internal Revenue Service, including the prohibition in the plan of ex parte communication between appeals officers and other Internal Revenue Service employees to the extent that such communications appear to compromise the independence of the appeals officers.

H.R. 2676, Internal Revenue Service Restructuring and Reform Act of 1998, Pub. L. 105-206, § 1001 (a)

My clients and I believe that over the years the Sacramento Appeals Office has effectively become part of the examination team and that it is impossible for the individual investors to receive an impartial review from that office. We request that jurisdiction of the matter be handled in the National Office by individuals capable of negotiating a global settlement, at least somewhere besides Sacramento.

IRS Knowledge of Tax Matters Partner Conflict of Interest

As mentioned, my clients' tax bills for the 1981 through 1986 years stem from a Memorandum of Understanding ("MOU") between Jay Hoyt and the IRS, signed on May 20, 1993. Jay Hoyt personally negotiated this settlement and was not represented by counsel during the negotiations. The Sacramento Appeals Office actively participated in the negotiation of this MOU.

While the IRS negotiated this MOU, it was investigating Jay Hoyt for criminal violation of US income tax laws and knew he had a conflict interest with the other partners. Hoyt's concessions in the MOU resulted in huge tax liabilities for the individual partners; but, absolved Jay Hoyt and his family, including Jay Hoyt's wife, from large tax liabilities. By Jay Hoyt's actions, the investor partnerships conceded huge interest payments made to an entity owned by the Hoyt family, Hoyt & Sons Ranches ("Ranches"). These interest payments apparently had not been included in Ranches' income. Thus, while the MOU created huge tax liabilities for the individual partners, the Hoyt family's tax liability was actually significantly reduced.

At the time Jay Hoyt signed the MOU, he was under investigation for tax return preparer penalties. He had also been under criminal investigation between the periods 1983 through 1987 and again from October/November 1989 to November 1991. There is also evidence that the Criminal Investigation Division was working with the Postal Inspector when it "raided" the Hoyt business offices in 1995. It is unclear if the IRS ever stopped its criminal investigation of Jay Hoyt. He was never notified that the criminal investigation had been terminated. In spite of these severe conflict of interests, the IRS, including the Sacramento Appeals Office, continued to negotiate with Mr. Hoyt, as the representative of the partnerships. This is true even though the IRS had the ability and the duty to remove Jay Hoyt, due to the criminal investigation, pursuant to Treas. Reg. § 301.6231(c)-5T.⁽²⁾

This issue is the crux of the problem. Hornbook agency and partnership law have long held that when a third party knows that a partner has a conflict of interest with the partnership in a matter, that third party cannot rely on the words, actions, or signature of the conflicted partner to bind the partnership to any agreement regarding that matter. The Second Circuit Court of appeals applied this basic rule of agency and partnership law in TRANSPAC DRILLING VENTURE 1982-12, et al., v. COMMISSIONER OF INTERNAL REVENUE, 98 TNT 130-6, 82 AFTR2d Par. 98-5016 (2^nd Cir. 1998). The Transpac Court refused to allow a partner under criminal investigation to bind the other partners to concessions to the IRS. The IRS could have easily prevented years of litigation, astronomical amounts of penalties and interest, and the swindling of hundreds of innocent investors⁽³⁾ merely by recognizing this basic rule to remove Jay Hoyt as Tax Matters Partner.

IRS Bad Faith

In approximately 1992, interested partners organized a group ("Settlement Committee") to participate in settlement negotiations. Prior to the 1993 settlement between Jay Hoyt and the IRS, the Settlement Committee attempted to negotiate a settlement with the IRS. During these negotiations with the Settlement Committee, the IRS, through Appeals Officer William E. McDevitt, improperly required that Jay Hoyt make personal concessions before the IRS would make "greater concessions" to the individual partners. These concessions included Jay Hoyt conceding the tax return preparer penalty, a penalty that reflected Jay Hoyt's personal actions and was not related to the substantive tax liabilities of the individual partners.

On July 24, 1992, the Settlement Committee obtained a Letter of Intent from Jay Hoyt wherein Hoyt agreed to sign any settlement reached between the IRS and the Settlement Committee. Specifically, the Letter of Intent from Jay Hoyt stated that he agreed to the IRS conditions.

The Settlement Committee met numerous times with the IRS and believed it had reached a tentative basis for settlement with the IRS. This tentative basis for settlement was a global settlement and would have ended the Hoyt litigation for all matters. When the Settlement Committee arrived at what they believed to be the decisive meeting concerning this global settlement, the members found out that the chief IRS negotiator was retiring that day. No meeting took place.

The Settlement Committee met at least one more time with the IRS and that was with Mr. Cantalupo, the then head of Appeals for the Western Region. At that meeting, the Settlement Committee presented Mr. Cantalupo with the Letter of Intent. While the IRS professed interest in continuing negotiations with the Settlement Committee, the Committee received no significant communications from the IRS concerning settlement after the Cantalupo meeting. The Committee also never received any statement from the IRS rejecting the proposed global settlement. Inconceivably, the Sacramento Appeals Office instead entered into the MOU with Jay Hoyt.

SPECIFIC RESPONSE

November 28, 1998 Cover Letter

In this letter Mr. Wilson states that although the IRS is mandated by Congress to take appropriate action against the promoters of abusive tax shelters, section 6103 of the internal revenue code protects the results of such actions from disclosure. This statement is irrelevant and misleading in this case. The IRS never took any action to stop Jay Hoyt as a promoter of an abusive tax shelter. In fact, its concerns regarding disclosure never stopped the IRS from disclosing to the negotiating investor groups precisely what concessions the IRS would require from Jay Hoyt. No disclosure limitation, all of which the IRS ignored, prevented the IRS from undertaking action to stop Jay Hoyt as a promoter of an abusive tax shelter. The IRS's citation of these disclosure limitations is merely an attempt to absolve itself of its own mishandling of this matter.

General Information Regarding Hoyt Partners

First, the IRS response provided contains misleading or inaccurate information prepared by the Sacramento Office as follows:

1. IRS Information: "They have also used this ruling as an approval of the shelter for investment purposes. The Bales ruling related specifically to investments prior to 1980. In this case, one of the issues before the court was whether the activity was engaged in for profit. Because the Tax Court found the partnership to be a bonafide business, the investors claimed they had won the Case. They failed to recognize that the Tax Court decision also found that deductions and investment credits were overstated."

Taxpayer Response: These statements are misleading. In Bales v. Commissioner, T.C. Memo. 1989-568, the Tax Court found:

1. The stated sales price for the cattle was reasonable;

• The financing had economic substance;
• The "benefits and burdens" of ownership passed to the individual partners;
• The transactions had economic substance;
• The activity was entered into for a profit;
• The debt was bona fide;
• The expenses incurred were ordinary and necessary (i.e., allowed);
• That the investment tax credit was allowed; and
• That I.R.C.§ 6621(c) (tax motivated interest assessment) was not applicable.
  

Specifically, the Tax Court did not find that the deductions and investment tax credits were overstated. The taxpayers won on every substantive issue in front of the Tax Court. However; after trial, but prior to opinion, and without the participation, consent, or knowledge of the other individual investor-partners, Jay Hoyt conceded to the IRS that the individual partners were not "at risk" on the promissory notes. This concession, not the Tax Court, is what limited the expenses and deductions that the individual partners could take on their individual returns. While the Tax Court did not specifically rule on the "at risk" issue, it did find that these same promissory notes had economic substance and that the benefits and burdens of ownership passed to the investors. Nothing in the Tax Court opinion indicates that the IRS would have won the "at risk" issue, if it had been presented to the Court.

The individual partners rightly perceived that the Bales Court's opinion was a total victory. The impact of Jay Hoyt's concessions on the Bales partners' individual returns was absent from the Bales opinion. Most partners did not know and were not told by Jay Hoyt, that he made any concessions after trial. (Note: The opinion reflects the judge's analysis of the substantive legal issues and does not reflect the final adjustments made to the taxpayers account.) However, notwithstanding the Bales opinion, the IRS continued to treat the Hoyt partners as participants in an "abusive tax shelter" and offered them a traditional "abusive tax shelter" settlement. A settlement that would have forced the majority of the partners into bankruptcy, if they accepted it.

Rather than relying on my evaluation of the case, I request that you review the actual opinion and then determine whose analysis of the case is more accurate.

2. IRS Information: "After receipt of the Pre-filing Notices, some of the partners filed new Forms W-4, Employee's Withholding Allowance Certificate, which included excessive allowances based on the partnership deductions and/or credits. These Forms W-4 were filed to purposefully circumvent the effect of the previously issued Pre-Filing Notices. Therefore, it was determined that they did not meet the requirements of the Internal Revenue Code (the Code) Section 3402 and related Employment Tax Regulations. Thus, their employers were directed to disregard the subsequently filed Forms W-4 and to withhold at the Single rate with zero allowances."

"Although there were no formal or administrative procedures for appealing the IRS's decision concerning the withholding allowances, the taxpayers were able to request a redetermination. Upon the taxpayer's request, they were allowed a reasonable amount of allowances, once proper substantiation was provided." [Emphasis added.]

Response: On the advice of Jay Hoyt, Hoyt partners did make changes to their Forms W-4. However, the method described and used by the IRS to correct any allegedly improper W-4s was not in accord with its own IRS Manual provisions. The Internal Revenue Service Manual §4299 describes the procedures used concerning "questionable" Forms W-4. The Manual states that a form letter will be sent to the taxpayer informing the taxpayer that his or her Form W-4 has been selected for review. The IRS employee reviewing the Form W-4 must contact the taxpayer, interview the taxpayer, and document the final conclusion using "all the facts and circumstances that lead up to [the conclusion]."

Instead of following this procedure, the IRS changed the Hoyt partner Forms W-4, without prior notification to the partners and, apparently, without even reviewing the taxpayer's income tax returns to determine marital status. The IRS uniformly changed all the challenged Form W-4s to Single and Zero.

Only when an aggrieved partner contacted the IRS, did the IRS did redetermine the appropriate allowances, often increasing the allowances. However, the IRS information implies that the IRS only changed the Forms W-4 once; i.e. - after the taxpayer had filed a new Form W-4 requesting "excessive allowances." However, the IRS made many changes to an individual Hoyt partner's Form W-4 and often not in response to a change made by the Hoyt Partner. For example, the IRS changed exemptions that it had previously determined to be correct in its "redetermination" process. The following is an actual example of changes made by the IRS to one couple's allowances. Documents are available to substantiate this conduct.

[MATERIAL REDACTED]

The justification provided by the IRS does not explain all of the above changes to this couple's Forms W-4. It certainly does not explain changing the wife's W-4 from a very reasonable Married with 1 exemption to single with zero exemptions. Further, the partners who contacted the IRS about changing their W-4s were directed to speak with the IRS Sacramento District, where the case was managed by the IRS and Chief Counsel. These Hoyt partners would then be asked to settle their individual tax liability. This settlement contact is an inappropriate use of the W-4 program.

3. IRS Information: "Many of the partners have expressed their anger and frustrations over the continuation of the partnerships. Although the IRS is mandated by congress to take appropriate action against the promoters of abusive tax shelters, IRC section 6103 protects the results of such actions from being disclosed."

Response: The IRS failed to take any effective action as "mandated by congress." I.R.C. §6103 did not prohibit the IRS from removing Jay Hoyt as the Tax Matters Partner while he was under criminal investigation for violating the Internal Revenue laws of the United States. In fact, the IRS is required to remove Tax Matters Partners that are under criminal investigation because the "criminal investigation for the violation of the internal revenue laws relating to income tax will interfere with the effective and efficient enforcement of the internal revenue laws." Temp. Reg. § 301.6231(c)-5T. Jay Hoyt's removal would have effectively alerted the partners to many of the problems. It is unlikely that Jay Hoyt could have continued to sell partnerships interests, if he was removed as the Tax Matters Partner when the IRS commenced its criminal investigation of him. A partner, without Jay Hoyt's conflicts, could have easily replaced Jay Hoyt as Tax matters partner and dealt with the IRS. The partners would have at least had the opportunity to discover Jay Hoyt's deceptive practices in a timely manner.

I.R.C. § 6103 also did not prohibit the IRS from enjoining Jay Hoyt from promoting "abusive tax shelters" under I.R.C. § 7408. The IRS determined that the Hoyt partnerships were "abusive tax shelters" and used this determination as justification for many of its actions against the individuals. However, the IRS never attempted to enjoin Jay Hoyt for conduct concerning promoting abusive tax shelters or for aiding and abetting the understatement of tax as permitted under I.R.C. 7408 since 1982. An injunction also would have effectively alerted the individual partners to Jay Hoyt's fraudulent and deceptive activities. At a minimum, it would have stopped the sale of additional partnerships. The IRS began auditing the Hoyt partnerships in 1977 (or earlier). However, Jay Hoyt was allowed to continue organizing and selling partnership from 1977 to 1997. The majority of the individual tax liabilities would not have even existed, if the IRS had acted as permitted by law.

CONCLUSION

I urge you to review this matter and to require the IRS National Taxpayers Advocate Office or the General Accounting Office to investigate the IRS's conduct. I do appreciate any attention you can devote to my clients. If you have any questions or if I can assist you in any way, please contact me at the above address or phone number. Thank you again for your consideration.

Sincerely,

ARTHUR H. SHEALY

1. At page eight of this Memorandum of Understanding, Mr. Spooner blithely recognizes that the partners have potentially suffered a theft loss as a result of Jay Hoyt's actions; yet, he allows Jay Hoyt to bind all these partners to an agreement which bankrupts most of them.

2. The IRS is required to remove Tax Matters Partners that are under criminal investigation because the "criminal investigation for the violation of the internal revenue laws relating to income tax will interfere with the effective and efficient enforcement of the internal revenue laws." Temp. Reg. § 301.6231(c)-5T.

3. Jay Hoyt is currently under indictment for wire fraud.