Editors Note: Amalie L. Tuffin is a member of the Research Triangle Park law firm of Daniels Daniels & Verdonik, P.A.
________________________________________________________________________________________Last month I wrote about the Justice Department’s and the IRS’s increased focus on enforcement of federal tax laws, and in particular the fact that KPMG LLP was a major target of the government’s probes (see the article at www.localtechwire.com/article.cfm?u=12026 ). On August 26, KPMG and the Justice Department reached an agreement to defer prosecution.

While this would seem to be good news for KPMG, the cost to the firm was extremely high.

As discussed in my prior article, certain tax shelter sales by KPMG have been under investigation for several years. These tax shelters were devised around methods aimed at helping taxpayers create large “paper” losses which, for tax purposes, offset large capital gains generated from the sale of family businesses and other similar transactions. A number of the (then) “Big 6” accounting firms and others profited greatly from selling such tax shelters in the late 1990s.

It is estimated that the tax shelters sold by KPMG and others reduced federal tax revenue by close to $1.5 billion dollars, and published reports have indicated that KPMG earned around $124 million in fees from selling such shelters between 1997 and 2001.

In connection with these transactions, the Department of Justice filed an “Information” in federal court in New York City, charging KPMG with conspiracy to defraud the IRS, tax evasion, and preparing false tax returns. In the deferral agreement and the related statement of facts, KPMG admitted that from 1996 to 2003 it, through its partners, employees and agents, engaged in “unlawful and fraudulent” conduct with regard to these transactions.

A $456 Million Fine

Under the deferred prosecution agreement, KPMG agreed to pay a fine of $456 million ($128 million of which represents fees it earned from the suspect transactions).

In addition, KPMG agreed to significant other conditions as well as restrictions on its ability to practice, including: (i) eliminating its private client tax practice by February 28, 2006; (ii) eliminating its compensation and benefits tax practice by February 28, 2006; (iii) significant limitations on the tax opinions it can provide; (iv) instituting a permanent, firm-wide compliance and ethics program; and (v) having its business, operations and compliance with the agreement overseen by an independent monitor selected by the Justice Department.

Finally, as part of the agreement KPMG agrees to fully cooperate with the IRS, Justice Department, and other law enforcement authorities in their investigation and prosecution of other parties implicated in the tax shelters. Richard Breeden, the former Securities and Exchange Commission chairman who has overseen compliance program at MCI (formerly Worldcom), has been appointed to act as the independent monitor of KPMG’s compliance efforts.

The cost of this agreement to KPMG and its people is high. The firm will have to terminate the employment of hundreds (if not thousands) of people who work in its private client and employee benefits and compensation tax groups. As the firm cuts costs in order to pay the almost half a billion dollar fine, others may lose their jobs as well. In addition, the reputation of the firm has certainly taken an additional blow with the admission of wrongdoing contained in the Information.

This, combined with the limitations on its practice set forth in the agreement, are certain to cause it to lose clients in the weeks and months ahead. Ironically enough, however, the agreement affirms that KPMG will continue to audit the Justice Department’s books. This, more than anything else, is a sign of why KPMG was allowed to enter into the deferred prosecution agreement. An indictment would almost certainly have signaled an end to the firm and reduced the ranks of large auditors down to the “Big 3”, a number believed by most observers to be too small from a competitive viewpoint.

If KPMG fully complies with the agreement between now and December 31, 2006, then the Information will be dismissed with prejudice (i.e., the Justice Department will not be able to refile the indictment), and no further related charges will be brought against it.

If it does not fully comply with the Agreement, the Justice Department can choose to either extend the period of the deferred prosecution agreement or to proceed with prosecuting KPMG on the charges in the Information—charges to which it has already admitted as part of the deferred prosecution agreement. In other words, KPMG has every incentive to fully comply with the agreement in order to avoid a criminal prosecution that would likely spell the end of the firm.

Former KPMG Partners and Others Indicted

At the same time as the Information was filed, the Justice Department indicted nine individuals, including former KPMG partners, investment advisors, and a lawyer, on charges related to the suspect tax shelters.

The indictments reached people who worked at the highest levels within KPMG, including Jeffrey Stein, a former deputy chairman of KMPG, John Lanning, a former vice chairman of the firm’s tax services, as well as Richard Smith and Philip Wiesner, former heads of the firm’s National Tax Practice. Also indicted was Raymond J. Ruble, a former partner at the prominent law firm of Sidley Austin Brown & Wood LLP.

Each of the persons indicted face up to five years in prison if convicted, as well as monetary fines. Other KPMG partners, as well as its outside counsel, investment bankers, financial advisors and others remain at risk of being prosecuted as more information comes from KPMG under the Agreement.

What the Agreement and Indictments Mean

Last month I speculated that the investigation and any prosecution of KPMG and its former partners could spell the beginning of the end of the current wave of government prosecutions of corporations and their professional advisors. Now, however, I don’t believe that will be the case.

The IRS has recently publicly announced that it has engaged in a large-scale transition of personnel from back-office support positions to front-line investigation and law enforcement positions. The Washington Post has reported that the charges against KPMG’s former partners “are expected to be the first in a wave of actions against professionals who profited from aiding high-net-worth customers shield income from the Internal Revenue Service during the economic boom.”

I know many professionals are concerned that the focus on prosecution will prevent professions from doing their jobs to the best of their ability. While all acknowledge that there are legal and ethical lines which should never be crossed, the line where aggressive tax planning changes over to criminal tax evasion is fuzzy at best. Professionals now have every incentive to stay far away from that line, which may prevent them from advising their clients to the best of their ability.
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Daniels Daniels & Verdonik, P.A. has been serving the legal needs of entrepreneurial and high technology clients for more than 20 years. Amalie L. Tuffin concentrates her practice in the representation of entrepreneurial and technology-based businesses, focusing on corporate, taxation and securities matters. Questions or comments can be sent to atuffin@d2vlaw.com