Disgorgement Remedy Based on Unpaid Taxes From Wylys’ Securities Trading Profits

Sept. 29 — Samuel Wyly and the estate of Charles Wyly must pay a total of $188 million plus prejudgment interest based on taxes they would have paid on profits from offshore trusts (SEC v. Wyly, S.D.N.Y., No. 1:10-cv-05760, 2014 BL 267268, 9/25/14).

Judge Shira A. Scheindlin issued an order Sept. 25 that the Wylys disgorge the amount following a May 12 jury verdict in the U.S. District Court for the Southern District of New York against brothers Sam and Charles Wyly on nine counts of federal securities violations using offshore trusts to trade in securities for the primary purpose of avoiding taxes.

The takeaway from the case is that “if a client has conduct that can be subject to a variety of investigations, the practitioner must be aware that exposure may exist on a variety of fronts,” James Mastracchio, head of the tax controversy practice at Baker & Hostetler LLP in Washington, told Bloomberg BNA Sept. 29. A practitioner should consider “if there is a way to approach it with a global settlement. Sometimes that is possible, and sometimes it is not,” he said.

Offshore Trusts.

Between 1992 and 1994, Sam and Charles established a group of offshore trusts and subsidiary entities in the Isle of Man. The Wylys used those entities to exchange stock options and warrants for private annuities. They received the securities for serving on the boards of four public companies.

The public companies never issued Forms 1099-MISC, Miscellaneous Income, for the exercise the options and warrants, because the Wylys disclaimed beneficial ownership upon transfer and convinced the companies that the private annuity transactions weren’t taxable events.

The jury found that the Wylys maintained beneficial ownership of the securities at all times and that the brothers failed to file the proper disclosures with the Securities and Exchange Commission. Thus, the trusts were grantor trusts under tax code Section 679 with the Wylys, as grantors, subject to tax on the income from the trusts.

Fine Line.

Mastracchio noted “a fine line between what is a legitimate tax structure and what the government would view as a tax shelter and sham. Offshore entities can have a legitimate purpose such as asset protection.”

Mastracchio said, “In the offshore voluntary disclosure program, you see foundations, trusts and corporations where clients decide to liquidate and unwind the structure. In others, they have a legitimate purpose, and the structures survive the program.”

Bryan C. Skarlatos, a partner at Kostelanetz & Fink LLP in New York, said “it’s important when dealing with offshore trusts to make sure they are both set up and run correctly. In this case, the entities weren’t run correctly, because the jury found that the Wylys exercised too much control.” Skarlatos made his comments to Bloomberg BNA Sept. 29.

Skarlatos said the degree of control was the issue in the Wylys case. “These trusts aren’t automatically tax avoidance vehicles. However, if they aren’t operated correctly, and the grantors exercise too much direct control, they can be seen as tax avoidance vehicles.”

Tax Evasion Intent.

Scheindlin based the disgorgement on unpaid taxes rather than securities violations. “There is no evidence in the record that the purpose of this fraud was to manipulate or distort the market. There is ample evidence, however, that the driving purpose of the securities fraud was to conceal the Wylys’ relationship to the IOM trusts and preserve the preferential tax treatment on secret offshore profits for as long as possible,” Scheindlin said.

Scheindlin said the purpose of the Wylys’ securities fraud was to conceal their relationship to and control of the trusts and, thus, maintain their tax benefits.

Using unpaid taxes as a measure of disgorgement wasn’t a violation of tax code Section 7401, Scheindlin said, because the case wasn’t a civil action for the collection of taxes. “Rather, this is a civil action for securities law violations, the remedy for which is measured by the amount of taxes avoided as a result of the defendants’ securities violations,” the judge said.

Charles Wyly died in 2011 while the case was pending.

Susman Godfrey LLP represented the Wylys in the remedies portion of the case. The SEC was represented by Bridget Fitzpatrick, Hope Augustini and Gregory Nelson Miller.