A major supporter of the UA and one of its largest benefactors are suing an international bank, saying they were misled into making a legally dubious $41 million investment.
The University of Arizona Foundation and two of its biggest supporters, Karl and Joan Eller, filed the suit against Swiss-banking giant UBS AG and its affiliates in July in Maricopa County Superior Court.
It seeks to recover an unspecified amount in damages related to back taxes, interest and penalties the plaintiffs had to pay after the IRS found the investments to be an “illegal tax shelter.”
The suit accuses the bank of civil racketeering, civil conspiracy, aiding and abetting fraud, and aiding and abetting breach of fiduciary duty. The case has since been transferred to federal court.
The accusations stem from investments the UA Foundation and the Ellers made more than a decade ago in what was called a contingent deferred swap, a complex strategy designed to aid extremely wealthy individuals in reducing their income taxes on investments.
The UA Foundation declined to comment on the lawsuit because the issue is pending. The Star was unable to contact the Ellers or anyone at UBS who could comment.
How it happened
The suit says the investment dates to 1999, when the Ellers sought to “make charitable contributions and to gain returns on their funds.”
The Ellers and an accountant met with representatives from a Seattle-based hedge fund called Quellos Group, who subsequently sold them on the idea of the contingent deferred swap, or CDS, as a way to achieve both goals.
A contingent deferred swap provided the investor a way to convert higher-tax investment income into lower-tax capital gains.
The Quellos representatives provided the Ellers with an opinion letter from the PricewaterhouseCoopers accounting firm attesting to the legitimacy of the deal.
The Ellers ultimately were persuaded to invest more than $41 million in a pair of CDS partnerships designed to shield income from taxes and earn interest, a portion of which was later donated to the UA Foundation.
The suit contends that “UBS and its co-conspirators” conducted a scheme to defraud plaintiffs and other investors, “convincing them to invest in the CDS strategy in exchange for substantial fees, while concealing that the CDS strategy was an unlawful tax shelter.”
Quellos and the other players knew about the IRS issues with the CDS going back to at least 2002, the suit says, because the IRS had audited the partnership in 2003 for the tax years 1999-2002.
But the Ellers were unaware of any problems until November 2006, when they received notice from the IRS informing them of the government’s desire to recover back taxes plus interest and penalties.
When the Ellers told Quellos and PricewaterhouseCoopers of their IRS issue in 2006, the claim says, they were advised to file a letter in protest to the government because “the CDS was a good transaction and there was nothing wrong with it,” according to the lawsuit.
The Ellers say they were persuaded to litigate the issue with the government despite their CDS partners’ knowledge that the tax shelters were illegitimate.
UBS has not yet filed an answer to the lawsuit, but the bank has paid the government large penalties for its participation in CDS schemes.
And the architects of the CDS strategy, Quellos bosses Jeffrey Greenstein and Charles Wilk, were sentenced to four years in prison in 2011 for their role in a separate tax-avoidance scheme.
The lawsuit says the UA Foundation and Eller settled the issue of back taxes related to the CDS investments. As part of the settlement, the IRS disallowed most of the tax benefits they received between 1999 and 2002 and assessed a 5 percent penalty.
How the CDS worked
This complicated investment strategy, which the IRS ultimately labeled “an abusive tax shelter,” was designed to take standard investment income and convert it to capital gains, subject to taxes at about half the rate.
In many cases, the standard income would face a 40 percent tax while the capital gains were taxed at 20 percent.
The scheme involved creating a partnership among the investor, someone to act as a general partner in an investment vehicle, an accounting firm to act as tax adviser and a bank to loan the partnership money.
In simple terms, the investor would make payments into the partnership, which would later be written off as losses. After about two years the partnership was dissolved, and for tax purposes the funds therein were treated as the lower-taxed capital gains.
In practice, the schemes were usually much more complex, often with multiple special-purpose entities conducting large volumes of short-term trades for the appearance of actual investment activity.
In addition to sheltering income from taxes, a CDS could yield actual profits for the investor, which might be used to pay off the lower tax obligation.
“THe audit lottery”
Valparaiso University law professor Del Wright Jr. said tax shelters like CDS and others bring up issues of fairness.
“If you have a lot of zeros behind your name, you get to play the ‘audit lottery,’” Wright said.
That audit lottery, he said, is a game designed with complexity in mind to keep the IRS at bay, and one only the super-rich can play.
He estimates the chances of the IRS finding tax shelters and auditing those who benefit from them is, at most, 15 percent.
It’s simple economics for those with the means to pay for the professional advice to help them avoid taxes, he said.
For example, in a CDS someone may have invested tens of millions of dollars and ended up paying a tax burden half the size they would have needed to if it were claimed as regular investment income.
Even if the IRS found out, Wright said, the taxpayer would only be required to pay the original tax amount, some interest and a minor penalty.
“Why not play, if your penalty is usually capped at 20 percent of the benefit?” he said.
Wright, who recently wrote a paper on tax shelters for the Arizona State Law Journal, was formerly a tax attorney, a trial attorney with the U.S. Department of Justice tax division and an investment banker with Bank of America.
He said the big-money, abusive tax shelters could be minimized if the penalties were stiffened, making the risks of participating higher, or by make it easier for clients to sue financial advisers who misled them into an abusive tax shelter, or with more criminal prosecutions.