In an unprecedented decision today, a federal tax court judge refused to let two California couples end a long dispute with the Internal Revenue Service by paying their taxes and dropping a lawsuit against the government.
Even though the taxpayers admitted they owe the government $57,000, they still must go ahead with a trial in the case because hundreds of millions of dollars of other person's money are at stake, said Judge Arthur Nims.
Nims acknowledged that this is the first time the federal government has refused to let a taxpayer settle an income tax dispute by paying everything the IRS demanded. The judge issued the ruling after IRS attorney Theodore Kletnick charged that the two California couples -- named Smith and Jacobson -- have been "bought off" in an effort to keep the case out of court.
Kletnick said Merrill Lynch, Pierce, Fenner & Smith, the nation's biggest stockbroker, has agreed to pay the two couples $114,000 -- twice as much as they owe in taxes -- to settle the case.
Smith and Jacobson's dispute with the IRS centers on tax deductions they claimed for an investment called a "silver straddle" that was arranged for them by Merrill Lynch.
Kletnick yesterday described silver straddles as "a flagrant, abusive tax shelter" whose only purpose is to allow wealthy people to pay less income tax.
The IRS has claimed since 1977 that silver straddles are not a legitimate tax deduction, but this is the first time it has gone to tax court for a final ruling on the question.
If Smith and Jacobson lose their case with the IRS, it will establish a legal precedent for the IRS to challenge thousands of other taxpayers who have claimed hundreds of millions in tax deductions from silver straddles.
Merrill Lynch has been the most active brokerage in arranging so-called tax straddles, but virtually all the major investment firms have handled them, IRS officials said.
Merrill Lynch officials said the brokerage is "not involved in the case" and refused to comment yesterday on Nims' ruling. The company would neither confirm nor deny that it had offered payments to the Smiths and the Jacobsons. Thomas W. Smith, a Merrill Lynch vice president and attorney for the company, said Merrill Lynch has settled a lawsuit brought against it by the two couples. "I guess it's reasonable to assume that's where they're going to get the money," Smith said in court today.
None of the defendants in the case -- Harry and Patricia Smith and Herbert and Ruth Jacobson -- was in court today. Both live in San Diego, Calif. The two couples were partners in a real estate venture in which they earned large profits in 1973. Through Merrill Lynch they arranged a silver straddle that was supposed to allow them to pay less income tax on their earnings from the real estate deal.
Tax straddles are a complicated commodities transaction in which taxpayers normally are able to change a short-term capital gain -- which is taxed the same as ordinary income -- into a long-term capital gain -- which is taxed substantially lower.
After the IRS challenged their tax returns, the couples sued Merrill Lynch, blaming the broker for their tax troubles, and also sued the IRS, challenging the government's demand for additional taxes.
IRS officials did not claim today that it was illegal for Merrill Lynch to pay the two couples to settle the dispute with the IRS.
But government attorneys did accuse the brokerage firm of trying to stall a tax court decision.