IRS committed fraud in pilots' tax evasion case, court rules

SAN FRANCISCO -- A federal appeals court has ruled the Internal Revenue Service committed fraud and acted deceptively after giving secret deals to two pilots in return for their testimony against 1,300 other pilots who had bought into the same tax shelters.

The 9th U.S. Circuit Court of Appeals on Friday overturned a previous ruling against the pilots who were found guilty of tax evasion and were ordered to pay more than $2 billion in penalties.

In order to remedy the IRS misconduct, the court ordered that all the pilots should receive the same deal that one of the pilots received.

As part of the secret deal, pilot John Thompson escaped paying the taxes he owed and received a $60,000 refund through falsified tax returns prepared with help from the IRS. Thompson used the refund to pay his legal fees. He also collected $20,000 in interest, according to the ruling.

The second pilot, John Cravens, also received a secret deal.

IRS lawyers Kenneth McWade and William Sims, who prosecuted the case, never revealed to the tax court that the two pilots' cases had been settled, much less revealed the conditions of the settlement.

The appeals court said the lawyers' silence turned into outright misconduct when, during a trial, it became apparent that Thompson was going to testify about his settlement and McWade quickly shifted his question to unrelated topics.

The ruling requires the IRS to pay tens of million of dollars in tax refunds, interest and legal fees to the pilots who paid the disputed taxes more than 20 years ago.

The court criticized the IRS for not taking serious action against the lawyers who tried the case. McWade and Sims were suspended for two weeks without pay. They both insisted in testimony that they had behaved properly.

The IRS office in northern California did not immediately respond to requests for comment Sunday.

The group of pilots participated in an investment program and tax shelter designed by now-deceased Honolulu businessman Henry Kersting who claimed the shelter was a legitimate investment. The program allowed the pilots to purchase stock with loans from Kersting-controlled entities that were financed with promissory notes.

The investment enabled participates to claim interest deductions on their individual tax returns, according to the court.

The IRS discovered the scheme in 1981 and did not allow the deductions and sent bills to the pilots for additional taxes and penalties.