Leona Helmsley would have made a colorful spokeswoman for the tax-shelter industry. "Only the little people pay taxes," she cheerfully asserted in 1989, shortly before her conviction for tax evasion.
Of course, Helmsley's wrongdoing — which amounted to about $1 million in unpaid federal taxes through fairly ordinary fraud — seems petty next to the grand tax dodges of a decade later. Enron's inventive shelters, for instance, helped it completely avoid paying taxes on the $2.3 billion of profit it reported for the years 1996-1999. "Compared with what we saw in the '80s, shelters have gotten more and more outrageous," says Louis Marett, a partner with Testa, Hurwitz & Thibeault LLP. "It's gone from being a retail industry to a wholesale industry."
In 2000, alarmed by how audacious and costly tax shelters had become (a recent study by the journal Tax Notes estimates that the Treasury loses $10 billion to $20 billion annually as a result of shelters), the Internal Revenue Service began to crack down. The government's effort, which has accelerated in the past year, has brought stricter enforcement and an array of new disclosure requirements. And it's not just the IRS that is taking action: In October, Congress passed a massive tax bill that, if signed into law, would add even more regulations designed to keep companies honest. "The stakes for noncompliance are higher than they were a few years ago," says Deborah M. Nolan, commissioner for the IRS's Large and Mid-Size Business division.
Unfortunately, the risks for law abiding companies have also climbed. According to tax experts, even companies that scrupulously adhere to the tax code are now more likely to face government scrutiny. As regulators cast a bigger net, they will inevitably haul in more than a few unintended fish.
The IRS crackdown has two main components. One (see "Taxpayer Beware") is a more active pursuit of tax-shelter promoters and investors. The government has taken many law and accounting firms to court to force them to hand over client lists. The lists, in turn, have led the government to those that have bought the shelters. "This was an underutilized tool for us," says Jonathan R. Zelnik, a senior counsel at the IRS who focuses on potentially abusive transactions. "It's been very effective in helping identify taxpayers who have done abusive transactions."
Success with the promoter investigations has helped the government convince many investors to give up their shelters voluntarily. For example, in May the IRS offered a settlement to those that had bought the "Son of BOSS" (named for the offshoot of the bond and option sales strategy) tax shelter. The settlement offer — which still required investors to pay all back taxes, interest, and a reduced penalty — attracted more than 1,500 companies and individuals.
Another component of the crackdown — forcing greater disclosure from filers — is more controversial. The IRS has published a list of transactions that all filers must disclose. While not necessarily prohibited, these transactions raise a red flag for regulators (see "What to Disclose," at the end of this article). When a company makes a disclosure, the IRS examines it to decide whether it has a true business purpose or is merely a tax-saving gimmick.
The IRS also hopes to improve disclosure through the new schedule M-3, which requires companies to provide a fuller explanation of tax-book gaps. Wide differences between the numbers reported on financial statements and for tax purposes are a hallmark of shelters. Schedule M-3 will take effect for tax years ending on or after December 31, 2004.
And then there are the tax-accrual work papers. These documents — typically prepared by a company's auditors — lay out a company's rationale for the amount of money it sets aside for tax positions it thinks the IRS could challenge. It's understandable that the regulators would be interested in the work papers, since they clearly address any aggressive positions the company is taking. Before the current crackdown, the IRS rarely requested these documents, but now it asks for them when a company has engaged in one or more listed transactions. "The IRS always had the ability to get accrual work papers, but never pressed as hard before," says Marett.
Too Much Transparency?
Not surprisingly, some finance professionals find the government's tactics alarming. "My feeling is that it's overkill," says Tom Kelly, director of tax and treasury at Pall Corp., a $1.8 billion manufacturer based in East Hills, New York. "You're disclosing so much that you're basically laying out your tax planning before the audit starts."
To be fair, it's hard to imagine how the IRS could effectively curb shelters without some heavy-handed tactics. Tax shelters are deliberately hard to spot, often involving complicated trusts, partnerships, and overseas accounts that are themselves hidden in tax documents hundreds of pages long. And since the IRS lacks the resources to examine many of the tax returns it receives, many abusive transactions go unnoticed.
Still, there are real concerns. One is that legitimate transactions could draw an expensive IRS investigation. Consider the example of a money-losing sale of a partnership. While this has been a feature of fraudulent tax avoidance, it is also routine when a company exits a failing joint venture. "You're inviting scrutiny by selling a legitimate joint-venture partnership at a loss," says Mark Weinstein, a partner with Hogan & Hartson LLP. "When you're sitting on the fence trying to decide whether or not to sell, you may well say, 'Let's not sell, because we're just going to open a Pandora's box.'"
A company might also find itself in trouble if it invests in a fund that engages in transactions such as currency swaps. While swaps are a standard hedging technique, some require disclosure under IRS rules — even for the company that's investing in the fund. As with the partnership sale, the prospect of IRS scrutiny could prompt a company to forgo an otherwise attractive transaction.
Nolan acknowledges the problem, and says the IRS is working to get better at distinguishing legitimate transactions from illegitimate ones. "The disclosure rules do sweep in some legitimate transactions," she admits. "But we're gaining more experience, and our processes will allow for making the distinction." She points out that schedule M-3 should help, since it gives the IRS much of the information it needs to make a judgment.
There is also the worry to which Kelly alluded: at some point, greater transparency means showing the IRS how you think about your tax planning. Examinations of tax-accrual work papers are especially worrisome. "Client work papers contain sensitive information that could reflect aggressive reporting positions," says Weinstein. "It's like handing the IRS a road map so that they can go after these items and disallow them." In some cases, taxpayers have attempted to assert accountant-client privilege, but so far the courts have upheld the IRS's right to review the documents.
For its part, the IRS recognizes that work papers are a sensitive area. "There is a competing balance," says Zelnik. "We want to encourage companies to make an accurate assessment of their tax position without fear that the service will come in and pick the tax-accrual papers up. It's something we use judiciously."
Congress Piles On
Finally, there is the fact that Congress and state legislatures are getting into the act just as tax-shelter activity is waning. Congress's tax bill, which President Bush is expected to sign, shuts down a number of shelters and adds much higher penalties. (At the last minute, law makers stripped out other controversial items, including CEO signoff on the tax-planning process and a whistle-blower provision.) California passed its own tax-shelter legislation last year. "We've already seen a shift in corporate culture thanks to changes like Sarbanes-Oxley, increased [Securities and Exchange Commission] oversight, and IRS enforcement," comments Timothy McCormally, executive director of Tax Executives Institute Inc. "Some of these new proposals are just an unnecessary piling on."
All of the focus on tax shelters puts finance executives in a familiar bind — fulfilling their duty to ensure their company pays no more in taxes than it has to, while keeping on the right side of the law. "Face it — the pressure is always there to keep a low effective tax rate for the company," says Kelly. At the same time, pressure from the IRS is unlikely to abate: with the federal budget deficit reaching record levels and new tax cuts possible, the government seems likely to step up its tax-collecting efforts.
For now, at least, the impulse at most companies seems to be to steer clear of trouble. "Tax strategy has become a bad word," says David Davidson, a partner with Accenture's finance and performance management business. "Companies don't want to hear about creative tax-planning ideas." That's certainly true at companies such as Allergan, an Irvine, California-based pharmaceuticals firm. "We are very conservative on transactions, and don't do anything significant without running it past our auditors prior to signing," says CFO Eric Brandt.
This doesn't mean that abusive shelters are gone for good, of course. Tax evasion is easiest when tax laws are complicated and ambiguous, and the tax bill recently passed by Congress will add to the clutter. "As long as Congress writes detailed, complex tax laws, someone in the private sector is going to find a loophole," comments Weinstein. "And they'll figure out a transaction they can run through that loophole and market as a shelter."
Don Durfee is research editor at CFO.
At the height of the tax-shelter boom, Raymond Ruble, a lawyer with Brown & Wood in New York, was a prolific author of opinion letters. Ruble wrote hundreds of letters stating that various tax shelters — shelters promoted by firms he had relationships with — would likely be acceptable to the IRS. Many companies and individual investors assumed that such letters would shield them from penalties if the day came when the government decided that the shelters were not, in fact, acceptable.
The assumption was wrong. A number of recent cases — in particular the August ruling that defunct hedge fund Long-Term Capital Management had evaded millions of dollars in taxes — have shown that courts don't view such letters as an automatic exoneration. "There was a thought by some that if you hired the right firm and they gave an opinion, you'd be protected," says Jonathan R. Zelnik, a senior counsel at the IRS. "But as the [Long-Term Capital] case shows, the opinion letter is just one factor in determining whether you have a reasonable belief that the transaction works."
Now the IRS has been pressing law firms to hand over the lists of clients for whom they wrote such letters. "The IRS and some law firms have been battling it out in the courts," says Louis Marett of Testa, Hurwitz & Thibeault LLP. "And the IRS is generally prevailing." —D.D.
What to Disclose
The IRS defines six major categories of reportable transactions:
- Transactions in which the promoter requires confidentiality.
- Transactions in which the investor has contractual protection (for example, a refund of fees if the promised tax savings don't materialize).
- Transactions that generate tax losses above a specified level (for example, $10 million in a year for a corporation).
- Transactions with a significant book-tax difference.
- Transactions involving a brief holding period.
- Transactions similar to 30 specific shelters the IRS has identified so far.
Source: Internal Revenue Service