Tax Shelters: Will They Stand Up?

The IRS has taken a predatory stance against tax shelters. But several court decisions have altered the rules of the chase.

Remember the war on tax shelters? During the Clinton Administration, then- Treasury Secretary Lawrence Summers called abusive tax shelters “one of the most serious compliance problems in the U.S. tax system.”

He backed up his words with new regulations on tax-shelter promoters, greater disclosure requirements for corporate taxpayers, and a more-aggressive Internal Revenue Service audit staff.

With the election of a business-friendly President in George W. Bush, some tax directors might have expected the IRS crusade to be toned down. But that hasn’t happened. Despite recent taxpayer victories in court against the IRS, Assistant Secretary of Treasury for Tax Policy Mark Weinberger has repeatedly warned that the IRS will continue to enforce existing tax-shelter rules vigorously.

Fueling that resolve is the fact that tax shelters have become a far more politically charged issue in the past few months, thanks to–you guessed it–Enron. Along with all the other financial engineering tricks that Enron pulled off, it managed to pay next to no income tax in the past five years, despite reporting robust–if ultimately illusory–earnings in its financial statements. Add in the fact that the federal government is once again running budget deficits, and the topic of tax shelters makes for good sound bites.

“I’m a tax-cutter, but if there’s one thing I can’t stand, it’s a tax cheat,” said Sen. Chuck Grassley (R-Iowa) in a January 17 press release. The ranking minority member of the Senate Finance Committee has vowed to help introduce new legislation that will make it easier for the IRS to combat abusive tax shelters, which it estimates rob the Treasury of at least $10 billion annually.

All this attention, of course, creates a potentially greater source of risk for corporate finance chiefs seeking to reduce their tax burdens. While the IRS defines a tax shelter as any transaction undertaken with a significant purpose of tax avoidance or evasion, CFOs are expected to make investment decisions on an aftertax basis. They are also expected to consider all legal means to minimize the corporate tax burden. “It’s what I get paid for,” says one tax director of a large retailing company. “Like most taxpayers, I want to take an aggressive position if I think there’s a reasonable chance of succeeding,” adds another in the hospitality industry.

Those chances of success may have increased in the past year, thanks to favorable outcomes in court for a number of companies. Recent cases have shown that judges don’t always have the same notions as the IRS about what constitutes a “valid business purpose” or when a transaction has “economic substance.” Still, legal experts say the verdicts don’t necessarily suggest that the IRS’s campaign against tax shelters will be quashed by the courts. “It’s halftime, and too soon to tell if the advantage has shifted to the taxpayer,” says attorney Jean Pawlow of Miller & Chevalier, in Washington, D.C.

Show and Tell

For the IRS, the advantage is clearly in having information. Since February 2000, the agency has required promoters of tax shelters–which include accounting firms, banks, law firms, and securities brokers–to register all tax shelters they market to individual and corporate taxpayers. They are also required to supply the IRS with lists of all the investors that undertake the transactions. “It’s supposed to throw sand in the gears,” says Robert Gordon, president of securities broker Twenty-First Securities. “The purpose of it is to make things easier for government auditors, but it also makes taxpayers think twice about using something on a list.”

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