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.

As of last September, more than 3,000 shelters had been registered and the Tax Shelter Committee of the Large and Mid-Size Business Division of the IRS had approved investigations of five promoters that had failed to register shelters. While the IRS hasn’t released any information on the investigations, it did announce an agreement with Merrill Lynch last August “relating to tax-shelter registration penalties” that resulted in “a substantial payment” to the IRS. Others could be facing penalties as well. “I think there are still quite a few shelters that haven’t been registered,” says David Harris, head of the Office of Tax Shelter Analysis, which was created by the IRS two years ago.

The February 2000 regulations also require companies to disclose all potential tax shelters in their tax returns. The IRS has composed a list of 16 “reportable transactions” that it considers potential shelters, but requires all transactions in which tax avoidance is a “significant purpose” to be reported. So far, companies have been less than forthcoming. “A lot of practitioners have said that they would like to disclose their transactions, but are concerned about tax-understatement penalties,” says Harris. And not without reason: penalties can reach 40 percent of the tax savings at issue.

In an effort to bring more transactions out of the woodwork, the IRS recently agreed to waive penalties if companies voluntarily disclose questionable transactions by April 23. Says Harris: “CFOs and tax planners have to understand that we have focused our resources on these transactions, and if promoters have marketed their products to a number of people, we’ll find the companies on a list.” Apparently, finance chiefs are willing to take that chance. While Harris expects the number of disclosure filings to increase as the deadline approaches, few companies have yet taken the IRS up on its offer.

And the Verdict Is?

One reason why finance chiefs aren’t rushing to disclose their potential shelters may be the string of recent courtroom defeats suffered by the IRS. Before last year, the IRS was untouchable, amassing an 11-0 record in tax-shelter cases, most of which were tried in the U.S. Tax Court. Since then, however, several of those victories have been reversed in district courts. “What a difference a year makes,” says an attorney who closely followed Compaq Computer’s successful appeal of a U.S. Tax Court ruling on a so-called dividend-stripping transaction in the Fifth Circuit Court of Appeals. “A year ago the government was winning everything, but now the courts of appeal are taking a cold, hard look at the facts.”

While the variations on tax shelters are infinite, their ultimate aims are the same. Some, such as Compaq’s ADR (American Depository Receipt) arbitrage strategy, generate capital losses to offset gains. Other transactions, like the purchase of corporate-owned life insurance policies, involve the borrowing of large sums of money in order to deduct interest payments. In all tax-shelter cases, the IRS essentially argues that the company would not have undertaken the transaction were it not for the tax benefits it generated. Companies can counter the argument by proving the transaction has the potential to produce a profit.


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