Shelter Fallout

How much will the government's crackdown on tax shelters affect ordinary companies? More than you think.

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.

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