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March 2003
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Busted Tax Shelters – Wealthy Sue Accountants for Bad Advice March, 2003 Hot Topics
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IRS Crackdown on Tax Shelters
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IRS is cracking down on abusive tax shelters, and that’s bad news for hundreds, if not thousands, of extremely wealthy taxpayers who stand to lose millions in back taxes, interest and possible penalties. These tax shelters, a lucrative service provided by two prominent accounting firms, are under IRS audit and those who paid millions to participate in the shelters are now suing their professionals for bad advice.
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Sprint Officers Caught Using Abusive Shelters
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The simmering abusive tax shelter problem boiled over last week when Sprint disclosed that its chief executive, William T. Esrey and the company’s president, Ronald T. LeMay, could owe more than $100 million in back taxes because of their participation in an Ernst and Young tax shelter.

Evidently, Ernst and Young sold the tax shelter for $5.7 million on the premise that Esrey and LeMay could exercise their Sprit stock options at a substantial profit, yet avoid paying taxes for 30 years. The tax shelter used a questionable “basis shifting” technique that IRS subsequently identified as abusive. First, a series of hedging transactions were used to convert ordinary income to capital gains. Next, the scheme raised the basis of the assets so no capital gains would be paid when the assets were sold.

Similarly situated taxpayers have begun suing their accountants and attorneys for negligent advice regarding the promotion of these tax shelters.
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Accounting Firm Advises Sprint and Its Officers, A Conflict of Interest?
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In this case, Ernst and Young did accounting work for Sprint. In what has become the incredibly lucrative field of devising tax shelters, Ernst and Young evidently charged $5.7 million for the tax shelter transaction provided to Esrey and LeMay, while $2.5 million in auditing fees charged to Sprint. Audit-related services accounted for another $2.6 million, so the auditing side of the ledger totalled less than the fees charged for the tax shelter.

Congress and the SEC are investigating there should be regulations governing the apparent conflict of interest that arises when an accounting firm represents the company and its top executives on personal tax matters. Also, the area of tax opinions legitimizing abusive tax shelter promotions is another issue under Congressional scrutiny.
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How the Schemes were Promoted
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Taxpayers claim that two accounting firms thus far, Ernst and Young and KMPG, collected millions in fees and required clients not to disclose the nature of the tax shelter or seek independent advice regarding the legitimacy of the scheme. Usually, a trusted advisor to the taxpayer, such as the taxpayer’s accountant or banker, would vouch for the tax shelter presented by the large accounting firm. Often, a legal opinion from a renown law firm would bless the tax shelter.

In one case, the legal opinion evidently cost $75,000 and was reused at least 43 additional times, each at a cost of $75,000. Thus far, the accounting and law firms accused of promoting questionable tax shelters have denied any wrongdoing, claiming that they stand by their advice or that the taxpayers were fully apprised of the risk when they signed up.
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IRS Uncovers Abusive Tax Shelters by Offering Limited Amnesty
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It appears that IRS, in a rare stroke of genius, uncovered these tax shelters though a tax amnesty program aimed at corporate tax shelters. To IRS’s surprise, about 1,000 individual taxpayers came forward under the program and disclosed their participation in the shelters, thereby providing IRS a roadmap to the existence of hundreds, if not thousands, of other individuals and businesses participating in various tax shelter schemes. In fact, Esrey and LeMay supposedly took advantage of the amnesty program to disclose the questionable tax shelter involved to avoid penalties on the transaction.

Recently, IRS has followed-up on its success in the abusive tax shelter program by offering limited amnesty to taxpayers involved with offshore bank accounts and credit cards. See: http://www.taxprophet.com/hot/Trust%20Scam%20Files/amnesty.html

The apparent objective is to discover widespread tax cheating by allowing participants to “come clean” and confess their participation. In return, IRS will waive any civil fraud penalties and potential criminal prosecution for tax fraud. It only takes a small number of taxpayers to participate since the lead from just one participant in a tax shelter will provide IRS with a roadmap to the promoter as well as their client list.
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The Use of Legal Opinions as Audit Insurance
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These tax shelters were devised to hide the true nature of the deal by creating a labyrinth of transactions designed to make it difficult for IRS to uncover. Also, the legal opinion blessing the transaction was supposed to act as insurance against IRS assertion of negligence penalties. Thus, if caught, taxpayers were supposed to be at risk for taxes and interest only. Assuming the taxpayer placed the taxes saved in a conservative investment that paid interest, the economic risk would be minimal.

Many taxpayers exercised stock options at the height of the stock market and avoided taxes on the inflated valuation of their stock at that time by participating in these tax shelters, their stock value has since plummeted (or they invested their “tax” dollars in stocks which have fallen in value) and is now worth much less than the taxes owed. Thus, engaging in these risky tax shelters may cost participants their entire net worth, as claimed by Sprint chief executive, William Ersey.

Also, the notion that a legal opinion written by a law firm with a vested interest in the transaction would prevent the assertion of negligence penalties is suspect, especially when the taxpayers were not permitted independent advice regarding the propriety of the transaction. As most tax attorneys recognize, legal opinions regarding the validity of a tax shelter are nothing more than sales pitches, rather than a scholarly expositions regarding the actual law as applied to the true facts.
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Legal Opinions Often Ignore the Tax Shelter's Lack of Economic Merit
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There are numerous disclaimers and bogus assumptions, but there is a general absence of critical analysis of the overwhelming legal authority against these transactions.For instance, invariably these transactions do not pass the “form over substance” test imposed by the courts with respect to tax-motivated transactions, yet most legal opinions gloss over this glaring defect by addressing the technical form of the deal.

In one tax shelter transaction which I analyzed for a client, I questioned a legal opinion drafted by a nationally prominent law firm. The opinion’s author told me that he omitted a critical court case directly on point against the transaction because he believed “the court was wrong!” Unfortunately, attorneys cannot ignore adverse legal precedent because it hurts their case and this omission rendered the entire opinion worthless, if not fraudulent. Fortunately, this exchange occurred during a telephone conference with my client on the line, and after he heard this answer, he chuckled and said “no thanks” to the offered tax shelter -- and lucky for him that he saw the light.

Unfortunately, many taxpayers, under a hard sell from tax shelter promoters and facing millions in taxes, regard a legal opinion as insurance that the deal is legitimate, when the opinions, in reality, hold no legal weight whatsoever. The real purpose of an opinion letter is to prevent IRS from asserting negligence penalties, in addition to the taxes and interest owed. The theory is that the taxpayer sought independent legal advice on the transaction and was advised that, on balance, the transaction should be considered legitimate.

Such an opinion, however, does not shield the taxpayer from owing taxes and interest, and IRS is expected to assert negligence penalties as well, since the legal opinions provided are, apparently, part of the tax shelter scheme. They are written by a captive law firm earning huge fees for providing cover to the promoter, and the opinions lack any serious analysis of the facts and law pertaining to the particular shelter. Often, adverse precedent is ignored or declared irrelevant when, in fact, that very precedent will often decide the case against the taxpayer.
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© 1995-2004 Robert L. Sommers, attorney-at-law, all rights reserved. This article and internet site provides information of a general nature for educational purposes only and is not intended to be legal or tax advice. This information has not been updated to reflect subsequent changes in the law, if any. Your particular facts and circumstances, and changes in the law, must be considered when applying U.S. tax law. You should always consult with a competent tax professional licensed in your state with respect to your particular situation. The Tax Prophet® is a registered trademark of Robert L. Sommers.