Copyright © 1999 Robert L. Sommers, all rights reserved.June, 1999 Hot Topics- Part One of a Two-Part Series
I have written several articles concerning "trust scam artists" (see my Trust Scam Bulletin Board) and how they market their bogus tax schemes to unsophisticated taxpayers. These schemes rely on hucksters selling decades old "snake oil" based on frivolous interpretations of the Constitution and ones freedom to contract. They have the same general characteristics: (1) a hard sell; (2) appeal to patriotic or religious themes; (3) a "something-for-nothing" pitch; (4) mounds of paperwork to pretend that legitimate business transactions are occurring; and (5) a frivolous and discredited interpretation of the tax law.
Not surprisingly, the courts have uniformly dismissed these trusts with disdain, calling them sham transactions, devoid of any meaningful economic substance. Heavy penalties, and sometimes prison, await these trust scam artists and their unsuspecting followers.
This months hot topic focuses on the tax scam artists from the other end of the spectrum: The accountants and investment firms pitching bogus tax shelters to large corporate clients, and lawyers who support them with dubious legal opinions. While these schemes engender serious discussion and debate in lofty legal journals, at bottom, these "corporate tax shelters" are remarkably similar to the trust scams pitched to the gullible.
Similarities include: (1) a hard sell and promotion; (2) a promise to gain "something-for-nothing"; (3) the fear that others are doing it and you are naïve not to participate; (4) a bogus reading of the tax law (usually a distorted and literal reading of a code provision that clearly did not contemplate the proposed transaction); (5) little or no financial risk to the participants (i.e. the taxpayer is left in essentially the same economic position after the transaction as before); and (6) once the courts have analyzed the details, they reject them as a sham.
Ironically, the sham transaction doctrine nails both the trust scam artist and the sophisticated corporate tax shelter pitchman alike.
Of course, the one major difference is that penalties are almost never levied against the corporations or promoters involved, and criminal prosecution is out of the question. If caught, corporations will owe the taxes they should have paid anyway, plus interest. Consequently, the economic risk of engaging in a sophisticated tax sham is virtually eliminated, whereas, those involved in trust scams are faced with huge penalties and possibly jail.
Why the disparate treatment? One reason could be that those in charge of enforcing the tax laws look forward to lucrative careers with the accounting and investment firms pitching these schemes. There is an element of gamesmanship between the tax-brokers and IRS, which makes for lively debate in legal journals and at tax conferences.
Also, the pitchmen go to great lengths to hide the transactions from the government, often requiring "confidentiality" agreements among participants. The transactions themselves are complicated and usually involve a novel, but nevertheless frivolous, interpretation of the tax code, making detection much more difficult.
In contrast, the trust scam artists are a crude and primitive bunch who "red flag" their documents with claims of constitutional or religious immunity from our tax laws.
The old-fashioned stereotype of the bi-focaled, milquetoast accountants with eyeshades, pencils and ledger sheets has given away to the accountant as a "circus pitchman on steroids." Global accounting firms are now so powerful, even lawyers are quaking in their boots! After gobbling-up prestigious law firms in Europe, these accounting firms have started their assault on the U.S. legal profession, insisting that in today's global economy, they should be allowed to practice law, as well as accounting. [Evidently, the accounting firms relish the negative publicity heaped on the law profession.]
The bar is now bracing for mega-legal/accounting firms that will eliminate the distinction between the two professions. The legal bar should be concerned, since accounting firms have paid little heed to concepts like conflicts-of-interest, confidentiality, the duty of undivided loyalty to a client, and other professional standards imposed on lawyers. This is evident in the corporate tax shelter arena where conflicts-of-interest are of little concern to those pitching deals to clients.
In addition, these accounting firms have turned from their role as independent auditors of the world's largest corporations, and have become tax-shelter hustlers to these very same corporations. Armed with an international client base, the big accounting firms have begun brokering tax advantages between their U.S. and foreign corporations by exploiting the complexities of U.S. tax law to create transactions that, apart from tax advantages, have no legitimate business purpose.
Of course, U.S. tax law ignores sham transactions and these "tax brokers" are fully aware of that. But they also know the IRS will probably not find out about them. The goal is to have 9 of 10 transactions slip through the IRS audit system and on the one that is caught, make sure there is enough "legitimacy" to prevent penalties. Therefore, although one in ten transactions may be disallowed, just the tax and interest will be owing no penalties or jail.
Forbes magazine exposed this newest form of tax cheating in its cover story "Tax Shelter Hustlers" dated December 14, 1998. It made chilling reading. According to Forbes, it obtained a confidential letter from the global accounting firm Deloitte & Touche in which the firm demands a contingency fee of 30% of taxes saved through the use of its "strategy" to save taxes. Touche promises to defend the client at audit, but not in court and will refund a portion of the fee if a tax liability is sustained. Sounds like Touche is an equity partner, rather than a fee-based advisor, in the transaction -- and that's the point. These accounting firms are creating and aggressively selling corporate tax shelters for a piece of the action.
Although the actual deal is usually very complex, the strategy is not. The idea is to exploit the words in the tax code to produce a result that was never intended - usually .a literal reading of provisions taken out of context -- then hope the IRS won't find out. With the recent attack on the IRS by Congress, the agency has cut back on audits, thereby making the market for esoteric tax schemes less likely to be detected.
According to former IRS Commissioner Lawrence Gibbs (as quoted in the Forbes article), the esoteric corporate tax shelters being peddled today are similar to the individual tax shelters of 20 years ago: "It's virtually the same thing, with a bit more sophisticated produce. Once something like this gears up, it's hard to stop, and the government is far behind the curve."
While the tax shelters of 20 years ago were popular with individuals paying 50-70% in taxes, the corporate tax shelters of today do not appear to be tax-rate driven, since the corporate tax rates have not changed much over the past 20 years. Instead, these shelters are appealing because they use sophisticated financial instruments and involve international tax structures.
In other words, the promoters and taxpayers believe they are more creative, quicker and cant outsmart the Congress and the IRS. In essence, these tax shelters have an "attitude" of intellectual superiority to them. What is also noticeable is the lack of ethics or morality in these structures, because these shelters are blatantly without economic substance.
These deals are hard for IRS to uncover because they do not have obvious red flags. Without viewing the transaction as a whole through the sham transaction prism, each step looks perfectly innocent and legal. For example, a typical partnership between two corporations which is adequately funded, documented and reported on tax returns will look innocent until the actual business activities of the venture are scrutinized.
By its nature, the sham transaction doctrine applies when the "deal" is finished, since it compares the economic result at the end of the transaction with the economic position of the parties before the transaction, then determines whether any meaningful economic activity occurred.
By stringing the transaction through layers of companies or over two or more tax years, the true economic substance becomes very hard to detect. In other words, the promoter structures the transaction to force IRS to see only the trees (a sale in one year, a distribution in another) not the forest, knowing that the IRS must first see the forest before it can apply the sham transaction doctrine.
The rise in corporate tax shelters is based on the complexity of the tax code and Wall Streets experience with the stock derivative phenomenon (financial investments that hedge against risk). The new corporate tax shelters rely on three main factors:
(1) the hope that IRS will not discover the transaction (old-style audit roulette);
(2) a novel interpretation of the tax code that could "literally" apply to the transaction. This point is important since to avoid penalties, these schemes need a tax opinion, often based on a set of unrealistic assumptions, stating that it might work (although no one serious believes the taxpayer will prevail in court); and
(3) the ability to hedge against significant economic risk (the "derivative" mentality).
The first factors objective is to force IRS to spend its resources ferreting out these transactions and unraveling them. If, for example, a corporation engages in ten such transactions and IRS finds one of them, in which all that is owed is back taxes and interest, the risk is clearly in the corporations favor.
The second factor mitigates the risk to the taxpayer and its advisors. If IRS is able to impose severe penalties on the taxpayer, the pitchmen and their supporting cast, IRS gains the advantage, even though it may find only one in ten. This is where IRS must counter-attack.
The third factor makes the transaction work since invariably there is a party that stands to gain nothing except a small fee for participating. These deals usually have two parties: one that receives an improper tax advantage and a nominal party that is paid a fee for participating in the scheme. The nominal party has no desire to take a "real" financial risk in the superficial venture, so there must be sophisticated hedges against any potential economic harm. Because the transaction is devoid of economic risk, the courts, once they untangle the scheme, have little trouble applying the sham transaction doctrine.
Traditional tax planning focused on the client's tax needs, using the code to plan for future business-related transactions and how to minimize the tax bite. In contrast, today's aggressive tax shelters focus on real or imagined loopholes in the Internal Revenue Code and then a product is created for sale to corporations. Instead of sitting down with a client and analyzing their tax picture for appropriate tax planning strategies, the new approach has become, "Do I have a deal for you! Buy into this exotic financial arrangement and we'll eliminate your taxes and we will take 30% of the tax savings."
The modern corporate tax shelter scheme is easy to detect and analyze, despite the obfuscation designed to hide it, since they have one or more of the following elements:
An investment or accounting firm will create the investment and then try to sell it.
The promoter will act as a broker, rather than as an advisor and will receive a piece of the action (i.e. the tax savings generated from the scheme), usually called a commission or contingency fee. In reality, the promoter has an equity interest in the deal.
The potential fee will be many times greater than the typical hourly rate charged to a client for advice. The promoter might agree to defend the client on audit or refund a portion of its fee if the shelter fails - in other words, the promoter takes an entrepreneurial risk in the enterprise to justify its "equity" interest in the action.
The shelter requires a bifurcation of income and losses, with income flowing to an entity that will not pay taxes on it, and losses being deductible by the promoter's client (the U.S. taxpayer corporation).
A partnership is usually used to structure the transaction since the investment income and losses can be specially allocated among the partners.
Sometimes, when the scheme involves the exploitation of a code provision, a corporate reorganization is used.
One partner receives the tax benefit, usually a loss.
The other partner receives the "income." Note: Income is allocated to this partner, but there not an actual payment of profits. In other words, the "income" is purely a tax and accounting entry.
Not surprisingly, the partner that receives the "income" does not pay taxes on it, either because it is a foreign entity (off-shore tax shelters have become popular), a non-profit entity that does not pay tax, or a corporation with an expiring net operating loss. The entity receiving the income usually receives a small fee or percentage of the transaction for participating.
True economic risk is non-existent, thanks to complicated derivative-style hedging arrangements, either inside the partnership or outside of it. The venture's "profits" are likely to equal savings account rates in other words, these are complex arrangements that yield the same return as plunking the money in the bank. Typically, investments that adjust to inflation are used short holding periods in government, bank or corporate debentures (debt). the absence of real economic activity, apart from the tax benefits flowing to one of the parties, are the hallmarks of these deals.
The carefully crafted shelters will attempt to add some theoretical economic substance to the transaction (if interest rates rose to 50%, the deal would have made money - type of argument) so that their experts can testify in court that the transaction was structured as a legitimate business deal. Of course, the taxpayer has no hope of prevailing on this argument, but it mitigates against penalties.
The promoters aggressively market the scheme to corporations and require confidentiality agreements with respect to the scheme. At this point, the hard sell is similar to the trust scam promoters pitch to his audience. Different audience, same hard sell. The lure for the corporate taxpayer is some "new-found" loophole in the tax code which, if interpreted literally (instead of interpreted in a manner consistent with the purpose of the provision or the context of the sham transaction doctrine) could reduce the corporations taxes substantially.
Note: It is hard to believe that the taxpayer or his advisors realistically believe that the transaction, if challenged, would survive court scrutiny. The point is to structure a transaction to give it a one-in-three chance of prevailing to avoid penalties if the taxpayer is caught. To this end, large fees are paid to financial analysts and law firms who then create piles of paper substantiating the economic significance of the deal and its legality under the tax code. By avoiding penalties, the transaction becomes a risk worth taking. Once again, the corporation is playing audit roulette, rather than making an honest attempt to comply with tax laws; it is attempting to shift the odds in its favor.
In summary, although the actual investment may be extremely complicated, the overall structure of the deal is not: a promoter devises a scheme based on a distorted reading of the tax code; receives an equity interest in the tax breaks which greatly exceeds the value of the services rendered on a hourly basis; tax benefits are divided such that one party receives the benefit of a tax deduction or credit and the other party receives the accounting income, but does not pay tax; and the entire transaction has been structured to save taxes, rather than as a legitimate profit making venture.
[Next month, the ACM Partnership case, and suggestions on how the government can stop the tax brokers.]
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