January, 2004 Hot Topics [an error occurred while processing this directive] IRS Cracks Down on Attorneys Writing Phony Tax Shelter Opinions [an error occurred while processing this directive] Introduction [an error occurred while processing this directive] The tax shelter industry has finally caught the attention of Congress and IRS. This practice is replete with nationally prominent law and accounting firms willing to write bogus legal opinions for fees reaching $1 million or more per opinion. Previously, efforts to punish these firms had largely been left to disgruntled clients who, despite paying seven-figure professional fees, were then stuck with millions in back taxes, penalties and interest when IRS rejected their attorney's argument. Of course, just a fraction of those participating in these shelters have been caught, which means the Treasury is out billions of dollars - and they know it.

Purpose of Tax Shelter Opinions [an error occurred while processing this directive] The legal tax shelter opinion serves as "insurance" against penalties should a taxpayer ultimately be caught - greatly reducing the financial risk of engaging in the proscribed behavior. Since the taxpayer claims reliance on an expert legal opinion as the basis of the investment, the negligence penalty is negated on the theory that the taxpayer relied on an expert, therefore was not negligent.

IRS Fights Back [an error occurred while processing this directive] Embarrassed by Congressional scrutiny and criticism regarding its inability to make a serious dent in the proliferation of tax shelters, IRS has resurrected its moribund Office of Professional Responsibility to regulate professionals practicing before the agency. Cono Namorato, a tax lawyer with Caplin & Drysdale, has been appointed its new director and is responsible for investigating allegations of misconduct and negligence against agents, attorneys, and accountants representing taxpayers before IRS, including negligent or fraudulent tax shelter opinions.

The IRS strategy is to make sure the person in charge of a firm's tax department is on the hook for tax shelter opinions emanating from partners and subordinates. Under the new rules -

Lawyers who head tax practice departments of legal firms will now be held responsible for violations committed by lawyers under their command.

Disciplinary actions, leveled against a department head personally, could include a proscription against his representing clients before IRS.

NOTE: This sanction would be more effective if it provided that the entire firm was barred from representing clients before IRS - which would mean the firm could not be involved in IRS tax audits and appeals, thus risking a substantial portion of their tax-related business.

This personal responsibility applies even if the lead attorney did not actually participate in the opinion; he is responsible for the acts of all those who work in his practice group. Supervision of other partners, should take on a prominent role in light of these new standards.

Congress Weighs In [an error occurred while processing this directive] The new IRS rules do not levy direct financial penalties against those crafting these tax shelters; however, Congress is focusing on legislation intended to circumvent increasing tax shelter abuses. Senators Baucus and Grassley have authored a bill that would impose penalties on firms that "knew or reasonably should have known" of IRS violations by any of its partners. This approach is reminiscent of the recent SEC response to accounting scandals in the securities industry involving Enron and Worldcom.

Understand, the tax shelters created by these firms never involved bona fide transactions with true economic substance; these deals would never have occurred absent the lure of major tax benefits. Many shelters involved business strangers joining forces to jointly benefit from a complex and legally unsupportable transaction that purportedly generated huge tax savings with negligible economic risk -- other than the enormous fees paid to the promoters! The tax shelter opinions invariably did not address the actual facts of the deal - instead, they relied on a hypothetical set of facts and danced around, or expressly ignored, the legal precedent that would apply to deny the tax benefits if the transaction were challenged in court.

As with other tax evasion schemes, such as the trust scam and off-shore banking charlatans, IRS has subpoenaed firms to obtain the names of clients who may have used potentially illegal tax schemes. Naturally, several of these firms have not responded to the subpoenas, claiming attorney-client privilege, although it appears the courts will eventually rule against them, because the Internal Revenue Code requires that tax shelter promoters maintain listings of their clients.

Recently, some of these firms have been sued by disgruntled clients who found themselves audited by IRS and their deductions disallowed. Many tax-shelter buyers contend that the firms are guilty of legal malpractice alleging that they should have known the shelters they designed and promoted would not pass IRS scrutiny.

Big Business - Fattening the Bottom Line [an error occurred while processing this directive] Moving away from hourly billing or flat fee charges in the 1990s, many firms began billing on a value basis. Firms would write opinion letters and then bill for a percentage of the amount the client saved in taxes. Treasury official Gregory Jenner, says that, "The practitioner then, to a certain extent, had a stake in the conclusions. Whereas previously the practitioner tended to be more independent."

Following the lead in the securities industry, where investments were fractured into component parts, accountants and attorneys began devising investment structures to bifurcate income and deductions, distributing the income to an entity exempt from U.S. taxation (either a foreign corporation or a tax exempt organization) while providing deductions to the U.S. taxpaying corporation or wealthy individual.

In the wake of an under-funded IRS, resulting from Congressional displeasure with the agency during the mid 1990s, tax shelter sales became big business. IRS lacked sufficient resources to go after the promoters, staff reductions resulted in fewer returns being audited, and there was less manpower to scrutinize complex and esoteric tax shelter schemes. Currently, it appears the pendulum is swinging back and Congress and IRS appear united against the tax shelter promoters and their rich clientele who are not paying their fair share of taxes.

Conclusion: [an error occurred while processing this directive] IRS has several of the major law and accounting firms within their gun-sights and if it gets access to their client lists, there will be many wealthy taxpayers squirming in their gilded chairs. Time will tell whether the government is serious about cracking down on these tax cheats, or whether, as a skeptical public has witnessed time and time again, this politically-connected group will skate and IRS will continue hassling the lower and middle class taxpayers over such things as the child care credit and the dependency exemption.

For more information on this topic, see: Busted Tax Shelters - Wealthy Sue Accountants for Bad Advice.

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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.