Guest Article

Tax Shelters Not So Protected Any More (For Shelterers, No Less The Sheltered)

By Alvin D. Lurie
August 11, 2003

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The sun that rises also sets, said the old king in Ecclesiastes; for every thing there is a season. It may be that we are seeing the end (at least for a time) of the season of the shelter.

I mean the over-the-edge, outside-the-envelope kind. Planning designed to reduce taxes, per se, will not end, of course.

Taxes have not been very popular with mankind since the beginning of recorded civilization. Just look at the old cave paintings and early papyrus scrolls. "To tax and to please, no more than to love and be wise," said Burke, "is not given to men." England lost a big chunk of its empire beginning with an incident in Boston Harbor over a tax on some tea. George Bush -- the other one -- lost a presidency because of lip service that didn't match his tax policy.

Of course, we have had tax shelters as long as there have been taxes -- not all abusive, to be sure. What can be more benign, if not blessed, than the parsonage allowance? The tax bar for decades since enactment of the modern income tax has shown no shame in using the 16th Amendment as mobsters use the 5th or pornographers use the 1st. When Luke coined his famous admonition, "Woe unto you, lawyers," he certainly wasn't scolding them for their involvement in tax shelters. Besides, back then, in biblical times and for 20 centuries since, the extent of the lawyer-shelter connection was their dirty little secret.

No more. An intrepid chairman of the taxation section of the American Bar Association didn't mince words when, speaking to the Ways and Means Committee about the aggressive use of tax products to improperly reduce tax liabilities, he called "the linchpin of these transactions the opinion of the professional tax advisor." (Stefan Tucker, March 10, 1999.) Putting a finer point on it, another chairman of that august body called it an "ethical failing -- the lack of professionalism -- that is clearly a factor in the tax shelter problem." (Paul J. Sax, letter to Sen. Moynihan, March 21, 2000.) More recently, still another former chairman, James Holden, observed, in that tax section's NewsLetter (winter 2002), that tax professionals (be they in law or accounting firms), writing what he called "marketing opinions" or "penalty protection opinions," address the tax issues implicated in a shelter "with an attitude of optimism rather than detached objectivity." (Needless to say, he was not endorsing such a Panglossian approach.)

Note, please, these are not government officials putting out scare talk (you'll find some of their quotes near the end of this piece). These are practitioners in private practice. For another such message, read what a very prestigious private-sector advisory body to the TE/GE Division of the IRS (called the Advisory Committee on Tax Exempt and Government Entities) says in its recent report to the Service, exhorting "legitimate practitioners who care about good tax policy" to blow the whistle on abusive transactions. (Report of TE/GE Project Group on Abusive Tax Shelters, 5/20/03.)

Of course, the line between abusive and responsible tax planning can be indistinct. But like the now much-quoted Supreme Court pragmatic definition of obscenity (and there is more than a little obscenity in some of the shelters promoted by some of the biggest names in the tax business), one can usually know abuse when one sees it. Bittker and Eustice, in their classic Federal Income Taxation of Corporations and Shareholders, writing of business transactions cast to mask their true substance, offered a touchstone for fingering a tax abuse: "The lawyer's passion for technical analysis of the statutory language should always be diluted by distrust of a result that is too good to be true."

What Price Civilization

If "taxes are what we pay for a civilized society," as the great jurist Oliver Wendell Holmes put it, one must infer that a sizeable portion of the Fortune 500, other highly successful corporations, their executives, and other very high net worth individuals do not think civilization is worth the price. How else to explain the rapidly growing proliferation of "abusive" tax shelters employed by would-be taxpayers who are most able to pay ("would be," that is, but for the tax shelters) who have exempted themselves from declaring the full amount of their presumptive income and resultant tax liabilities?

In one recent case, a household name, American Home Products (now Wyeth), paid a $7 million fee to the promoter of the scheme plus $4-1/2 million to tax-indifferent foreign partners necessary to its accomplishment, as well as other heavy transaction costs, rather than pay a capital gain tax on $605 million of gain, which the scheme had enabled it to offset by claiming a comparable amount of paper losses while actually incurring only $8 million of real losses. To put this in context, that American company, which in its most recent quarter alone reported net income of over $1.57 billion, denied the U.S. fisc almost $212 million by hiding income in a shelter so flimsy it couldn't stand up against a knock on the door. The mechanism was to create a partnership with a foreign partner not subject to U.S. taxation (hence tax indifferent), for the purpose of engaging in a series of securities purchases and sales allowing the partnership to claim a massive tax gain that was allocated to the foreign partner and a massive tax loss allocated to the U.S. corporation.

In another situation we saw a new kind of morality play out in the boardroom of a giant Dow Jones-listed company -- an unlikely place for an attack of morality to break out, most would have supposed in the post-Enron light. The board of directors of Sprint summarily fired its two top executives for having employed an elegant tax shelter designed by the company's auditor, Ernst & Young, to eliminate taxes on almost $300 million of ordinary income on the gains they realized on exercising stock options. The "shocked" reaction of the directors to this gaming of the system cannot help but remind one of Claude Raines' retort to being informed of the corruption in Casablanca -- "I'm shocked, shocked." For the record, at last report E&Y was standing by its advice; but since the executives' executions in the boardroom the IRS has come down hard on the scheme employed by the Sprint executives (and many others), called the compensatory option sale shelter -- known to the "in" crowd as COSS -- which employs an intrafamily assignment of the option designed to control the timing, amount and character of the compensation income in the family unit. Massive tax deficiencies are expected by the Sprint executives; and it does not take a lot of imagination to foresee litigation cropping up between the dismissed executives and the Sprint auditors, and perhaps other professional firms implicated in development and/or blessing of the program.

This past July 2 saw three important publications from Treasury and IRS, two bearing directly on the COSS transaction: (i) temporary and proposed regulations (TD 9067), (ii) a notice describing the litigating position of the Service and at the same time declaring the COSS to be a "listed transaction" (Notice 2003-47), and (iii) a press release (IR-03-84) announcing a settlement with E&Y requiring payment of a $15 million penalty for what the Service said were violations of the list maintenance and registration requirements pertaining to potentially abusive tax shelters. The press release did not reference the COSS promotions or any other shelters that the firm had been involved in; but the simultaneity of the release and the COSS regulations and accompanying Notice was surely more than coincidence. The regulation itself involves a highly technical narrowing of the previous section 83 regulations, that the Service obviously believes will frustrate the timing games that are involved in intrafamily assignments of compensatory stock options, by preventing the sale of the option from closing the compensatory transaction under Code section 83 in any case of an intrafamily assignment regardless of whether it can be defended as arm's-length.

Patriotism And Taxes

It is axiomatic that no one is obliged to pay more than his fair share of taxes. Another great jurist, Learned Hand, said it better than anyone else:

• Any one may so arrange his affairs that his taxes shall be as low as possible;

• He is not bound to choose that pattern that will best pay the Treasury; and

• There is not even a patriotic duty to increase one's taxes.

Little could the learned judge have known what mischief his words would lead to well over a half century later, inducing a later judge to observe what should not have needed such commentary, that "the freedom to 'arrange one's affairs' does not include the right to engage in financial fantasies." The corollary of paying no more than one's share is paying no less, as Hand himself made clear in deciding the famous Gregory case -- probably the seminal tax shelter decision -- against the taxpayer.

The paired precepts -- pay no more but pay no less -- are the foundation stones on which a sound tax system must rest. They are flouted by the above transactions, when tens of thousands of taxpayers less able to pay than the taxpayers in question are ultimately required to pay more than their share, to make up the amount by which the shelter-seeking taxpayers have paid less than their share.

That did not actually happen in the American Home Products case, but only because the appeals court reversed the holding of the trial court that would have allowed achievement of the sought-after tax avoidance. The central proposition relied on by the court was the so-called Business Purpose Doctrine, which, as applied to this case, meant that an entity such as a partnership injected into a transaction for no non-tax business purpose will not be recognized for tax purposes. There have, however, been countless cases where the shedding of one's fair tax burden has been successfully accomplished because the IRS does not catch up with the scheme (sworn secrecy is an important currency demanded of participants by the promoters of many abusive tax arrangements), or, if it does, the Commissioner's determination is overturned in court.

It's Not Just the Principle... It's Also Very Personal

That is a proper prism through which to view the nature of the abusive tax shelter problem. It affects us all in a very personal way, because our tax liabilities will be impacted by the inability of the system to collect taxes where they are due. It also affects the tax system, which rests heavily on the willingness of taxpayers generally to voluntarily self-assess themselves, which, in turn, depends upon the perception that the system is fair and evenly enforced. That perception can only survive so many reports in the public print of tax avoidance in high places through schemes too clever by half. Such reports also affect adversely "the attitude of some taxpayers toward their tax-paying responsibilities," in the words of a tax shelter report by the New York State Bar Association Tax Section, by inducing a copy-cat mentality ("if everyone is doing it, why shouldn't I?").

Let us stipulate that a tax shelter is not inherently bad. Most shelters have gotten into the tax law at the command of Congress. Indeed, pension plans have been dubbed "the quintessential tax shelter," with no pejorative connotations. Percentage depletion was Congress' gift to the oilmen (and their powerful representatives in the people's house). The parsonage allowance provides shelter in two senses of the word, as does the homeowner's mortgage deduction. But shelter was found by inventive tax planners within and between the interstices of sections of the Tax Code, in places not considered by the Congress, or in words of a tax statute taken out of context. That was the beginning of the drift towards designer shelters, that led to the current state of affairs. Judge Hand wrote many years ago, Congress cannot be thought to have covered every transaction whose "facts answer the dictionary definitions of each term used in the statutory definition." Nevertheless, arguing for the transaction's sanction from the literal words of the statute is legitimate planning, and has won many a day in court; and Judge Hand would not have had it otherwise.

Tangled Webs Weaved

As the reader must surely appreciate by now, my focus here is not tax planning per se, that is, the arrangement of one's business or investment affairs in a way to pay the least taxes consistent with the economic and business realities, but rather the aggressive marketing of elegant, convoluted avoidance techniques to taxpayers -- more often than not corporations and very high net worth individuals who are not clients of the promoter -- for the sole purpose of earning outsized fees, on the extraction of a commitment of confidentiality from the prospect so as to protect the exclusive and repetitive commercial use of the avoidance strategy by its designer (and, of course, to prevent its detection and dismantling by the IRS).

The shelter patterns have been many and varied, constructs that demand admiration for their ingenuity no less than condemnation for their abuse of the system, "tangled webs weaved to deceive," in the poet's words. Thomas Pynchon used a phrase in "Gravity's Rainbow" that has attached itself improbably to one of my synapses: "transmogrify common air into diamonds through Cataclysmic Carbon Dioxide Reduction." He wasn't talking about tax shelters, but doesn't the changing of air to diamonds speak to the process of constructing tax gems out of thin air? (As far as I know there is no such thing as cataclysmic carbon dioxide reduction.)

But tell me, what is a "Bond & Option Sales Strategy," the proper name of the BOSS shelter I will momentarily discuss? And what is one to make of "Currency Options Bring Reward Alternatives," a brazenly named scheme marketed under the name COBRA, which is now the subject of a suit brought against Ernst & Young, its closely affiliated law firm, McKee Nelson, and two outside law firms who supplied some of the design and supporting legal opinions, in which the plaintiffs' complaint alleges almost every deadly sin imaginable (including racketeering)? Then there is the even more brazenly named COSS, that, as already noted here, is the acronym for "Compensatory Option Sale Shelter" -- with "shelter" right there in the title!

A favorite shelter of mine -- that is, an exemplar of the art of the shelter designer, being at once brilliant in its construction, bold in its reach and facile in its handling of intricate tax concepts, but flawed at least as much in its naivety as in its unconscionability -- was marketed by PriceWaterhouse Coopers as the BOSS (letters derived from an essentially nonsensical group of words presumably chosen just to produce a punchy acronym). It consisted of a series of contrived steps enabling taxpayers to claim losses for liabilities they never really assumed and capital outlays that they in fact recovered, founded on a stretched reading of basis rules and the deconstruction of the transaction into discrete parts each of which, taken alone, technically passed muster under a particular Tax Code section, but which taken together artificially inflated tax basis by exploiting the unforeseen interaction of separate tax rules. The IRS killed it with a "caveat emptor" press release. It also exacted a stiff penalty from PriceWaterhouse, presumably at least partly predicated on its handling of its legal obligations under the IRC and the tax shelter regulations in such promotions as BOSS.

I understand that the penchant for these swashbuckling names is passing (at least for the present) -- a sign that the IRS actions are having an impact. One firm has given up the name "Predator" assigned to its tax structured strategies group. For a time the Service was overwhelmed, if not overmatched, by the plethora of such schemes that ran across the entire spectrum of tax law --income tax, gift and estate tax, pension and welfare benefit law, and charitable entities. The Service responded with a stream of regulations and rulings designed to drive "potentially abusive tax shelters" into the sunlight by identifying particular transactions which the Service deemed especially suspect, and by forcing their registration, disclosure as part of taxpayers' returns and the maintenance of lists of participants by organizers and sellers. Early in 2002 the Treasury issued its "Enforcement Proposals for Abusive Tax Avoidance Transactions"; and it has now issued its latest "final" regulations, a very comprehensive set of requirements that should go a long way to taming the beast.

A Very Good Year

2003 has been a good year for the Service in the courts. January saw the publication of several decisions that will greatly strengthen the hand of the Commissioner, two of which coincidentally went against Merrill Lynch, a principal purveyor of tax structured strategies. One was a decision by the Tax Court that struck down a tactic that venerable house devised for its own use to manufacture an overstatement of basis by a mere $400 million that would have achieved over $30 million of tax savings. (The decision is, of course, appealable.) The other decision, which is described above, went against America Home Products, an M/L client, which was looking to avoid a capital gain tax of some $212 million.

A third decision this past January is quite bizarre. It is not a tax shelter decision as such, but did grow out of a very crude tax shelter scheme, designed and administered by a Honolulu businessman, one Kersting. Almost 2,000 taxpayers bought into it as a way to claim entirely artificial interest deductions. The issue was decided in a test case that would, by agreement among the taxpayers, determine their respective tax liabilities. Of course, the court denied the deductions. The problem was that the IRS trial attorney was so determined to win a favorable result that he bought the testimony of two of the participants, offering to reduce their tax assessments by the amount of their attorneys fees in return for their testimony as to the artificiality of the scheme. Of course, he concealed from the trial court the settlement with the witnesses. The appellate court was so outraged by what it called a "fraud upon the court" that it imposed on the IRS itself the sanction of providing to every one of the taxpayers whose liability was affected by the decision in the test case the same result as the Service had granted to the "cooperative" witnesses (perhaps the first tax shelter in which the Service itself was complicit). The case is proof that there can be such a thing as too zealous a pursuit of tax shelters by the IRS.

A decision in March caused quite a stir. Just as a consensus was building that "janitor insurance" had run its course -- the COLI scheme for generating massive corporate deductions for interest expense incurred incident to a program of insuring every employee in sight -- Dow Chemical Company won a most surprising victory in a federal district court in Michigan. The judge, in a remarkable suspension of disbelief, concluded that Dow had established a legitimate business purpose for its highly leveraged, essentially after-tax cost-free run around the venerable four-out-of-seven rule, because it was thereby enabled to provide "a source of cash to cover unfunded future medical obligations for its retirees."

Dow's probable elation proved to be short-lived, because less than a month later the Sixth Circuit court ruled that the leveraged COLI plan of American Electric Power Company was a sham. That's the very same court to which the Dow case will be appealed. The court wrote, "The opportunity for tax arbitrage... was the real motivation," and added that "the tax benefits generated by the circular policy-loan interest deductions arose 'from thin air'."

Ex Cathedra

The IRS does not always wait for a court to lay down the law before it asserts its own authority. Acting on the authority Congress provided to it and on its own tax shelter regulations to declare a transaction "potentially abusive," hence a "listed transaction," it has unleashed an ever-increasing flood of such ex cathedra announcements, usually by "notices." There have been several of particular interest to the employee benefits community in just the first six months of 2003. Revenue Ruling 2003-6 targeted the use of an ESOP to hold S corporation stock in a way to channel greatly disproportionate benefits to highly paid executives, while the rank-and-file received what the Service called "insubstantial benefits," principally by use of management companies; it was followed by temporary and proposed regulations to the same effect.

Notice 2003-24 signaled the end of abusive uses of the collective bargaining exemption under IRC sec. 419A(f)(5) as a way to enlarge deductions beyond the restrictive limits of sections 419 and 419A. The notice warns menacingly that anyone who "willfully counsels or advises the evasion or defeat of tax" by means of arrangements described in the notice may be guilty of a criminal offense under myriad provisions of the Code "or other federal law," in addition to becoming subject to civil penalties.

I have already spoken of Notice 2003-47, and the accompanying temporary and proposed regulations, which lowered the boom on the COSS program. In News Release 2003-51 the Service stated, for those slow to catch the signals, that "the Treasury Department and IRS are moving aggressively to combat abusive tax avoidance transactions," and then highlighted the steps it is taking to that end, and illustrated that by citing the enforcement statistics (at 4/15/03): 78 promoters under investigation, 239 summonses, 77 referrals to the Justice Department.

Punishment Befitting The Crimes

Even if the IRS attorneys in that Honolulu businessman's case went over the line, other, higher Service officials have made clear the government's determination to squelch what is seen as an assault on the integrity of the tax system. We will "not be gentle," said veteran IRS tax specialist Richard Wickersham, in addressing an employee benefits seminar in Los Angeles. Beyond just tax penalties, he warned, "there is a criminal side."

In the just-mentioned news release -- issued, it just so happens, on April 15th last -- Treasury Assistant Secretary Pamela Olson is quoted as warning shelter promoters and taxpayers who bought their products to "come in from the cold before they get caught." She added: "The IRS is building an enforcement web to catch and eliminate tax shelters ... Taxpayers should come forward now, before they get tangled in the web." The recently resigned chief counsel of the IRS, B. John Williams, is also quoted in that same news release: "We will continue to pursue promoters and taxpayers to ensure they are complying with their legal obligations, and will take them to court if necessary."

In a speech to the Tax Section of the NYSBA at the annual meeting this past January, Mr. Williams reminded lawyers -- those working in government and those in private and corporate practice -- they are all officers of the court, with the sanctions and responsibilities that implies. He also urged his listeners not to cavalierly write penalty-protecting opinions, because the protection might not be there when push comes to shove, even against the imposition of fraud penalties on the client.

Who Will Protect The Protectors?

For the lawyer, a more personal question is what protection will be available to the protector, i.e., the opinion writer, against recourse not only by the government, but by disgruntled taxpayers who relied on the opinion. Several cases, some decided, others pending, are already testing that question, and it is foregone that we will see an increasing number of such cases. I have described some of these in my above lines. I have written about others in another venue, and will refer the reader there for the gory details. See "Woe Unto You Lawyers and Other Advisers in the Abusive Tax Shelter Business," NYU Review of Employee Benefits and Executive Compensation: 2003 (LexisNexis 2003).

But permit me to direct your attention to the COLI transactions (more fully described in the NYU piece) that brought Wal-Mart into court to sue AIG and another major insurer, alleging that the company lost more than $150 million due to negligence, misrepresentation and breach of fiduciary duties in the sale of such product. WalMart, the world's largest corporation, presented itself in its complaint as an innocent at the mercy of sharpshooters in this world of fancy tax footwork. Such modesty! The complaint details the alleged activities that the insurance brokers and consultants involved in the matter engaged in, most tellingly, "opinion shopping" to obtain professional opinions on various risks, rejecting those that did not support COLI and continuing to seek further opinions until satisfied. The complaint sets forth a catalogue of the risks a professional assumes when engaged in developing, promoting, recommending, advising, selling or administering a financial product that requires tax savings to make it fly. That case is pending.

A case commenced only recently involves a program that became very celebrated when it was featured in a couple of front-page stories in The New York Times in July and August last year, involving an aggressive use of reverse split dollar life insurance, allowing the passing of substantial wealth by parents to their descendants at the cost of minimal gift taxes relative to the property transfer and no estate taxes. The complexities of the transaction require an article devoted solely to it; again I refer the reader to my discussion in the above-cited piece in the NYU Review of Employee Benefits and Executive Compensation. I mention it here to draw attention to the lawsuit commenced this past June in Los Angeles, by the man who bought the policy (a $48 million jumbo) and his wife (the 81-year old insured life) against Jonathan Blattmachr (the lawyer who designed the plan), his law firm, the insurance brokers who sold the policy and the insurance company that issued it. The complaint seeks many millions of dollars in compensatory and punitive damages but does not presently complain of the tax opinion on which the transaction rests, which the Service has indicated it will not respect because of extending prior favorable rulings governing cash balance plans beyond their intended scope. It can be anticipated that, before the case reaches trial, the complaint will be amended to include allegations regarding the quality of the tax advice and the further damages ensuing from the deficiencies the Service likely will assert.

Still another high-profile tax shelter case is likely to result in litigation against the shelter designers and advisers. This one concerns a $40 million tax deficiency the Service has asserted against the notorious hedge fund, Long Term Capital Management, that imploded five years ago, setting off shock waves in financial communities around the globe. The person who counseled the firm to engage in certain questionable derivative trades apparently lacking any reasonable opportunity for profit and designed only to wipe out one-third of a billion dollars of taxable income of the firm, was one of its own principals, the estimable Dr. Myron Scholes (the very same of Black-Scholes fame), who received a multi-million bonus from his partners for finding and vetting their $300 million tax shelter. Given the small, intimate circle of investors who were let in to the LongTerm Capital club, it is doubtful that Dr. Scholes will be asked to give back his bonus; but the two very prominent New York and D.C. law firms who are reported to have received a total of $1 million for the tax opinions involved probably have set up reserve funds against future contingencies.

Did I not say, taking it from the top, that the sun also sets?

Report of the Chairman

Finally, let me turn the microphone over to the current chairman of the Taxation Section of the American Bar Association:

"[T]he many pieces of the anti-tax shelter administrative and legislative jigsaw puzzle are finally starting to come together and are beginning to put a real damper on temptations to promote and engage in tax-abusive behavior. Practitioners will be expected, indeed obligated, to play a more significant role in this important battle to preserve the integrity of our tax system."

-- Herbert Beller, Esq. in the ABA NEWSQuarterly (Winter 2003)

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Copyright 2003, A.D. Lurie

Alvin Lurie has spent many years as a practicing pension attorney, and was appointed as the first person to administer the IRS' ERISA program in the National office in Washington. He is back in practice and can be contacted at Alvin D. Lurie P.C. in New Rochelle, New York, telephone (914) 235-6575.

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