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Wealth Management: Helter Shelter

Ever since the colonists dumped British tea into Boston Harbor, Americans have been going to great lengths to protect their wealth from the tax collector. When the government increased the levy on horse-drawn coaches with metal—not wood or leather—suspensions, shrewd entrepreneurs sold retrofitting kits that enabled carriage owners to travel on the newest metal springs sans tax. When Uncle Sam imposed the income tax, barons such as Carnegie and Rockefeller sheltered their fortunes with dozens of private foundations. Indeed, we are no strangers to schemes with varying degrees of gray area.


Past efforts to avoid taxes, however, may pale next to the widespread tax sheltering in the 1990s. Spurred by the growing ranks of tech executives, Internet entrepreneurs, and other newly minted millionaires, leading tax firms put their best financial alchemists to devising creative shelters. Some of the more infamous are known by such acronyms as BLIP, BOSS, OPUS, and COBRA. In 2002, these particular schemes enabled more than 2,000 individuals with incomes of $200,000 or more to pay nothing in federal taxes, the highest percentage from that income bracket to avoid taxes since 1994. These findings do not sit well with the IRS. Commissioner Mark Everson has warned that he “will enforce the law with particular vigor” against people who have attempted to cheat the system by entering into illegal shelters.

Not all tax shelters are under the microscope. In fact, the majority of Americans participate in some form of one; the mortgage-interest deduction and retirement plan contributions are both legal means of reducing or avoiding tax liabilities. However, a recent spate of IRS lawsuits and seizures of assets raises questions as to whether tax-saving investments thought to be legitimate might now be at risk of an IRS investigation. Even if you participated in shelters that you thought were legitimate, you might be concerned that you were unwittingly put at risk for an audit by a tax counselor who gave faulty or deceptive advice.

This concern is not unfounded. In the 1990s, some promoters (firms that sell the shelters) took advantage of a shrinking IRS staff and created questionable shelters. “Tax advisers in the ’90s became somewhat cavalier about the rules,” says Christopher Rizek, an attorney with the Washington, D.C., firm of Caplin & Drysdale and a former tax attorney for the Justice Department. “Some of it was that they were swept up in the go-go era, but a fair bit of it was audit lottery—they were confident their [client’s] number would never come up.”

From the IRS’s perspective, a shelter is illegal if it has no legitimate business or economic justification, if its only purpose is to avoid taxes. For a transaction to qualify for tax deductions, attorneys say, it must have some economic value and the potential for profit. “The first question I always ask clients is, ‘Would you ever enter this deal but for the taxes?’ ” Rizek says.

Additionally, experts advise that you determine whether there are dramatic differences between the “book” accounting for a partnership or transaction and its “tax” accounting. Too large a gap may indicate that the promoter used overly aggressive assumptions about the tax treatment. (Book accounting involves the actual numbers; tax accounting results in figures that reflect gains minus losses.)

If you were not allowed to retain documentation, or if you were required to sign a confidentiality agreement before making the transaction, the shelter could be suspect. Promoters have argued that these pledges prevent leaks to rival firms, but critics contend that the agreements are a means of preventing the details of questionable tactics from falling into the hands of a whistle-blower. “If the promoter says, ‘You can’t show this to anyone else,’ I think that’s a big red flag,” says Philip Wolman, chairman of the tax practice at Buchalter, Nemer, Fields & Younger in Los Angeles.

Henry Camferdam Jr. wishes that he had been armed with this advice when he and three business partners met with Ernst & Young in November 1999. Camferdam and his colleagues were seeking counsel on how to legally shield $70 million in profits that they had earned by selling their computer business. First, they were made to sign documents stating that they would not discuss how the COBRA shelter worked. Only then did tax partners present them with a strategy that the investors now claim was not approved by the IRS. COBRA, an acronym for Currency Options Bring Reward Alternatives, creates paper losses on international currency transactions. These losses are then claimed to reduce an individual’s tax liability.

Camferdam agreed to the deal and paid fees of about $7 million for a plan that reduced the taxes to almost zero on the sale of the business. Later, the IRS decreed that losses from COBRA transactions would not be allowed. Now, Camferdam is fearful that he and his partners could be liable for $20 million in taxes, penalties, and interest, and is suing Ernst & Young for luring them into “an illegitimate tax sham.” Ernst defends its action, calling the suit “without merit.”

Another questionable safe-haven scheme involves offshore partnerships with numerous foreign-based or nonprofit participants. Experts say that the nonprofits could be in the partnership for the sole purpose of being matched up with individuals with tax liabilities—as the IRS alleges was the case with BLIP. This accounting procedure is known as basis shifting. It works like this: The losses from an investment made by one taxpayer “shifts” to another participant so that the second investor does not pay a tax on the earnings. (The IRS contends that BLIP was used by at least 186 individuals who claimed $4.4 billion in artificial losses.)

In the past, it was difficult for the government to discover the offshore shelters—and names of participants—but this is changing. “Ever since 9/11, there’s been a tremendous willingness among other governments to cooperate with the IRS,” says Martin Press, an attorney with Gunster Yoakley in Fort Lauderdale, Fla., and vice-chair of the American Bar Association’s Task Force on Federal Tax Reform.

If none of these warning signs applies to you or your investments, experts suggest that you do nothing. “I’m not so sure there are any advantages to filing an amended return,” offers James M. Hanley, an attorney with Preti Flaherty Beliveau Pachios & Haley LLC in Portland, Maine, and a former tax trial attorney. “If you have a valid legal opinion that [the shelter] is permissible, you’re not likely to pay fraud or negligence penalties even if you’re discovered later. In most cases, I would say to just ride it out.” Also, Commissioner Everson’s declaration notwithstanding, resources remain limited: In 2002, just 2.1 returns out of every 1,000 partnerships and other entities that pass profits along to shareholders were audited, down from 5.1 per 1,000 in 1993.

Unlike past crackdowns, the IRS is hoping to improve its recoveries by targeting promoters and then compelling them to provide the names of clients. In the past year, the IRS has brought actions against U.S. Ambassador to Barbados Earl Phillips Jr., the estate of the late Treasury Secretary William Simon and his son, and Johnson & Johnson heir Robert Johnson because of their participation in KPMG’s BLIP shelter, which for some clients involved a Cayman Islands partnership and a Swiss bank. If the government prevails in its suits, participants could be liable for back taxes, accrued interest, and perhaps even penalties.

Though it divulged the names of its clients, KPMG defends its actions and has reaffirmed that its advice to clients was “appropriate.” What’s more, American Express and Visa were forced to divulge the names of millions of cardholders who established offshore accounts to conceal spending.

The promoters are resisting the government’s pressure, but court watchers predict that the IRS will be allowed to gain possession of those client records. Therefore, if you know that the IRS is targeting a law firm or CPA that constructed a shelter for you, experts suggest consulting with a tax attorney—not an accountant. Unlike an attorney, who can invoke attorney-client privilege, accountants could be compelled to share the details of your conversations. It should be noted, however, that the IRS ordered Jenkens & Gilchrist, a Dallas law firm, to release the names of clients that it had placed into certain tax shelters. The firm continues to refuse, citing attorney-client privilege. In some cases, attorneys say, clients are advised to voluntarily pay any realized tax savings from a questionable shelter—while retaining the ability to later claim the credit if the shelter is determined to be legitimate. This way, clients avoid accruing interest and penalties.

As a final measure, some investors are suing the promoters. Odds are that the plaintiffs will not recoup the taxes or receive any punitive damages because most promoters have to convince a judge only that there was at least a sliver of validity to a partnership’s premise. Investors could, however, recoup the fees as well as back interest and penalties.

The increased awareness naturally has made some people shy away from tax shelters altogether, but experts say this is not necessary. The state bar or accounting society can divulge that a tax promoter has been sanctioned by the IRS or another professional group—a sure sign that it should be avoided. Potential investors should also ask whether a new shelter will have to be registered with the government. Under a law Congress is expected to enact next year, accounting firms would be required to disclose 25 types of transactions that are known to create significant losses for tax purposes—as well as the names of involved clients. Another point to consider is whether the promoter has what is termed an “opinion letter” written by an outside law firm validating the plan. These letters can serve as a get-out-of-jail-free card, because even if the shelter is overturned, the IRS will usually forgo additional penalties that can run upward of 20 percent of the tax.

Granted, there is a time-honored history of taxpayers’ taking whatever means necessary to limit how much they render unto Caesar. But with the IRS training its guns on the tax shelters of the 1990s, it helps to have as much ammunition as possible to fight back. 

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