Tax Shelters In 2005 Action and inaction at the Treasury and in Congress.

Alphabet Soup SILOs, BOSS and son, and other denizens in the zoo of shelters.

Tax Shelters In 2006

In January, 2006, Dennis B. Drapkin, Chair of the American Bar Association's Taxation Section wrote to senior US congressmen to complain about the effects of clauses in the Tax Relief Act of 2005, passed by the Senate late the previous year, which would codify the 'economic substance' doctrine in US tax law.

Mr Drapkin wrote among others to Senators Charles Grassley (Chairman of the Senate Committee on Finance) and Max Baucus (Ranking Member of the Senate Committee on Finance), as well as to House members William Thomas and Charles Rangel.

The letter identified three provisions of the Act which would:

• codify the “economic substance” doctrine and create a 40% penalty for “noneconomic substance” transactions;
• require a 20%, nonrefundable down payment for certain offers in compromise; and
• create increased penalties and restrict access to judicial review in an attempt to reduce frivolous tax submission.

'However well intended,' writes Mr Drapkin, 'these provisions may have significant ramifications for bona fide business transactions that are far removed from the tax shelter transactions that are the intended target of the legislation. Moreover, the concerns that underlie this legislation were recently addressed by the tax shelter provisions enacted in October 2004 as part of the American Jobs Creation Act of 2004'.

The ABA revealed that it supported legislation clarifying that when a court determines that the economic substance doctrine applies, the taxpayer must establish that the non-tax considerations in the transaction were substantial in relation to the potential tax benefits, and supported legislative clarification that in evaluating the potential economic profits of a transaction, all costs associated with the transaction, including fees paid to promoters and advisers, should be taken into account.

'To the extent that the legislation incorporates these concepts,' continues the letter, 'we believe it will improve the state of the law. In other respects, however, as we have previously written, we continue to oppose codification of the economic substance doctrine. We further believe that enactment of the separate penalty scheme tied to satisfaction of the economic substance doctrine would create unnecessary complexity and confusion.'

Mr Drapkin also expressed serious concerns about the requirement for a 20% non-refundable deposit: 'Because the 20 percent nonrefundable down payment requirement could dramatically reduce available outside funding for potential offers, there is a significant risk that the proposal could decrease the number of legitimate offers submitted, the number of offers accepted and the number of individuals reentering the tax system,' says the letter, which recommends that the proposal not be adopted or, at a minimum, that it be deferred for further consideration.

As regards frivolous conduct penalties, the letter suggested that they should be imposed upon taxpayers requesting CDP hearings 'only (i) where the request is based on arguments or positions the IRS has identified as frivolous in published pronouncements and (ii) after the taxpayer has been afforded the opportunity to withdraw the request or supplement it with information that would render the relevant published pronouncement inapplicable.'

Later in January, the US government followed up its tax shelter victory over Big Four accounting firm KPMG by investigating three lawyers at the prominent Dallas-based firm, Jenkens and Gilchrist for their alleged role in certifying abusive tax schemes.

According to a New York Times report, three lawyers at the firm's Chicago practice, the centre of its tax operations, are under investigation for signing off so-called opinion letters testifying to the legitimacy of tax shelters such as COBRA (currency options bring reward alternatives), which was outlawed by the IRS in 2000.

However, the report said that there is no indication that the law firm itself is a target of the criminal investigation, and a spokesman revealed that the company is "cooperating fully" with the investigation.

Often costing $75,000 or more each, investors use opinion letters as an insurance policy if challenged by the authorities, showing they took steps to ensure that a particular transaction was legally watertight.

One of the lawyers under investigation is said to have earned $93 million in fees from 1999 through 2003 by selling opinion letters and by designing and selling certain shelters, the Times reported, citing persons familiar with sealed documents filed in connection with a previous civil case brought by investors against Jenkens & Gilchrist.

It is believed by the Treasury Department that at least $2.4 billion in artificial tax losses have been claimed by clients of the law firm stemming from their use of tax sheltering arrangements.

This was not the first time that Jenkens & Gilchrist had come under the spotlight for its role in formulating and selling tax shelters. In 2004, a federal judge ordered the firm to hand over the names of clients who invested in tax schemes formulated by its Tax and Estate Planning Practice Group and its Structured Investment Practice, between June 1998 and June 2003. It marked the first such summons to have been issued to a law firm to obtain the identities of participants in tax shelters deemed abusive by the IRS.

In April, the IRS won a significant legal victory in its campaign to deter the use of so-called 'abusive' tax shelter schemes, after the US Tax Court ruled that the 'Son of Boss' scheme is illegitimate.

The ruling by Judge David Laro related to the sale of R. J. Thompson Holdings, a day-trading firm in Omaha, Nebraska, by its founder and former chief executive Randall J. Thompson, for $13 million in cash to TD Waterhouse of Canada in June 2001.

The IRS believed that Thompson used a Son of Boss scheme to create an artificial loss in order to slash the amount of federal taxes he owed on the sale, and disallowed more than $20 million in tax losses. Thompson, through a partnership, decided to challenge the IRS.

Son of Boss evolved from an earlier scheme known as ‘Boss’ (bond and option sales strategy). The scheme utilises a complex set of derivative transactions to reduce tax liability and was commonly used in the late 1990s to offset large one-off gains such as the sale of a business.

The ruling is significant as it marks the first time that a court has ruled on the Son of Boss scheme, and Judge Laro's decision could have an important bearing on the outcome of the trial of 18 individuals facing criminal charges related to sale of tax shelters by the accounting firm KPMG.

Lawyers for the defendants, 16 of whom were former KPMG executives, argued that their clients did nothing illegal because the tax courts had not hitherto established whether the tax shelters were improper.

The defendants in the KPMG trial faced conspiracy and fraud charges for their role in creating and selling tax shelters viewed by the IRS as close relations to Son of Boss.

In May, in a stunning reverse for the IRS, it was ordered by a US Tax Court Judge to repay millions of dollars in taxes, fines and interest to a group of taxpayers, after officials from the agency were found to have effectively bribed witnesses to win a tax shelter case.

The case centred on the so-called Kersting tax shelter, named after Honolulu businessman Henry Kersting, which allowed airline pilots and their families to purchase stock in one of Kersting's companies. In exchange, the pilots received promissory notes, on which they would have to pay interest, but which allowed them to claim interest deductions on their tax returns.

In the early 1980s, the IRS ruled that the Kersting tax shelter was illegal and began pursuing a number of investors who had used the scheme. Many of these eventually settled with the IRS.

However, according to Colorado Attorney Declan J. O’Donnell, who represented 100 of the 500 taxpayers who settled with the IRS, three witnesses were effectively bribed with cash, pre-paid expenses, tax settlements below par, and ten years of added tax benefits so that they would testify against six pilots.

In its opinion, the United States Tax Court stated that all of the settled cases in the Kersting Tax Shelter program should receive 64% of their monies back as a sanction.

This was perhaps the first time that such a judgment has been made against the federal tax collector, certainly for such a substantial amount of money.

"Fraud on the court is rare and has only occurred a few times in our country’s history," Mr O'Donnell observed in a statement.

"This particular ruling is the only time the IRS has ever been adjudicated with a money judgment against them. All others were either sanctioned or the cases were retried," he added.

Mr. O’Donnell believed that this penalty judgment against the IRS is unique, perhaps the only large money judgment against any national taxing authority ever. His clients and the settled group will receive an estimated $56 million from the IRS in due course.

In June, a federal judge granted final approval to a settlement proposed by accounting firm KPMG to compensate investors who made use of its tax sheltering arrangements.

Under the settlement approved by U.S. District Court Judge Dennis M. Cavanaugh on June 2, the approximately 200 clients would receive $153.9 million to cover transaction costs for the tax shelters, but not back taxes and penalties.

The average payout would be $825,000, with the class-action counsel Milberg Weiss Bershad & Schulman netting $24.6 million.

The proposed settlement was designed to cover former clients of KPMG and the law firm of Brown & Wood (now part of Sidley Austin) who participated in the tax shelters known as Blips, Flip, Opis and Short Option Strategy. These were the shelters that were the subject of KPMG's settlement agreement with federal prosecutors in August, under which KPMG agreed to pay $456 million in penalties, but would not face criminal prosecution as long as it complied with the terms of its agreement.

The settlement was less than the initial proposal which totaled $225 million approved the previous October after about 50 tax shelter clients declined to participate in the deal. These litigants would be permitted to pursue claims against KPMG and the Sidley firm on their own.

Judge Cavanaugh ruled that the offer was "fair, reasonable, and adequate," and was keen to draw a line under the case which he stated could extend "for at the very least another few years.”

In a related case, 19 defendants, including several senior KPMG employees and lawyers with Sidley Austin, faced criminal charges for their roles in selling the tax shelters which were deemed "abusive" by the Internal Revenue Service. The agency has estimated that the tax shelters helped investors avoid some $2.5 billion in taxes.

In January 2007, New York District Judge Loretta Preska agreed to dismiss a deferred criminal charge against KPMG resulting from the settlement reached by KPMG and the Justice Department over the sale of improper tax shelters in 2005.

Former executives of KPMG who are facing separate criminal charges attempted to prevent the dismissal, claiming that KPMG's refusal to pay their legal fees amounted to a breach of KPMG's agreement with the government; but the judge did not agree.

The trial of the former employees was delayed after the trial judge cited concerns over the dispute concerning who should pay the defendants' lawyers. In an order made public in November, US District Judge Lewis A. Kaplan stated that questions over whether KPMG should pay legal fees for the former executives probably wouldn't be resolved before the criminal trial's scheduled start date in January.

"Given all of the current uncertainties, it is impossible now to predict with confidence when the charges in the indictment may be tried," he said. Consequently, the judge delayed the trial date. Later it was set for September, 2007.

The 16 former KPMG employees and two others are accused of selling tax shelters which were deemed "abusive" by the Internal Revenue Service. The agency has estimated that the tax shelters helped investors avoid some $2.5 billion in taxes.

However, the trial bogged down when in June, Judge Kaplan found that prosecutors violated the constitutional rights of the former KPMG partners by pressurising them to cut off payment of legal costs to the defense. The former executives then filed a civil complaint against KPMG seeking advancement of defense costs.

A trial on the fee issue was scheduled for October, but KPMG appealed Kaplan's ruling, saying the matter should be dealt with by arbitrators rather than the Courts.

In March 2008, it was reported that the US government was attempting to revive its case against 13 (of the original 19 defendants) of the former KPMG partners.

The case, billed as the largest criminal prosecution in US legal history, was, as previously stated, thrown out by US District Judge Lewis Kaplan in July 2007, after he concluded that the government had denied the defendants their constitutional right to counsel by pressuring their former employer to cut off payment of legal fees.

But at a hearing in the US Second Circuit Court of Appeals, the government argued that it had not brought any pressure to bear on KPMG to stop paying the defendants' legal fees, and that any violation of their rights had only been temporary.

While it was normal practice for KPMG to pay the legal costs of former employees accused of wrongdoing, it reversed its policy in this case, fearing that, by being seen to be helping the defendants, it could bring about an indictment on the company itself.

According to the so-called 'Thompson Memorandum,' written in 2003 by then-Deputy US Attorney General Larry Thompson, prosecutors may consider a company's payment of legal fees for "culpable employees and agents" when deciding whether to indict the company.

Tax Shelters In 2005 Action and inaction at the Treasury and in Congress.

Alphabet Soup SILOs, BOSS and son, and other denizens in the zoo of shelters.