VideoLeona Helmsley would have made a colorful spokeswoman for the tax-shelter industry. "Only the little people pay taxes," she cheerfully asserted in 1989, shortly before her conviction for tax evasion.
Of course, Helmsley's wrongdoing — which amounted to about $1 million in unpaid federal taxes through fairly ordinary fraud — seems petty next to the grand tax dodges of a decade later. Enron's inventive shelters, for instance, helped it completely avoid paying taxes on the $2.3 billion of profit it reported for the years 1996-1999. "Compared with what we saw in the '80s, shelters have gotten more and more outrageous," says Louis Marett, a partner with Testa, Hurwitz & Thibeault LLP. "It's gone from being a retail industry to a wholesale industry."
In 2000, alarmed by how audacious and costly tax shelters had become (a recent study by the journal Tax Notes estimates that the Treasury loses $10 billion to $20 billion annually as a result of shelters), the Internal Revenue Service began to crack down. The government's effort, which has accelerated in the past year, has brought stricter enforcement and an array of new disclosure requirements. And it's not just the IRS that is taking action: In October, Congress passed a massive tax bill that, if signed into law, would add even more regulations designed to keep companies honest. "The stakes for noncompliance are higher than they were a few years ago," says Deborah M. Nolan, commissioner for the IRS's Large and Mid-Size Business division.
Unfortunately, the risks for law abiding companies have also climbed. According to tax experts, even companies that scrupulously adhere to the tax code are now more likely to face government scrutiny. As regulators cast a bigger net, they will inevitably haul in more than a few unintended fish.
The Clampdown
The IRS crackdown has two main components. One (see "Taxpayer Beware") is a more active pursuit of tax-shelter promoters and investors. The government has taken many law and accounting firms to court to force them to hand over client lists. The lists, in turn, have led the government to those that have bought the shelters. "This was an underutilized tool for us," says Jonathan R. Zelnik, a senior counsel at the IRS who focuses on potentially abusive transactions. "It's been very effective in helping identify taxpayers who have done abusive transactions."
Success with the promoter investigations has helped the government convince many investors to give up their shelters voluntarily. For example, in May the IRS offered a settlement to those that had bought the "Son of BOSS" (named for the offshoot of the bond and option sales strategy) tax shelter. The settlement offer — which still required investors to pay all back taxes, interest, and a reduced penalty — attracted more than 1,500 companies and individuals.
Another component of the crackdown — forcing greater disclosure from filers — is more controversial. The IRS has published a list of transactions that all filers must disclose. While not necessarily prohibited, these transactions raise a red flag for regulators (see "What to Disclose," at the end of this article). When a company makes a disclosure, the IRS examines it to decide whether it has a true business purpose or is merely a tax-saving gimmick.
The IRS also hopes to improve disclosure through the new schedule M-3, which requires companies to provide a fuller explanation of tax-book gaps. Wide differences between the numbers reported on financial statements and for tax purposes are a hallmark of shelters. Schedule M-3 will take effect for tax years ending on or after December 31, 2004.
And then there are the tax-accrual work papers. These documents — typically prepared by a company's auditors — lay out a company's rationale for the amount of money it sets aside for tax positions it thinks the IRS could challenge. It's understandable that the regulators would be interested in the work papers, since they clearly address any aggressive positions the company is taking. Before the current crackdown, the IRS rarely requested these documents, but now it asks for them when a company has engaged in one or more listed transactions. "The IRS always had the ability to get accrual work papers, but never pressed as hard before," says Marett.
Too Much Transparency?
Not surprisingly, some finance professionals find the government's tactics alarming. "My feeling is that it's overkill," says Tom Kelly, director of tax and treasury at Pall Corp., a $1.8 billion manufacturer based in East Hills, New York. "You're disclosing so much that you're basically laying out your tax planning before the audit starts."
To be fair, it's hard to imagine how the IRS could effectively curb shelters without some heavy-handed tactics. Tax shelters are deliberately hard to spot, often involving complicated trusts, partnerships, and overseas accounts that are themselves hidden in tax documents hundreds of pages long. And since the IRS lacks the resources to examine many of the tax returns it receives, many abusive transactions go unnoticed.
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