Why Some Tax Shelters Could Bomb

The Treasury is moving to close some corporate loopholes and limit others.
Lisa YoonFebruary 2, 2001

Call it a crackdown on corporate welfare. The U.S. Treasury is dismantling two types of tax shelters that it says have been abused by companies, and proposing tighter rules for the use of legal opinions that support companies’ use of shelters.

“Abusive tax shelters are the most serious compliance problem in the U.S. tax system,” former Treasury Secretary Lawrence Summers said in a statement on the eve of President Bush’s Inauguration.

As one of the final acts of the Clinton administration, the Treasury announced that the IRS has disallowed the intermediary- transactions and contingent-liability tax shelters. The move will keep companies from using them to avoid capital gains taxes. Not only will the IRS disallow tax benefits from the transactions, but it could impose penalties on companies that use them and those that promote them.

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The intermediary-transactions shelter created a loophole for companies that wanted to sell their stock and buyers who want to purchase the company’s assets rather than the stock itself. In such a situation, the shelter allowed buyer and seller to transact the deal using a loss-generating or tax-exempt entity, such as a not-for-profit, to absorb the capital gain.

The second type of shelter that the IRS is blocking, the contingent liability shelter, will make it more difficult for companies to produce tax benefits by routing certain liabilities through subsidiaries. Companies used the shelter to transfer liabilities, such as deferred employee compensation or other potential liability, to a wholly owned subsidiary or a shell company, which bought stock and then absorbed the liability. The company would take a deduction upon the transfer, sell the subsidiary, and take another deduction upon the sale of the subsidiary. The IRS said it finds companies’ use of the contingent liabilities shelter to take the deduction twice especially troubling.

In its notice, the agency said that though companies claim a variety of reasons for using this transaction, “the Service and the Treasury are not aware of any case in which a taxpayer has shown a legitimate non-tax business reason to carry [it out].” The notice adds that any reasons companies do give “are far outweighed by the purpose to generate deductible losses for federal income tax purposes.”

The rulings came one week after the Treasury announced a proposal to crackdown on the legal opinions that companies typically use to justify tax-shelter transactions.

The proposal, which faces a public hearing on May 2, would increase the likelihood that companies pay penalties when they are found to have violated tax laws even if they have a legal opinion supporting their actions. It could also subject advisors to penalties if they endorsed the transactions. The move was triggered by organizations, including the American Bar Association, who argue that the current opinion rules are outdated and need revision. The supporters of the proposal contend that the current rules can put lawyers and accountants in compromising situations. For example, client companies could demand that lawyers write ethically questionable opinions, and threaten to go to other lawyers if they don’t comply.

The new standards would also prohibit lawyers and other advisers from taking a cut of the money companies save using tax shelters, and would require lawyers and accountants to be substantially more judicious in checking the legal structure of tax-shelter arrangements. For example, a lawyer may not endorse a tax- saving technique simply because it’s unlikely to show up on the IRS’s radar screen.

David Hariton, a tax partner at New York-based law firm Sullivan & Cromwell, says the proposed rules would be useful. “I think it will be helpful to divorce the lawyer’s opinion from the question of penalties. Companies should be calling lawyers to get their advice, not to obtain protection from penalties.”

However, he takes issue with the implication that the onus is on lawyers to police tax- saving deals. “Having said that, I don’t think a lawyer can play a useful role as a factual watchdog. Lawyers simply don’t know enough about the ultimate facts to play that role, and their principal job is to give advice about legal concepts,” argues Hariton.

According to Tim McCormally, director of tax affairs of the Tax Executives Institute, companies should be fairly comfortable with the new rules, if passed. Only those that lean toward more-aggressive use of tax shelters will find the new standards limiting, he says. “If you have a taxpayer out there that doesn’t mind being aggressive, and that taxpayer can no longer secure an opinion so that it becomes more at-risk in engaging in a particular transaction, that taxpayer might say, ‘Gosh, I don’t like these rules,’ but that’s kind of an attenuated reaction.”

There is the chance that the Bush administration could reverse the decisions, but, McCormally says it’s too early to tell what impact the new Presidency will have an the tax-shelter environment. However, he emphasizes that companies should not assume that President Bush’s corporation-friendly stance will mean a wholesale reduction in tougher tax-shelter legislation. Says McCormally: “Just because he’s pro-business doesn’t mean he’s going to let people get away with murder.”

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