IRS and Merrill Lynch Settle on Tax Shelter Dispute

In agreeing to the first-of-its-kind settlement, Merrill avoids possible civil sanctions.
CFO StaffAugust 29, 2001

The Internal Revenue Service, as part of an effort to curb abusive tax shelters, reached a settlement resulting in Merrill Lynch & Co. making a “substantial payment” in connection with corporate tax shelters that the brokerage firm marketed a decade ago to big-name clients, reports the Wall Street Journal.

The settlement, undisclosed but understood to be under $10 million, involves Merrill’s failure to register tax shelters that generated losses through transactions, later determined to be shams, that were designed to save companies hundreds of millions of dollars in taxes with deductions that eventually were disallowed.

In agreeing to the first-of-its-kind settlement, in which it “neither admitted nor denied” its culpability, Merrill avoids possible civil sanctions. The pact could signal similar actions in the future against other tax-shelter promoters, such as securities, accounting, and law firms, according to Deborah Nolin, deputy IRS commissioner for the agency’s large- and midsize-business division. Although Ms. Nolin wouldn’t discuss the Merrill settlement, she told the Journal it was part of a “strategic initiative” to rein in illegal tax shelters.

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The tax-shelter structure, which Merrill marketed to eight major corporate clients in 1989 and 1990, was disallowed by the IRS in multiple decisions later upheld by the U.S. Tax Court. The transactions involved contingent installment sale notes.

The IRS said in its statement that Merrill has “implemented a general tax review for investment vehicles it markets. The review process is intended to assure compliance with tax-shelter registration and listing requirements under federal tax laws.”

The tax agency had disallowed deductions claimed by the Merrill clients for losses that offset capital gains on major asset sales, ruling that the transactions that generated the losses were shams that lacked economic substance. The tax court first ruled in May 1997 against Colgate-Palmolive Co.

Other companies that used the Merrill-designed structure included AlliedSignal Inc., which combined with Honeywell International Inc. in 1999; American Home Products Corp.; Borden Inc., which now is owned by Kohlberg Kravis Roberts & Co.; Brunswick Corp.; Dun & Bradstreet Corp.; Paramount Communications Inc. (now part of Viacom Inc.); and Schering- Plough Corp.

The IRS has been cracking down harder on corporate tax shelters for the past several years, claiming abusive vehicles cost the federal government billions each year. In 1997, Congress passed legislation that beefed up tax-shelter disclosure standards for promoters and clients. The Clinton administration in February 2000 issued detailed rules implementing the new law.

The IRS appears to have gone after Merrill under the pre-1997 law, although IRS officials wouldn’t comment on when their probe of the firm got started, says the Journal.

Lee Sheppard, contributing editor of Tax Notes, a weekly publication, told the newspaper that the IRS position in the Merrill situation was weakened by the fact that it was relying on a 1984 tax- shelter registration requirement that was aimed at investments marketed to individuals, instead of the Clinton-era rules.

Among other things, the new rules require promoters to register arrangements that arguably fit the definition of a tax shelter, and promoters also must maintain lists of their clients for the deals. Taxpayers who use the shelters, in turn, must disclose that to the IRS when they file their returns. The IRS says it is matching up disclosures, registrations and client lists.

Nolin of the IRS told the Journal the agency is now working to compare disclosure statements by corporate taxpayers with registration filings by tax-shelter promoters. Part of the IRS strategy to crack down on tax-shelter abuses is to “pursue promoters for failure to register,” she added. The IRS has asked 25 shelter promoters for investor lists as part of the program, she said.

The business-friendly Bush administration may not necessarily curb the IRS’s vigilance. According to Richard Andersen, a tax partner in the New York office of the law firm of Arnold & Porter, while the Bush administration may soften some of the most extreme aspects of the Clinton-era crackdown on such shelters, failure to register will remain a top priority for the IRS as it pursues such cases. “The only really effective enforcement mechanism they have is disclosure,” he told the Journal.