IRS Cites Firms on Tax-Avoidance Plan

The agency notes that its efforts are directed at all tax-planning strategies, not only listed tax-shelter transactions, that it determines to be o...
Ed ZwirnJuly 28, 2004

The Internal Revenue Service announced that its “eight-figure” settlement with two financial firms should warn others that the agency is getting tough on “aggressive” tax-avoidance strategies. The announcement noted that the agency’s efforts “are directed not just at listed tax shelter transactions, but at all tax planning strategies determined to be overly aggressive by the IRS.”

In this case, the strategy that the IRS determined to be improper was the trading of slices of mortgage pools by Diversified Financial Corp. a unit of the Diversified Group of New York, and AVM LP of West Palm Beach, Florida. Acting independently, the firms improperly traded non-economic residual interests (NERIs) in real estate mortgage investment conduits (REMICs).

According to the regulatory agency, NERIs are REMIC securities that entitle the holder to little or no cash flow, but typically generate phantom taxable income for the holder in the early years of the REMIC and corresponding amounts of phantom tax losses in the later years. While the phantom losses can be used to offset income from other sources, the holder is prohibited under applicable law from offsetting the phantom income with any type of loss or deduction.

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According to the IRS announcement, the two firms purchased NERIs from various Wall Street investment banks and resold them to a Wyoming limited liability company owned by two Irish companies not subject to U.S. tax.

Trading REMICs and their accompanying residuals is legal, according to The New York Times — but under the United States tax code, only certain entities are allowed to own residuals. Unqualified entities include foreign individuals buying directly, pension plans, and entities with net operating losses.

The “eight-figure” settlement, the exact amount of which was not disclosed by the IRS, requires full disgorgement of profits and payment of an additional 20 percent penalty. It “also preemptively shuts down the deduction of over $1 billion in phantom tax losses arising from the NERIs,” the IRS maintained.

“We have demonstrated, without litigation, that taxpayers must be prepared to pay the price for aggressively interpreting the law even if it is unrelated to a listed tax shelter transaction,” said IRS Chief Counsel Don Korb, in a statement.