Asymmetrical Information

I think you're off base here. The problem with what the accounting firms have been pitching is not that they were looking for ways to reduce their clients' taxes. The problem is that they're pitching shelters that simply do not work under any reasonable interpretation of existing law. The secrecy is not about protecting intellectual property, it's about hiding the ball from the IRS to enhance their clients' chances of surviving the audit lottery. From what I've seen, the major accounting firms have really sold their souls on this stuff, and they fully deserve the wrath of God that's now descending upon them from both the government and their clients.

Thanks for a reminder as to what makes Friedman a great writer; a well grounded insight into human naure. I'd go you one better, though in your comments about the tax code: As long as the taxes are based on a definition of "income", and the tax rate is high enough to make it worthwhile to pay advisers $1000/hour, then the code will be unworkably complex.

What's with the dig at liberals? The transactions engaged in by the Sprint executives were at least partially (I don't have the full details) designed to covert ordinary income into capital gains, given the different marginal rates applicable to the two forms of incomes. As you say, you can't fault people for trying to recharacterize their income in that way. But who is responsible for there being different rates on capital gains and ordinary income? No one group, left or right, bears a disproportionate share of blame for complexity in the tax code. Which is, I think, what gives rise to tax avoidance strategies such as these.

Furthermore, I would have thought that the dumbest thing about that article was the fact that Huffington does not mention that the IRS (perhaps in something of a tardy manner) is now disallowing the transactions and assessing the taxes that were due when the Sprint executives exercised their options. However, given the fall in the value of their shares, the Sprint executives now face tax bills larger than their net worth. That certainly dampens any outrage I have about the situation.

It goes without saying that accountants shouldn't be encouraging clients to do things that are plainly illegal. But I've studied sufficient accounting to lack your faith that it is easy -- or even possible -- to know what is illegal. Given that, I think it's inevitable that accountants will push the envelope.

The first thing that is misunderstood about tax shelters is that they are often legal. See your 401(k) and large estate plans. SOME tax shelters are beyond the pale. Tax shelters ARE a reasonable interpretation of the law, 99% of the time, if you look at the steps individually. Its perfectly legal to arrange your affairs for the lowest tax consequence. Where the whole game becomes interesting is where a literal application of the tax law results in a windfall to the taxpayer. Not one step is illegal, but on the whole, it smells to high heaven because of the tax results: Law of Unintended Consequences anyone? Most tax shelters that don't involve fraud are upended because the results are, well, stinky and its basically offends the court and the IRS.

And I've spent enough time working with the Internal Revenue Code for a living to know the difference between good, aggressive tax work and outright shams. Yes, there's lots of room for interpretation of tax rules, and there's lots of opportunities to structure transactions in a tax-advantaged way, but that's not what the shelter business is all about. I've seen stuff from major accounting firms that would make a tax protestor blush. Sham transaction/business purpose principles have been part of tax law since the thirties. Applying those principles is vague at the margins, but tax shelters blew past the margins some time ago. It's one thing to defend legitimate tax planning, but the major accounting firms have been trading on their professional stature to provide a veneer of respectablility to transactions that would be borderline go-to-jail/suspension from practice before the IRS stuff if a smaller player did them. What they've been doing is bad for their clients, bad for their firms, and bad for the tax system. It's about time they were called on it.

from what i've seen, one of the issues is that the shelters weren't just a bad interpretation.. they had already suffered adverse rulings...

while no one can predict what the tax law actually is until trial (which is bad) you can generally predict it after, and since westlaw is rather effective, saying I don't know is kinda stupid!

and it's fair to dig at liberals, because they create high tax rates, most tax rebates/deductions (eitc? etc), and have allowed the irs to become a ridiculous behemoth that eats money

Jane,

I will grant that the tax law is so complicated that it is hard to comply with; I know, because that is what I do for a living.

That said, I don't think my profession has exactly covered itself with glory by marketing tax shelters. These shelters typically use percieved anamolies in the tax law resulting from technical computational rules to achieve a non-economic result; they do not exploit "social engineering" (not that there isn't plenty of misguided social engineering and industrial policy in the Code). I challenge anybody to find "social engineering" in the Saba Partnership
shelter.

The "confidentiality agreements" may not be entirely designed to protect intellectual property - all of the big firms marketed similar shelters. The agreements also serve to hide the transactions from the IRS.

You question whether"...it is easy - or even possible - to know what is illegal." It isn't always easy, or possible, but it usually is. It is also possible to make a transaction incredibly complicated simply to hide a clearly improper result. It is reasonable to assume that the confidentiality agreements are, like unneeded complexity, largely intended to obscure transactions that are unable to withstand scrutiny.

The tax code is clearly too complicated. That doesn't excuse the practice of marketing flaky tax shelters. The tax law - like, say, Iraqi weapons inspections - can only operate effectively in a reasonably open environment; no tax law,no matter how simple, can operate when the "inspectors" have to play hide and seek with tax shelter promotors. Yes, accountants will always "push the envelope." That's fine; what isn't fine is wrapping impropriety in obscurity and pleading complexity.

None of us knows exactly was done by E&Y for the Sprint executives. At this point, other than the IRS and the media claiming that these were abusive tax shelters, we don't know that they were abusive. The Service often cries wolf about these things. Frequently, the transactions are upheld by the courts. Does that make the something that was once "clearly beyond the pale" smart tax planning?

As for the confidentiality agreements. They were never used to prevent the IRS from knowing about the transactions -- what client is going to narc on himself? The purpose was to prevent the other firms from knowing what was going on AND to lock the client in to using our services (and paying our fees). These agreements never seemed to work. I helped design a strategy to defer the taxes on the exercise of stock options (NOT the one E&Y used). Despite the use of confidentiality agreements, virtually all the major firms had a version of the transaction within 6 months of our first client presentation.

I'll bet that her anti-SUV org. is set up as a non-profit, that a smart accountant set it up, and that it enables her to deduct a number of otherwise non-deductible expenses.

MWB --

I also have spent my career working with the Infernal Revenue Code (no typo). The question I have is this: How can one "reasonably interpret" something that is absolutely illogical, wildly inconsistent, and preposterously vague? Is it "reasonable" to follow the literal dictactes of a statute and/or regulations to a result that appears too good to be true? Or must taxpayers ignore the words of the Code and Regs, thus putting them in the ridiculous position of determining Congress' and Treasury's "intent" when calculating their tax bills?

The "business purpose/sham transaction" doctrines are also a joke. The IRS relies on them when taxpayers cite their literal compliance with the Code....but then the IRS will disallow any tax deduction or credit claimed by a taxpayer who substantially complies with the substance of a Code section, but not its archaic form. Heads IRS wins, tails taxpayer loses.

Congress has made its own bed on this. The Code is a complete shambles, and therein lies the very reason why "shelters" are possible in the first place.

I also disagree with your take on the confidentiality agreements. All the brokerage houses, accounting firms, and white-shoe law firms guard their "products" jealously in an attempt to gain an elusive competitive advantage over one-another. The confidentiality agreements have nothing to do with disclosure to the IRS, as these NDA's are clearly discoverable upon IRS audit. The confidentiality agreements also have no impact on the probability of an audit. Indeed, most of the "shelters" are purchased by large corporations who are under continuous IRS audit.

Of course, with recently issued transaction disclosure regulations, the Treasury has so greatly expanded the idea of "shelter" that it includes countless everyday, ordinary business transactions that NOBODY would deem inappropriate. Taxpayers must now disclose these transactions on a special form (in addition to its regular reporting in the tax returns themselves), filed in duplicate (of course). Stupidity reins in Washington, however, so that the expansive definition of a reportable transaction will mean that the IRS will be so inundated with filings of forms disclosing harmless transactions that the very purpose of the form -- to alert the IRS to "questionable" dealings -- will be destroyed.

Joe, I don't mean to denigrate your profession, and agree with much of what you say, but I think you miss, or underestimate, what effect human nature has on tax code compliance. The rewards for non-compliance are are simply too great, and the underlying normative inhibition against failing to comply with a code formulated purely to benefit whichever political constituency is more powerful is too little, to reliably inhibit the behavior that is increasingly occurring.

Imagine if automobiles could not be locked, did not require a key to start, were untraceable without a lengthy investigation, and were distributed based upon the whims of politically powerful political consituencies. My prediction is that automobile theft would skyrocket, since it would be relatively easy to do, the chance of getting caught would be small, and there would be a wide-spread perception that the automobiles themselves were distributed in a manner that had little to do with moral legitimacy.

Today, if one is a renter, a more powerful political constituency, homeowners, has decided that your tax burden should be higher, simply because it has the power to enforce that view. Various other powerful constituencies, along with the politicians who seek to purchase votes, have acquired the tax credits or deductions they favor, to the detriment of those outside of those constituencies.

Democratic processes are useful tools, but this is where democracy fails, and simply becomes a means for the more politically powerful to impose it's will on the less politically powerful, and thus force the less powerful to pay a higher percentage of government expense. Such a system does not foster norms consistent with tax compliance, since the system has devolved into a simple, raw , exercise of power. If devising ways to force others to pay a higher share of government expense, regardless of any consideration other than having the power to successfully do so, is the predominant political activity in a society, along with devising ways to have that tax revenue funnelled into one's own pocket, then normative constraints fade, and complying with the tax code is increasingly seen as a sucker's behavior. A complex tax code, combined with redistribution of wealth as the primary political activity, does more to delegitimize government than any other factors, and to expect widespread compliance in such an environment is naive.

If one wishes to cut down on tax cheats, a good first step would be to steeply lower rates, have fewer brackets, and eliminate all deductions. Of course, such a move would likely reduce the amount of wealth to be redistributed, thus lessening the ability of politicians to purchase votes, or to buy votes by promising less tax exposure (to the detriment of others, of course), which is why the chance of this occurring is so small. Looks like were stuck with human nature no matter what we do.....

Believe me, I have no interest in defending the Code. It's an abomination and its complexity invites aggressive planning. It ought to be torn out by the roots.

But there's still a difference between looking for tax-advantaged ways to conduct business and simply creating huge mounds of paper that are somehow supposed to make income disappear. It is not good practice to, for example, react to a federal appellate decision saying that your transaction doesn't work by changing a couple of immaterial facts and keeping right on pitching the thing. For several years now, there's been stuff in the professional journals bemoaning the aggressiveness of what's been happening and wishing people weren't under such economic pressure to keep doing it. Through all of that, the big accounting firms were leaning hard on their clients' finance people to buy shelters or put themselves at a competitive disadvantage.

It's entirely possible that by the time Congress gets finished, the cure will be worse than the disease, but I am really glad right now that I steered clients away from some of the things that were pitched to them.

The tax code is better encrypted than most CIA secret transmissions. I am a tad over six feet tall, and the standard printing of the code towers over me.

A says "...some highly imaginative tax shelters dreamed up by the accounting alchemists at Ernst & Young."

Uh, no, they were dreamed up by our congresscritters.

"... how tax shelters are a byproduct of mostly liberal attempts to use the tax code to do a little stealth social and economic engineering without taking the manly risk of telling the voters about it...."

So you're saying that the new Bush budget proposal was written by those secret liberal economists the President keeps hidden in the basement of the Old Executive Office?

Thank goodness a good conservative President such as we now have stood up for a manly budget that cut back on tax shelters, and offered no new ones!

He's so unlike those damn liberals, whose fault tax shelters are!

Gary, I don't think we're using the same definition of tax shelter. As far as I know, Bush isn't setting up tax shelters, and his tax code modifications are minor compared to the Democratic plans in terms of complexity. You may not like the dividend reduction plan, but if it passes in the form that most people expect -- parity with CG -- it will reduce, not increase, useless tax transactions.

Jane, with all due respect--and I do respect your work greatly--I think you may be the one with a skewed understanding of the kind of tax shelters that have been in the news. I think you may be defending something different than others are attacking.

The tax world's version of the Starr Report came out today. The Congressional Joint Committee on Taxation issued its 745-page report on Enron's tax shelters. It can be accessed at the Joint Committee Website, if you can't wait for the paperback.

This promises a good look at how these things work.

we're all familiar with the kind of crap that you have to go through to reduce your taxes...

personal shelters and business shelters are similar but diffderent, and there's alot of stuff you wouldn't normally do outside of taxes...

the "useful purpose" rules are complete crap! you should be allowed anything that explicitly follows the letter of the law, no intent measurement at all... all it is is cya for idiot congresscritters and irsvampires

if they make dumb rules that create havoc, they should be forced to pay (all non military government employees and their spouses should be jointly and severally liable for their actions and those of their subordinates... lot more conscientious decisions)

Can someone explain preceisely how the shelters that are being discussed work. I would love to convert some ordinary income into capital gains.

BTW, when it comes to makingthe tax code complex, Mr. Bush's proposal concerning imputed dividends to shareholders for corporate earnings on which dividends are not paid but corporate taxes are paid really has few peers.

The IRS Code is over six feet tall? No way. It fits in a thick book (three inches thick), but it is only one book. If you add the regulations, you add about six more volumes. The thickness sets in when you add the revenue rulings, procedures, notices, etc. And THEN you get the court cases -- etc. IF you add all THAT up, you will get a pile significantly taller than six feet (the tax court memos cases take up at least eight feet -- wihtout the regular tax court cases and the district, appeals, and Supreme court cases).

The tax shelter as described -- and the description is so scanty that indeed perhaps I am mistaking it for something more garden-variety -- doesn't sound all that extraordinary. There are many means for converting ordinary income into capital gains, none of which are available to those of us without large amounts of capital. It's not, as the sarcastic tone of the left half implies, that I think that tax shelters are admirable. Rather, I think they're completely impossible to prevent, and I've got a hundred years of economic history on my side. I've seen no evidence that efforts to eliminate them do anything except produce work for lawyers and accountants. And I'm willing to bet that Huffington's accountant squeezes out every last drop to reduce her "fair share". Whining about other people not paying their fair share when you're seeking out every quasi-legal tax break for yourself is the height of hypocrisy -- and stupidity.

Dwight, I'm pretty sure you're wrong. If you want to compare complexity between Republicans and Democrats, there's just no contest. Clinton's special long term cap gains rate is the source of many of our favorite tax shelters, as are the "targeted tax cuts" he was so fond of. Other candidates are the changes in tax treatments of options, increases in the top marginal rates which dramatically increase the incentive to cheat, especially when contrasted against the special low CG rate, "Urban Empowerment Zones" and other tax-favored entities aimed at poverty reduction that somehow conspired to benefit wealthy contributors... it was Reagan who simplified the tax code over hefty Democratic protest (and a fair amount of carping from his own party); it was largely Clinton who complexified it again. (there was some increase under Bush, but the rate of change was dramatic under Clinton). If the dividends passes at parity, as most people expect, it will simplify rather than complexify the code and associated shelter, as a large component of current income shifting is in investment gains, and the favorable dividend treatment will sharply reduce the incentive to use options for companies that are not high-growth, cash constrained youngbloods.

Dwight: Without specific details, we cannot know for sure what the E&Y/Sprint transaction looked like. But from what has been reported, it appears the transaction involved an investment in a "contingent defered swap". Under this arrangement, the executive would "swap" the investment return on one hypothetical basket of securities for the investment return on another hypothetical basket. The contract would require the executive to pay his side of the contract currently (resulting in a current ordinary income tax deduction that would be used to offset the income from the exercise of the options). The counter party to the swap would be required to pay its side of the contract at the end of the contract's term, say in 24 months. Approximately 6 months before the end of the contract term, the executive would sell the swap contract to someone -- the proceeds would produce a capital gain. (Note: I've left out a lot of details, but that's the essence of the transaction.)

Now, was this an aggressive transaction? Yes. But, these swaps are used all the time for legitimate business reasons. The tax treatment of every part of the transaction is proscribed by regulations. Very detailed regulations. They go on for pages. So, were these transactions beyond the pale? I don't think so. I could think of a number of ways the IRS could attack them and told my clients of those risks, but I also don't think the Service has a clear win either. (As a matter of fact, I don't think the Service can win if it tries to apply the Sham Transaction Doctrine. There was a lot of substance to these transactions. Real money exchanged hands. Clients made or lost a material amount. Instead, if I were working for the IRS I'd classify the client's costs of the transaction as "investment expense", A/K/A a misc. itemized deduction. The taxpayer would be in AMT big time and would end up paying more in tax than if they had not done the transaction.)

2 comments from the UK experience. Nigel Lawson's budget in the 80s set Capital gains tax to the same as the income tax rate 40%, and set a sngle lower rat of 25% (though the mysterious 9% 'National Insurance' tax was not clarified).
This is claimed to have removed lots of obscure fiddles, but of course every Chancellor since him has hacked the tax code about to make it more complex.

When 5th generation computing (AI) was all the rage a few years back, one of the proposed projects in the UK (along with natural language translation and all other hard AI problems) was an expert system desigend to understand UK tax and benefit law. It was never built.

Ariana Huffington turned weird almost immediately after her former husband left her for another man! My guess is that a number of conservatives treated her unjustly for the deterioration of her marriage. Am I perhaps engaging in argument ad hominem reasoning? No, I don’t think so. I am convinced that many people hold political positions for reasons that are not based on pure abstract reasons. Eric Erikson claimed that those embracing radical Leftist politics did so because of anger at their father (ie. Jane Fonda). This is also my view of the matter.

Some in this discussion have said the major accounting firms have sold their souls in order to sell these tax shelters. To a certain extent, that is no doubt true. It used to be accounting firms charged only by the hour not by some measure of the "value" created for a client. Most tax shelters produce fees far in excess of a firm's normal hourly rates. It may well be that chasing these revenues has clouded the vision of those in this side of the business.

IF it has, my experience is that the professionals involved are unaware their judgement has been compromised. At two of the major firms, a small part of my job was to assist in developing and implementing these types of strategies. Some of my peers at other firms would inquire how we could justify our position that a particular strategy worked because they could not. I made similar inquiries of them. (Usually, they learned nothing from me nor I from them.) Despite the fact we were aware another firm was doing a particular transaction, we would NOT do the transaction unless we could independently reach the conclusion it worked. Neither would the other firms.

Just how willing were we to stick to our guns rather than do something we could not in good faith support? Very. A $100,000 a year client was approached by a rival firm with a tax strategy we were aware of but could not support. The client wanted to know if we would help him implement the transaction. (Even though the rival had approached him about the idea first, he was willing to have us do the work and to pay us the $1 million+ fee.) I had to tell him we could not help him with the transaction, nor could we sign his tax return if he did the transaction without our help. He hired the rival to do the transaction AND to do his $100,000 a year in recurring tax work.

Believe me. If we could have convinced ourselves that the transaction worked, we would have gladly accepted the million fee and kept the client.

David,

I know you're simplifying, but could you explain just a touch more. As I read your explanation:

1. I get some ordinary income, say $1 million (not necessarily from option exercise I presume)

2. I enter into a swap arrangement that requires me to pay someone the million as the return on some notional portfolio ($25 million in treasuries maybe?) in exchange for a similar payment two years hence. Why is this outlay deductible? How does it differ from just taking the money and buying other types of securities? No deduction there.

3. Eighteen months hence I sell my right to the return payment, for, say, $1.05 million. Is this sale, at this price, guaranteed, or am I at risk as to the price of this transaction? Whence the capital gain? What is my basis?

Sorry to complicate the discussion, but the notion that ordinary income can be converted to capital gains without a "sham transaction" seems very strange to me.

Bernard: Let me try to answer your questions:

1. Yes, the income does not need to be from options.

2. Why are the taxpayer's payments under the contract deductible? Internal Revenue Code section 1260, and the regulations there under, determine the taxation of "notional principal contracts" like the swap arrangement I described above. That section specifically states the payments made (or received) under the contract are "ordinary" and not "capital" in nature. So, that's why the taxpayer's payments are not capitalized into the basis of the contract. (Congress had a good reason for making this rule. These contracts are frequently used in a business to hedge against changes in interest rates or commodity prices. Since, in this context, the contract is part of a business's operations, which produce ordinary income, it makes sense for the contracts to produce ordinary income too.)

3. No, your return payment is not fixed. If it were, the transaction would not work. (The return payment is based on the return on a custom basket of stocks and bonds, not on a recognized index.) While payments made under the contract produce ordinary income, the contract itself is a capital asset. Selling the asset produces a capital gain. Your basis in the contract is zero since you were able to deduct the payments you made pursuant to the contract.

Note, this transaction did NOT convert the income from the options into capital gains. It generated an ordinary loss that offset some or all of the income from the options. Then, by selling the swap contract I recognize capital gain. (Economically it has the effect of converting ordinary income into capital gain, but its not the same thing.) I could have achieved the same economic result by going into the ranching business and buying a bunch of race horses or dairy cows. (As a cash basis taxpayer, I would be able to deduct the cost of the livestock up front). But who wants to shovel all that manure?

David,

Thanks. Cute. The payment you're entitled to under the swap would be ordinary income, but the contract to receive the payment is a capital asset, even though the two things are logically equivalent. Of course, an ordinary stock or corporate bond is really just a contract to receive a risky future payment too.

So suppose I have a portfolio of securities. I contract to pay someone the income from portfolio now, in exchange for them paying me the income from the same portfolio three years from now. Two years from now I sell my contract. Looks like I've done the same thing, so why is this not widespread?

Note to IRS: I am NOT doing this

Because the transaction is a "sham transaction" -- it has no purpose other than the avoidance of taxes, and is thus disallowed. Swaps have a legitimate business purpose, and the executives who were using them assumed some (small) risk and transaction loss, unlike the transaction you describe.

Bernard - You've got the general idea. (And "cute" the the proper technical term for many of these ideas. But what was cute in 1999 is beyond the pale post-Enron.)

Why is this thing not more wide spread? First, you cannout use the same portfolio on both sides of the transaction. The portfolios can be similar, but there must be material investment risk or the Sham Transaction Doctrine would likely apply. Second, for the sake of simplicity, I left out some crucial steps. It really is a very complex transaction (involving forming an offshore partnership, hiring an offshore investment manager to run the partnership, etc.). Ignoring the "value added" portion of the professional fees, it still would not be worth doing without $1 million or more of income to "manage". Not a lot of people in that income range.

Why is my risk less than theirs, as long as the underlying portfolio is the same? What difference does it make if I own it? I have no guarantee as to dividends etc.

And are you claiming that the transactions these guys entered into (as opposed to swaps in general) had some legitimate business purpose other than tax avoidance? What were they hedging , exactly?

Bernard - I am afraid this is getting too technical for most people. (Only a true tax toad like me could possibly enjoy it.) Using the same portfolios for both sides of the transaction would mean you were not "swapping" anything. Instead, you would get back exactly what you paid (plus a time value of money factor). So, this would not be a "swap", it would be a loan (structured in the form of a swap). The code section I cited earlier would not even apply to this transaction.

Did the swap in the transaction I described hedge anything? The taxpayer would say yes. The IRS would say no. The taxpayer's story would be that he had invested in a partnership that engaged in foreign currency trading (or similar activity). The swap (done inside the partnership) hedged the foreign currency trades.

I agree this is probably not too interesting to most posters. I see your point about the portfolio, but after all it's possible to construct "different" portfolios that are in fact similar, or to follow super-conservative trading strategies designed to preserve capital.

I suppose the courts will tell us the answer someday.

Thanks for your explanations.

David,

Thanks from me, also. I know I tarred with a broad brush in my comments above and that a lot of people in the tax world did not sell their souls on this stuff. But I do think that major accounting firms got caught up in a mass hysteria over tax shelters that produced transactions that were the professional equivalent of some of the wackier Internet companies (I'm not saying the Sprint transactions are in that category, but I've seen some that were). Now we're all going to pay for it. By the time the politicians get finished, they'll have tried to fix a lot of stuff that isn't especially broken, life will be more difficult for us and our clients, and the Code will be more impenetrable than ever.

MWB - You're welcome. There was a lot of schlock being peddled. But what's schlock and what's not is not always easy to tell from an IRS Notice. :)

Where the firms went wrong was not with the tax strategies per se; it was the mass marketing of them. At one of the firms we had telemarketers calling people who were selling their businesses. Any long term relationship with these type clients? No. Then how could we know them well enough to be sure the strategy was appropriate for them? We couldn't. The predicable result was clients entered into unsuitable transaction. (Note: I did not directly participate in this type of mass marketing, but I at times helped those who did.)

For my country and profession, I wish a lot of this did not happen. I too fear the cure will be worse than the disease. The real solution would be to tax capital gains and ordinary income at the same rate and to lower the rate to below 30%. When the 1986 tax act went into effect, it all but killed tax planning.

If I had to depreciate computer equipment over five years instead of expense it, I would stay about 4 years behind in my computer equipment. Where would I get 8 inch floppies?

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