Tax Shelters Under Attack

By Raquel Meyer Alexander, Randall K. Hanson, and James K. Smith

In Brief

Attorneys and Accountants Operate Under Different Rules

Increased public and regulatory attention has been directed toward the tax shelter programs pushed by legal, accounting, and investment banking entities. As recent high-profile investigations and settlements demonstrate, the IRS is now aggressively pursuing the purveyors of questionable tax shelters. The IRS’ main tactic is using recently passed disclosure requirements to find shelter techniques and customers. Law firms can use the attorney/client privilege to fight such disclosure demands, but the recently enacted accountant/client privilege is far weaker and narrower. As a result, the authors suggest that tax accountants consider positioning themselves as responsible advisors with legitimate strategies, rather than take on the IRS in a possibly losing fight.

The IRS and the Treasury Department are mounting an aggressive attack on tax shelter programs marketed by law firms and accounting firms. The Treasury estimates that $10 billion of taxes are evaded annually by improper or questionable tax programs. Through recent tax amnesty provisions for tax shelters, the IRS has identified over $30 billion in lost tax revenue.

The IRS’ main tactic to halt abusive tax shelters is to force disclosure of the promotion and use of shelters. These disclosures can then be used to target shelter promoters and questionable tax returns. The most recent tax shelter disclosure rules, in the form of final IRS regulations, took effect February 28, 2003. The IRS has also created a new senior executive post within the Office of Chief Counsel that is responsible for the early detection and interdiction of abusive tax shelters. Nicolas DeNovio, a respected Washington, D.C., attorney with international tax experience who has worked with Pricewaterhouse-Coopers, has assumed this position.

Congress has introduced several bills that require additional disclosures of information by both the taxpayers and the tax shelter promoters. The proposed legislation would create stiff penalty provisions for entities that fail to disclose the sale and use of shelter programs. For example, tax shelter promoters could be assessed penalties up to $200,000 or 50% of fees for failing to report required transactions. Tax shelter promoters also must contend with a number of lawsuits from tax shelter investors. Law firms, accounting firms, and financial institutions have all been sued by investors in various tax shelters. These lawsuits are receiving widespread media coverage, and the tax shelters are facing increasing public scrutiny.

Because disclosure opens the door to IRS scrutiny, promoters are understandably reluctant to comply with the new disclosure rules; many claim that the information is protected by either the attorney/client privilege or the tax practitioner/client privilege. In this regard, accountants are at a distinct disadvantage to lawyers. The attorney/client privilege has existed for centuries while the tax practitioner/client privilege dates to the IRS Restructuring and Reform Act (IRSRRA) of 1998, which specifically excluded the privilege as it relates to corporate tax shelters. Thus, accountants most likely will be forced to comply with the tax shelter disclosure requirements. The attorney/client privilege is significantly broader and more powerful, giving law firms selling tax-consulting strategies an apparent competitive advantage over accounting firms. Ultimately, law firms may be forced to disclose the same information as accounting firms. But so long as the public perceives lawyers to be exempt from disclosure requirements, law firms will likely enjoy an advantage in the tax consulting market.

The IRS has responded to the tax promoters’ claims of privilege by issuing over 100 summonses to force the release of the information. In June 2002, PricewaterhouseCoopers agreed to comply with the summonses issued to the firm and to cooperate with the IRS to ensure compliance with all disclosure regulations. The PricewaterhouseCoopers settlement was significant because it was the first settlement reached with a defendant that had the ability to raise a confidentiality argument. Merrill Lynch agreed to a similar settlement in a tax shelter case in August 2001 by paying the IRS between $7 million and $10 million, but it is unlikely that an investment firm had the same right as PricewaterhouseCoopers to raise the tax practitioner/client privilege. The IRS indicated its resolve by filing petitions to enforce the summonses it had issued against Arthur Andersen in September 2002. KPMG has also claimed privilege in connection with the Arthur Andersen problems, but in a recent district court ruling, the court found that many of the documents sought were not subject to the tax practitioner/client privilege under section 7525 of the 1998 IRSRRA.

History of IRS Tax Shelter Disclosure Requirements

The IRS’ main strategy is to shine a bright light on shelter transactions by requiring those involved to register the shelters and to disclose what shelters were sold to whom. Disclosure requirements for tax shelters were required beginning with the 2001 tax year. Tax shelter promoters are required to obtain a registration number for each shelter and register it with the IRS. Furthermore, tax shelter promoters are required to keep user lists and copies of all promotional materials. Initially, only corporations were required to disclose their use of a tax shelter and to attach to their tax return an outline of the shelter used. Disclosure requirements have now been expanded to individuals, partnerships and their partners, S corporations and their shareholders, and trusts. In December 2001, the IRS offered a 120-day amnesty period in which taxpayers that came forward and disclosed tax shelters had accuracy penalties waived. By the program’s end, 1,633 shelter plans were disclosed by 370 corporations and 810 taxpayers. The IRS used this information to find tax shelter promoters that had not provided disclosures and to identify new tax shelter transactions. Many attorneys and tax accountants initially felt secure in refusing to respond to the disclosure requirements by insisting they were providing privileged tax advice. The IRS disagreed and issued 132 summonses to eight different accounting, law, and investment banking firms. The summonses demanded customer lists, opinion letters, and other documents. The Merrill Lynch and PricewaterhouseCoopers settlements were considered major breakthroughs for the IRS, not only for the substantial cash payments and information turned over to the IRS, but also for the signal sent to other professional firms engaged in tax shelter work.

The disclosure requirements are considered essential to the IRS’ fight against tax shelters because the information provided by the promoters and taxpayers involved in the tax shelter industry allows the IRS to target questionable transactions and tax returns. The IRS only audits one out of every 172 returns (in 2001), so clearly they need to target key returns to be effective. The IRS is not content with only using the disclosure rules, and is currently considering a number of other options. Some of the other tools being considered include introducing additional tax shelter legislation, strengthening the Circular 230 rules regarding the issuance of tax opinions for tax shelters, being more aggressive in requesting tax accrual workpapers from companies using tax shelters, and strengthening the partnership antiabuse rules. In addition, the IRS implemented another strategy in June 2002 by introducing a rule that requires individual taxpayers, partnerships, and S corporations to include a statement on their tax return if they have participated in “listed” or questionable tax shelter programs. Previously, only corporations were required to make such designations.

While the strategy of requesting tax shelter information from accounting firms is beginning to bear fruit, some accounting firms remain willing to gamble on the tax practitioner/client privilege. These firms may argue that the tax practitioner/client privilege covers “tax advice,” which includes tax consulting ideas marketed by the accounting firm. Tax planning or tax reduction goals may fall under the umbrella of tax advice and be protected by the tax practitioner/client privilege. The IRS would counter that such services fall under the corporate tax shelter exception to the tax practitioner/client privilege, but it is very difficult to determine when an idea crosses the threshold from protected tax planning to unprotected corporate tax shelters.

During 2002, both the Senate and the House of Representatives proposed legislation to impose strict penalties on those who implement or promote tax shelters. Under the Senate bill, promoters would be fined $10,000 for each day they withhold client lists and for failure to disclose results, up to a $200,000 fine or 50% of fees, whichever is greater (75% if intentional). However, the IRS is not waiting on this legislation; it has already toughened its stance with respect to tax shelters by expanding disclosure regulations to individuals, trusts, partnerships, and S corporations. The IRS and the Treasury Department have indicated that regulations under development will require even more disclosures, such as disclosures by indirect participants of tax shelter programs. The IRS recently issued final anti–tax shelter regulations, which became effective on February 28, 2003. The newest regulations set forth six categories of tax shelter schemes that must be disclosed:

The disclosure requirements give rise to concerns over how these disclosure requirements will affect the relationship between lawyers and accountants and their clients who purchase tax planning strategies. Do these disclosures violate the confidential attorney/client or tax practitioner/client relationships? If the disclosures are considered privileged and protected by law, will the IRS lose the fight against illegal tax shelter programs? To understand this area it is important to distinguish the attorney/client privilege from the tax practitioner/client privilege.

Attorney/Client Privilege vs. the Tax Practitioner/Client Privilege

The attorney/client privilege grew out of the common law. Attorneys are advocates for the client, and in order to ensure adequate representation, clients must feel secure in disclosing confidential and possibly incriminating information to their attorney. With this privilege, the client can be confident the attorney cannot be forced to divulge any information provided by the client. The attorney/client privilege is a powerful tool that enhances the relationship between attorneys and the clients they represent and defend.

By comparison, there has never been a common-law accountant/client privilege, and until recently, there may not have been a great need for one. Historically, accountants were not advocates per se, but rather individuals endowed with a responsibility to the investing public, creditors, and stockholders as well as to clients. Accountants were deemed independent analysts who did not represent their clients in court and therefore were not perceived to be advocates that needed privilege to adequately assist the client. Accountants have frequently asserted that their relationship with the client has changed over the decades and that they are now entitled to privilege. The courts have not accepted this perspective. Approximately one-third of the states have passed accountant/client privilege statutes, but these statutes are limited in scope and are not recognized in federal courts, which could force accountants to disclose information provided by clients. Although distressing to all accountants, these rulings were especially problematic for tax accountants that could be forced to divulge damaging client information to federal tax court judges.

The courts have extended attorney/client privileges to accountants that work under an attorney. Specifically, information provided to accountants could be deemed privileged if an attorney who represented a client brought in an accountant to assist the attorney in representing the client. Under this scenario, the accountant could not be forced to divulge any information disclosed by the client. However, this limits accountants to a secondary advisory role that is unsatisfactory to most professionals engaged in tax consulting practices.

The accounting profession, frustrated by an inability to compete with tax lawyers, lobbied Congress for relief. In 1998, Congress granted a limited tax practitioner/client privilege in the IRSRRA (section 7525) that basically extended the attorney/client privilege to confidential communications between taxpayers and federally authorized tax practitioners. This was heralded as a major victory for tax practitioners; however, this privilege has many limitations.

First, the privilege granted covers only communications made for the purpose of obtaining legal tax advice, such as representation before the IRS. There is concern that any information gained though an audit or from providing consulting services is not related to representation before the IRS and would, therefore, be subject to forced disclosure. Second, the privilege does not apply to actions by any state agency or federal agency (e.g., the SEC) other than the IRS. A third limitation is that the tax practitioner/client privilege specifically excludes any written communication in connection with the promotion of a tax shelter to a corporation.

Another problem with privilege stems from the waiver doctrine. Privilege is waived for all communications that have any public disclosure of that same subject matter, including tax returns. The courts have upheld the IRS’ position that any information that may be part of a tax return cannot be considered privileged. When disclosing information regarding the use of a tax shelter, privilege is automatically waived for all information surrounding the tax shelter. Finally, the protection afforded under IRSRRA section 7525 applies only to civil proceedings. The IRS can simply allege tax evasion and the tax practitioner/client privilege is eliminated.

Do the rules still favor lawyers? Given the very limited nature of the tax practitioner/accountant privileges, the answer appears to be yes. Nevertheless, attorneys face similar problems with their privilege. The IRS’ new Chief Counsel, B. John Williams, Jr., has indicated that he does not believe that the attorney/client privilege protects attorneys in the tax shelter area for a number of reasons. First, the attorney/client privilege only covers legal advice and does not extend to information that will be incorporated into a tax return. A significant portion of the tax shelter information will end up on tax returns and, therefore, should not be protected. Second, the attorney/client privilege is waived when the protected information is communicated to third parties. Williams contends that much of the tax shelter legal advice provided by attorneys, such as tax shelter opinions, is circulated to third parties and, therefore, is not protected by the attorney/client privilege. Despite these limitations, the attorney/client privilege is still considered by most legal commentators to be a greater deterrent than the tax practitioner/client privilege and, unlike the tax practitioner/client privilege, it does not contain an explicit exception for corporate tax shelter work. As a result, attorneys are much more likely to fight court-ordered disclosure rulings.

The intriguing question that remains is whether law firms will feel compelled to disclose all required information surrounding the marketing of tax shelter programs. The IRS has taken the position that certain tax shelter programs are subject to disclosure rules, regardless of whether the promoter is an accountant or an attorney. In addition, the implementation of these tax programs affects the tax return preparation; thus, the waiving of privilege would automatically occur. Law firms will take the position that providing tax planning advice constitutes legal advice which is not subject to disclosure under the attorney/client relationship. Attorneys have never been given the public watchdog role as accountants have, and they certainly have a much more persuasive argument for privilege than accountants.

Recent Litigation Against Tax Shelter Promoters

The Enron collapse brought information distortion, tax evasion, and tax shelter use to the public’s attention and to the top of regulators’ agenda. It has been estimated that Enron’s tax saving strategies distorted revenues by nearly $2 billion. Enron created 881 offshore subsidiaries as part of its strategy to shelter tax dollars. The Joint Committee on Taxation has released a document in which Enron’s strategies are disclosed along with the names of the financial institutions, public accounting firms, and law firms that developed and signed off on these tax shelters.

Another major tax shelter controversy involved Sprint. Two Sprint executives were recently forced out of their jobs because of their involvement with a tax shelter designed by Ernst & Young. Under this tax shelter plan, the executives were assured they could defer taxation on the stock options for 30 years, instead of having to pay taxes annually as the options were exercised. The two executives assert that they will owe $123 million in taxes if the IRS invalidates the tax shelter they relied upon. The IRS has taken the position that the tax shelter plan used by the Sprint executives was clearly illegal. Apparently, hundreds of companies purchased this same shelter plan.

In Asheville, North Carolina, three businessmen sold a mall at a huge profit and relied on a tax shelter pitched by First Union Bank and KPMG to avoid taxation. The IRS disallowed the tax shelter plan and the businessmen have commenced a lawsuit against the bank and the accounting firm. The individuals had been advised that the shelter they purchased did not have to be registered since it was a “tax investment strategy,” not a tax shelter.

Many large accounting firms have received administrative summons from the IRS to turn over names of clients purchasing tax shelter products. In 2002, several “John Doe” clients of Ernst & Young and BDO Seidman have claimed privilege and sought an injunction against the firms to prevent the disclosure of their names to the IRS. KPMG was also issued a summons by the IRS to turn over tax shelter client names, and claimed privilege for thousands of documents. As the IRS aggressively attacks questionable tax shelters, many anticipate a flood of lawsuits against promoters either to recoup losses or to prevent identities from being disclosed.

Implications for the Accounting Profession

The IRS is aggressively investigating tax shelters, and this campaign highlights a number of important issues for accountants to consider. First, it highlights the inadequacies of the new tax practitioner/client privilege. The privilege as currently written is vague and needs to be either clarified or rewritten. Accountants should not rely upon section 7525 of the IRSRRA to protect their clients in disputes with the IRS, especially when tax shelters are involved.

A second major issue is whether accounting firms should voluntarily comply with the tax shelter disclosure requirements in order to repair their damaged images. Some within the profession have charged that tax shelters have corrupted the entire tax practice. Accounting firms may be shortsighted in seeking the financial gains associated with promoting questionable tax shelters. The better strategy might be to avert future scandals by backing away from more risky tax shelter deals and limiting their participation to legitimate strategies that they have no fear of disclosing to the IRS. Clients may prefer tax consultants who have chosen to willingly comply with the IRS disclosure rules, rather than those who have chosen to wage war with the IRS. This could be a selling point for many accountants, at least compared to attorney advisors that may insist upon hiding behind the powerful attorney/client privilege.

Finally, accountants should encourage the IRS and the Treasury Department to police the activities of lawyers who market tax shelter programs just as aggressively as they have pursued accounting firms that promote tax shelters.

Raquel Meyer Alexander, PhD, CPA, is an assistant professor of accounting, and
Randall K. Hanson, JD, LLM, is a professor of business law, both at the University of North Carolina at Wilmington.
James K. Smith, PhD, JD, LLM, CPA, is an assistant professor of accounting at the University of San Diego.

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