Commentary: Tax-Shelter Crackdown: Theater or Reality?

By Howard Gleckman

From the look of things, the Internal Revenue Service has declared war on the tax-shelter industry. The agency is forcing accountants, lawyers, and other promoters to reveal the names of their clients and details of complex tax schemes. And new Commissioner Mark W. Everson sounds like one tough cop: "The IRS will enforce the law...with particular vigor [against those] who enter into abusive shelters to game the system," he said at his installation ceremony on June 11.

Surely, the campaign has slowed an explosion of shelters. But there may be less to the effort than meets the eye. Despite a handful of high-profile cases, overall IRS enforcement is at its lowest level in a decade. And the agency rarely hits either promoters or their clients with tough penalties. Meanwhile, the Bush Administration has resisted congressional efforts to grant the IRS broad new authority to shut down financial transactions that have no purpose except to cut taxes. As a result, the IRS may be unable to root out the most sophisticated abuses. The agency is "well-intentioned," says Senate Finance Committee Chairman Charles E. Grassley (R-Iowa). "But they need to do more."

The stakes are huge. Outside experts estimate that shelters cost the Treasury at least $10 billion a year. And the Multistate Tax Commission said on July 15 that shelters are costing states one-quarter of their potential corporate tax revenue this year. But because shelters are so hard to identify, the IRS concedes it has no accurate estimate of their magnitude.

Until corporate malfeasance became a national scandal last year, the Administration showed little interest in shelters. Accountants, lawyers, investment bankers, and other promoters routinely ignored rules that required them to register deals. In January, 2001, the Bush team opened the door to new shelters when it declined to appeal a court ruling in a case against Rite Aid (RAD ) Corp. that let parent corporations and their subsidiaries take deductions for the same expenses. And during Bush's first 14 months in office, Treasury barred only one specific shelter -- vs. more than a dozen that were blocked in 1999-2000.

Treasury began to get religion after Enron Corp.'s collapse. The Administration, which had close ties to the energy giant's top execs, didn't want to look as if it were protecting corporate tax cheats. And the intense Treasury probe of terrorist money-laundering kept stumbling onto offshore bank accounts set up to shelter the incomes of wealthy Americans. Congress, which bashed the IRS through the late 1990s for abusing taxpayers, suddenly began demanding a crackdown on tax fraud.

So the IRS reversed course. In July, 2002, it began demanding customer information from promoters such as accountants Ernst & Young and KPMG. On June 20, 2003, the agency sued to force Dallas law firm Jenkens & Gilchrist to name its shelter clients.

But while new Commissioner Everson, a Texas businessman who's a newcomer to the tax world, promises to make life tougher for shelter-lovers, he'll have a tough time putting much of a dent in the trade. Why? For one thing, the IRS needs more agents. According to a Syracuse University analysis, in 2002 the IRS had 20% fewer revenue agents than it had a decade earlier. It audited just 2.1 returns per thousand of partnerships and other entities that pass profits through to shareholders, where much sheltering occurs. That's down from 5.1 per thousand in 1993. The number of civil fraud penalties imposed fell from 555 to 159, and federal tax prosecutions fell from 1,011 to 490. Says Stanford University law professor Joseph Bankman: "The IRS is hopelessly outgunned."

The agency also lacks the authority to impose tough penalties on promoters and taxpayers -- a business' maximum penalty is only 20% of the amount it understates its tax. That's way too low. Corporations often negotiate down their tax liability in disputed transactions. Thus, regardless of the penalty, they are often better off cheating on their taxes, even if they get caught. Doubling penalties, to 40%, and making them nonnegotiable would be a big disincentive to companies that are thinking about playing the audit lottery.

But many experts say the most effective addition to the government's arsenal would be one Treasury and the IRS don't want: a law that bars deals unless they have a business purpose beyond just avoiding tax. Grassley is developing legislation that would put the burden on companies to prove that their deals meet this standard -- a development that would make it much harder for pricey lawyers to game the rules. But Assistant Treasury Secretary for Tax Policy Pamela F. Olson argues that such a law wouldn't stop sleazy deals, adding: "You're going to hurt businesses trying to carry on legitimate transactions."

The target isn't legitimate deals, just over-the-top tax-avoidance schemes. The IRS deserves credit for cracking down on some promoters. But if the Bush Administration and Congress don't get more aggressive, shelter builders will still find many ways to help clients dodge Uncle Sam.

Gleckman covers taxes from Washington.

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