Demolishing Shaky Tax Shelters

As the feds continue to scuttle dubious and outrageous schemes, new players are reshaping a chastened financial-advice industry

By Joseph Weber

New York Attorney General Eliot Spitzer may get all the press, but the Justice Dept. and IRS have reason to strut, too. The two have amassed an impressive enforcement record against businesses and the individuals and advisers who transformed sketchy tax shelters into business-as-usual in the late 1990s.

In June, the IRS and Justice were successful against a third major accounting giant, when KPMG admitted "unlawful conduct." And since 2000, the IRS has collected $3.5 billion from about 1,200 taxpayers who invested in just one kind of shelter. "We have changed the landscape," says IRS Commissioner Mark Everson.


  Thanks to the shelter crackdown, mainstream firms seem to be steering clear of the sometimes bizarre schemes that flourished at even reputable outfits in the late 1990s and early 2000s, industry observers say. Enriched by the bull market, the wealthy fell for elaborate deals that were short on economic value and designed solely to create paper losses to offset taxable gains.

"No one is selling the kind of junk that was being sold in 1999," says Joseph Bankman, a Stanford Law School professor and taxation expert. "The market has pretty much dried up."

Of course, tax management -- the legal kind that helps lower tax bills through planning and investment -- certainly hasn't gone away. The tax-services bazaar has expanded into a wider set of providers -- from law firms to Wall Street and insurers, which are happy to help well-heeled companies and individuals to lighten their tax loads .


  Annuities marketed by the likes of Hartford Life Insurance and TIAA-CREF, for instance, allow buyers to build proceeds tax-free over time and then cash out after they're retired when they can pay lower tax rates. Similarly, such firms as Fidelity Investments and Merrill Lynch (MER ) offer donor-advised funds, which help the well-off take deductions for charitable giving today while doling out the gifts over time.

Mutual-fund firms, moreover, are cooking up all sorts of tax-protected products, from plain-vanilla municipal-bond funds to others that invest in securities producing interest exempt from the dreaded alternative minimum tax. "People are definitely looking for things" to minimize the tax bite, says Sharon Oberlander, a first vice-president for investments and wealth management adviser for Merrill Lynch & Co.'s Global Private Client Group.

And certainly, the tax-advice business hasn't gone away, even as it spreads beyond the Big Four and other accounting firms. Major law firms increasingly have gotten into the act, since giants KPMG, Ernst & Young International, and PricewaterhouseCoopers were sullied in 2003 investigations spearheaded by Congress.


  Complex areas such as deferred compensation are driving top executives to law firms such as Chicago-based Kirkland & Ellis and New York's Wachtel, Lipton, Rosen & Katz, and benefits advisers such as North Barrington (Ill.)-based Clark Consulting. Without professional help in understanding the law and rules, a layman would have to wrestle with "pages and pages of gibberish," says Kirkland & Ellis senior partner Jack Levin.

Still, under intensified legal and enforcement pressures, the market for minimizing taxes may now splinter. Employers who want to help their top executives contain their tax bills on ongoing pay, for instance, will likely work through such law firms and compensation consultants, especially since accounting firms are now restricted on how much they can advise both executives and their employers.

People with big estates to preserve and pass on will still turn to private bankers and personal accountants for help with trusts and other devices. And the so-called "mass affluent," who have comfortable six-digit incomes and investable cash, will likely look more to lower-cost financial planners and mutual-fund outfits, such as Vanguard and Fidelity, which are pitching tax-advantaged investment funds.


  No matter who's offering the help, taxpayers who want to ease a tax burden now must make doubly sure their efforts will pass muster with the IRS. Though pressed for resources, the agency continues to pursue tax evaders and lately has been particularly attacking misuses of charitable organizations. One scheme now vexing the IRS: individual donors who set up charities that they control -- and which appear primarily to benefit the donors.

In another scheme, taxpayers donate easement rights to historic home facades to preservation outfits and then claim deductions, even though local zoning may bar the homeowner from making any changes. Such deductions are illegitimate, the IRS has ruled. Worried about boutique promoters and offshore transactions, IRS Commissioner Everson sees "a lot more to do."

No doubt, shady advisers who at one time dominated the shelter business will try to evade the crackdown. "Their life is bringing planning ideas to clients," says Ronald Pearlman, a law professor at Georgetown University Law Center and former Treasury Dept. official. "The IRS has got to get to these marketers if they are peddling this aggressive stuff."


  But for many firms and taxpayers, the cost of dubious advice or products has simply become too high. Just ask KPMG, as it negotiates with Justice to stave off legal action, or any of the taxpayers who followed its slickly merchandised tax-cutting advice during the boom.

KPMG has scrapped the tax-shelter unit that smudged its name, offloaded a clutch of partners involved in it, and promised to do better. No doubt tax-shelter promoters will be back plying their dubious trade once the latest storm settles down. But for now the revenuers seem to have the upper hand.

Tax-Reduction Tools:

Annuities. Gains grow tax-free and are taxed based on income level when they are sold, typically in retirement.

Donor-advised funds. Donors get immediate deductions, then direct contributions to charities of their choice over time.

Charitable lead trusts. Some investment proceeds can pass tax-free to a child or other beneficiary.

Health savings accounts. Employees invest money for health care, with funds rolled over annually, and the gains grow tax-free.

Low-income housing. Investors join partnerships that own housing for low-income people, then receive tax credits.

Small-business investments. Returns on investments in small business may be taxed at just 14% rather than at an ordinary rate of as high as 35%.

With Nanette Byrnes in New York and Howard Gleckman and Mike McNamee in Washington

Weber is BusinessWeek's Chicago bureau manager