Inside The KPMG Mess

Why eight partners may be facing jail time -- and what the suit could mean for the tax-shelter business

On Aug. 26, the Justice Dept. won a landmark tax-shelter case when accounting giant KPMG admitted to criminal tax fraud and agreed to pay $456 million in penalties. The government will defer prosecution and drop the case after Dec. 31, 2006, if KPMG stays out of the shelter business and cooperates with prosecutors in related cases. It could have been a lot worse for KPMG -- think back to Arthur Andersen's fate. But for the eight former KPMG partners and an outside lawyer whom the government has indicted, the price may be high indeed. What's more, the case is sure to send shock waves through the accounting and legal professions, where individuals are now on notice that they are no longer immune to government prosecution. Here's a look at what the charges are all about, how they may play out, and the wider implications of the case:

What does the Justice Dept. claim KPMG and its partners did?

The government alleges KPMG and its partners committed tax-shelter fraud by selling illicit deals and then misleading the Internal Revenue Service about the transactions it orchestrated for wealthy individuals between 1996 and 2003.

The shelters were called BLIPS, FLIP, OPIS, and SOS. All were allegedly designed to create phony losses that investors could use to reduce their taxes. For example, BLIPS -- "Bond Linked Issue Premium Structures" -- were sold to at least 186 wealthy individuals and generated at least $5 billion in tax losses. A client would borrow from an offshore bank to buy foreign currency from the same bank. Roughly two months later the client would sell the currency back to the lender, creating what the government contends was a phony tax loss that the client could then deduct from his capital gains and income from other investments. SOS was a similar but more complex currency deal; FLIP and OPIS involved investment swaps through the Cayman Islands, a well-known tax haven. The IRS contends that all these loans and investments were risk-free, sham transactions designed solely to reduce taxes -- to the tune of nearly $12 billion in phony losses that cost the Treasury $2.5 billion.

Are the deals illegal?

The IRS says so, but the courts have not yet ruled on the matter. The IRS has a mixed record in shuttering such transactions. Under what is known as the economic-substance test, the IRS has claimed that shelter deals done solely to reduce taxes are improper. But federal courts have sometimes ruled that such transactions are O.K., even if they carry no economic risk or opportunity for reward beyond their tax savings.

Does that mean the KPMG partners and the outside lawyer may get off?

Possibly, but they face a tough battle. Lawyers for the individuals charged deny the allegations and are likely to cite the deals' uncertain legal status in their client's defense. But "the government has a very strong case," says Sheldon D. Pollack, director of legal studies at the University of Delaware. "A lot of the transactions were so aggressive that there's no basis for claiming they're legitimate."

Still, Justice worries that it may not be able to convince a jury that these immensely complex deals were illicit. So the indictment goes beyond the question of whether the deals themselves were proper. It alleges that KPMG, its eight former partners, and the outside lawyer conspired to mislead the IRS by lying about the details of the shelters. For instance, on BLIPS, the defendants allegedly presented the currency purchases as seven-year investments -- even when they knew most clients cashed out after 67 days. The deal's documents also said KPMG, its law firm, and other parties operated independently, while Justice charges that they worked together to package the shelter.

How will these charges affect the tax-shelter business?

Major accounting and law firms have sharply curtailed their marketing of tax shelters, at least for now. One big worry: lawsuits brought by angry clients forced to pay back taxes and penalties. KPMG will argue that its clients were savvy investors who knew they were taking risks to reduce their taxes. But the firm's admission of guilt will overwhelm that argument, says Stanford University law professor Joseph Bankman: "Once the firm admits wrongdoing, it's a boon to a private party that bought the shelters and wants to sue the firm."

Now, most shelters are being peddled by tax "boutiques" operating on a much smaller scale. Those firms can fly under the IRS's radar more easily than can the Big Four accountants or national law firms. But if the government wins convictions against the KPMG partners, even these firms may become wary about how they market their deals.

Can't Congress simply outlaw shelters?

Most abusive shelters are based on legal tax-planning techniques -- but carried to extremes. That makes it hard to draw sharp lines between legitimate tax planning and illicit shelters. The Senate Finance Committee has been pushing for years to enact into law the criteria that the IRS uses internally: If a transaction has no economic purpose beyond simply reducing taxes, it would be illegal. So far the White House and the House have blocked that change, but Finance Committee Chairman Chuck Grassley (R-Iowa) is likely to keep trying. The case should give him new ammunition.

Does the government usually bring criminal charges against partners?

No, at least not in the past. In his 30-plus-year career, University of Georgia accounting professor Dennis R. Beresford says he has seen only one partner at a major firm sent to jail for professional misbehavior. That changed with Enron: Since 2002 the government has indicted more than 20 tax lawyers, and many more may be in the Feds' sights.

In this case, Justice feared an indictment of KPMG would put the firm out of business, leaving only three international firms to audit large corporations. But prosecutors were under tremendous pressure to punish shelter promoters -- so they targeted the individual partners.

How will the KPMG case change the accounting profession?

What's striking, industry experts say, is how KPMG has thrown its former partners overboard while giving the government evidence to use against them. The case "sends a very solid message to any partner: Even if what you're doing has the firm's blessing, if the firm gets in big trouble, you're going to be on your own," says Jonathan Hamilton, editor of Public Accounting Report, a Las Vegas newsletter.

The $456 million fine could cost every one of KPMG's partners as much as $300,000. They will also bear the cost of civil damages awarded to former clients. That open-ended liability, without the promise that the firm will stand behind them, may cause the profession to shift from long-standing partnerships to a corporate structure.

Will these charges force tax professionals to clean up their act?

Nothing concentrates the mind of a wayward professional -- or one who's contemplating actions that cross an ethical line -- like the threat of jail time. "There must be partners in other firms thinking: 'There but for the grace of God go I,"' says Paul R. Brown, an accounting professor at New York University's Stern School of Business. The truly sleazy shelter peddlers, who can pack up their boiler rooms and flee when the G-men come knocking, may not be deterred. But partners at major law and accounting firms will think twice about pushing too hard for tax-shelter millions.

By Howard Gleckman and Amy Borrus, with Mike McNamee, in Washington

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