The majority of tax shelters are in full compliance with the tax laws, but an increasing number of these shelters have crossed the boundaries whereas they are being viewed as illegal, abusive tax shelters. So what’s the difference between a true business loss and a tax shelter loss? The substance of the event that gives rise to the loss is the key element which distinguishes a tax shelter loss from a true business loss.
Three elements are usually found in tax shelters, either separately or in combination.
• Leverage is obtained through various financing arrangements.
• Taxes are deferred to later years.
• Ordinary gains (100% taxable) are converted to capital gains (40% taxable), or capital losses (50% deductible), are converted to ordinary losses (100% deductible), which in both cases, result in a lower tax liability.
Front End Loading. This is a term used by the IRS for excessive deductions that are taken in the early years of a tax shelter. Some illegal front end practices are:
• Deducting Prepaid Interest.
• Not including prepaid income.
• Deducting capital items by classifying them as advisory fees, management fees, or interest.
• Deducting excessive depreciation, amortization, or depletion by using the wrong method, too short of a useful life; and/or too large a basis.
In the 1999 Erwin N. Griswold Lecture before the American College of Tax Counsel, former ABA Tax Section president James Holden stated:
“Many of us have been concerned with the recent proliferation of tax shelter
products marketed to corporations…the marketing of these products tears at
the fabric of the tax law. Many individual tax lawyers with whom I have
spoken express a deep sense of personal regret that this level of Code
gamesmanship goes on.”1
Son of BOSS1, BLIPS, and COBRA are code names for some major players in the illegal, abusive tax shelter arena. Let me shed a bit of light on each of these tax shelters for you.
BLIPS Tax Shelter
BLIPS2 is an alleged criminal tax shelter promoted by KPMG, LLP. In August 2014, the Internal Revenue Service levied penalties against the BLIPS funds and a jury convicted the principals of the funds’ general partner, Presidio Growth LLC, for criminal tax evasion related to the BLIPS scheme in 2008. Those principals included former KPMG executives John Larson and Robert Pfaff. A third principal, investment adviser David Amir Makov, pled guilty on related charges. This is the most recent incident involving a major abusive tax shelter that has taken place.
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1 James P. Holden, 1999 Erwin N. Griswold Lecture before the American College of Tax
Counsel: Dealing with the Aggressive Corporate Tax Shelter Problem, 52 Tax Lawyer 369 (Winter 1999)
2 BLIPS (Bond-linked issue premium).
Son of (BOSS) Tax Shelter
The Son of BOSS tax shelter involves the same concepts employed by other tax shelters to reduce or eliminate capital gains; the creation of an artificial tax loss to offset a capital gain. The magnitude of tax dollars lost to the U.S. Treasury, as well as the logic of its creators is what sets this shelter apart from others. A big part of the problem is that the dysfunctional logic of our current tax code2 provides the opportunity for abusive tax shelters to come into existence.
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1 Initially there was a BOSS (Bond Options Sales Strategy) tax shelter, which was struck down by the IRS. Changing the original shelter slightly, clever promoters created the Son of Boss.
2 The “tax code” is shorthand for the U.S. Internal Revenue Code (IRC). The tax law is comprised of the tax codes and regulations, as well as judicial case law.
COBRA Tax Shelter
COBRA1 is an offsetting-option tax shelter designed to generate large paper losses that could be used to reduce taxable income. This tax shelter was developed by the now, defunct law firm Jenkens & Gilchrist and marketed by the accounting firm Ernst & Young and used currency option spreads courtesy of Deutsche Bank.
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1 COBRA (Current Options Bring Reward Alternatives)