What is a tax shelter?

A tax shelter could be accurately described as an investment that a smart person would find dumb, absent tax considerations. This definition highlights an important characteristic common to most corporate tax shelters: the lack of significant economic risk of loss or potential for gain to the taxpayer(s) seeking the tax benefit. Through hedges, circular cash flows, defeasances, and similar devices, the participant in a shelter is insulated from significant or all economic risk. Transactions with little or no economic risk typically generate little or no pre- tax profit. In light of the expectation of little or no pre-tax profit, no one rationally would participate in such transactions without significant tax benefits. After factoring in expected tax benefits, however, a negligible pre-tax profit is transformed into a significant after-tax return.

Corporate tax shelters can arise even in transactions that produce more than a negligible amount of pre-tax economic profit. For example, a corporation may attempt to disguise the tax avoidance nature of the transaction by placing high-grade, income-producing financial instruments in a corporate tax shelter. In recent corporate tax shelters involving public companies, the financial accounting treatment of a shelter item has been inconsistent with its federal income tax treatment.” ¹⁶

What Rules Apply to Tax Shelters?

The Internal Revenue Service maintains a comprehensive list of rules that apply to the regulation of tax shelters for both corporations and individuals.¹⁷ In confronting the problem of abusive tax shelters, the IRS has articulated the following strategy:

The Internal Revenue Service is taking steps to combat abusive tax shelters and transactions. A comprehensive strategy is in place to:
- Identify and deter promoters of abusive tax transactions through audits, summons enforcement and targeted litigation.
- Keep the public advised by publishing guidance on transactions and shelters that are determined to be abusive.
- Promote disclosure by those who market and participate in abusive transactions.
- Develop and implement alternative methods for resolving abusive transactions claimed by taxpayers.” ¹⁸

Whether or not the present approach towards dealing with the problem of abusive tax shelters will prove effective in the long run remains to be seen. The settlement initiative offered to those taxpayers invested in the ‘Son of Boss’ shelter represents the latest IRS attempt at curbing these abuses.

The Son of Boss Tax Shelter

One recent IRS initiative regarding abusive tax shelters has been the settlement offer made to participants in the Son of Boss shelter that was marketed during the late 1990s and into the year 2000, estimated to cost taxpayers more than 6 billion.

Son of Boss [wa]s a sophisticated, multi-layered scheme designed to create artificial tax losses to offset profit from the sale of a business or other large, one-time gain. Participants each evaded between $10 million and $50 million in taxes.¹⁹

The settlement offer was made in Announcement 2004-46 The IRS announced that “for efficient tax administrative reasons,” it will offer Son of Boss investors an opportunity to quickly close out their tax disputes. Under the terms, eligible taxpayers must have conceded 100 percent of the claimed artificial tax losses and in some cases accept the imposition of a penalty. Participating taxpayers were to be allowed to treat as a loss their out-of-pocket transaction costs, typically promoter and professional fees.

The settlement initiative established a three-tiered penalty structure: No penalty if they voluntarily disclosed the Son of Boss transaction under Announcement 2002-2. If there was no voluntary disclosure, a mandatory penalty of: 10 percent for those whose Son of Boss investment reflects the first and only abusive tax shelter investment; and 20 percent for those who have participated in other abusive transactions listed by the IRS.

Promoters and others who received fees in connection with the Son of Boss transaction and also invested in Son of Boss deals would not be eligible. Also ineligible were taxpayers in cases in which the Service has informed the taxpayer (or the Tax Matters Partner of a TEFRA partnership) that the Service has designated, or is considering designating, the Son of Boss transaction for litigation in accordance with Chief Counsel procedures for designating cases for litigation.”²⁰

As of July 1, 2004 the IRS had uncovered at least 500 previously undisclosed Son of Boss transactions ²¹. As of March 16, 2005, IRS interim reports showed 1,039 participating investors had settled their cases by paying or agreeing to pay more than $2.7 billion in taxes, interests and penalties.

No Tags