The scandal over Enron’s bankruptcy filing is causing a sea change in corporate and government attitudes about highly structured “tax shelter” schemes. The increased attention is one more reason corporate investment officers are taking a harder look at tax credits authorized by Congress for certain types of real estate and business investments.
Corporate investors may have thought they had a green light to pursue aggressive tax shelters when President Bush took office, shelving Clinton administration efforts to increase Internal Revenue Service (IRS) scrutiny of tax-avoidance schemes. In the midst of the Enron scandal, investors can no longer rely on the IRS to go easy on enforcement. In short, aggressive schemes are now fair game for the IRS, Congress and the press.
“It was a shock to read that Enron may have used nearly 900 tax-haven subsidiaries to avoid taxes and hide its financial debts,” said Sen. Chuck Grassley (R-Iowa), ranking member of the Senate Committee on Finance. It turns out that Enron didn’t pay any income tax in four of the last five years, according to a report by the Citizens for Tax Justice.
“This is one more example of why Congress should act on tax shelter legislation,” he added. Grassley wants to “fully assess the role that offshore tax havens may play in facilitating tax shelters. I’m a tax cutter,” Grassley continued. “But if there’s one thing I can’t stand, it’s a tax cheat.”
The Enron scandal will continue to draw angry attention to abusive tax shelters – even though Enron’s hundreds of subsidiaries may have been intended mainly to hide the company’s debt from investors rather than to hide tax liabilities from the IRS.
The executive branch is already giving tax shelters a harder look. Many experts feel that in its first year, the Bush administration was not eager to prosecute corporations for tax shelter violations and would rather work with the companies to encourage them to disclose their questionable transactions and pay their back taxes.
But recently, there have been more cases and notices coming out of the IRS, said Timothy McCormally, executive director of the Tax Executives Institute, Inc. “The audit side has certainly picked up,” agreed Peter Norton, a tax attorney with Baker & McKenzie. The Internal Revenue Service’s Tax Shelter Committee sent out 28 initial “soft letters” to tax shelter promoters in 2001, in addition to approving an investigation of a dozen promoters. Most of this activity came near the end of the year.
Regarding enforcing tax shelter laws, “there’s certainly the will on the IRS side, and there’s getting to be the will on the Treasury side,” said Lee Sheppard, a lawyer and a contributing editor for Tax Notes magazine.
In addition, the Treasury is dissatisfied with the number of disclosures, according to statements by its own officials. Ninety-five corporate taxpayers disclosed more than $4.4 billion in transactions listed as highly questionable from January through November 2001, significantly more than disclosed in 2000. To encourage even more taxpayers to come forward, the IRS is offering to waive penalties for those that disclose.
This is not a free pass, IRS officials said. Taxpayers that disclose tax shelter transactions still have to pay the back taxes they owe, plus interest.
Disclosures benefit the IRS by resolving tax shelter cases and bringing in tax dollars without dragging the taxpayers to court. The IRS has traditionally been at a disadvantage prosecuting tax cases because corporations will spend whatever it takes to defend themselves, while the IRS has a less flexible budget.
Meanwhile, the legislative outlook for tax shelters keeps changing. A comprehensive bill that explicitly outlawed almost every conceivable type of tax shelter died in Congress soon after its champion, President Clinton, left office. Tax shelter promoters helped kill the bill. They argued that since, at the time, so many corporate taxpayers were being found guilty in their trials, the IRS didn’t need more legal ammunition to prosecute wrong-doers.
Now, many such cases are being reversed on appeal. This sounds like good news for tax shelter promoters. However, these same reversals in court have revived Congressional interest in tax shelter legislation. For example, in the wake of an appeal by Compaq, the Treasury is considering asking Congress for an “ownership test” for financial assets, one of the pivotal issues in the case.
And once Congress gets involved, there’s no telling where it will stop. Even GOP members love to win votes by attacking “corporate welfare.” One thing is for sure, talk in Congress of liberalizing the alternative minimum tax for corporations is probably not going to lead to any action in 2002.
The moral of this complicated story is very simple. “Aggressive tax planning is risky,” said Ronald Pearlman, professor at Georgetown University’s Law Center. The mood of the regulatory agencies, Congress and the federal courts have all flipped and in some cases flipped back in the past two years. However, the corporations involved in abusive tax shelters can be investigated as long as 10 years after the fact. “You can’t just do the transaction and move on,” Pearlman said.
“Certainly, anyone who does these sorts of transactions nowadays is going to pay attention to detail,” Norton said. “With the idea that it’s eventually going to go to trial.”
The new scrutiny of high-flyer investments comes at the same time that Congress and the White House are offering investors new and lucrative programs for “doing well while doing good,” that is, tax credits for investing in facilities that serve a public purpose.
The low-income housing tax credit (Sec. 42 of the Internal Revenue Code) has been on the books since 1986, and the credit for historic preservation even longer. In 2000, Congress showed its strong support for the housing program by increasing tax credit authority 20% in 2001 and 20% this year.
New in 2002 is the New Markets Tax Credit for investing in commercial real estate and business ventures in low-income neighborhoods. In 2003 or 2004, look for President Bush to win enactment of the ultimate in government-sanctioned, feel-good tax reduction techniques: A tax credit to encourage construction of low-cost homes for sale to first-time buyers.
Scrutiny of abusive tax shelters should increase demand for housing tax credits, said Frederick Copeman, national director of affordable housing services for Ernst & Young, LLP.
For large financial services firms, well-established housing and historic tax credits are the only logical choice.
“When we look at the spectrum of tax strategies available to our company, it certainly adds comfort to be travelling on a well-worn path. And it is far more interesting to consider credits, which absolutely reduce taxes (and increase net revenues) than any mere deferral of taxes,” said David W. Kunhardt, vice president of Community Investments at AEGON USA Realty Advisors, Inc.
“The low-income housing tax credit and the historic tax credit were deliberately designed by Congress as incentives for private investment, which have survived the test of time – and which enjoy strong Congressional and public support,” he added. “It is less risky to work with these programs than others, particularly any marginal tax strategies that may be legitimate today, but will be re-characterized as ‘loopholes that need to be plugged’ tomorrow.”
Telling a corporation to replace abusive tax shelters with tax credit investments is a little like telling a heroin addict to give up the drugs for jogging. Like jogging, the benefits of tax credit investments come over five to 10 years and require substantial due diligence.
Tax credits are not a quick fix. Internal rates of return for housing tax credit investments tend to be around 7.5% to 7.75% (though yields are rising) with little or no residual, according to Kevin Costello, executive vice president in charge of corporate investments for Boston Capital. But the risks are low, and rates of return for individual investments are very predictable, Costello said, thanks to the nation’s strong demand for affordable housing.
The schemes of tax shelter promoters, in contrast, serve up an immediate return in tax benefits for very little immediate effort but with a strong risk of eventually being taken to court. In addition, because most abusive tax shelters arise from peculiarities in the taxpayer’s own company, there is no new business to learn. It’s difficult to call these transactions investments, since money that goes into abusive tax shelters tends only to stay long enough to come out looking like something other than taxable profits.