How tax shelters work

how tax shelters work

NEW YORK (CNN/Money) - The heyday for tax shelters may be coming to an end as the government widens its investigation into tax shelter fraud that costs taxpayers billions of dollars.

Eight former executives of accounting firm KPMG, as well as an outside conspirator, pleaded not guilty to charges of conspiracy to commit tax fraud last week, but the case appears far from over as a U.S. prosecutor said he expects charges to be brought against 12 more additional defendants.

KPMG, one of the final Big Four accounting firms, also admitted to wrongdoing in the fraud case, which generated at least $11 billion in phony tax losses and cost the U.S. $2.5 billion in evaded taxes, according to the Department of Justice.

A tax shelter is a type of investment that allows someone to reduce their tax liability. Examples include investments in pension plans and real estate. You can also reduce your taxable income if you have losses on investments.

But when shelters are designed solely for the purpose of avoiding taxes, they become abusive. The tax shelters marketed to wealthy clients in the KPMG case used various means to do this, according to Lee Sheppard, a contributing editor at Tax Analysts, a nonprofit organization that publishes tax resources.

How do abusive tax shelters work?

The following offers a simplified explanation of one method accounting firms used to help their clients falsify tax losses.

  • Let's say a newly-minted millionaire, Joe, has incurred a large capital gain of $20 million on the sale of his business. He wants to create an "artificial" loss to shelter it from taxes. To do so, his accounting firm advises him to enter into offsetting options. In our example, Joe will buy and sell options in identical amounts at identical prices on the euro/U.S. dollar foreign exchange rate.
  • When Joe buys a call option, he purchases the right to buy a certain number of euros at a certain price (called the strike price), on or before a certain date -- for a premium of $20 million. He simultaneously sells (or "writes") an option with the same strike price and expiration date, for which he receives a premium of $20 million.

    The premiums offset each other. But as the writer of a call, Joe is obligated to deliver euros at the contract price.

  • Joe then transfers his options to a partnership with a friendly "accommodation partner," someone paid hefty fees to enter into a partnership that serves no real business purpose.
  • The accounting firm argues that Joe's cost basis in his partnership is equal to the $20 million paid to buy call option. But, remember, the partnership also holds the call that Joe sold. The value of Joe's partnership interest is really zero because the partnership is obligated to deliver euros under the written call option. However, the accounting firm argues that Joe doesn't have to account for that obligation. Therefore, when he sells his partnership interest for zero, he claims a tax loss of $20 million, even though he has incurred no real economic loss.
  • In summary, Joe creates an overstated tax cost for a partnership interest by transferring offsetting options to the partnership, but he really didn't lose any money. His net economic cost, minus fees paid to promoters of the shelter and dealers, was nominal.
  • What's illegal?

    Entering into offsetting option positions isn't illegal, it just doesn't make very much economic sense, experts said. But when transactions like these are conducted solely for the purpose of evading taxes, that's where fraud become an issue. Furthermore, in some cases the transactions weren't even carried out, but were created on paper only.

    The IRS calls what Joe did an "inflated partnership basis transaction," and it is among the 30 transactions the government body has identified as abusive. Now, according to regulations, any tax shelter that engages in these "listed" transactions must register with the IRS.

    The individuals in the KPMG case, in addition to designing the shelters, have been charged for not registering the tax shelters with the IRS; supplying opinion letters that said the shelter were "more likely than not" to withstand an IRS challenge; falsifying documents; and filing and causing to be filed fraudulent tax returns.

    KPMG is shaking up its management. Click here for more.

    Click here to read more about the indictment of the former KPMG executives.


    Category: Taxes

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