homesheltersuncovering schemesprospects for reform
interview: charles rossotti

Mr. Rossotti, you spent your life as a businessman. Tell me about business. What business were you in? What business did you build up?

I started in helping to grow a company called American Management Systems, which was a company that worked on putting computer systems in for big companies and government agencies and do things like telephone billing or financial management -- basic computer systems.

Most of the IRS commissioners are tax lawyers, people who come out of the tax business. Was it unusual for you to be the chief of the IRS?

I think this thing is going to rebound, especially as the economy improves. It may change its form somewhat. People will have to maybe work a little harder to come up with these shelters, but it will come back.

It was unusual. I was the first businessman at least since World War II. All of the other former commissioners were tax experts, and they're lawyers or accountants.

So when you came into the IRS, what did you find?

I came in when it was under quite a bit of attack for doing a lot of things that people didn't like. There were a lot of complaints from taxpayers with problems with computer modernization program. So it was a situation that, I guess, in business you'd call a turnaround, in some respects.

Of course, the agency still continued to collect $2 trillion a year, so it was doing a major part of its job. But the basic idea was to try to reform it to make it run more like a modern business -- to deal with people a little bit better, and to just generally be more efficient and better managed all the way around.

You barely got into the IRS [when] there were hearings on Capitol Hill. What [was] the impact of the Capitol Hill hearings on the IRS?

I think there were some very dramatic hearings just before I took office and then continuing afterwards. That actually was just the sort of the last step in about two years of studies and criticisms and press stories and horror stories complaining about various things at the IRS. So it was in a situation where people were a little bit hunkered down. They were like people that were in a foxhole with a lot of incoming artillery shells coming in.

Did it inhibit the IRS to have that kind of public pressure, particularly from Congress?

photo of rossotti

A Republican businessman, Rossotti was tapped by President Clinton to become the IRS commissioner in 1997 and served in this position for five years. He is also the author of the forthcoming book, Managing in the Bull's-Eye: Turning Around the IRS, the Organization with the Most Customers and the Lowest Approval Rating in America. In this interview, Rossotti describes his shock at the degree to which the problem of bogus tax shelters had infected the tax system. He tells FRONTLINE that in his estimation, the U.S. government loses between $250 billion and $300 billion each year due to nonpayment of taxes, and that he believes tax shelters are the biggest single piece of the problem. Rossotti says the IRS was hopelessly understaffed and underfunded in trying to keep up with tax fraud. It was, he says, like "taking a knife into a gun fight." He believes that the tax shelter problem will rebound as the economy improves and says that the only way to solve the problem is for Congress to pass an economic substance law that outlaws any transaction whose sole purpose is a tax benefit.

It definitely created a morale impact, definitely created confusion over what was going on. People thought that they had been doing things that were expected of them for many years, particularly with respect to collections of taxes, where there had been pressure from the administration, previous administrations as well as through Congress to make sure the collections stayed up and to collect overdue debts and that sort of thing, which is part of what the IRS is supposed to do. So they felt, "Gee, we're doing what we're supposed to do. Now we're under attack." They begin to question everything about what they were doing.

Is the IRS walking on eggs?

People were unsure of themselves for a while. Then that was part of my job or anyone's job that would have taken over as a leader -- to try to, on the one hand, respond to the legitimate concerns and problems -- which there certainly were about some of the things about the way the agency worked -- while still not letting it interfere with the ongoing work.

Actually, one of the remarkable things is that there were some drop-offs in some of the enforcement statistics for a few years, the basic work of the agency, [and] people carried on. I mean, they kept processing returns, they kept doing audits. They kept doing the things that they were supposed to do.

But it was a traumatic period, as [it] would be [for] any organization that was going through that much change. …

You mentioned a drop-off in enforcement. [Was this], in part, in response to all this public pressure?

It was really longer term than that. There was a continuing drop just because of resources -- the agency having cut 15,000 people over a period of time. At the same time, there were more tax laws and more tax returns. So before any of the hearings or any of those problems, you had continuing drop-offs, just due to resources and workload.

Then on top of that, when Congress passed the reform law, it imposed a considerable number of new procedures and taxpayer rights, which were good things to do, but they took more resources. They also took some time to learn how to do. Then on top of that, you just had the general disorientation from all the change.

So there was a period where some of the more commonly used measurements of enforcements, like how many properties were seized and how many assessments were made, did go down for a couple of years, although by taking certain steps to reduce the impact of that the total tax revenue impact was rather small. But nevertheless, it did have that effect for a couple of years.

You're a man who came out of the computer world. … What was your assessment of the IRS computer system when you came in?

One of the reasons that I was actually asked to take the job was because I did have a background in technology. There had been some major problems in the late 1980s, early 1990s, with trying to update the IRS's computers. Some of those projects were not very successful. Quite a bit of money was spent, and the benefits were not fully realized. That was one of the things that gave rise to some of the criticisms, and one of the reasons probably that I was recruited.

As I got into [it], it really was a serious -- and remains actually -- a serious problem. The IRS is totally dependent on computers. Virtually every employee in the IRS has to access data from computers every day. We deal with more people than anybody else in America, and we have the oldest systems. I'm not there anymore, but the IRS has some of the oldest computer systems. …

Today we're talking about tax shelters. Tax shelters have been around forever, or for a very long time, almost as long as taxes have been around. But for you coming into the IRS, as a businessman and the new commissioner, tell me, what was your first exposure? What was your discovery trail like on these tax shelters, and what was your reaction?

Well, of course, having been in business, I had people come in and try to sell me various things. I think anybody that's been in business has had somebody come in [and] say, "Here's a way that you can do this or that [to] manipulate the tax code and reduce your taxes." We just thought we were in business to run a business and not to engage in those sorts of things, so we never really took advantage of those. I always believed, in business, if it's too good to be true, it probably is too good to be true. …

But as I started to go in, one of the things I did at the IRS -- I traveled around a lot. I made it a point of traveling three or four times a month, if I could, out to some kind of a location. Of course, the very first couple of months I was there, I was traveling out to some of the big locations, like New York. So I was getting briefed on what these agents and what the people were doing.

So then they started to lay out for me some of the cases that they were working out that had really hyper-intricate schemes that people -- meaning promoters -- had developed to enable mostly large corporations -- at least at that time, it seemed like it was mostly corporations that were doing these things -- they were basically designed to, step by step, supposedly conform to each section of the tax code.

But in the end, what you had done is moved a lot of paper around. You had created something that usually was something like a tax loss to offset another gain somewhere else. Not a whole lot other than that had really changed when you cut through it all. …

When you see these, what's your reaction?

My reaction is, more people are buying into this stuff than I thought. Of course, the magnitude of it was very, very substantial.

On the other hand, it was basically just some people in New York. It was one promoter, one set of cases. We really didn't have any way of knowing how widespread that was, whether it was an isolated example. It was the way the IRS was organized then. Each district pretty much did its own thing. New York, being the financial capital, was sort of taking the lead on a lot of these things. So I thought, these are people in the agency that are doing some good work. But there were many other things going on at that point. It was just a learning point. …

At what point do you start to see this -- not just at the New York office, there are a few cases -- this is a bigger problem?

That was something that I'd say over the first year or so, or year and a half. I gradually picked up more data points, more information. For one thing, I was going to some other offices. So when I went down to an office in North Carolina -- where you wouldn't normally have thought about it -- and I found there are some other agents down there that were working on a completely different kind of a tax scheme. "Tax scheme" is my word. I thought they were tax schemes -- where somebody was supposedly leasing something like a railroad station in Germany from a tax-exempt entity, and then leasing it back to them and using that to accelerate some tax losses or tax deductions that they were then offsetting other taxes. I thought, "What's this going on here?"

It seemed like in respect to that one particular type of activity, that that was pretty widespread, too. But then as time [went] on, I was talking to a lot of people. The Treasury Department has a good network of people that they're talking to.

What was interesting is there were a lot of very good tax professionals, tax lawyers, tax accountants, who were pretty well wired into what's going on in the world. They're coming in and telling us about these things in addition to what we were finding internally because, frankly, most of them are very legitimate. They don't want to get involved in structuring those kind of transactions for their clients. But they get pressure from the competitive market, because somebody else goes into one of their clients and maybe is a tax director for a large corporation and says, "Look, why are you paying so much tax? I can figure out a way to get you a deal that will make it better, that will lower your effective tax rate."

The more conservative adviser, who is more squeamish and doesn't want to structure that, loses out, loses market business. So many of them were coming in and talking to us and talking to the people at the Treasury Department and talking to our lawyers and telling us of these things. That was another source.

What were they saying?

They were telling us about these kinds of transactions. They were coming in from the outside, just the same thing as our agents coming in from the inside, telling us that, "Look, there's a lot of activity out there of people marketing these kinds of devices to large corporations."

"These kinds of devices" were tax shelters? Phony deals?

Tax shelters, where they were taking advantage of allegedly legitimate transactions. Like, a lease is a legitimate transaction. A financing with an overseas bank is a legitimate transaction. So they would take those legitimate transactions [and] match them up with a whole sequence of other transactions to offset the first ones. But in the end, they would come back to the point where really nothing substantial had happened, in our opinion.

What's wrong with the shelters? Is this manipulation? Is this twisting the tax code against itself?

I think it is exactly twisting the tax code against itself. It's trying to be very clear about taking provisions that may have been designed for one thing and applying them to something else, or maybe taking a provision here and matching it up with a provision there -- putting them together so they effectively offset each other. You end up with essentially a paper loss that you can use to offset real income that you have somewhere else.

Some of the characteristics of these things that try to make them work -- oftentimes there would be some other party involved in these transactions that was not a U.S. taxpayer, for example, like a foreign municipality in Europe that would have no taxable reporting requirements in the U.S. If you could figure out a way to manipulate a transactions so that they ended up, according to all the paperwork, having a gain and [the] corresponding U.S. taxpayer having a loss, but money flowing back and forth so that essentially it netted out, what do you end up with? You end up with a loss reported by a U.S. taxpayer, [and] a gain reported by a non-U.S. taxpayer or some other entity that doesn't care whether they have a gain. The net is that the U.S. government loses its revenue. That's a typical kind of transaction they would do.

You mentioned this business about the train stations. There was something in Germany. Why would a major American bank want to lease 25-year-old streetcars or subway cars in Dortmund, Germany?

My view is that they said no American corporation would want to lease a municipal railroad station in Germany unless there was reason to do it to gain tax benefits. That's the essence of the argument. Are you doing something just to manipulate transactions to get a tax benefit, or is there some other business reason? …

Should the ordinary taxpayer be concerned about this?

I went into the IRS because I thought my whole reason I was going in was to try to make things better for the ordinary taxpayer. That was what I thought I was doing, and a lot of that was because people were complaining that they were getting bad services and not being treated right. So I wanted to try to fix that.

But the other way that the average taxpayer -- or at least the honest taxpayer -- really loses out in the tax system is not only because maybe they have a hard time getting through on the phone to the IRS, but because they're paying more tax to make up for the people who are not paying the tax.

I mean, if everybody paid their tax according to what was due, the government would have more revenue, and they could either reduce taxes or spend the money somewhere else to reduce the debt, but lower the general economic burden on everybody.

[Are you] saying these illicit tax shelters are shifting tax burdens from corporations, rich individuals, who should be paying more tax, onto the backs of the ordinary taxpayer?

Well, sure. If you've got any amount of money -- a billion dollars, $10 billion of tax, you name it -- that should be paid by a certain group of taxpayers, that they avoid paying through a means which is not really acceptable under the tax code, that $10 billion has to come somewhere. I mean, where does it come from? It comes from the rest of the people who are actually paying.

The honest taxpayer?

The honest taxpayer. And the honest taxpayer doesn't have to be just low-income taxpayers. There's plenty of honest high-income taxpayers. There's plenty of honest corporations. Whoever it is that's an honest taxpayer that's paying 100 percent of the bill -- if somebody else is only paying 50 percent, who is making up the difference? It's the honest taxpayer that is actually doing a diligent job of calculating and paying what they owe.

Of course, everybody has the right to try to figure out what legitimate deductions they have, and how to minimize taxes according to the rules. That's fine. But there's some line there somewhere. If you go over that and people reduce their taxes beyond that line, they're just basically being a free rider. That's the way I look at it -- they're a free rider, that everybody else is paying taxes is paying for it.

[Can you give me an example of a free ride corporations were getting?]

… This one agent [delved] into this one particular kind of leasing transaction, so that one corporate taxpayer that has done a hundred of these deals over three years that saved a billion dollars in taxes. That was one taxpayer.

As we got into this later on, we began to quantify this a lot more. We were never able to get a really precise number. But, clearly, overall it was easily into the tens of millions of dollars a year that the government was losing, that honest taxpayers were losing -- not just from leasing, but from the corporate-type shelters.

How big a problem is the non-payment of taxes?

If you look at the whole problem, the whole problem is anything that's not being paid that should be paid. That's basically what the honest taxpayer is making up. That's somewhere in the range of $250 billion to $300 billion a year, which basically means everybody is paying 15 percent more, if you want to look at it that way.

So a 15 percent surtax on average taxpayers, because somebody is not paying their share?

If you could collect 100 percent, yes -- which you'll never collect. But if you just looked at how much is not being collected just in round numbers, that's a fairly decent number, yes.

Fifteen percent is a big chunk.

Yes. You could double everybody's refund if you could collect 100 percent of it. You could give everybody twice as big a refund of the average debt if you just collected all the taxes that are due.

How big a part of this is the tax shelter problem?

It's probably the single biggest piece. But it's not anywhere near the majority, because there's a lot of ways that people don't pay tax that should be done. Some of them are not deliberate. Some of them are errors. People make errors. The IRS tries to collect them. There's a whole spectrum of things, where people [are] just flatly hiding the income, people not filing returns at all, to corporate shelters and so forth. So that $250 billion to $300 billion -- that's everything.

I would say that the corporate shelter-type activity -- which, by the way, is not limited to corporations, because very high-income individuals also use these same devices -- typically they have interests in several businesses and corporations. But that is certainly, I would say, the biggest single source of the gap.

People have said $50 billion a year.

I don't have enough to tell you that that's exactly right, but I've said tens of billions a year. Whether it's $50 billion, I don't know. But it's well into the tens of billions per year from this type of device, I believe.

And we've had this going on for how many years?

There were always tax shelters as long as there's been taxes. I think you pointed that out. But it seems like what happened is that, beginning sometime in the early 1990s, the economy started to boom. Corporate profits went up. People, as individuals, started to get big paydays from things like selling companies, stock market, stock options. All of this created a tremendous amount of income, a tremendous amount of tax, a tremendous amount of opportunity for people who wanted to try to sell devices to reduce that tax, to have a ready market.

So somewhere in the 1990s, beginning in the early 1990s to the late 1990s, it really mushroomed. There is no accurate data that tracks by year how much it was. There just isn't. We really started to get a handle on it better than we had before by the time I left office, after having worked on it seriously for probably about three years. …

The 1990s show a tremendous boom in corporate revenues, corporate profits. What do you see at the IRS and the Treasury?

We have some very good economists in the Treasury Department who track tax revenues. I was seeing that the tax revenues, especially for corporations, were not going up as fast as they thought they would, because what corporations were reporting to Wall Street and their shareholders was going up a lot faster than what they reported to the IRS.

Now, there should be some differences -- it's differences in the tax code. But that gap seemed to be widening, so that, together with the anecdotal information, while it wasn't absolutely precise or definitive, it clearly showed this was not an isolated promise. It was not a small issue. … We couldn't see any reason for [the gap] to be that wide, other than people were sheltering income.

So what does that say to you?

It says that what we learned from our agents, what we learned from the tax experts, what we learned from the IRS inspectors -- it turns out it was true. There were a heck of a lot of promoters marketing a heck of a lot of devices to a heck of a lot of corporations to shelter income, so they wouldn't pay corporate taxes.

So the corporate tax rate is coming down through these gimmicks?

The effective rate, yes, and that was exactly the way they were to be sold. They go to the CFO or the corporate tax director and say, "Why are you paying a higher effective tax rate than your competitor?" And that puts pressure on the honest tax director or the honest CFO to pay attention.

I used to hear this from tax directors. They said, "We're getting hammered by people coming in and telling our CFO that he's paying too much tax because the guy next door is paying less" -- meaning the actual percentage of tax paid as a percentage of profit, which is the effective tax rate, was lower somewhere else than in this company. That put pressure on, and that was the dynamic. …

Who is driving this process? Are these corporate tax directors who are saying, "Boy, I've got to do something to impress my CFO, my CEO? I'm fixing the bottom line by finding tax losses," or is it accounting firms and law firms and investment banks who are saying, "Hey, we've got this product?" What's the dynamic here?

The dynamic was that these things were being sold ... by promoters. And there were a whole range of promoters. They're lawyers, accountants, Wall Street firms. [There] were many of them, all involved in it -- big ones and little ones, regional ones and national ones. They were structuring deals, structuring proposals, going systematically to large taxpayers and offering ideas, as they would call them, in how they can reduce taxes. That's what they were doing.

Now again, there's a legitimate aspect of that. That's always been the case. I mean, there's nothing new about this. Tax advisers have always been going to taxpayers and saying, "We can be smart. We can help you how to structure your business through these taxes." So there's nothing inherently wrong with somebody going out and marketing their services, to try to tell somebody they can come in and look at their business and try to figure out how to reduce taxes.

[What was] the new wrinkle?

The new wrinkle was that they were packaging very complex products. They were literally marketing, as products, prepackaged documentation that showed how you could basically dial for dollars.

I mean, take some gain that you realized on a sale of a business or just ordinary taxes and structure one of these leasing transactions or one of these financing transactions or one of these foreign partnership-type transactions. There's a whole range of one of these special security issues. They go on and on and on, and say, "Look, it's all packaged. Here it is. We've got somebody that will offer you a legal opinion, maybe, that will say something that's seems to bless it." There's a lot of issues about what language people actually used.

But to give legal opinions on this, they would, in effect, promise to have somebody give a sort of a legal blessing to one of these things, which was an attempt to protect the corporate taxpayer against potential penalties. So they would package the whole thing. …

[Are you] talking about wholesale marketing of tax shelters [as opposed to] individual tax advice about you and your situation?

This is the key thing. There was still individual tax advice. But I think the thing that really proliferated it was, people would sit down and devise a product -- literally, they call it a "product" -- and then market it to anybody that might be in the position to use that product. That was basically the idea and that was what was proliferating in the 1990s.

There was tax shelters way back in the 1970s and 1980s, but they were generally a very different kind. They were generally marketed to individuals with the idea that you would buy something like an oil well or a cattle ranch or something, and supposedly take a depreciation deduction on it. That was the old style, and Congress wiped that out in the 1980s.

This was different. This is a much [more] upper bracket, because there is an expense to this. I mean, to pay all those advisers to come up with those shelters, to devise them to do all the complex paperwork -- these are pretty complex. In order to make them appear to be legitimate, you had to oftentimes, most of the time, recruit some counterpart, some other party that you'd get a transaction with, like the offshore bank in the other countries or the municipality in the European country. Whoever it was that you were doing the transaction with, you had to go through all the paperwork to do that. Not simple; money being wired back and forth.

Then there were lawyers and accountants all over the place. Then there were the promoters. All those people took a fee. It was expensive. So it wasn't the kind of thing that you could market to the average middle-income or even upper-income taxpayer. It had to be a very large taxpayer, or a very large corporation, and a lot of tax or a very high-income individual who maybe sold a business or got a huge gain on some stock options or something like that. Those are the only people that really were paying enough tax to make it worthwhile to pay all these fees.

So what's going on here? You're talking about law firms, you're talking about accounting firms, biggest accounting firms in the country. Investment banks. Nationwide household names. What's going on that people like that? We're counting on people like that; I am. Every ordinary citizen is looking to their accountant, looking to their lawyer to, yes, help them, but keep them within the law.

I think that was essentially was a key item here -- that people, who for many, many years and in many cases still even during the 1990s offered very high quality, professional, ethically driven professional services -- tax advice, accounting advice, in some cases. I don't think it's everybody. But in some cases, [they] went over the line to marketing prepackaged products, purely for the purpose of gaining fees and reducing taxes for the people they were selling to. I mean, it was just a business, and it was pretty lucrative for people in the business.

Now I want to be clear. Not every accounting firm, not every law firm -- in fact, a lot of the information we got, as I mentioned to you, came from tax practitioners, from tax lawyers, from tax accountants who knew about this, and said they didn't agree with it. They thought it was wrong. Then they would come to us and say, "Do something about this, because we're getting crowded out of the market by these competitors that are we believe going way too aggressively into marketing these pre-packaged products, and we don't want to do that."

You're right [that] everybody wasn't doing it. But you've got PricewaterhouseCoopers, Ernst & Young [paying] fines already for having marketed tax shelters. You've got the IRS going after KPMG, has gone after BDO Seidman and Arthur Andersen. And we've named five out of the top six accounting firms.

I can only talk about the ones that were publicly announced while I was in business. But there were settlements that the IRS did make with several of the big accounting firms and some Wall Street firms, where they came in and settled with us on disclosure for some of the things that we asked them for concerning tax shelters.

So that suggests the problem was pretty widespread?

I believe that it was widespread. My own personal belief is that a significant proportion of the high-level tax profession was engaging in some of these products. Some were more aggressive than others. But a significant amount of activity was going on by highly respected firms, no question.

Where is the IRS now? … Is the IRS playing catch-up ball here all the time? We're talking about being outgunned in terms of the computers. But it's also you've got very bright and very able people getting paid lots of money, and probably lots of them had a bunch of different companies, accounting firms, law firms, big banks, corporations. This seems like a very uneven fight.

… Yes, I think that the problem was that, as I looked at it, we were playing man-to-man defense, one-on-one. In a lot of cases, I think the bar association used -- I could use the example. It said the IRS was like taking a knife into a gunfight. We had a couple of agents here fighting against major well-staffed, well-organized corporations and tax advisers, and we were kind of doing it one case at a time, one agent at a time. So we were not in an even fight and in an even strategy there, a winning strategy.

Tell me what's it like inside the IRS to discover a tax shelter in a corporate return. What is that like? How big a problem is that?

… You might say, "The IRS audits the 1,200 largest corporations in America every year. They have for many years. So why weren't you finding these things?" On some of these corporate tax returns, it takes a pickup truck to deliver them. I mean, they're all on paper mostly at this point, because we haven't gotten an electronic form yet. So you've got this boxes and boxes of papers.

A pickup truck?

Yes, I mean you could have a pickup truck full of boxes to deliver on corporate tax, and you might have -- who knows how many subsidiaries, how many foreign entities that they have. Corporations are big and complicated, and there's a lot of tax code sections and provisions and so on, so forth. So you got a team of auditors that are going in there and they're working for a couple of years. But unless they know really what they're looking for, they could just not be able to find some of these transactions.

Are the shelters deliberately hidden?

See, this is another key point. I think that some -- not all -- but some of the some of the strategy of the promoters was to find ways of not only constructing the transactions to create this loss, but to find a way to embed them in this huge return so that they would not stick out, so that they would be very, very hard to find. Not everybody did that. But that was, I'd say, a pretty common practice. …

Then, of course, if you did find one of these transactions, you had the fact that what you were talking about was something that was structured so that they could claim that it did conform to the law. This was the whole structure. They would say, "Well, it conformed to this, and it conformed to that, and it conformed to that, and it was a legitimate business transaction, so then-- "

So why was it phony?

Because there was nothing that really happened. The taxpayer was just moving paper around and moving cash around back and forth. But in the end they weren't really doing anything -- at least in the ones that really are tax shelters. That's the contention that the IRS had to make.

Now that's a hard case to make sometimes. Sometimes they'll have a little bit of a gain. They'll say, "We actually gained something from this transaction." There was a case, where the IRS actually lost in court, where a U.S. computer corporation that had a gain was given a proposal by a promoter to buy and sell all in one day. I think it was $800 million or $900 million worth of stock in a Dutch oil company. It had nothing to do with their business. But they went and they sold the stock and they bought it back, or they bought the stock and then they sold it within the same day. Because of some complicated provisions related to a stock that is paying a dividend and then not, and then on a certain date they were able to show a loss on the return and offset it against the gain. …

The court upheld it, because they had a two-tenths of 1 percent profit. They had a two-tenths of 1 percent profit on $800 million without reference to the tax effect. The court said, "That's a legitimate transaction. They were just doing this to buy and sell stocks because they wanted to make a profit.

Yes, they made two-tenths, and it was a two-tenths calculation under one particular type of calculation that was disputed as to whether it was actually a profit at all. But let's give them that. They said they made this pretext. [The] court held up; they give them the tax. The IRS fought for years on it, and they actually lost the case.

So, yes, that's the kind of thing. After all this, finding it first of all, and then prosecuting it in terms of doing the audit and then going to court -- still, in some cases, you would find that the court would side with the taxpayer, which is another whole issue of whether the law is really correctly stated in this area.

Let me ask you about confidentiality. One of the things that we've run into in our reporting is that -- certainly the individual taxpayers, and maybe also the corporate taxpayers -- were told by the shelter promoters that they could not share any information about this. They couldn't go to their regular lawyer; they couldn't go to their accountant, and so forth. Yet they are saying there are legitimate deals. Does that raise a question in your mind?

It did. That was one of the things that, in some of the later regulations that we put out, we particularly targeted. In other words, if they were signing a confidentiality agreement that said they couldn't tell anybody about this, even other tax advisers, that to us was a signal that this was something that needed to be flagged as a potential tax shelter.

So that was some of the early regulations that we put out, which were aimed at getting more disclosure, so that we wouldn't have to try to dig through a pickup truck full of tax returns. That was one of the flagging items that we identified, also had a confidentiality agreement attached to it. …

We have talked to people in various German cities who have leased large facilities in their cities to American investors. Almost to a person, they have told us that they were bound by the contract not to reveal the name of the American investor. What does that say to you?

It says that they're trying to hide. That's one of the arguments that you got into with tax shelters is, what's a tax shelter that's different from just ordinary legitimate tax plan, where we trying to figure out a legitimate way to report our taxes? There is a gray area. There's no question there's a gray area. One of the arguments I always made at the Congress and elsewhere, and they said, "Well, maybe it's a gray area." But if it's so darned legitimate, why don't you just disclose it and talk to us about it? Then we can take a look at it, and then we can argue about the merits.

So we came down very, very hard that disclosure, and getting over this business about confidentiality, was a mandatory requirement. There's no way that you can argue that you're doing [legitimate] tax planning, but on the other hand, we don't want the IRS to know about it. That's the whole point of the tax system. You're supposed to report your taxes to the IRS. So taking the position that something's legitimate, but you're going to hide it, is completely and utterly contradictory, and has absolutely no standing as far as I'm concerned. …

As you start to gear the IRS to move, to deal with this mushrooming problem … you said one-on-one defense. It's a little bit like the cat going after the mouse. [How did you deal with the problem?]

… One, we organized to have a group of people across the whole country focusing on this problem. Secondly, we used the authority with the Treasury Department to issue regulations requiring people to disclose to us, so we didn't have to go out and find them one at a time. Then, as we started to get some responses on that, we started to do enforcement of summonses and actually get promoters to require them to give us the data on who they had promoted these to.

Some of the promoters settled with us very early on. They said, "Look, we don't want to be in this position. We don't want to fight the IRS. OK, we'll give you our information," and that was very helpful, because that gave us a picture. Then we could go to those taxpayers who had bought these in a much more informed, more efficient way.

So by the time you get to the end of 2002, what have you found?

… The last meeting I think we had -- what we just had in inventory was about 2,500 different transactions and about $50 billion in tax that we specifically knew about, but that hadn't been paid over the previous years, and of course, it was still coming in. But that was what we had in inventory by the time I left. …

If you're in New York, if you're in L.A., if you're in a big city and you're a big city businessman or you're in a corporation or you're a high net-worth individual in Texas or Arizona, whatever, are a lot of people in your circle doing this in the late 1990s?

I think that a lot of people are being offered it. Almost everybody is being offered it. If you haven't been offered it, you sort of aren't having a ride. But that doesn't mean that everybody bought into them. It is interesting that people's views, their sense of what's right and wrong, I guess, or what makes sense [for them] to do is quite varied. So, yes, everybody that was a big corporate taxpayer or a very high-income individual almost certainly was approached by one of these promoters many times. …

What does that say about the ethics and the thinking of the big shelter-promoter firms?

I think that some very respectable firms got pretty carried away during a period of time in the 1990s when we started to enforce some of this. Some of them came in and settled right away. "We don't want to do this anymore." Some of them didn't.

But something changed.

I think that the limits that people observed historically became certainly a lot less meaningful to a lot of firms that were promoting these things. But it's the "everybody's doing it" kind of syndrome.

But is that a danger to the tax system?

I think it's a danger to the tax system. I think it's a huge danger to the tax system if it persisted, because the basic premise of the whole tax system is that taxpayers report their taxes honestly and the tax advisers, whether they be lawyers or accountants, have ethical responsibilities to limit themselves to what really complies with the law. Certainly there's a gray area. But when people start saying that they think it's legitimate tax planning and it's just a legitimate tax dispute, but they don't want anybody to know about it, I don't think that holds water. …

Where is Congress in all this? Did you go to Congress? Larry Summers, I guess when he was treasury secretary, sent a package of proposals to Congress. What's going on in Congress?

One of the great debates is what is the law in the area of tax shelters. My view is, and I said to people, "We ought to outlaw tax shelters." People would say, "What do you mean outlaw tax shelters? Aren't they already illegal?"

The answer is, "Not in terms of anything the Congress has ever passed." The law about tax shelters for the most parts stems from a long series of complicated court decisions that go back to 70 years about the doctrine of supposedly what's called "economic substance," meaning that, if you go through a bunch of transactions, but there's really nothing that happens other than you structure the same taxes, that can be challenged and overturned as a tax shelter. But it's a very murky and frankly weak barrier, legally, I believe. …

So, bottom line, I think the Congress needs to change the law. They need to make it much clearer by act of Congress, not just by a set of sort of tax decisions in various courts.

Change the law to do what?

… I think Congress has to say it plain and simple that if you're just doing a transaction that's structured for tax benefits that you wouldn't do in the absence of the tax benefits, then it's a tax shelter and it's not legitimate.

The other thing they have to do is they have to put some clarification around when penalties have to be paid, because otherwise it's "Heads I win, tails you lose." Basically right now, the way things are, there are virtually no penalties imposed for use of tax shelters in practice. There are 10 penalties in the books, but they've been essentially never imposed and collected for the last 10 years, except for minimal amounts.

Why? Because if you can get a legal opinion … that has been viewed by the courts as essentially a defense against the imposition of penalties. It says, "Well, we [believe this is] a legitimate transaction and you had a different interpretation of the law. Somebody over here who is a lawyer blessed this and said it was OK. Now the IRS comes along and says it's not OK. Well, OK. You have to pay the tax, but you don't have to pay a penalty."

So what does that mean? … If you look at it as just an economist, if you have a gain potentially from gaining to this transaction and you have really no serious risk of anything other than paying what you would have paid in the first place, why not do it?

So that's another thing the Congress has to do is to … set some standards [that] just having a legal opinion, any old legal opinion, is not going to be sufficient to [avoid paying] a penalty.

What about the accountants and the lawyers and the shelter promoters? Are there penalties for them that are a deterrent? Do we have a sufficient deterrent to the shelter promoters?

The penalties on them really have to do with disclosure. In other words, some of the promoters have cooperated and have come forward and have agreed with the IRS to give the data. Others have just fought through the courts and have tried to prevent giving any data to the IRS. I think that's another area that needs to be clarified. It needs to be crystal clear that people that promote these kind of devices, broadly defined, have to at least disclose them, even if they want to claim that they're legitimate. They have to disclose them or pay some serious penalties, and that really is also a little dubious in the way the law is right now.

So you've got to have a law that does three things. One is, it makes it clear that a tax shelter is something that any transaction which really does not produce business results that people would buy into except for the tax benefits -- [that] is a tax shelter. There has got to be some clarification of the fact that just getting any old legal opinion doesn't protect you from penalties. And there's got to be much clearer requirements on the promoters to disclose what they have done, or pay some serious penalties.

All those things are on the books now, sort of, but not in an effective way. That's why I said the IRS, as the bar association article said, goes into a gunfight with a knife. I mean, it's got these legal tools, but they're not very powerful -- at least not powerful enough, in my opinion. …

So what's the problem? This has been going on for quite a while. You, the Treasury people, have gone up to Congress and said, "Let's get something done here."

Congress moves slowly on everything. I mean, they just do; that's democracy. There was some progress. The Senate in 2003, last year, did pass a bill which would cover maybe not everything you would like, but a lot of it would make it go a long way. I don't know whether it will get through the rest of the Congress, when it will get through the rest of the Congress. But it's just like anything. It has to get through the legislative process, which is not so easy. …

My opinion is … basically Congress needs to act. They need to outlaw tax shelters, period. I think they can do that. I think the Senate bill that passed in 2003 is a very good start towards that. …

What is your realistic assessment of where we are now in the problem of tax shelters?

I think we've slowed it down and we've stopped some people, but the fundamental drivers of this are still there. I mean, it's still a very profitable business for the promoters. There's still a tremendous amount of tax that can be saved. The law is still way too weak and too murky and the IRS still -- well, the IRS is doing a much better job. It's better organized and more effective. It still has limited resources.

So I think this thing is going to rebound, especially as the economy improves. It may change its form somewhat. People will have to maybe work a little harder to come up with these shelters, but it will come back. It's not gone now. It's just slowed down. I think it will come back in a serious way as the economy improves, unless some of the steps that need to be taken are taken. That means basically the Congress passing the right kind of law to really deal with this, and secondly, the IRS having enough resources to cope with it.

You put a lot of the responsibility on Congress to take action. You're saying unless Congress acts, and unless Congress acts to outlaw tax shelters and unless they give the IRS enough resources, we're in for more what we saw in the 1990s.

I think that's true. I don't know why it wouldn't be. Basically, it's a tremendously profitable business for the promoters. There are billions of taxes that you can save, and there's very little risk in terms of penalties right now for anybody. It's a fact. There's some risk, because people don't like to have to pay back taxes. There's always some risk in penalties. But it's just the equation is not in the right balance right now. …

How serious is the problem of resources for the IRS?

Then you've got the resource issue. One of the things that we did, because this was such a top priority, was to reallocate resources to do this. But it's just then leaves everything else uncovered. The IRS simply does not have enough resources broadly to cover even the most serious compliance cases.

I would say that when we looked at it, if you look at all of the different kinds of non-compliance that we knew people were not paying -- not just these designer-type shelters, but people hiding money on offshore accounts, people just not filing returns at all -- all those categories, even the most significant ones that we knew about, we were probably only covering maybe 30 percent of them. So we're leaving 70 percent of them uncovered, which means that people are robbing banks on all four corners and we'll only be able to stop one robber.

One out of four?

Yes. That's just not good enough, I think. Now in the designer shelters, because it was so important, we put so many resources on that [to] try to cover at least the ones we knew about. But then you've got everything else that's uncovered.

It doesn't require enormous number of resources. But the IRS does have to have enough to modernize its computers and to gradually build back its staff at least 2 percent or 3 percent a year. That's my feeling, that, together with the legal changes that I hope Congress will pass, over time we could really, really make this thing work a lot better. …


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posted february 19, 2004

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