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Tax Shelters and Penalties: Reasonable Cause, Opinion Letters, and Other Issues


Friday, July 25, 2008


President and Publisher
Tax Analysts

Sutherland Asbill & Brennan

Tax Division
United States Department of Justice

Tax Analysts
* * * * *

(9:07 a.m.)

MR. BERGIN: We're going to get started, everybody. Okay, thank you.

Good morning. How is everybody?

Good. Welcome to the latest in the Tax Analysts series of discussions on key issues in tax policy and tax administration. The topic for today is tax shelters and penalties. I'm Chris Bergin, the president of Tax Analysts, the nonprofit publisher of Tax Notes, Tax Notes Today, State Tax Notes, Tax Notes International, and many other fine print and online products on federal, state, and international taxation.

This is the fifth year in which we have conducted a series of discussions on tax policy. If you are new to our discussions, let me say it's great to have you here. And if you were with us last week on Capitol Hill, where we hosted a discussion on the 10th anniversary of the IRS restructuring law, let me say, Good to see you again.

I need to take just a moment to explain our process today. I will open things up with some brief — and they will be brief — remarks to introduce our topic. I will then introduce our distinguished panel of three speakers who are seated around the table. Each of them will address aspects of our topic. After that, we will open up the discussion to all of you, and we encourage all of you to participate. Whether you are seated at the table or just a bit away from it, just wave and I'll find you.

We are recording this event, and we will post the transcript to our Web site, as we do for all our discussions. There will also be an audio version available on the Web site. If you haven't seen our Website, there's also a video version of our conference last week available now. It's a link.

Also, for media purposes, we are on the record. So when I recognize you, please tell us who you are, or I will nag you to. For those of you away from the table, we have hand-held mics that we will quickly get to you. I will moderate the discussion, and we will end by 11:00.

Now on to our topic. We are here today to talk about tax shelters, a topic that we at Tax Analysts, and specifically Tax Notes magazine, are not unfamiliar with, as most of you know. In fact, and not to brag, it was Tax Analysts that more than 10 years ago exposed the most recent threats of abusive tax shelters.

Of course, true to the Tax Analysts tradition, when we began to expose the latest wave of tax shelter abuses, we had no problem in knowing the promoters of the schemes. For example, we poked fun at the names they would invent for their "tax solutions," as they called them. I often wondered if these folks spent as much time thinking up a tough name for a tax solution as they did for using the code to game the system. One of the most infamous names of these products was BOSS. Even though it's an acronym for the sort of wimpy "Bond Operation and Sales Strategy," it still sounds a pretty tough thing when you call it "the BOSS." Besides, "Sharks" and "Jets" were taken, at least on the west side of New York.

But I have an idea for a new musical today. How about "BOSS Marries the Bride of Frankenstein?" They have a son. You got it, the son of BOSS. And the son has many offspring, and most of them are a little bad. And they have offspring; many of them are so-called 1040 filers and many of these filers claim to be innocent bystanders. Altogether they destroy the tax system, sort of like at the end of "Little Shop of Horrors."

To discuss these and other issues, we have a distinguished panel that I will introduce. And to mix things up, I will introduce them in the reverse order in which they will speak. After they speak, we will open things up for what should be a lively discussion.

To put things in baseball terms — it is summer, after all — our closer will be Dennis Donohue, who is the chief senior litigation counsel in the Tax Division of the Justice Department. He served as lead attorney in the Shell Oil refund suit as well as the CM Holdings, AMerican Electric Power, and The Coly v. Dow Chemical Co., COLI Coley cases. Recently, he handled Chem. Co. v. United States, and he is currently lead attorney in various high-profile Son of BOSS cases.

Let me help you here, Dennis, so you don't have to say it: He is here today on his own behalf, so the views he expresses are his, not those of the government.

For middle relief, we have Jerry Cohen, who is partner at Sutherland, where he works on matters of tax planning and controversy. In 1979, President Carter appointed him chief counsel for the Internal Revenue Service, a position he held with distinction until 1981.

Our starting pitcher today will be Tax Analysts' own Lee Sheppard, who has been a contributing editor for us for more years than either of us probably want to think about. Lee also covers more areas of the tax law than I have time to get into, so let me take some liberty in paraphrasing what a great mentor of mine told me some years ago: If you don't know who Lee Sheppard is, you are probably in the wrong room.


MS. SHEPPARD: Well, the organizers of this were really excited about it, and I did not want to say to them on Wednesday morning that it's more likely than not that I'm going to be here.

We were looking at a weather forecast that said that the remnants of the hurricane were going to plop themselves into New York, and that would mean that the subway tunnel would flood near me, the Amtrak trains would flood, tracks would, or there would be no service, and the airports would close. And that's what travel is in the sort of dilapidated infrastructure we have here.

So then there's this other sort of observable phenomenon we have in New York: We have a lot of rich people who don't feel like paying their taxes, but they love to throw money at charities that make them feel good, and they like to put their names on things. So I think what we should do to settle the Son of BOSS cases is find the taxpayers that have been written up and you say, okay, you get an infrastructure project, and you have to pay for the whole thing and you can put your name on it.

I mean, it's sort of like what they do in Britain, where you can settle your estate taxes by giving your pile to the government, to the National Trust.

You know, why don't we just let these guys rebuild infrastructure and put their names on it?

So let's go back to why we're here. And it was kind of amusing. I rode up in the elevator with Mortimer Caplin, who is a former IRS commissioner. It's sort of like, oh, here we have history and I'm here to talk about history, because he can certainly testify to all the years we've screwed up the penalties.

And we're here because we screwed up the penalties again. Because what we keep doing — and we don't look back each time we do it, and we're actually about to do it again because we are going to start on a penalty reform project — but what we keep doing is we keep not enforcing the penalties we have, and from we add layers of new ones. And sometimes you get overlap.

My understanding now is that we have some overlap, but not much. But the non-enforcement of the previous set is kind of worrisome, because every time, you have to get new language and you have to have new concepts, and they don't really mean anything different than the old ones.

So what we did in the '80s, we had two penalty reforms in the '80s: One in '82, one in '89. The one in '82 gave us some productive things.

The one in '89 was supposed to be a clear-out of overlap, but it also got rid of the negligence penalty. And I kind of liked the negligence penalty, you know?

And I kind of wonder — when you look at the shelters that folks were doing in the late '70s and early '80s, where you had the overvalued asset and you had the non-recourse debt that the customer wasn't going to pay — why wasn't that negligent? You know, why was nobody negligent then and we had to have new penalties?

And now you look at the regulations we've got, you look at the Regulation section 6664-4 and you see what it takes to get out of a penalty and you say, well, why isn't that working? I mean tax — the corporate taxpayer has to have — if you're in a shelter, you've got to have substantial authority. You've got to have a good-faith evaluation of the facts and the authorities.

And only after that do you get to say there was no definition or basis in the law? You know, if we were serious about that, would we have had the ACM partnership case? The Son of BOSS cases, which are our poster child?

As I read the reasonable cause — and what you have there is you have sort of a technical position, and you can debate that, and then you have facts, which are — and we're going to assume here that you did the transaction, that you executed the trades, that you didn't do things like get your documents wrong and have to backdate them, and you didn't do anything that was fraud. Yeah, but you have some hokey-looking facts. Well, why does that wash, you know? If we'd have been enforcing all of this over the years, we wouldn't be here.

But now we're in a very weird situation, where you have the IRS asserting penalties where — in cases where we might think that's not a great idea. And then you have judges imposing them when they're really, really angry, like the Jade Trading case, where the judge looked at the whole mess and said, well, the government is asserting a bunch of penalties here, so I'm just going to uphold them all in the alternative.

And that — on the one hand, yeah, that's — judges have the power to do that, but on the other hand, you don't want seeming arbitrariness. But let me stop ranting here and sort of talk a little about what works.

One of the things that has really worked, that we got in 1982, was substantial authority. Because — and right now we're having this debate, which I think is kind of putting the cart before the horse as to whether taxpayers and practitioners should be held to more-likely-than-not as our substantial authority. And it's putting the cart before the horse because, first of all, there's a lot of big taxpayers. The publicly traded companies, they're already on more-likely-than-not.

And as I understand it, they're on something heavier than more-likely-than-not for FIN 48, which is basically the best thing that's ever happened to the IRS.

But the other thing is when you look at, well, what do you have to do to get to more-likely-than-not on something, and I've never understood this assigning percentages to things, even though people seriously do it and the accountants want to do it and that's their business.

When you're trying to show that you're more likely than not, you have to have substantial authority somewhere along the way, you know? Because that's what gets you to more likely than not, the case and the circuit you're in that says you can do this.

So you might want to sort of take that thing that works when you're doing the penalty reform and say, okay, let's just key everything off that. And if you look at it that way, then it doesn't really matter whether — and I'll get to section 6694 in a minute.

When we reopen the preparer penalty, do we bring the preparers up to where we — you know, do we bring the taxpayers up to where the preparers are now, or should we bring the preparers down to where the taxpayers are?

It doesn't really matter, because what you really want is you really want somebody who did their transaction and you really want some credible legal basis for the return position.

And so that — and the other thing that we've got that works, and we know that it works because it even works in Britain, which is disclosure. So it is a good idea to keep in the law levels of penalties that say if you disclose it, you get a lower penalty than if you didn't disclose it.

Reasonable cause as an exculpation standard I have a bit of a problem with because I think it has become meaningless. I mean, even though we've got regulations, and they're good regulations and they say what it should say, you have folks saying, well, no, I've got an opinion; therefore, I have reasonable cause. And they've been getting away with it for a lot of years, really up until now, when they were throwing down marketing opinions.

How am I doing on the time here? I'm okay? Okay, good. So let us — let's talk about 6694 for a minute. If I haven't annoyed people enough already, I'll do it now.

Everything's going on a tax return. Everybody's a preparer. 6694 actually always said that, but the penalty was teensy, so it didn't matter. Now what we have is we have the raised standard in the statute because Congress was disgusted with the kind of advice people were giving — and Congress is not the only one who approaches things this way. You know, you — Congress was approaching it from the standpoint that the taxpayer's an innocent. So they're saying we can't let people advise people to do these things, and they raised the standard.

But then the tax administrators in the recent set of regulations, in order to put the standard back to where they thought it should be, they removed a lot of people from the statute. They removed the high-end lawyers who were complaining about it. But they also removed a whole bunch of folks who are not professional advisers from the preparer statute. All the investment bankers and boutique tax planners and commodities traders and banks and what have you, these are groups of people who are causing a whole lot of trouble. And we had an opportunity here to bring them into the preparer net and apply penalties that would get their attention. And those regulations have removed them.

And when Congress reopens the preparer rules — because they are going to do that — this has to be undone.

Everybody's got to be a preparer. Because if these folks aren't preparers, then what happens is you've just set yourself up for the next round of tax shelters. If you have a set of people who can advise away all they want with the full knowledge that what they're doing is going to be a return position, and there are no punishments for them anywhere in the system, then you're off to the races.

And I've — people who've read my privileged articles know that I don't believe that any of this stuff isn't return preparation. If it's heading toward a return — I mean, maybe there's hypothetical advice out there, but if it's — if you're advising somebody and they're taking the advice and they're sticking it on a return, it's part of return preparation.

But then people would say, oh, no, no, no, no, Circular 230 picks up the folks that the preparer rules drop, but that's not true either.

Circular 230 picks up people who are practicing before the IRS. It's not clear that it picks up tax-shelter boutique advisers.

At one of these ABA meetings recently, the head of the Office of Professional Responsibility said, Look, I'm getting all kinds of complaints about folks, but none of these folks are — not none of them, but a large chunk of them are not deemed to be practicing before the IRS, so I can't do anything about it.

Plus, you — Circular 230 is not really the vehicle to get the attention of the folks that you're really, really worried about. The vehicle to get their attention is a statute with a big penalty in it. You know, if we have to argue about whether they're practicing before the IRS, then sanctions that say you can't practice before the IRS and there's no vicarious liability for your firm are not going to cut it.

On Circular 230 itself, I mean, I — that just — the whole premise of what we're doing is just weird to me, because you're starting out with the assumption that the customers need consumer protection from the purveyors of tax shelters or just their advisers, which is kind of loopy.

And then you're saying, well, the advisers have to write their opinions in such-and-such a way, when what you're really worried about — because, look, I don't care what advisers tell their customers. I'd actually rather have them level with this. You know, I'd actually rather have them say something like — instead of I can't write you a more likely than not opinion, how about, look, you can go ahead and do this, but it's a loser in court? How about that, you know?

So I don't care what they tell them. You know, I don't care if people want to give opinions on BlackBerrys. That's between them and their malpractice insurers.

You know, what — the other premise that's bad here is that there is — that people can be in the business of selling penalty protection and that there's some kind of elaborate opinion that guarantees you penalty protection. And I would just take people out of that business pretty much altogether by saying, look, the fact of an opinion is meaningless. An opinion is not worth any more than the arguments that are in it.

There does have to be a contractual relationship between the provider and the customer such that you shouldn't be able to use a marketing opinion. And the opinion absolutely, positively has to be disclosed at the examination level. I mean, the idea that there's — you've got an opinion and it provides penalty protection, but you're not going to disclose it, is just ludicrous.

What else do we have here? Now, where are we going here? We're in a kind of a dangerous phase here, because while some people are thinking about penalty reform and the little overlaps — we have before Congress a couple of economic substance codification proposals, one or the other of which is fairly likely to be enacted. And given the — the drafters of these think — I just have to back up. I'm okay on time, right? Okay, yeah, I can finish this.

The drafters think that they're just stating in a statute what the common law says about economic substance and putting on a conjunctive test. They don't think they're writing a replacement. They are writing a replacement, but they don't think that.

So what you have is you're going to get a statute which has got kind of a weak version of the economic substance test in it, but you are going to get a conjunctive test. And this thing has strict liability penalties in it.

Now, it also has, because the drafters think they're just codifying the common law, it gives judges a lot of discretion as to whether to apply the economic substance doctrine at all. But if you've got these draconian penalties in there, you run the risk of a judge saying, look, I really think this is hokey and awful, but I'm going to say it has economic substance because it's not so awful that I think we should have a 30, 40, whatever it is — depending on which version passes — percent penalty here. You don't want decisions like that out there.

And so what you want to think about, and this is back to my original point — and the other thing is, if you want to have draconian, you can go all the way to 100 percent. We've got 100 percent penalties if you don't pay your employment taxes. You go to Bankruptcy Court, the IRS is standing there in line with their 100 percent penalty for that stuff.

If you really want, you know — if your object is to scare people and this is like the death penalty and stuff — because that is what some of the drafters will say. They say, oh, no, we don't want to apply it, we just want to scare the hell out of people. That's what you want to do? Hey, go all out at 100 percent. You know, maybe that'll get people's attention, but you don't want a situation where a judge is not going to apply this thing.

And you might want to think about, well, get it lower, but get it where there's a bit more certainty of application. Because if you've got a penalty that is never applied or is applied arbitrarily when a judge just gets really angry with the taxpayer and their lawyers, you're not getting the deterrent effect that you want.

So there's where I am. Thank you.

MR. BERGIN: Jerry?

MR. COHEN: I'll try to concentrate more on what I think penalty policy ought to be. Lee referred to the clearing up of the penalties back in the '80s. At that time, the penalties had become a problem because Congress was enacting a penalty every time they saw something they didn't like. And so you had all of these stacked penalties. You could have one transaction with a number of penalties.

Senator Pryor put together a committee and got a Republican and a Democrat — Ken Gideon and I chaired it. And a number of major VPs — tax of large corporations to be on it, and we made a lot of suggestions. The IRS at that time was suggesting that we have a no-fault penalty.

That was designed to try to prevent the audit lottery. Most of the shelters at that time were being done at levels that are far below the wealth level of the individuals who have gone into the shelters that we're seeing in the courts now. And the idea was to try to discourage that audit lottery.

Well, Mark McConaghy said we can't get a no-fault penalty. What they gave us was evaluation penalty. That's all that came out in the first round of penalties, and that did address the compliance problem at the time. The compliance problem was valuation, overvaluing cattle, mines, books, even Bibles that were being overvalued and then given to charities. So that addressed that. But sometimes when you have a problem that you're addressing with penalties, you need to turn back and see if you can correct the code and get rid of the problem rather than try to do it just with penalties.

Then, a more-recent phenomena has been to use penalties as revenue-raisers. One of the policies that we put out in our committee was don't use a penalty as a revenue-raiser. The best penalties are those that don't raise any revenue, because they encourage the conduct that the penalty is designed to encourage.

Another policy for these penalties is they have to be understood. You can't scare people — Lee, even if you put the death penalty on, you'll scare them, but you can't scare them with a penalty that they don't understand.

And that's a real — when you tinker with these penalties — and I'll mention a little later section 6707(a), where you have a penalty of 20 percent, then it goes to 30 percent if you didn't disclose the penalty, and then you have other ramifications. You get into a hodgepodge that really makes the penalties un-understandable.

You have to have a penalty that people understand they will incur if they engage in the conduct that you want to discourage.

Look at the attempt to control the preparer community. Lee referred to that. It doesn't cover everybody. And so how do you discourage preparers? Well, you put out a 200-plus page set of regulations that all these preparers are going to read and understand; right? I've got it sitting on my desk, and as soon as I get enough time to get around to it, I will understand maybe at least 50 of those 200 pages. That's just exactly a backwards way to go after encouraging conduct or discouraging conduct when it's bad behavior.

Now, a fine-tuning of the penalties is another thing that I think is something that ought to be discouraged. For example, Congress has come back with a specialized penalty treatment for reportable transactions and reportable abusive transactions — so-called RATs — and lifted transactions. They've made the lifted transaction penalties so draconian that it seems to me the IRS has stopped listing transactions. They've at least gone into slow motion on listing transactions.

It even resulted in a new category of transactions: Transactions of interest. And I think that was a commendable way for the IRS to deal with the difficulties that are on listed transactions. And when you put in what Congress has now put in for listed transactions — penalties up to $200,000; pay your fine; go straight to jail; you cannot have a judicial review of this penalty and no one can take it off but the commissioner — penalties that no one can take off but the commissioner — you really not only discourage listing transactions, which I think has happened, but you can discourage examination, the agents in the field from raising particular theories that are going to result in these very harsh penalties because they feel that it's probably going to be thrown out when you get to appeals.

So I think you've got to be very careful about doing — in a penalty, to design a penalty regime like it's a set of tax reorganization rules strikes me as being really wrong, and that's what I'm seeing.

Now, to temper some of this, Congress put in section 6694, the provision dealing with good faith and reasonable cause. That's an interesting one, but we've got to decide what is reasonable cause. Lee would make it much easier by saying you can't depend upon any opinions, that if you want to get an opinion to lead you, that's fine, but don't bring it out and say that it can prevent a penalty. That would be very interesting.

I do like the idea of — if you're going to rely on an opinion to prevent a penalty, you need to disclose it at examination. You'll ultimately have to disclose it, because the courts are very clear. You can't rely on a penalty and disclose only the opinion, but very likely, you've opened subject matter and you've got to disclose everything that your counsel told you.

So that would be interesting. I like the idea, Lee, of saying if you want to rely upon an opinion to avoid a penalty, it ought to be something that you disclose to the examining agent.

And the transactions, the shelters we're seeing today, almost all of them are going to be examined. These are not the doctors, dentists, lawyers that we saw in the late '70s and the '80s. These are very, very wealthy individuals who get examined with rapidity.

I think you can't use penalties to coerce settlements. I think that is a real misuse of penalties, and I'm seeing that regularly. I've seen only one controversy, one examination in recent years where the agents had not tried to impose a penalty. I think that's really wrong. They're putting them on, waiting for appeals to go ahead and take them off in the hopes that appeals will get something, will sustain one of the adjustments that are being made as a trade-off for getting rid of the penalty.

Dave Robeson, when he was national chief of appeals, said you can't tradeoff penalties. I thought that was probably right. You should examine the penalty as it is, but you shouldn't be using penalties to coerce settlements. The epitome of that was Commissioner Mark Everson's Son of BOSS settlement, where he said you can take this settlement, give up your adjustments, and take a 10 percent penalty. You must take at least a 10 percent penalty. And if you don't take this settlement, we're going to go for a 40 percent penalty.

I asked the then-chief counsel what happens if the taxpayer had two very solid opinions from people not involved with the shelter and had his own personal longtime tax adviser who was reputable saying that this actually worked? And the answer was, well, we'll probably lose that one.

Well, if you're going to lose that one, you don't set up a penalty.

And then, Chris, I'll give you some time back. I'll touch on the final thing that I think is wrong, and that is, I think you have to be very, very careful when you have strict liability penalties.

A strict liability penalty for failure to disclose a listed transaction may make some sense if you know what's listed. But a listed transaction encompasses not only what's described in the notice — and it's described with some particularity because it's generally been written with the promoter's material or the opinion in the lap of the person who's writing it. I know that's the way I wrote one dealing with master lithographs.

It seems to me that you just can't have a strict liability penalty unless you want agents not to try to raise that matter.

You see what happened today. Well, look what's happening if you have a strict liability penalty for economic substance. And we have courts going all over the place on what is economic substance.

That just — that strikes me as setting up a penalty that probably is not going to be raised or enforced, and then you have a useless penalty.

So with that, Chris, I'll turn it back over to you.

MR. BERGIN: Thank you, Jerry.


MR. DONOHUE: Thank you. We all bring to the table our different backgrounds, our different sets of experiences on this issue of penalties. What I bring to the table is a background as a government litigator, as you've heard. And a government litigator who spent a good part of my career, and probably almost exclusively in the last 15 to 20 years, litigating tax shelter cases.

Now, before I begin on some substantive comments, I want to say I cannot comment on my existing cases. So if I see any of my opposing counsel in here, and if you think I'm saying something that sounds familiar, it is not.

What I can comment on, though, is existing case law. And also, I can comment on the congressional investigations that have taken place on the issue of abusive tax shelters.

And there has really been a sea change in the type of tax shelters that have existed in the '70s, in the '80s, and the early '90s, and the type of tax shelters that sort of sprung up in the late '90s, in the 2000s. And that sea change was the subject of a very extensive investigation and report by the Senate Permanent Subcommittee on Investigations of the Senate's Governmental Affairs and Homeland Security Committee.

The report was issued in 2005. And it was titled, "The Role of Professional Firms in the U.S. Tax Shelter Industry." And what the report — if I can sort of summarize it in a few words — what it concluded is that some of the most respected firms — law firms, accounting firms, and banks — had essentially been engaged in developing and designing tax shelters, and mass marketing them in what they called a generic tax shelter format. Generic tax shelter format.

In other words, they got out of the business of individually designing and assisting their clients on a one-to-one basis and went into the mass market of tax shelters. Now, this was a sea change from what happened in the '80s, because as the committee reported, those shelters were essentially by what the committee referred to as shady fly-by-night operators.

But these were the most respected — some of the most respected law firms, accounting firms, and banks that were engaged in these transactions.

And number two, what it reported was — is that there was intense internal and external pressure to develop these tax shelters within the various firms. And it pointed out that some of the best and brightest professionals were engaged in activity which would design, develop these shelters, and then push them through the review process of these firms. And ultimately, in combination and in partnership with law firms and banks, mass market these tax shelters.

If you had to sort of put one word of the culture that took place back then, it would be "greed." There's no other really way to describe what was going on.

Now, the focus of these professional firms, their effort was to create a tax shelter essentially that would generate artificial paper losses. Not real economic losses, but artificial paper losses. And that these losses essentially would be able to offset the capital gain income or the ordinary income of wealthy taxpayers, some of whom had been very, very lucky by the 1990s in the economy of that era.

And despite intensive efforts to conceal these transactions by the promoters, the scale of the transactions and the number of people involved was just too vast. And ultimately, they were discovered.

And when they were discovered by the Internal Revenue Service, what happened was that they were audited. And the vehicle normally used as a platform for these shelters was a partnership. It was this partnership vehicle which allowed these tax shelters essentially to generate these artificial paper losses.

And when the Service reviewed the transactions on audit, not only did they issue what are known as FPAS, which had the effect of disallowing the losses or requiring gain that had essentially not been reported, requiring this gain to be reported, but they also issued a panoply of penalties. And the penalties were probably three in number.

They're in some instances more, in some instances less. But they were generally the substantial understatement penalty, which is a 20 percent penalty; the negligence penalty, which is a 210 percent penalty; and as Jerry mentioned, the substantial or gross valuation misstatement penalty, which, if it's substantial, it's 20 percent, and if it's gross, it's 40 percent. And since there's no stacking of penalties in these cases, the maximum penalty normally was 40 percent.

Now, the question I suppose we're all asking — and it's been posed by my colleague speakers — were these penalties too severe? Were they too draconian?

The Internal Revenue Service has instituted a settlement initiative of these cases. And I suppose the question would be is their settlement initiative too severe, too draconian?

To sort of get a historical perspective, and since I can't comment on any of my existing cases, I'm going to take you back to the case law of these what I'll call old-style shelters: The book shelters, the master recordings, the shelters that I and other government attorneys litigated in the '80s and the '90s.

Now, the case law dealing with those shelters essentially looked to, among other standards, the negligence standard. And what the courts were saying is, well, the case law and the regulations, they look to whether or not the taxpayer made a reasonable effort to report the correct amount of tax on a return, such that if these deductions seemed to be too good to be true, they would or should have recognized this, or at least using an objective standard, a reasonable and prudent person would have recognized this.

So that was sort of the test.

Would a reasonable and prudent person under the circumstances, in preparing and reporting the tax benefits from these transactions, would they have realized that these type of tax benefits were simply too good to be true?

So what the courts back then were looking to was essentially an analysis of the tax benefits. And what they said in many cases was, well, what you have here, taxpayer, is a tax write-off of 4, 6, 8 and sometimes 10-to-1 to your investment. And that tax write-off could translate into tax benefits that were anywhere from 125 percent, 150 percent, 175 percent, or 200 percent.

And as one tax court judge put it, to anyone who was not incorrigibly addicted to the free-lunch philosophy of life, that type of scheme would have seemed to anyone to be a wholly transparent sham.

And that's the sort of indifferent language, including, for example, the Third Circuit in a case called Neontology — that was sort of the type of analysis which the courts were looking to. Did it seem too good to be true?

Well, now let's take that type of analysis and apply it to these new shelters of the late 1990s and 2000. Now, there, the type of tax write-offs that you had, they simply dwarf these tax write-off ratios of the shelters of the '80s. You're seeing tax write-offs of sometimes 50 to 100-to-1. And they translate into tax benefits that are many multiples — exponentially in some cases — greater than the tax benefits of the shelters of the 1980s.

So you ask yourself, too draconian these penalties? Too severe in these situations? But it all depends on what the courts do. Many of these cases now are in the pipeline. And of course, it will be — in time, we will have some idea as to how the courts are going to look at these cases.

Let me touch on one aspect of these new tax shelters. And that is the defense that is ordinarily raised, and that's the reasonable cause, good-faith defense under section 6664(c) of the Code.

Now, how do taxpayers raise that defense? And remember, we're in the context normally in these cases of partnerships, so it has to be raised at a partnership level. Without going into the technicalities of distinguishing between a partner level and a partnership level defense, the Internal Revenue Service has prepared and issued regulations making it very clear that only the partnership can in fact raise a defense in these cases based on reasonable cause/good faith.

Well, what ordinarily we've seen is a legal opinion. But remember, I started by pointing out that who was part of the co-promotion of these schemes? These schemes depended in their marketing effort on a legal opinion.

Now, there's a calculus in these shelters which permeates almost the entire tax shelter industry, and that is, as Jerry mentioned, that of the audit lottery. It's ordinarily — it is — probably your chances are better of winning the state lottery than getting audited. And that calculus is a strong calculus that is taken into account by tax shelter promoters.

But what happens if you are?

Ultimately, your transaction is discovered. What happens there is that you dust off, at that point in time, a tax shield opinion, the sole purpose of which essentially was to insulate you from penalties if the transaction was discovered.

Well, these opinions, as I said, were written by tax shelter promoters, law firms, and sometimes very respectable law firms. And how do they ultimately conclude that the tax benefits of these transactions are more likely than not correct?

There's some fancy footwork that goes on in these opinions. And Lee wrote a very, I think, cogent article on how it works. It works — the opinion works by assuming facts that essentially resolve the issue of whether or not the transactions have economic substance.

So if you walk in and assume the transaction will generate a profit, a reason — the test is under economic substance, a reasonable possibility of profit, if you walk in and assume that, well, of course, you can issue an opinion very quickly that says, yes, the transaction is more likely than not to have economic substance.

How? Well, you just went ahead and assumed it had economic substance.

The test for economic substance is an objective test. It's whether or not a reasonably prude investor would, under all the circumstances, have been able to conclude that the transaction would generate a reasonable possibility of profit, taking into account all the transaction costs. Well, when you take into account all the transaction costs on these transactions, which are huge, and they usually depend on a percent of the desired tax loss — I mean, that's — I'm sure I'm not speaking anything new to this audience, but that's how it works. These firms essentially based what their fees were on what a client's desired tax loss was.

So when you look at it through that lens, you're looking at essentially an opinion that assumes the very issues that, as one court said, appears as if it's more of an advocacy piece than some type of very reasonable and calculated legal analysis to guide a client's decision.

And so ultimately, the question becomes is that all you got? Is that what you're relying on as your defense in these cases?

Now, Jerry mentioned, well, we have situations where we can assume that there is not only the promoter or promoters' opinions on these transactions, but we can assume that we have totally independent opinions. Now, if you make that assumption, you have totally independent opinions, the question that I would have is how could they possibly have arrived at this independent opinion if they had done due diligence with respect to the transaction? If you did due diligence with respect to the transaction, it seems to me all you need to do is scratch a little bit under the surface and realize that this entire transaction has been put together for one and one purpose only, and that is to generate enormous artificial tax losses.

So from my perspective, you're hearing sort of a set piece by someone who has litigated tax shelter cases. And when I go before a court and I speak on penalties, I am looking at it through my set of lenses, which is a set of lenses which obviously is different from others' in the room. But if you are dealing with this issue, what I said is essentially the hurdles that you will have to overcome in order to prevail on the issue of penalties.

Thank you.

MR. BERGIN: Thank you, Dennis.

All right, I'm going to open it up for questions now. Remember, we're taping this so that others can benefit from it as well, so speak into a microphone, please, and identify yourself.

MR. LOBEL: I'm Marty Lobel. And I must confess, I'm not a traditional tax lawyer, but I am a litigator. And one of the things that I think both Lee and Dennis have raised is the fact that the IRS is totally incapable of enforcing the law. They don't have the resources. They don't have the people.

I was peripherally involved in the Walt Anderson case, which was supposedly the largest single tax evader, and the IRS could spare one auditor, the U.S. attorney had one lawyer, and main Justice, Tax Division, supplied one junior lawyer for the largest single tax evasion case they claimed occurred in its history. Now, when you're talking about these kind of cases — and he was represented, by the way, by a public defender, who actually did a very good job.

Now, if you're talking about these kind of cases, the tax shelter cases, and you have these kind of lawyers representing the government against the lawyers that Caplin & Dmslae Patner Mort Caplin has or Jerry has in his firm, they're outgunned. They don't have the resources. They don't have the money. They don't have the experience, in most cases, to really oppose it.

And the investigation is really overwhelming, because they all have partnerships layered on partnerships. The hearings before the Permanent Subcommittee on Investigations last week and their report expose the kind of problem we're facing.

UBS, one of the largest, allegedly most respected banks in the world, admitted to having 19,000 "allegedly legal accounts" by U.S. taxpayers whose sole purpose appeared to be tax evasion. And when the IRS was asked whether they were going to request the names of all 19,000 after the hearing, the response was how the hell would we handle that?

They don't have the resources. They know there's tax evasion there, and they don't have the resources.

So if you're caught in a penalty situation, and your draconian penalty, when your chance of auditing gives you a little bit of running room to try and get these guys to come in and confess error — because that's the only way they're ever going to get caught, a small percentage of them. And I think the real responsibility here is not so much whether we're having to rely on draconian penalties to get these cases settled and resolved, it's the Congress's fault and the IRS's fault, which in many cases seems to feel they're more advocates for their clients, the large- and middle-sized corporations, than the taxpayers. They're so overwhelmed.

And how — Jerry, you've opposed many of these cases. How well staffed is the U.S. Government compared to your troops?

MR. COHEN: I wouldn't have the same opinion. I think they've sent out very, very good lawyers, like Dennis and others. I've seen them very well-prepared. They are now using lawyers — to try a particular shelter, for example, they'll use the same lawyer, so he's very familiar with the shelter. And I think that if you look at how the cases are coming out, you'll see they're doing very well.

Now, that doesn't go to whether they're catching all the cases. That's not at the legal area — level. That has to do with the things that some of these penalties are aimed at. Transparency, so that the Service knows that this is going on, that has to do with the Service having enough of a budget to actually send out enough agents to pick up all of these cases. They should be. You know, 19,000, a lot of those may be legitimate, a lot may not.

But it horrifies me to think that the Service doesn't have enough people to investigate that. There are a lot of people who are angry about the testimony that's coming out, and they want the Service to have enough people to do this. The Congress has always — we used to testify on the Service's budget. And at the end of the testimony, you were allowed to ask for a budget that was equal to what the administration told you you could ask for. And so at the end, after they were through taping, they'd say is that enough money? We'd say, gosh, no, that won't do the job at all. But you got what the administration would give you. They give the IRS too much and they begin to get too many constituents calling in and complaining.

MS. O'CONNOR: I might like to address just a couple points, if I might. I'm Eileen O'Connor. I was head of the Justice Department Tax Division from '01 to just last summer. And Walter Anderson did have more than two lawyers for the government. They were in the United States Attorney's Office and in the United States Department of Justice. So what you see in the newspapers is not necessarily all that's brought to bear. And Walter Anderson I do believe is doing time right now.

As far as the government being outgunned, I will say yes, it is entirely true that if you go into a courtroom where there is a significant tax shelter case — which Walter Anderson was just plain old tax evasion, tax fraud — but if you go into a tax shelter case, you will see a distinctly different number of lawyers representing the government than are representing the taxpayer. And I would offer that that's not necessarily because the government doesn't have enough lawyers, but because the taxpayer has too many.

I did sometimes wonder what those 24 lawyers for the taxpayer were doing in there.

MR. LOBEL: That's billable time.

MS. O'CONNOR: That is exactly right.

They were running up the fees. And as Jerry was kind enough to point out, the government's record in tax shelter cases has been very good this century, this decade.

And I agree with you about Congress needs to fund law enforcement more. You cannot rely entirely on the government catching wrongdoers for law enforcement. You also have to count on the fact, and that's what this conference is about, is penalties.

If you do get caught, it hurts. And so your disincentive is not just you're going to lose the benefit, but also you're going to be hurt. So you need the penalty structure to provide a serious and meaningful disincentive.

And one final point. The Tax Division, I'm proud to report because this is one of my great achievements — the Tax Division budget rose by 50 percent while I was there.

MR. LOBEL: But it's still too low.

MS. O'CONNOR: It is. It is still too low, yes.

MR. CAPLIN: The problem starts — I'm Mortimer Caplin. But the problem starts at the top.

Unless you have a President who has a respect for the IRS and the importance of the tax system to a democracy, it's not going to happen. He has to give it a priority, OMB has to be in tune, and you have to try to get the message down to Congress. But even then, of course, you have problems. My own experience of being patted on the back for the wonderful job we're doing and we're back behind you, but then when you've got the appropriations slip, it was only a fraction of what you asked for.

Having said that, the audit level has just been cut to the bone. At one time, we were auditing as much as 5 percent of returns. It's like .5, maybe it's approaching 1 percent now. And we have to do something about that. People have to understand that there's a reasonable chance that their return can be examined.

And I think you're doing a great job and I just applaud your words, your whole message. We as tax lawyers try to do the best job we can for our clients. If we have an issue, we'll fight for it. We don't want to overpay tax. We have a certain boiling point beyond which we'll not go in terms of advice and things of that sort, and that boiling point varies, and it went to pieces in many areas of the country during the last '90s. So really, it's a horrible epoch in our professional history.

But I happen to be a supporter of the more-likely-than-not rule. I think that our whole system ought to be based upon that as a standard.

We have to be able to have some room there if someone feels that a statute is unconstitutional or that there's some strong basis why they should challenge it, disclose what they're doing and very apparently disclose it, and not get lost in this great big point — one-half of 1 percent of returns being audited. Even though you disclose it, it might not be examined.

But I do think that if you're going to sign a jurat on a tax return to the accuracy of what you have filed with the government, then we could have a more-likely-than-not standard across the board.

MR. BERGIN: Thanks, Mortimer. We got somebody back here?

MS. REID: My name's Robena Reid. I work for the federal government. This is a question for Mr. Donohue.

Could you comment on the fees that were paid to the law firms that generated those opinion letters? As I understand it they were substantial.

And to get those opinion letters cost the shelter provider, or the shelter beneficiary, quite a lot of money. Is that correct?

MR. DONOHUE: Well, you're putting me sort of in a very touchy situation. Let me base my answer on publicly disclosed information.

I mentioned before that it's not a secret that, in fact, various law firms charged a fee based on a percent of the desired loss. And let me throw a figure out of in some instances that was 3 percent. Now you can do the math yourself. If, in fact, you're looking for a $100 million loss, that's a tidy sum of money. But what's even more important is, is that these were template opinions. And remember, they were mass-marketed.

So even where law firms did not base their fees on a percent of the desired loss, if you're charging fees of $50,000 or $100,000 per template opinion letter, and you're mass-marketing these, it's not long before the amount of fees that a particular law firm is going to receive is huge.

Now, it's been reported in the press as to the amount of fees, for example, that Jenkins and Gilcrest received. And if my memory serves me correct, the figure that was reported was in the neighborhood of $80 million. So the bottom line is that this was an extremely lucrative field for many law firms.

MR. ODINTZ: Hi. This is Josh Odintz and these are my own opinions. I think it's important to — if you look at the current situation with LGT (Bank of Liechtestein and UBS, the problem is a lack of transparency. The taxpayers in those cases did not feel compelled to disclose their transactions.

The same situation existed in the late '90s. We had a regime that was a fig leaf that did not have a significant penalty for failure to disclose a tax shelter. And so the IRS had to rely on envelopes from disgruntled employees, had to rely on whistleblowers, and that was the only way the IRS was finding out about some of these mass-marketed shelters.

When there was a strict liability penalty, suddenly every corporation was very focused on disclosing every type of transaction that could potentially run afoul as a listed transaction or a reportable transaction. And that's why the IRS has much more transparency about these transactions and it actually has a sense of the scope of the problem.

So that strict liability penalty does work in certain situations and the fear of that penalty changed conduct.

I think when we look at what's going on with LGT and UBS, we see once again a desire not to disclose. And I think we need to enact laws that force these taxpayers to disclose the type of data so that the IRS can properly audit these transactions.

MR. BERGIN: Thank you. Jerry?

MR. COHEN: Very quickly. At the time they were revising the matters, I suggested that they keep the statute of limitations open where you did not have disclosure. I think that goes a lot further than a penalty.

MR. OCHSENSCHLAGER: Tom Ochsenschlager. I'm with the AICPA. Let me just push back a little bit on the more-likely-than-not proposition we've been talking about.

The problem with more-likely-than not is that it would require an enormous number of disclosures. Because with the constant changes in the tax law and the uncertainty that develops — I mean, we see court cases all the time, they're going in different directions on very similar factual situations — we would have an enormous number of disclosures that would be required.

And as we talked about earlier, the IRS, frankly, doesn't have the resources in order to wade through all the disclosures that would be required.

So I don't think, frankly, it would be effective. And I think there'd be many situations where people would be disclosing transactions for which they had very good support for what they were doing, but, nevertheless, they would have to disclose it under the more-likely-than-not rule. And for many taxpayers that would be an intimidating factor.

You know, we — I'll take the Knight case that just came through the Supreme Court. Obviously, because it was in the Supreme Court, there were differences in the circuits, circuit courts, on that. And many people thought that they were closer to the facts of the case that was in Ohio than the case that was in Virginia. That'd be a very reasonable position for them to take under the circumstances. And whether that requires disclosure or not I think is, to my mind is just burdening the IRS with a lot of additional information they can't effectively use.

So I think the standard that the taxpayers are under right now, substantial authority, which most people believe is a 40 percent chance of prevailing if it were challenged by the IRS, is an appropriate standard. I don't think it needs to be cranked up to more-likely-than-not.

And I'll just add one other aspect to that. The penalties now are — and the AICPA supports the penalty level, I might add. But for more of our members it would be $1,000 a return. And where you have a situation where they could be taking positions — let me give another example very quickly.

As you know, there's been some controversy with conservation easements for the farmers. And the question is whether the conservation easements are payments in lieu of production and, therefore, eligible for the manufacturing credit, but also, at the same time, subject perhaps to self-employment tax, or whether they're not eligible for either one of those.

To make a long story short, the IRS, until very recently, has not been providing guidance on that. So many of our members who are preparing tax returns in the Midwest were taking what they thought was a very reasonable position one way or the other. And is that — if that's not more-likely-than-not because there was no authority out there for a long period of time, should all of those returns have a disclosure on them? Which, frankly, wouldn't do the IRS any good and it would add extra burdens and probably extra cost in preparing the returns on the part of the preparer.

So I think, in my view, more-likely-than-not has gone too far in the direction. Substantial authority is perfectly adequate to handle most of these situations. Certainly no tax shelter would pass the substantial authority test.

MR. BERGIN: Lee, did you have something to say?

MS. SHEPPARD: You know, actually some tax shelters might pass the substantial authority test.

That's your problem because you're arguing about the legal standard. Where tax shelters fall down is hokey facts. And what we're having trouble with with the hokey facts is in a high-end deal, and whether it's an individual or a corporation, if you did it — you know, assuming that you didn't defraud, assuming that you did your paper right, you did your paper and there's no reason not to believe that, you know, this paper you signed with the Accommodation Bank isn't for real.

And so, you know — and that's why we're sort of floundering around with economic substance here, and what I'm seeing is it's all connected. Because we're trying to deal with, okay, you had a colorable legal argument for what you did.

You might have substantial authority, you might not. But what you did on your facts was completely hokey. And I might add that, as I read Circular 230, it doesn't require a whole lot of investigation of the facts by the person who's signing the opinion. And we're floundering around with the economic substance doctrine to deal with hokey paper facts that are more real-looking than what we had in the '70s and '80s.

So, you know, the legal standard doesn't really enter into that. And like I said, I'm not too concerned about whether it's set at more likely than not or substantial authority.

What you're raising on disclosure is two issues, which are very important and which always get lost in this. One is — I mean, I believe more disclosure is better. And if the IRS starts getting disclosures of stuff that they don't think is relevant, then they can always say, hey, you know, here's a notice. Please don't disclose that transaction. Fine.

The other thing is, you know, there's a lot of stuff that is literally disclosable now, that is a compliance issue for which there is no authority because nobody's gotten around to answering the question. And if you're looking at somebody who's really trying to comply and they're trying to fill out some big, complicated return, and there's no authority one way or the other on the position they're about to take, then actually those disclosures are good for the IRS because they tell them, you know, maybe you ought to answer this question.

But I get really disgusted when the questions are just not simple, but they're straightforward stuff that affects a lot of taxpayers, and that thing ought to be answered. And that shouldn't drag everyone into some kind of penalty regime.

The other thing — well, without rabbiting on here, one of the things, if we sit back and we look at the calculus of the folks — and I'm talking corporations and very wealthy individuals here, who went into the shelters in the '90s — we know that the failure to audit was a very big problem on the individual side.

But if you look at their calculus and you say we want you to have a certain penalty for basically borrowing from the government, then maybe you do things in your penalties to address that calculus.

Because certainly a corporate tax manager, when they're doing something really aggressive, they're not looking at it like, well, five, eight years down the road, I'm going to win my case in court or even go to court.

They're looking at it like, well, I'm basically borrowing from the government at the large corporation deficiency interest rate for five or eight years, and I've got an opinion here that says I don't have penalties.

And right now, when you're looking at the population of son of BOSS customers, some of whom have quite a bit of money, they're looking at it like, well, I'm going to have to pay, but maybe I can get out of penalties here.

I don't — you know, I don't think — and so then you — that suggests other different solutions. That suggests maybe you ought to just put that deficiency interest rate up to a junk bond rate, and people won't take that bet, you know. Or that you ought to, when we know we've got — in a lot of shelters, we know we've got a basis abuse. That goes across shelters, right? But sometimes a judge will say the valuation penalty works here and sometimes the judge will say it didn't. It was a penalty that was written in the days where you could point to the —

Where we could point to the asset. There's the building that was flipped 18 times. There it is. And you overvalued it.

Whereas if in the cases we've got now, yeah, you overvalued the asset, but a whole bunch of other things about it weren't clear and it's not clear that that penalty sticks, maybe you ought to widen that penalty to some sort of basis — abuse penalty, you know.

And what you would be doing in each of those cases with basis abuse and with interest is that's kind of no-fault. You know, that's kind of like don't be borrowing money from the government with crazy positions if, you know, the five or eight years or whatever, whatever your statute is and whatever the audit cycle is, it's just going to be really expensive for you.

MR. BERGIN: Back here.

MR. CRION: Yes, Tom Crion from Deloitte Tax. You know, I think back of the cases I've read on tax shelters, and the one that comes to mind particularly is the Camelot case on COLI. And the judge basically said in that case, on substantial authority, said, well, you've got a lot of cases, taxpayer, but your facts don't fit those cases. They're different.

So my experience is, in the tax shelter area, from reading the opinions, if the judge doesn't like your case, he's going to distinguish whatever you're relying on based on your set of facts and he's probably not going to like your more-likely-than-not position as well. So in my view, at least from the judicial experience I've seen, most taxpayers who get involved in a tax shelter can't meet the substantial authority test.

MR. BERGIN: Thank you. Over here?

MR. JACKEL: Monte Jackel, I'd like to go back a bit to the economic substance codification as an example, at least as I see it, of some of the problems that have been occurring here. It's been four or five years since that proposal has been out. It's not been enacted.

Now, from my own personal experience, I tried twice to encourage debate, wrote articles. Not a single other practitioner constructively contributed to the debate. The government itself was, within chief counsel and Treasury, to put it charitably, not constructive in the debate.

And the government itself bears a heavy burden, in my opinion, in terms of the problem. Of course, they haven't acted. They had an opportunity to get a uniform standard and we still don't have one.

There is a problem in the proposal with the penalty. I'm not sure exactly what the solution should be, but inaction's not the solution.

And on the tax shelter litigation, a lot of these cases really shouldn't have been litigated to begin with. It's not establishing any precedent. It's wasting resources inside the chief counsel and other parts of the government.

So I think we all share the blame here and we should really get going to at least do something constructive.

MR. BERGIN: Thanks, Monte.

MR. REGAN: I want to pose a question to Dennis. I know you're here obviously in your personal and not institutional capacity. My name is Mitt Regan, Georgetown Law School.

To what extent, Dennis, do you believe that there will be in the future continuation of actions against professional firms as entities, as occurred with KPMG and Jenkins and Gilcrest, as opposed simply to individuals in those firms?

And in particular, to what extent will the fact that we now have only four major accounting firms, as a practical matter, constrain the government in its efforts at least to move against those on the accounting side?

MR. DONOHUE: I am really the wrong spokesman for that question. Again, I am on the civil side, not the criminal side, of the tax enforcement efforts. That's number one. And what I know about the criminal side is probably as much as anyone in this room knows and probably not too much more than that. So my efforts have been almost exclusively dealing with essentially representing the government in civil tax shelter litigation.

Now, obviously in the cases that I have litigated, the accounting firms, the law firms, and the banks have played a large role in connection with essentially these shelters being able to manipulate, if I can use that word, the tax laws.

Because the type of shelters that are currently in the litigation system are extraordinarily complex shelters, you do not simply spend a few hours looking at the code and ultimately come up with these shelters.

It takes really a very, very highly coordinated effort between accounting firms and some of the best and brightest in those accounting firms. It's amazing what people spend their time on essentially to conceive of these shelters. And then that's just the first step of it.

The next step of it is ultimately to make sure that there's adequate financing for the type of shelters. Without the financing aspects of this or without the necessary brokerage aspect of this, these shelters would not see the light of the day.

And then there is the law firms in there, who are involved in this, and essentially their ability to use legal opinions as a marketing tool. So the question is, when you add all this up and you see what happens, it's obvious that firms who have been engaged or individuals who have been engaged in that type of practice are under extreme exposure, not only civilly, but potentially criminally.

And, of course, that's what we see. And as I'm sure you all know, September, if my date is correct, 27th, the first of the KPMG trials will start. There are — I believe now it's down to four individuals in which the first trial's going to start.

So we'll get a good picture as to criminally how this is going to pan out. One of the defendants who is going forward is one of the individuals who was very, very prominent in the writing of some of the tax shelter opinions.

So that's probably as cautious of an answer that I can provide.

MR. BERGIN: Good job. Sir?

MR. ALEXANDER: Is that me?

MR. BERGIN: That's you, sir. Don Alexander.

MR. ALEXANDER: Don Alexander.

MR. BERGIN: I'll do it for you.

MR. ALEXANDER: A couple of points.

Going back to the shelters of the '70s, the basic question was whether the cattle actually existed, whether there were cattle.


MR. BERGIN: Good point.

MR. ALEXANDER: Frequently there weren't and you could maybe stop there. And here we have much more complex situations devised by some very, very intelligent people, whose intelligence and whose greed outran their judgment.

Will we have this again? Because I think we had it pretty well controlled at this point and it's somewhat unlikely that we'll have a new promotion of son of BOSS or grandson of BOSS. Where are the granddaughters, Lee? Why is it son of BOSS and not daughter of BOSS?

MS. SHEPPARD: I don't know, you know.

What I — can I — I want to go after you're done, though.

MR. ALEXANDER: Okay. So it goes.

But we've got to dream up some new shelters.

Whenever Congress decides to assign another task totally unrelated to the computation of what should be income subject to tax to the IRS, Congress creates the opportunity for those who were dealing in the '70s and '80s with nonexistent cattle to deal in the 2010s and '20s with nonexistent or perhaps somewhat less-than-fully existent things that Congress now wants to benefit through the tax system.

Why through the tax system? Well, those making the proposal don't have to pay for the cost of the proposal, so the tax system is what you do. And both our presidential candidates have various wonderful things to solve America's economic problems all on the back of what we have discovered to be the overburdened IRS.

IRS isn't all that overburdened. They've got a lot of people. They've got a lot of resources. They need to use them wisely and they need to use them taking into account the fact that if they don't try to make sure that our system works to produce the revenues that it should, nobody else is.

Mort mentioned a 5 percent audit coverage that took place, I guess it did, years and years ago. I was told when I arrived at 1111 Constitution Avenue and tried to check on that 5 percent coverage that those were single-issue audits. Whether they were or not, I don't know, I wasn't there. Were you there, Mort?

MR. CAPLIN: I happened to be there.

MR. ALEXANDER: Anyway, what we need to try to —

MR. CAPLIN: None of them were office audits. Some correspondence audits.

MR. ALEXANDER: Well, we have correspondence audits today and they're equally ineffective today as they were 50 years ago.

MR. CAPLIN: But the actual field agent audit was very heavy.

MR. ALEXANDER: Well, we won't get back into this ancient history as much as I would be delighted to do. But we do need to have a strong system of penalties.

Lee pointed out the loan metaphor. It was a metaphor, not an analogy, right, Lee, this time? The problem is that the lender doesn't know that the lender has made this loan unless a number of things happen. The first is an examination. The second is raising the issue of the examination. And the third is pursuing the issue.

Then we discover that we've got a loan. Should we charge a market rate of interest on that loan? Of course not. Maybe triple the market rate. Okay, Lee, your turn.

MS. SHEPPARD: I think that would take out of a few of the corporate folks, you know. Because on the individual side it's very clear that the answer is audits. But — and we do have to interject that Don uttered the absolute classic remark, which is a line I wished I would have written, when the Wall Street Journal, I think, asked him, you know, why the accounting firms were turning themselves into shelter mills. He said, because some of these people don't have their first Lexus yet.

What was I going to talk — I have forgotten my train of thought here. Oh, are we going to have another round? Yeah, absolutely we're going to have another round. And we're setting ourselves up for it right now.

And I'm going to reiterate what I said about section 6694, because, look, we're not having tax shelters now because we've had this wave of enforcement, but it's also we are not in a bull market. There are no people forming nonsensical Internet companies out on the West Coast and bales of money are falling on their heads and they're, you know, zeroing out their tax returns by visiting their friendly shelter promoter. That's one of the reasons we're not having shelters right now. It's nobody's got the profits.

But if you take it — I want to take it out of the fraud context. If you have no cows, you have a fraud. If you did your son of BOSS, but you didn't do the commodities trades, you have a fraud. And so you're at least in civil fraud and maybe criminal, right?

If you take it out of that context and you papered everything right, then section 6694, the statute, says that the law firm that helped you and the accounting firm that helped you and the commodities trader that helped you and the bank that helped you, those are all preparers. Okay?

But that 6694 proposed regulations that we just got say only the accounting firm basically is the preparer because they did your return for you, and the rest of these guys are not preparers.

So you have people doing this, they know it's going on a return, and they're outside the preparer net. And I want them inside the preparer net because the only thing that's going to get their attention is if they have to give back some of those millions of dollars of fees.

MR. BERGIN: Here and then here.

MR. PARAVANO: Thanks, Lee. Jeff Paravano, Baker & Hostetler. I had two things —

MR. BERGIN: Go ahead. I'm sorry.

MR. PARAVANO: Two things I'd like to say. One about 6694 is Lee is exactly right. I haven't read those regulations yet and I don't plan to because it's — Congress needs to take responsibility and get a uniform standard. Whatever it is, it is, but they need to do it and they need to get it done.

When I was at Treasury, I would have never even authorized writing regulations that extensive and broad and thick on something that you know needs to be fixed and will be fixed soon. The package will become worthless, I think, before I need to know it, at least I hope so.

Congress also needs to take some responsibility for complexity. Yes, some people are ignoring facts and that's clear. But other taxpayers are struggling mightily with a very complicated code. They need to be able to take a position with their eyes open with disclosure and not worry about penalties.

And I think as penalties are drafted you need to keep that in mind. You can't have a four-pronged test. You need to be careful that when there's a complicated situation, if someone's willing to do it, tell you about it, clearly tell you about it, tell you about it on a separate form that's attached so you can see it and so you can understand it, there really shouldn't be a penalty in that situation. And if we're not there, then the whole system suffers.

The last thing I'd like to say is that, just on Monte's point, when I was at Treasury, we encouraged the IRS never to litigate a case for purposes of establishing precedent. Litigating cases should be to enforce the law, to make sure that the law's enforced.

And if the answer's not clear, we encourage the IRS to come to Treasury, to come to the Hill, and to make the answer clear. We should decide tax policy. We should decide it based on a lot of considerations, not the narrow facts of one case, and have a judge decide it on that basis, and then broadly applied. So I would hope that would continue, too.

I think the Justice Department is enforcing the law in most of these cases, not necessarily trying to establish precedent.

Josh is here for establishing precedent. We have Treasury and the IRS and their regular writing authority to establish precedent. And I think we need to keep all those things in mind as we move forward on penalties.

MS. SHEPPARD: Maybe what you need on the compliance disclosure is some sort of a milder disclosure form that doesn't bring in the penalty system. Some sort of open-questioned disclosure form that you can say, look, this is the position we're taking, you know. You tell us what the answer is, kind of thing. And people could file that if they wanted to and then it would go in a different bin and not in the penalty bin and the listed transaction bin.

MS. WOLLMAN: It's Diana Wollman. And I want to make a comment and then I want to ask Jerry and Dennis a question.

The comment is — I'm not going to comment on everything that's been said about 6694, although I will say that I don't agree with everything that's been said. But let's just say that we rewrite history a little bit and we say that the entire purpose of 6694 is to put a practitioner or preparer, whatever you want to call them, in the role where they have a responsibility to tell the client the truth about the possibilities of penalties, what the rules are, how to get out of them, what the standards are, what the possibilities are. Let's say that is the entire purpose of 6694.

And what it says is, in my rewriting of history, it says if the strength of the position is so certain, whatever that threshold is, you don't have to do this. But if you're anywhere below that, then you basically have to give them a fair and balanced disclosure of what the penalty rules are and how they apply to them.

And if that's what 6694 is all about, then I think that there'd be a lot of people who would have a difficult time disagreeing with it and saying that it was bad policy. And then you wouldn't have so much of a fight about who's in and who's out because I think we'd all agree that that's really what practitioners should be doing. We might disagree about where that threshold is, but I think we'd all agree that that's really what people should be doing.

So that leads to my question, which is — and I thought what Jerry said about the penalty rules being too complex was just right on. I completely agree with you. And I think that a lot of people don't know what the penalties are. I think a lot of big corporations don't know and certainly a lot of the individuals don't know.

How much do the two of you think that it would change behavior if people, one, knew what they were, and, two, reasonably thought there was a possibility that they would apply to them? How much would that change behavior on the front end? And leave out of it the question of being picked up or not being picked up.

MR. COHEN: I'll start off, Dennis. I don't think you can leave that out of it. I think that is, at the individual level, that is a dominant theme. And if I had a wealthy individual who was asking me what the chances are of being audited, the answer has got to be you have to assume that you're going to be audited.

MS. WOLLMAN: Okay, right. So assume — so let me ask the question a little bit differently.

Assume people are going to be audited. Assume that everyone's going to be audited. Do you think that — you know, Lee talked about this mind-set of, well, the worst thing that can happen to me is I have to pay.

Do you think that if people really understood penalties and really believed that there was a possibility they'd apply, that that would change behavior?

MR. COHEN: No. That would be a quick answer. I've not in my practice seen penalties be a deterrent factor on any action that's being taken by a taxpayer. I think when the taxpayers are being advised, if there is a substantial chance for a penalty, they're being advised not to do this, at least I hope that that is what they're being advised.

I want to throw out one other thing. I have found paying interest to be a major factor for individuals. That's nondeductible. It is at a fairly high rate. And I'm finding that even with corporations that can deduct some of their interest that that is a big factor. The government's interest rate is higher than they're borrowing at.

And you're seeing that because with the clients I'm seeing, as soon as they — they come in after they've been picked up, I work most at the controversy level, and the first thing they want to do is see what they have to pay, depending upon the chances I tell them of succeeding. And they want to get some money in so that they stop the running of interest.

We add the interest abatement period, but if it's a tax shelter, and that's pretty broadly defined, you don't get the advantage of that. So they're paying in that money. Interest is a deterring factor, more so I think than the issue of penalties.

MR. CAPLIN: Jerry, we're finding a whole new practice on refunds of interest.

MR. COHEN: Yeah, absolutely, Mort.

That's right.

MR. BERGIN: Dennis?

MR. DONOHUE: Again, let me be cautious because what I can say is potentially subject to a number of the matters that I have before me, so let me see if I can answer this question and not disclose anything I should not be disclosing.

Tax shelters promoters are very, very cognizant of every new regulation, proposed regulation, temporary regulation case that comes down. Their essentially modus operandi is not essentially to say, oh, my goodness, this applies to us, let's stop in our tracks, pull up, and start some other type of work.

Their whole focus is essentially to see, based on what the service has issued — and to give an example, Notice 2044, which was the notice that came out in August of 2001, and essentially — or 2000 — and essentially made a point of saying if you're engaged in tax transactions which have artificially inflated basis of partnership interest, we are not only going to disallow the losses, we are going to assert penalties.

Well, the first thing on the promoter's mind when they saw Notice 2044 was to distinguish their transaction from the transactions in Notice 2044 or, alternatively, to go back to the design of their transactions and make an argument that their transactions were substantially different or at least not substantially similar to a Notice 2044 transaction.

So the question is will — as to the tax shelter promoter, will the issuing of new regulations deter them? The answer is, in my judgment, my personal judgment, no. Will it have an effect of deterring others, taxpayers who are honestly interested in making sure that they're complying with the law? And the answer there is, it depends on who they go to for advice.

If they go for advice to a tax shelter promoter and those who are in league with him, the likelihood is, again, no. If they go to their independent tax adviser who makes an honest and reasoned assessment of the situation, the answer is yes, I definitely think so.

SPEAKER: Depressing answers.

MR. JACKEL: Oh, is it my turn?

Just speaking from experience, and I don't want to be repetitive from what I said before, but I've spent some time working at IRS chief counsel. I've spent some time working in the Treasury's Office of Tax Policy. I've spent some time working in accounting firms where these things were being concocted, created, developed, and sold. Okay? And I've observed several things.

First, I think the main problem that I see is the failure — again, I hate to point the finger at the government — the failure of the Treasury and the Internal Revenue Service chief counsel to provide meaningful guidance with sufficient advance time on difficult but unpopular issues. Because the government frequently doesn't like to put out positions that they're going to get criticized for or that are unpopular.

Second, it's been five years. Congress should have codified economic substance as a uniform standard. Nothing's been done. The President characterized it as a — not as a loophole-closer, but everything as a revenue-raiser. Congress didn't fight back and we're nowhere on that front.

There needs to be some action on standard of review of cases at the appeals level. It probably has to be statutory, and I've seen no action on that front.

I still believe — you know, and I heard Jeff's comment, I just don't believe that litigating these, what I call cookie-cutter tax shelters, even though the government obviously needs to do something if these cases aren't settled, is productive with the government's limited resources. It chews up huge time. The PSI Division and chief counsel are responsible now for the shelters. It ties up those lawyers' time to such an extent that they cannot provide guidance on the projects they need to provide guidance on. The system, the way it's developing now, is out of control.

Now, I don't know what else to say, but we really need to get going on something if you want to solve the problem.

MR. BERGIN: Thank you.

MR. CAPLIN: I want to say, you left out one thing.

MR. JACKEL: I tried to include everything, but I'm sorry.


MR. CAPLIN: Well, I think an important thing, the question of personal responsibility. Professional standards, your own standards of ethics.

MR. JACKEL: That's true.


MR. JACKEL: But what happened in the firms, okay, which the government people here need to understand, is that it's very difficult when your employer is putting pressure on you to produce, okay, when the philosophy of the organization is, yeah, we want to hear the technical concerns, but the business guys will make the decision on whether the thing is sold.

That cultural thing I've seen is not — things have changed somewhat in that regard, I can clearly say that. But I personally was fortunate in I was able to push away someone on one well-known transaction because of certain issues. And but for that, such huge pressure would have been brought to bear by the organization, it would have been almost impossible to say no.


So — and I couldn't tell you the pieces of paper that would flow through your desk, you would know who's involved in these deals because the same paperwork from the same places would be flowing across your desk. Okay?

Yes, professional responsibility is important, but the professionals lose respect if they don't fear action by the government in providing guidance, and the guidance providers are not doing their job.

And until they do their job, don't fault — look, professionals shouldn't — greed was a large part of it, but a large part of it is government inaction, congressional inaction. And you can have these seminars and you can talk, but action is what counts. What else can you say?

MR. BERGIN: Jerry?

MR. COHEN: I'd like to make two quick comments. One, the whole shelter phenomena has been, as poor as our economy has been, very good for the economy of tax controversy lawyers.


And then I'd like to make one other comment on settling shelters and the resources of the government. The first shelter that hit the fan, so to speak, was something called FLIP and OPIS, which was a very technical shelter. We put together a group of 50 attorneys and worked out a global settlement that brought in 97 percent of the cases and over 50 percent of the shelter investors sued the promoter. Now I thought that was a very, very good result for the tax system.

On the other hand, son of BOSS came out with a very, what I was calling, Dennis, a draconian settlement, global settlement, proposal. And they're going to litigate a lot of son of BOSS cases. And one is going to come along now and then, like Sala, in which the government loses.

And every time — you can win, Lee, you can win 10 of these cases and you lose one, and you encourage the phenomena to start up again.

MS. SHEPPARD: Yeah. Well, you know, I agree and I've said this in print that that settlement offer was not a good one. Because, you know, if you look at the taxpayers' calculus — and I think they also underestimated the taxpayers.

As a defense lawyer I know says, this is a much better class of client than the previous group. You know, they've got a lot of money. They have enough money to litigate, and litigating is expensive. The doctors and the dentists didn't have the money to litigate. They're looking at big, whopping interest bills already and they're litigating to get out of penalties.

I mean, if you're realistic about it, you don't really think you're going to win that case in court, although there might be courts where you — on the legal part. You know, you never know what the facts are going to look like in court. But on the legal question you probably are not betting that you're going to win it, but you're just trying to get out of penalties.

Now, when you're doing a settlement offer, you're — if you're the IRS and you're doing the settlement offer, you're not doing it because you like it. I mean, when the IRS gave all those people in all those hokey shelters in the '70s and '80s, gave them 2-to-1 when they were trying to write off 10-to-1, they didn't give — and it was 2-to-1 plus your costs, right?

They weren't making that settlement because it didn't put a knot in their stomach to make it. They were making it to clear the decks. You do a settlement to clear the decks, even though in numbers you don't have the numbers.

I mean, you had numbers in the '70s and '80s of tens of thousands of people in particular shelters because this really was public. It was sold with prospectuses. So you did the settlement and you, you know, took an Alka Seltzer or a Tums and a Tagamet or something and you did it.

But this settlement offer was weird in that it had penalties in it. And as I understand it, nobody was eligible for the 10 percent penalty. So even if you were going to have penalties, you should have a knock-down.

It had no costs in it, you know, and then it had 100 percent of the taxes and interest. And so you had some — you got some very rich people and there's a boatload of them on the West Coast because that's where the money was in the tech boom. This is tech boom-money we're talking about.

You got people with a lot of money who are saying, yeah, I'm going to continue to fight this because I don't want penalties. And you had a lot of them settled, but the people who settled, as I understand it, were the ones whose — you know, their documents didn't line up and, you know, you had to settle to get out the door because something horrible was going to happen to you if you went to court.

And that's not a comment on the merits of any of this. That's just a practical point about, you know, how yucky it is settling. I mean, I personally think that the government could probably get all the rest of the cases right now, or most of the rest of the cases, if they said you could come in without penalties and just give us the taxes and interest.

Because you're really in a very touchy point here that the government really should not want to take the chance of losing another son of BOSS case. Even though, you know, yeah, you can point to Sala and say it's sui generis because there's a lot of very weird factors, including the government's own behavior in that case, that make it sui generis. But that's not going to discourage a taxpayer who's got the money to fight.

MR. BERGIN: We've got time for a couple of more. Jim?

MR. WHITE: Jim White from The Government Accountability Office. I've got a follow-up on Dennis's last answer, which I interpreted to mean that he had a lot of doubt about the effectiveness of penalties as a deterrent. And so my question is do you have any advice on what would be a good deterrent here or a stronger deterrent than penalties?

Does raising the audit rate, raising the probability of getting caught, is that an effective deterrent here?

MR. DONOHUE: What I'm going to say now is totally personal. I think there can't be anything more effective than what is going on in New York. Raising the bar for those who promote these programs from civil to criminal I think is going to send alarm bells throughout our respected professional firms.

Now, it remains to be seen as to what's going to happen in these criminal trials. But there is essentially a new tack that's being taken. We haven't seen professional firms and individuals from professional firms, certainly the most respected, being prosecuted for their involvement in tax shelters. If those trials wind up ultimately in a number of these individuals being found guilty, I think that's going to make a big, big difference.

MR. BERGIN: Okay. I'm going to close it now. We're about out of time.

Let me first thank everybody here.

Very smart room. Let me also thank our panelists. You guys were great.

And I'd also like to thank our guys, the Tax Analysts guys, who put this together and worked so hard to make these things work. Thanks, guys. I said that on tape now.


Thanks, everybody.


(Whereupon, at 10:58 a.m., the PROCEEDINGS were adjourned.)

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