Introduction

In late 1999, an unmarked manila envelope arrived at the U.S. Department of the Treasury.¹ The appearance of a mysterious envelope at the Treasury was not uncommon at that time. Every once in a while, Treasury officials would receive a parcel containing the prospectus for a complicated tax evasion strategy. They assumed that the documents came from tax professionals who had been shown the materials by a client or had come across them at work. These professionals, worried that the Internal Revenue Service might never discover the tax ploy, wanted to alert the agency so that it could close down the strategy and prevent the loss of millions of dollars in tax revenue. Torn between their concern that the tax shelter would allow wealthy individuals improperly to avoid millions of dollars in taxes and their obligation to protect client or employer confidences, some professionals chose to try to protect the federal fisc. Anonymity was the fig leaf that allowed them to make peace with the fact that by sending the materials to the government they were betraying their clients’ or employers’ confidences.

The manila envelope that happened to arrive at the Treasury that fall contained marketing materials describing a shelter known under the acronym BOSS, which was being promoted by Big Five accounting firm PricewaterhouseCoopers. From the look of the documents, BOSS was being offered to high-wealth individuals who wanted to avoid paying any taxes on large capital gains.² If, as it turned out, the promotional documents described an abusive shelter—one whose claimed tax benefits were not recognized by the law—Treasury officials would be able to use the detailed description as a roadmap to shut down the shelter and find the taxpayers who were claiming tax benefits from the strategy. Government officials immediately began analyzing the documents and sharing them with other government agencies.

The timing of the envelope’s arrival was propitious. In November, Congress was scheduled to hold hearings on the problem of abusive tax shelters. A year earlier, Forbes magazine had run a cover story on “The Hustling of X-Rated Shelters,” which had described in detail questionable strategies being offered by the Big Five accounting firms.³ According to Forbes, these shelters were being marketed under confidentiality agreements and designed to look like complex investments to avoid detection by the IRS. After the article came out, firm representatives insisted that any strategies they were selling were bona fide investments whose purpose was not solely to reduce or eliminate taxes. They were also adamant that there was no widespread abusive tax shelter problem that needed to be addressed through new legislation. Powerful members of Congress, wary of the IRS’s claims that a crisis was imminent, were prone to agree. For tax officials concerned that there was a serious and spreading problem, the contents of the manila envelope were corroboration that at least one major accounting firm was actively promoting abusive tax strategies.

Earlier in 1999, KPMG, another Big Five accounting firm, had approved for sale a tax shelter known under the acronym BLIPS.⁴ This tax elimination strategy turned on obtaining a loan at an above-market interest rate. Deutsche Bank, recognizing the potential for lucrative fees, agreed to provide the funds. Beginning that spring, two tax partners at KPMG involved in the review repeatedly raised concerns that the shelter would not hold up in court. When they were finally able to review the loan documentation during the summer of 1999, their fears were confirmed. The loan from the bank was a loan in name only, since the funds were not permitted to leave the bank. Despite these concerns, KPMG tax leaders pressed on, eager to get BLIPS to market because of its potential to bring in significant revenue. Before too long, the partners who had raised doubts about the shelter had been marginalized. The firm went on to make $50 million from the sale of BLIPS, which did not come to the attention of authorities until several years later.⁵ When the government finally discovered BLIPS, it estimated that the shelter had cost the Treasury at least $l.5 billion in uncollected tax revenue.⁶

Meanwhile at Ernst & Young, a team of tax lawyers and accountants formed specifically to design and market tax shelters was very busy marketing a shelter similar to BLIPS. COBRA, as this shelter was known, had been developed in collaboration with Paul Daugerdas, a tax lawyer and partner at Jenkens & Gilchrist, a notable corporate law firm based in Dallas, Texas.⁷ Daugerdas had joined the firm a year earlier. With two other lawyers from his old firm, he opened a Jenkens branch office in Chicago devoted to developing and promoting tax shelters. Daugerdas essentially ran his own show in Chicago with only minimal oversight from the firm. Soon the revenue began to pour in. COBRA was so successful that a small army of associates from the Dallas office periodically had to be flown up to Chicago to deal with the enormous backlog of paperwork that was generated by the sales of the shelter.

BDO Seidman, a second-tier firm, was also in the game. In early 1999, the firm had been suffering significant financial difficulties. Revenue from tax shelter activities promised to turn the situation around. Denis Field, a lawyer and charismatic leader who would shortly rise to be the firm’s CEO, had formed a special group devoted to marketing tax shelters, known as the “Wolf Pack.”⁸ By mid-1999, the firm was enjoying almost $15 million in net profit from shelter sales. Field saw even greater wealth on the horizon. Predicting profits of more than $75 million the following year, Field exhorted tax partners with the slogan “Tax $ell$!” Like Ernst & Young, BDO also had turned to Daugerdas at Jenkens to help design and promote tax shelters.

Daugerdas’s group was not the only one at an elite law firm that was deeply involved in tax shelter activity. The efforts of accounting firms were abetted by lawyers at several other prestigious firms. These firms included Brown & Wood (later absorbed into Sidley Austin Brown & Wood), Arnold & Porter, Locke Liddell, Proskauer Rose, Seyfarth Shaw, and LeBoeuf Lamb. Tax lawyers at these firms developed ideas for new tax strategies and worked with accounting firms, financial institutions, and investment advisory firms to implement them. They also wrote hundreds of opinion letters that were intended to induce clients to purchase shelters and protect them from liability for penalties if the IRS discovered the shelters. Even though the lawyers in many instances had helped create the shelters, their opinions purported to be the objective advice of independent legal advisors. These cookie-cutter letters, which varied only in client details, earned their law firms millions of dollars in fees.

The turn of the twenty-first century represented the high-water mark for abusive tax shelter activity at major accounting firms and elite law firms. To address the epidemic, federal tax authorities had to launch a multipronged attack. They sought new statutes and regulations to tighten the federal tax code and went after taxpayers who had used abusive tax strategies. Recognizing that they needed to shut down the problem at its source, officials trained their sights on accounting and law firms and took actions that were virtually unheard of at the time. They issued subpoenas to firms requesting documents and information about clients, launched criminal investigations, and initiated tax fraud prosecutions against professionals. By the mid-2000s, the tax shelter industry had begun to contract, but not before a significant number of tax professionals and the accounting and law firms at which they worked had been drawn into the criminal justice system.

Spanning the decade between 1994 and 2004, the abusive tax shelter crisis likely represents the most serious episode of lawyer wrongdoing in the history of the American bar. Dozens of lawyers participated, dispersed among most of the major accounting firms and many prestigious law firms. The magnitude of this episode is reflected not only in the number of lawyers involved, but also in the depth of their involvement. In the savings and loan debacle of the early 1990s and the corporate scandals a decade later, lawyers were called to task because they had enabled and covered up client wrongdoing rather than attempting to prevent it. During these earlier episodes, “Where were the lawyers?” was an oft-repeated complaint sounded by critics. In the tax shelter episode, by contrast, the lawyers were difficult to miss—if you knew where to look. Inside the firms where they worked, their fingerprints were everywhere: on the shelters they designed, the promotional materials they prepared, the client pitches they made, and the opinion letters they drafted and signed.

How did such a widespread and systemic episode of professional wrongdoing occur? In this book, we offer an account of the circumstances that gave rise to the tax shelter industry. Among the factors that contributed to the emergence of the abusive shelter market were a lax regulatory environment and a highly competitive market for professional services. At the end of the twentieth century, the IRS was struggling with outmoded collection and tracking methods, inadequate analytic tools, and severe resource constraints. It was also dealing with a hostile Congress, many of whose members were intent on rendering the agency ineffective as part of a larger antitax and antigovernment crusade.

During the same period, the American economy was booming. Numerous entrepreneurs were creating and selling off new companies, reaping millions of dollars of profits in the process. Elite lawyers and accountants were not enjoying their share of the wealth, or so they believed. Major accounting firms and corporate law firms were functioning in increasingly winner-take-all markets characterized by fierce competition. In the accounting sector, revenues from audit services—long the core service provided by the Big Five—were flat. Driven by imperatives to grow and increase profits, major firms were casting about to identify new sources of revenue. At the same time, corporate law firms were competing aggressively among themselves for lucrative client engagements, partners with substantial books of business, and greater revenue.

For tax professionals at these firms, shelters targeting the expanding number of newly minted millionaires facing substantial tax bills offered an avenue for increasing growth and profits. Tax shelters—and the supposedly independent opinion letters that accompanied them—could be marketed as products, yielding fees based on the number of virtually identical shelters that were sold. By charging a percentage of the supposed tax savings on a high volume of shelters, firms could escape the constraints on growth imposed by the hourly fee structure.

Despite the allure of lucrative fees, not all accounting firms succumbed, nor did all firms participate to the same extent. The accounting firms that were most deeply involved implemented organizational incentives that encouraged tax shelter development and marketing. Tax leaders at these firms also created organizational structures and cultures that celebrated tax shelter activities and channeled specialized expertise into devising transactions that involved hypertechnical interpretations of the tax code in order to help clients evade billions of dollars in taxes.

At law firms, tax shelter work was not institutionalized to the same degree. Loose partnership structures allowed tax shelter lawyers to work semiautonomously with little or no oversight by the rest of the firm. Whatever review and approval processes were instituted were inadequate, given the complexity and detail of the strategies involved. At Jenkens & Gilchrist, repeated failure to appreciate the risks of a tax shelter practice led eventually to the demise of the firm. Other law firms survived but ended up paying substantial penalties to government authorities and settlement awards to former clients. They also suffered significant reputational harms from government investigations and adverse publicity when their shelter activities became public.

In addition to shedding light on the environmental, organizational, and cultural dynamics that gave rise to systemic wrongdoing, the abusive tax shelter episode exposed deep vulnerabilities inherent in the American tax regime. At the highest reaches of wealth, the income tax system depends on the voluntary participation of taxpayers. Salaried employees are subject to automatic withholding, which gives them little room to avoid paying taxes. Individuals in the top 1 percent income bracket have significantly greater opportunities to structure their business affairs to minimize their tax burden. They also have the resources to enlist financial and tax advisors to devise highly complex tax-favored transactions that are very difficult for the IRS to untangle.

Traditionally, tax lawyers were expected to rein in high-wealth clients who wanted to avoid paying taxes. The U.S. tax bar has long adhered to informal professional norms under which its members advised their clients to refrain from overly aggressive strategies that improperly reduced taxes. These norms reflected an implicit agreement between the legal profession and the state. This agreement provided that lawyers enjoyed significant prerogatives, including freedom from external regulatory oversight, in exchange for a commitment to counsel clients to behave consistently with their legal obligations. Pursuant to this understanding, communications between clients and their lawyers are confidential and protected from disclosure so that lawyers can use their expertise to guide clients to comply with the law.⁹

The abusive tax shelter crisis represented a breach of this agreement. Tax lawyers not only did not advise clients against participating in questionable tax strategies, they also devoted substantial expertise and resources to designing such strategies and soliciting new clients to engage in them. One result has been erosion of the tax bar’s professional autonomy, as government authorities have insisted on more expansive regulation of tax counseling and advice. More broadly, although the episode did not occasion a seismic shift in the public’s views of elite lawyers, it provided grounds to distrust lawyers and the organizations in which they practice.

To address these concerns, the tax bar needs to recognize that the tax shelter episode was not the product of a handful of bad actors who hijacked the organizations in which they practiced in order to implement their nefarious schemes. Rather, it reflected the combined effects of a highly competitive market, weaknesses in the regulatory regime, and organizational environments whose structures undermined, or at least failed to encourage, traditional informal norms of tax practice. To focus on the wrongdoing of individual participants is to miss the institutional factors that contributed to the tax shelter episode.

We devote most of our attention in this book to describing the events that gave rise to the tax shelter market, and to the government’s mostly successful efforts to combat it. While we discuss some measures that might reduce the likelihood of a similar episode occurring again, we do not attempt a comprehensive analysis of how to prevent the next tax shelter wave. Tax practice is especially complex, and tax lawyers inevitably must exercise considerable discretion. We believe therefore that it is up to tax lawyers to devise regulatory and organizational systems to address the weaknesses that we expose in this book. Tax professionals are not passive agents in the environment in which they work, but actors who create and maintain the institutions that structure practice. This book is an invitation to the tax bar, and elite lawyers more generally, to engage—collectively and individually—with the project of strengthening dimensions of the regulatory regime that enable them to practice at the highest level and provide their best professional advice. It is also an invitation to lawyers to create organizational structures and environments conducive to these types of practices. In our conclusion we offer some ideas for pursuing these possibilities. Ultimately, however, the responsibility lies with the tax bar, and the legal profession more broadly, to claim a space for professional norms and practices and to devise the institutions and conditions that permit them to evolve and flourish.¹⁰