3   Gimme Shelters

The need for the IRS to focus more on collection and less on enforcement in the late 1990s could not have come at a worse time. Corporate taxpayers had growing incentives to eliminate or at least reduce tax liabilities as much as possible, while an emerging class of the superrich expanded individual demand for shelters. At the same time, accounting firms, financial institutions, and law firms all faced intensified competitive pressures that made the development of mass-marketed tax shelters a very attractive line of business. Unlike the 1980s, tax promoters could now rely on sophisticated financial instruments to construct shelters of forbidding complexity. The result was a major surge in abusive shelter activity, to which the IRS was slow to respond. While the demand for tax shelters had increased by the 1990s, the tax shelter boom of that decade was mainly a supply-driven phenomenon orchestrated by some of the major professional institutions in American society.

Demand

Corporate Taxpayers

At mid-twentieth century, corporations treated their tax departments as cost centers. Under this approach, the focus was on minimizing costs while meeting a company’s tax obligation. By the end of the century, however, many corporations had shifted to treating their tax department as a profit center. This latter model emphasized the tax department’s contribution to reported income through its minimization of the corporation’s tax liabilities. This encouraged tax departments to focus actively on tax planning activities that contributed to the company’s bottom line.

This shift in focus reflected increasing economic competition for U.S. companies in the last two decades or so of the twentieth century. In the three decades after World War II, many U.S. corporations held dominant positions in markets characterized by oligopoly rather than vigorous competition. In 1950, the United States produced about 60 percent of the manufacturing output of the seven largest capitalist countries.¹ Large-scale production created economies of scale that established formidable barriers to entry in many markets, limiting competition to large vertically integrated firms. In the decades immediately following the war, as L. G. Thomas notes, “transportation costs were high, there was little foreign competition, communication and data processing costs were high, and information moved slowly. Under these conditions strategic assets were very durable.”² Companies subject to relatively mild competitive pressures maintained profitability by raising prices, with little incentive to trim costs and operate more efficiently. The list of leading firms in various industries was relatively stable. A firm that was in the top fifth of its industry, for instance, had only a 10 percent chance of losing that position within five years.³

Reflecting the advantages of large-scale production, fewer than five hundred companies in the United States were responsible for almost half of the country’s total industrial output. These companies employed more than a fifth of all nonfarm workers in the United States.⁴ They owned about three-quarters of the country’s industrial assets and earned about 40 percent of its profits. Given their large capital investments, these firms had to be able to plan production with confidence that goods could be sold at a specific price. To accomplish this, they relied on a mixture of strict planning processes and collusion with other leading firms in their markets. The result was that “[t]he giant corporation of mid-century America necessarily possessed vast discretion and economic power.”⁵

In the 1970s, however, several developments began to emerge that reduced the importance of economies of scale, weakened barriers to entry, and intensified competition in many formerly stable industries. Communications and information technology made it possible for potential rivals with minimal vertical integration to compete with long-established companies. Instead of organizing the production process within a single firm, companies began to contract with suppliers around the globe to obtain the resources and services they needed at each stage of the process for the lowest cost and highest quality. With the appearance of computer systems, companies could use software for billing, procurement, inventory controls, and other operational functions. Within a few decades they were performing these functions and contacting current and prospective customers using the Internet. Traditional vertically integrated firms had high fixed costs and used large-scale production to minimize the cost per unit of the items they sold. Technology made it possible for newer firms to reduce fixed costs by constructing supply chains that could be adjusted based on fluctuations in demand and production. The old production system could now be segmented and assigned to a variety of suppliers in diverse locations. As a result, entry into many markets no longer required massive capital investment to minimize the costs of production.

Heightened competition at the global level became more feasible with the emergence of transportation and communications technologies such as satellites, overseas cables, and steel shipping containers.⁶ Companies used these technologies to move facilities abroad, contract with suppliers around the world, and launch enterprises in low-cost locations. Anyone could use software “to create a virtual company consisting of little more than a chain of supply contracts with an auction held at each link in the chain designed to get the best deal every step of the way.”⁷ Potential market entrants then began to lobby to dismantle the regulatory regime that had served to reinforce the oligopolistic markets of the postwar period. They argued that deregulation would spur competition that would provide better goods and services to consumers faster and more cheaply. This led many industries to eliminate the intricate network of cross-subsidies that was created to respond to the needs of various economic interests. Firms that once had been able to assure profitability by establishing predictable prices now had to maintain their margins by focusing more intently on reducing costs and operating more efficiently.

The result has been the appearance in many industries of “hypercompetition.”⁸ This condition is characterized by unstable competitive advantages that are continually at risk of being eroded by more innovative or efficient competitors. In such markets, “competitors must move quickly to build [new] advantages and erode the advantages of their rivals.”⁹ Any competitive advantage is temporary; financial returns are volatile, and firms must continually innovate throughout their supply chains to develop new sources of advantage. The effects of hypercompetition can be seen in the greater volatility of competitive position among firms in many industries. While a firm had only a 10 percent chance of falling out of the ranks of the top fifth in its industry in the immediate postwar period, by 1998 that risk had increased to 25 percent.¹⁰ Between 1970 and 1990, the rate at which companies exited the Fortune 500 quadrupled.¹¹ By 2000, the average U.S. company was losing more than half its customers every four years.¹² Scholars also have noted increasing volatility in recent years among firms in the same industry, as success depended less on the characteristics of the industry and more on the internal capacity of the firm to create new strategic assets as old ones rapidly depreciate.¹³ Indeed, the boundaries that defined particular industries themselves became increasingly fluid in the last two decades of the twentieth century as products and services were combined in different ways and competitors could emerge from any existing market.

These developments, which had their roots in the 1970s, coincided with the emergence of what economic sociologist Neil Fligstein has called the “financial conception” of corporate control.¹⁴ As firms became more diversified among product lines, markets, and industries in an effort to spread their risks, they evolved toward a multidivisional form in which decision making was more decentralized than in previous years. To the extent that firms became less vertically integrated, this prompted movement from a command and control authority structure to flexible production systems that granted more authority to persons at lower levels in the organization.

Since top management did not necessarily have production or marketing experience with all the fields in which a given company competed, corporations needed to develop a new conception of managerial control to coordinate their diverse activities. The financial conception of control treated multidivision companies as a collection of assets competing for internal investment from top management on the basis of their comparative rates of return. As Fligstein remarks, “the financial conception of control viewed the central office as a bank and treated the divisions as potential borrowers. The central office would invest in divisions that showed great potential and divest those in slow-growing markets.”¹⁵ The firm’s central goal was to “allocate capital across product lines in order to increase short-term rates of return.”¹⁶ The industries in which a company operated thus matter less than the relative profitability of its various units, which management could determine by using standard financial criteria.

By the 1990s, the prevalence of hypercompetition and the financial conception of control led many companies to treat their tax liabilities as costs of business that could be minimized through the use of sophisticated financial techniques. As one observer suggests, “modern corporate strategists perceive income tax liabilities as another cost of business that can and should be managed, like inventory costs or environmental regulations.”¹⁷ The “active management of corporate tax liabilities” became a common phenomenon unlikely to recede in light of the growing refinement of financial planning strategies.

Given this approach to tax obligations, corporate tax departments had an incentive to engage in tax planning activities up to the point at which the marginal cost of doing so equaled the marginal increase in reported income resulting from the tax decrease that they achieved. The focus on contribution to reported income provided a metric to evaluate a tax department’s performance by managers who might have lacked the tax expertise otherwise to assess the quality of the department’s activities. Firms that adopted a profit-center performance standard for their tax departments ended up with lower effective tax rates.¹⁸

The notion that “tax departments are increasingly counted on as innovative profit centers and that tax managers are increasingly provided incentives to produce profit”¹⁹ was well established by the turn of the twenty-first century. In a 2001 survey of corporate tax departments in manufacturing companies, the measure used most often to evaluate department performance was the tax savings it provided.²⁰ More than half indicated that this metric affected the compensation of tax department employees. In a survey of Fortune 1000 tax directors, 46 percent ranked the effective tax rate as the most important consideration in pursuing the tax department’s goals, compared to 16 percent who ranked compliance first.²¹ As one prominent tax practitioner concluded in 1999, the “senior corporate managers now perceive a corporation’s tax liability not as an inelastic and inevitable misfortune, but rather as a necessary cost that responds to aggressive management, just like other corporate expenses.”²²

Individual Taxpayers

The growing concentration of wealth in the United States also created demand from individuals for tax shelters at the turn of the twenty-first century. From 1970 to 2000, the share of income going to the bottom 90 percent of all Americans decreased from almost 67 percent to a little over 52 percent.²³ The share held by the top 10 percent rose from 33 percent to almost 48 percent. Furthermore, the share held by the top 1 percent increased from a little under 9 percent in 1975 to more than 21 percent in 2000, a rate of increase of almost 143 percent. The concentration of income is even more pronounced when we consider that by 2000 the share of income held by the top 0.1 percent was almost 11 percent, compared to about 2.5 percent in 1975, an increase of 337 percent.²⁴

The wealthiest Americans enjoyed significant increases not only in their share of the nation’s income, but also in the amount of income that they commanded. Adjusted for inflation, the average income of the top 10 percent of United States taxpayers rose from $130,327 in 1970 to $185,136 in 1995. By contrast, average income among the other 90 percent fell from $31,470 in 1970 to $30,171 in 1995. The average after-tax income of the wealthiest 1 percent of households rose from $322,733 in 1970 to $617,882 in 1995, an increase of more than 91 percent.²⁵

A substantial reason for the large spike in income among the wealthiest households was a huge increase in executive compensation over the last few decades of the twentieth century. The percentage of income based on wages, salary, and pensions for the top 1 percent increased from just under 53 percent in 1975 to a little over 63 percent in 2000, while the percentage of income from dividends dropped during that period from almost 13 percent to about 5 percent. The change in source of income from 1975 to 2000 was especially dramatic for the top 0.01 percent of Americans. The percentage based on compensation increased from just under 26 percent to almost 61 percent, while the percentage from dividends declined from 40 percent to about 5.5 percent.²⁶ Between 1992 and 2000, the average pay of the CEO of Standard & Poor’s 500 companies increased from $3.5 million to $14.7 million.²⁷ A comprehensive study of executive compensation from 1936 to 2003 indicates that for the period 1970 to 1979, the average CEO received about forty times the pay of an average worker. By 2003, the ratio was 367 to 1.²⁸

At the same time that executive compensation was rising sharply, entrepreneurs in the Internet technology sector were also reaping large financial rewards. The Internet boom of the last years of the 1990s resulted in especially outsized gains in wealth for persons who cashed in shares of technology companies. What venture capitalist John Doerr described as “the greatest legal wealth creation in history”²⁹ generated a potentially lucrative market for transactions that would shield this income from taxation.

The increase in share price on the opening day of initial public offerings (IPOs) for just a few companies illustrates the broader phenomenon. Priceline opened at $16 a share and closed the day at $69.³⁰ The founders’ stake in the company was worth $4.3 billion. Netscape’s opening price was $28 per share; it closed at $58.25, with trading of 14 million shares. Founder Jim Clark’s shares were worth $565 million, venture capital firm Kleiner Perkins’s stake was worth about $260 million, the company’s new CEO’s shares were worth almost $245 million, and the programmer who had developed the browser held shares worth $58 million.³¹ Trading in EarthWeb began at $14 a share and spiked to almost $49 a share; the founders’ stake in the company was worth $65 million each. Pre-offering shares of TheGlobe.com were $9 a share; the company closed at a price of $63.50 per share. The founders’ shares were each worth about $50 million.³² Webvan issued shares at $15 each, which moved to almost $25 dollars apiece by closing. As a result, the founder was worth more than $2 billion and the new CEO’s recruitment package rose to almost $300 million.³³ In April 1999, The Industry Standard featured a cover with the founders of Priceline.com and Broadcast.com and the headline “THIS WEEK’S BILLIONAIRES.”³⁴ The magazine noted that someone who had invested $100,000 in American Online eighteen months earlier would now be worth $1.3 million.

In the height of the frenzy, from October 1998 to April 2000, more than three hundred Internet companies had initial public offerings, with a good number enjoying comparable bounces in share price. Those who cashed in their shares before the market collapsed enjoyed huge paydays and were prime customers for shelters to shield that income.

The fact that some Internet fortunes were made without satisfying standard requirements for demonstrating business viability to potential investors may have made the paper losses generated by shelters seem a plausible basis for tax savings. In August 1999, for instance, Webvan saw a first-day increase of 66 percent in its share price despite the fact that it projected losses of $78 million in 1999, $154 million in 2000, and $302 million in 2001—or half a billion dollars in its first three years. Investors gave little weight to such projections on the view that the Internet was the basis for a “new economy” in which “time-honored methods of valuing stocks no longer worked and should be discarded.”³⁵

Supply

Traditionally, accounting and law firms were dedicated to providing individualized services to clients. This conception of professional service, which dated back to the early twentieth century in the United States, was animated by the view that human problems arise under conditions of uncertainty and are not subject to mechanical solutions. Instead, these problems called for expert judgment.³⁶ Historically, professional firms were organized to enhance the capacity for professional judgment. New hires worked under the close supervision of more senior professionals and were given greater responsibility over time over increasingly important matters. The partnership structure of firms, meanwhile, created a discretionary zone for experienced professionals to apply their expertise.

The rise of the tax shelter industry, which involved developing and marketing tax products to multiple clients, offers a window into how this traditional conception of professionalism came under strain at the end of the twentieth century. In particular, the episode illustrates how financial incentives, filtered through organizational mandates, distorted the exercise of professional expertise.

At a macro perspective, the tax shelter market is one example of how professional firms have become vulnerable to intensified market forces in the last quarter of the twentieth century. As commentators have noted, the emergence of the tax shelter market is part of a larger transformation in which professional service firms have become more explicitly self-conscious business ventures. While claiming the trappings of professionalism, these firms conduct their day-to-day operations like any other business, driven mainly by the goal of profit maximization.³⁷ In this account, the assumption is that the incentive to increase revenue has supplanted professional judgment. Applied to the shelter market, this approach implies that shelter promoters, rather than assessing the legitimacy of the transactions they were promoting, were single-mindedly devoted to marketing them as widely as possible before enforcement agencies got wind of them and shut them down.

There is no doubt that among market participants, many of those involved wanted to make a quick return regardless of legal constraints. In addition, many nontax partners, who were not involved in promoting shelters, turned a blind eye to increased revenues from tax services. But the effects of market pressures on professional judgment turn out to be more complex. Many individuals swept up in the shelter market were highly regarded tax professionals with lengthy experience in practice. They spoke and acted as if professional standards and legal requirements mattered. Despite efforts to apply their best professional judgments, however, they often allowed the firms to approve and market abusive tax shelters. In these instances, organizational pressures and business rationalizations did not so much displace professional judgments as distort them. The rise of the shelter industry reflects the vulnerability of professional judgment to organizational imperatives in a period of intense market competition.

Accounting Firms in the Late Twentieth Century

By the second half of the twentieth century, the major accounting firms in the United States had risen to prominence by providing services to large corporations that involved audits of corporate financial statements and attesting to the reliability of various company representations. With the securities acts in the 1930s, outside accountants were given the responsibility for certifying that the financial statements of publicly traded companies were consistent with generally accepted accounting principles. As their corporate clients grew in size and expanded their activities, accounting firms grew and expanded with them. By the 1930s, the major firms had come to be known as the “Big Eight.”³⁸ Prohibited by ethics rules from engaging in competitive bidding or advertising, each firm developed an industry specialty. Based in Chicago, Arthur Andersen focused on traditional manufacturing industries, while Price Waterhouse was the auditor of choice for blue chip companies. Accountants also had been involved in tax return preparation since the enactment of the income tax laws. At major accounting firms, tax services—which included, in addition to return preparation, tax planning and representing clients in controversies before the IRS—were ancillary to audit services, which were the bread and butter (and jam) on which major accounting firms subsisted and thrived. Until the 1980s, the Big Eight earned most of their fees from audit services.

While not a dominant source of firm income, tax services fit comfortably with accounting services. With the enactment of the tax laws in the early twentieth century, businessmen had suddenly been required to maintain written records to support the determination of taxable income. CPAs were pressed into service to assist in preparing financial records. Tax accounting became an important subspecialty of the field.³⁹ Arthur Andersen led the way in providing tax services, developing a specialty in income tax in the 1910s, which it subsequently parlayed into audit and consulting engagements.⁴⁰

By the 1930s, all of the Big Eight accounting firms had specialized tax departments and provided tax-planning advice. A client might be contemplating a business deal, for example, and a tax specialist might suggest ways to structure the transaction to take advantage of available tax benefits and then assist with implementation. Tax professionals at accounting firms were also available to represent clients in controversies with the IRS. With the exception of tax return preparation, which was the bailiwick of accountants, the tax services offered by major accounting firms were not all that different from services offered by tax lawyers at corporate firms.⁴¹

The provision of audit, tax, and management advisory services—or consulting services as they were later known—fell under the traditional model of professional services, which were organized around the application of specialized expertise to the unique problems of individual clients.⁴² The hallmark of tailored or “bespoke” services was the billable hour. Calculating fees based on time expended was premised on the assumption that it was not possible to predict how much total time a matter might take up, since unforeseen circumstances—requiring additional research and investigation—could arise in any matter.⁴³ Not only were hourly fees favored in the provision of tax services, but until the 1990s contingent, or result-based, fees were banned.⁴⁴

In addition to the billable hour, accounting firms adopted other characteristics of the traditional professional model. Firms were organized to encourage the development and exercise of professional judgment. Despite their much greater size, accounting firms were set up as loose bureaucratic-professional partnerships, much like law firms. Individual partners had the final say on matters entrusted to them.⁴⁵ Accounting firms also instituted training and promotion protocols similar to those of law firms. Entry-level accountants were put through a rigorous multiyear training program during which they learned to apply technical rules and became familiar with the unwritten norms of their particular firms and the larger profession. Like lawyers in corporate firms, accountants at major firms were also subject to an up-or-out rule: if they were not promoted to a senior position in the partnership after a specified period of time, they were assisted in finding alternative placements.⁴⁶

Beginning in the 1960s, audit services began to experience pressure from different directions. Suits against firms proliferated as liability for the failure to detect fraud expanded.⁴⁷ When businesses failed during the economic downturn of the next decade, audit services came under increased scrutiny from the Securities and Exchange Commission (SEC), which threatened to take a more aggressive regulatory stance. In the meantime, anticompetitive barriers inside the industry began to break down under the threat of antitrust liability. In 1973, the American Institute of Certified Public Accountants (AICPA) was forced to lift its ban on competitive bidding for audits and, a few years later, its prohibition against advertising. Major firms, which had once enjoyed an informal agreement that they would not compete for each other’s clients, were now in audit price wars. In the decade that followed, competition increased as the number of corporate mergers and acquisitions surged and corporate consolidations left fewer companies to audit.⁴⁸

In the meantime, the audit process itself was undergoing changes, becoming increasingly rationalized. With the routinization of audit, the space for the exercise of discretionary judgment narrowed. Beginning in the 1960s, the AICPA began to issue regular research bulletins that sought to articulate the principles that were to guide the audit process. These principles were ultimately codified in accounting rules. At the same time, corporate clients began to use computers for data processing and storage. Automated systems reduced the need for auditors to play a role in gathering information and detecting fraud.⁴⁹ By the 1980s, audits had become commoditized. Nothing distinguished an audit provided by one Big Eight accounting firm from another and firms were no longer able to compete on the basis of quality or specialized industry expertise in the provision of audit services.

As revenues from audits flattened out, the major firms began to search for new service areas and business strategies. They turned to consulting, which appeared to provide a solution.⁵⁰ Having long offered management advisory services, accounting firms launched systematic efforts in the 1980s to build their consulting practices. These efforts, however, soon met with roadblocks. Led by SEC chair Arthur Levitt, that agency began to voice concerns that consulting presented a conflict of interest with the provision of audit services.⁵¹ Within the next decade, firms were forced to divest themselves of their consulting divisions because of ongoing pressure from the SEC. In Arthur Andersen’s case, the differences in its audit and consulting cultures eventually created insurmountable tensions.⁵²

When major accounting firms’ foray into consulting failed, the only competitive advantage left was their size and capacity, enhanced by computer networks, to audit their clients’ operations across geographically dispersed sites. With the increasing importance of size, major accounting firms, anxious that second-tier firms would overtake and displace them as the auditors for large multinational corporations, launched a series of mergers. In the late 1990s, the Big Eight became the Big Six and then the Big Five.

In the 1990s, accounting firms began to grow their tax practices, emphasizing the development of standardized tax strategies. Until this period, firms had offered individualized tax advice to clients on how to structure transactions to minimize tax liability along the same model as their provision of audit and consulting services. Tax advice focused on counseling clients about specific deals, and the strategies proposed arose in the context of clients’ individual business needs. In the 1990s, firms began to recognize the significant efficiency gains that would result from developing turnkey tax products for immediate use that they could sell to many similarly situated clients.

The impetus to create standardized products accelerated when the AICPA in response to regulatory pressure amended the rules governing tax advice to permit contingent fees. In the mid-1980s, the Federal Trade Commission initiated an investigation of accounting firms, contending that certain ethical prohibitions, including a ban on contingency fees, constituted unlawful restraints of trade. The investigation culminated in a settlement in 1990 under which the AICPA narrowed the prohibition of contingent fees to services provided to audit clients and the preparation of original tax returns.⁵³ Several years later, the AICPA issued rulings that made clear that a percentage fee was not, in any case, a contingent fee, since its payment did not depend on achieving a particular result.⁵⁴ The door was now open to firms to design and market tax products to multiple clients, charging fees based on the anticipated tax deduction generated by the transaction. In effect, accounting firms were able to earn percentage-based commissions for their tax strategies. So long as fees were structured so that they were due regardless of whether the client’s position would ultimately be upheld by the IRS or in court, a firm could escape the characterization of its fees as contingent on obtaining a particular outcome.⁵⁵

The focus on standardized products and the loosening of fee restrictions could not have come at a more propitious moment. During the late 1990s, the United States was enjoying the dot.com boom and its economy was surging. A large group of newly minted millionaires emerged who were ideal prospects for tax product sales. The major accounting firms ramped up their tax practices and went on a tax lawyer hiring spree, engaging in extensive entry-level recruitment at law schools and offering highly lucrative compensation packages to lure away senior tax partners from wellestablished corporate firms.⁵⁶ Between 1995 and 2001, the U.S. tax practices of KPMG, Deloitte & Touche, Ernst & Young, and PricewaterhouseCoopers more than doubled their revenue, from $ 2.4 to 5.6 billion.⁵⁷

Law Firms

The Guilded Age

Until the last two decades of the twentieth century, corporate law firms made up the segment of the legal profession that was most successful in organizing itself as a guild that enjoyed significant insulation from both market pressures and government regulation. The legal departments of corporate clients typically were quite small and focused on the most routine work. Clients therefore used outside firms for most of their legal needs. For much of the century, especially in the period following World War II, a company typically used one firm for most of its work. The relationship tended to be long term; a company rarely replaced a firm or shopped around to generate competition. This arrangement provided a firm with a regular work flow and a predictable income stream. The steady work served as an opportunity to train younger lawyers and generally minimized the need for partners to spend significant time attempting to generate business. Clients were institutionalized, passed on from senior to junior lawyers in due course. The benefit of having a firm familiar with its operations made a client reluctant to switch to a new firm that it would have to educate about its business.

Under these conditions, a law firm was able to develop what economists call firm-specific capital.⁵⁸ That is, a firm had unique assets that provided its lawyers with the opportunity to earn more by practicing in that firm rather than elsewhere. Lawyers in the firm gained access to regular work from clients and became familiar with their needs over the course of their careers at the firm. They also acquired professional training that imparted the particular ways in which the firm approached, organized, and performed legal work for its clients. In addition, they developed relationships with colleagues to whom they could turn for assistance and advice, which enhanced their productivity. If lawyers were promoted to partner, the availability of such firm-specific capital created powerful incentives to commit them to the firm for the course of their entire careers. Furthermore, clients regarded themselves as retaining the firm rather than individual lawyers. This made leaving the firm an unattractive option because lawyers would not be able to take clients with them.⁵⁹

Relative insulation from competition for both clients and lawyers gave law firms considerable control over their environment and afforded them the opportunity to structure their operations around their internal needs and their partners’ understanding of professional norms. They were able to bill clients at rates that they regarded as reasonable without having to account in detail for their charges. They decided how their work should be organized and their services delivered without the need for serious attention to efficiency. Indeed, the typical corporate law firm would have regarded concerns for efficiency as antithetical to the standards of professional quality by which work should be evaluated. The implicit model of service was the professional craftsman who was willing to spare no effort or expense in providing customized service. The scarcity of financial information about law firms reinforced the notion that pecuniary considerations were secondary to the pursuit of professional excellence as determined by one’s peers.⁶⁰

A firm’s internal organization typically reflected and reinforced lawyers’ sense of allegiance to the collective welfare of the entity. Partners were compensated mainly on the basis of seniority rather than calculations of each partner’s contribution to revenues. Decisions of any significance were made by the partnership as a whole, with limited reliance on formal lines of management authority. Every partner was personally liable for the obligations of the partnership. This meant that in theory any partner could be called upon to pay damages resulting from the negligence or misconduct of a colleague if the firm’s assets were insufficient to satisfy a claim. Partners were drawn from the ranks of associates who had spent the first several years of their legal career at the firm becoming socialized in its norms and values. Those associates who were not promoted to partner received assistance from the firm in finding positions in client legal departments or smaller firms to which the firm might refer business. Finally, for a good part of the twentieth century, members of major corporate law firms tended to have a common outlook because they recruited only white Protestant men from elite social backgrounds and a small number of colleges and law schools.

In a profession that was largely self-regulated until the latter part of the twentieth century, corporate law firms enjoyed even more freedom from external oversight than most other lawyers. State bar authorities generally concentrated their efforts on responding to complaints about lawyers who represented individuals, either in small firms or solo practice.⁶¹ Common law standards of liability were relatively protective of lawyers, and relationships with clients were such that any dissatisfaction with performance was likely to be addressed informally.

There were few regulatory provisions during this period that imposed obligations on lawyers engaged in specific areas of practice. Under the Internal Revenue Code, the Treasury Department had long had the authority to issue and enforce rules of conduct for tax practitioners, but there was minimal activity on that front. To a considerable degree, therefore, corporate firms’ independence from client influence was matched by their independence from oversight by the bar or the state. The conventional wisdom was that this absence of meaningful external control was not a problem. To the contrary, it was thought to be a precondition for adherence to the highest ethical standards.⁶² The relative economic security that the corporate law firm lawyers enjoyed ostensibly meant that they were subject to fewer pressures to engage in behavior that was regarded as problematic because it was overtly commercial. By contrast, lawyers in less stable practices with less wealthy clients were supposedly vulnerable to more temptation and client pressures to violate ethical rules.⁶³

These features of the corporate law firm enabled it to serve as an effective socializing agent until the latter decades of the twentieth century. Firms regulated behavior through a system of informal peer control that operated with minimal formal layers of authority. Partners regarded themselves as autonomous professionals with equal claims to participate in decision making and viewed hierarchical organization as ethically suspect. None of this necessarily meant that lawyers in corporate firms were more ethical than lawyers in other practice settings or that this was a golden age for the legal profession. Firms openly discriminated on the basis of race, sex, religion, class, and ethnic origin. While enjoying some measure of independence from immediate commercial imperatives, corporate lawyers’ close association and identification with long-term clients may have led them unthinkingly to assimilate their clients’ world views, compromising their independence in more subtle ways.⁶⁴ Nonetheless, firms committed to a particular vision of professional practice were in a position to instill that vision in the lawyers who worked in them.

Elite Tax Bar Practice

The relative insulation of law firms from market forces during most of the twentieth century created conditions that nurtured a relative consensus on how tax lawyers should approach the task of providing advice to clients on their tax obligations. Lawyers in elite firms during this period held a monopoly on furnishing tax advice for major corporations and high-wealth individuals. These lawyers were integrated into the transactional practice of their firms. They typically were consulted when corporate partners approached their tax colleagues about a business objective that a client of the firm wanted to achieve. Equipped with knowledge of the client’s goals, the tax lawyer then sought to structure a transaction that minimized the client’s tax liability. The value to clients of a lawyer’s advice rested on the lawyer’s capacity to provide independent judgment about how a court would treat the tax benefits claimed for a transaction. This judgment was informed by a sense of the internal coherence of the provisions at issue, the salience of judicially created standards, and an understanding of at least a general set of basic principles that animated the Internal Revenue Code. Close association with corporate transactional partners made tax lawyers familiar with the types of deals that were being done by corporate clients, which helped inform an assessment of the business purpose and economic substance of a given transaction.

Elite practitioners regarded the exercise of such professional judgment as the feature of their practice that distinguished them from mere technocrats who provided advice based simply on the literal terms of the tax code.⁶⁵ The lawyer’s aim was for the client to take a position that didn’t raise concerns with tax authorities, rather than a position that on balance would be financially advantageous even if challenged by the government. Because work came to the tax advisor from corporate partners whose clients had already decided to engage in some activity for business reasons, the issue of business purpose rarely tended to be contentious. In addition, because these transactions were intertwined with clients’ business affairs, courts were likely to defer to them on this subject.

Elite tax lawyers during this period tended to take a view of a tax advisor’s professional obligations that was sensitive to society’s interest in a well-functioning tax system. There was not complete unanimity on the scope of an advisor’s obligations and various practitioners formulated their responsibilities in different ways. Nor was it possible to express practitioner norms in the form of explicit rules; expectations represented more of a general approach to how a good tax lawyer was supposed to counsel a client in particular situations. Nonetheless, there was a broad consensus within the elite bar that professional judgment that drew on multiple considerations beyond the literal terms of the tax code imposed a limit on how far a lawyer should go to minimize a client’s tax liability. This view persists today among many members of the elite tax bar, but there was an especially strong agreement on it until the last two or three decades of the twentieth century.

The organized tax bar consistently insisted on the distinction between tax advisor and tax advocate in its struggles over the years with the American Bar Association regarding the professional responsibilities of tax lawyers. In various pronouncements, the ABA characterized advocacy as the lens through which to view a tax lawyer’s obligations, regardless of context. It declared that the lawyer owes “entire devotion to the interest of the client” and has described the IRS as the client’s adversary.⁶⁶ By contrast, the ABA’s Section of Taxation maintained that “a tax return is not a submission in an adversary proceeding,” and that lawyers who provide guidance to taxpayers in determining their liability were not simply advocates. Rather, they advised their clients on how best to determine their tax obligations.⁶⁷

Many influential members of the elite tax bar in the mid-twentieth century suggested that the tax advisor’s distinctive role involved a dual responsibility to the client and to the tax system as a whole. Prominent tax practitioner Seymour Mintz observed in 1963 that while a sizable segment of the tax bar believed that the tax lawyer owed undivided loyalty to the client, a “considerably larger group” would say that there was something “special and peculiar” about tax practice.⁶⁸ Similarly, Randolph Thrower, a private practitioner who served as IRS Commissioner, emphasized that tax lawyers “are vested with a professional responsibility to the public for both the law and its administration. One who recognizes no such responsibility is not a professional.”⁶⁹

Henry Sellin, a tax lawyer and former academic, emphasized the complex responsibilities of the tax lawyer by identifying four different functions that he or she performs: “(1) business/tax planner, (2) tax return preparer, (3) Internal Revenue Service practitioner, and (4) litigator/advocate.”⁷⁰ Only when “the administrative procedures of the Service have been completed and the case is in the courts,” he argued, does the tax lawyer become the litigator/advocate who has “only one obligation, to his client.” At that point, “his only obligation to the Service is that of one litigator to another—to abide by the rules of litigation.”⁷¹

Randolph Paul, who served in the Treasury Department and was a founder of the law firm Paul, Weiss, also expressed a conception of the tax advisor that reflected both devotion to the client and acknowledgment of special responsibilities. Although Paul never hesitated “to make any argument that I think will advance the client’s financial interest even though I may feel that acceptance of the argument in an opinion which is not carefully narrowed to the facts may create a precedent unfriendly to the best interests of the revenue,”⁷² he noted that tax advisors had certain obligations as a result of the particular nature of tax disputes. “One peculiar responsibility of tax advisers,” he observed, “derives from the fact that tax controversies are between the client and the Government, rather than between two private litigants. Our established procedures make the Government more dependent upon the taxpayer than is the private litigant upon the other side in an ordinary controversy.”⁷³

As some elite tax lawyers saw it, it was misguided to regard the relationship between government and the taxpayer as inherently adversarial. “The distinction between taxpayers and their government is wrong,” Henry Sellin declared in 1974, “for the government is the taxpayers, just as the taxpayers are the government. We are they and they are we.”⁷⁴ The citizen’s obligation to pay her fair share of taxes was a duty not only to the government but to other taxpayers.⁷⁵ Similarly, Merle Miller, founder of what is now the law firm Ice Miller, noted the “moral obligations owing by taxpayers to one another, because of their reciprocal positions as taxpayers.”⁷⁶

From this perspective, clients were part of a larger community whose survival required cooperation among its members. They might obtain a short-term benefit by not paying their fair share of taxes, but they and their fellow citizens would suffer substantial long-term injury if this became the dominant strategy for all taxpayers. The elite tax bar’s traditional norms therefore included some responsibility to further a client’s enlightened self-interest as a citizen in providing advice about tax obligations.

Members of the elite bar also suggested that tax advisors should foster respect for the tax system among their clients. An important responsibility of tax advisors, claimed H. Brian Holland of Ropes & Gray, was to explain the reasons for rules that to an uninitiated client might seem arbitrary or unreasonable. The lawyer “should not curry favor” with the client who complained by saying that the entire tax law is arbitrary. Explaining the rationale for rules provided for a “better understanding of tax laws and less friction between the public and the tax administrator.”⁷⁷ Similarly, Merle Miller urged lawyers against “aiding and abetting taxpayers in their suspicion, distrust and even animosity toward those who are writing and enforcing our tax laws.” The lawyer “must do his best to maintain in his fellow citizens a proper respect for the methods we have set up under a democratic system for the collection of each citizen’s share” of taxes.⁷⁸

To this day members of the elite tax bar have been especially notable for their skepticism, if not downright hostility, toward aggressive tax shelters. Elite lawyers have regarded themselves as working on “real transactions” aimed at “making money in the short-run or the long-run by increasing revenues or reducing (nontax) expenses,” as well as on “business-based financings” designed to raise capital. Their role is to “cast a desired business transaction in a form that is most beneficial from a tax perspective. The basic business purpose is a given but there may be choices as to form.”⁷⁹

By contrast, elite lawyers have regarded tax shelters as transactions driven mainly by the desire to reduce tax liability. As Wall Street tax lawyer Peter Canellos puts it, “The investment in a tax shelter is a fee paid for tax benefits. The investor either expects to lose it or expects a return with an economic yield that is below market on a risk-adjusted basis.”⁸⁰ Rather than responding to the tax concerns of a client who desires to enter into a business transaction, a “tax shelter professional” works to “create an artificial transaction to take advantage of a loophole. Such a transaction cannot be real—no one wanted to do the transaction before the loophole was discovered—it can only be made to appear real.”⁸¹ In such an instance, “only the lawyer’s wisdom and self-restraint stand between the client and the artful construction of transactions.”⁸² This aversion to aggressive shelters is premised on “the distinction between legitimate economic activity, which is assumed to be a social good, and pure tax planning, which is not.”⁸³ The elite bar traditionally has seen itself as policing this boundary, which it has regarded as essential to the integrity of the tax system.⁸⁴ Members of “the tax bar” and “the tax shelter bar” thus effectively operate in different worlds.⁸⁵

Members of the elite tax bar have been averse to recommending or providing opinions on tax shelters because of what Canellos describes as “concern about the systemic effects of shelters and the pressures on conscientious advisers to support questionable deals.”⁸⁶ As one practitioner suggested, tax avoidance plans that are doubtful are presented to lawyers daily. There can be a powerful temptation to accept them “because the administrative process is long in developing a technique for overcoming a specific tax-avoidance device.” As a result, “a tremendous amount of restraint on the part of the tax bar is required in order not to create [an] inequitable shifting of the fair load from your high-bracket taxpaying client to the low-bracket taxpayer.”⁸⁷

The elite tax bar’s traditional attitude toward shelters is expressed especially clearly in a 1980 law review article that features an exchange of fictitious memos between a senior partner at a law firm and a young tax associate who offers suggestions for reducing the tax liability of a new client.⁸⁸ The centerpiece of the associate’s recommendations is a “tax straddle” arrangement under which the client will buy and sell Treasury bill futures. “Due to a quirk in the law,”⁸⁹ the associate writes, the loss on a T-bill itself is treated as an ordinary loss that can be offset against the taxpayer’s income, while the gain on a T-bill future is treated as capital gain taxed at a lower rate. The client would follow through on the losing portion of the transaction so as to suffer loss on an actual bill, while structuring the gain part of the transaction so as to close it out before maturity. The result is that the taxpayer would be able to use the losses to shelter ordinary income, while enjoying capital gains treatment on any income from the transactions. The associate acknowledges some risk that the scheme will be disallowed, but suggests that the client engage in transactions masking the tax straddle that will decrease the likelihood that it will be detected on a return even if there is an audit.

The partner reviewing the memo disapproves of the associate’s approach: “There is in your memo no quest to sort out right from wrong, much less any attempt to determine the correct legal result under complex provisions. Instead your stance seems to be: let’s find an argument for the taxpayer and, having found it, let’s carry it as far as we can, so long as the downside risk is not too bad, while freely factoring in the possibility of nondiscovery into the risk assessment.” The result is a proposal that “corrupts the fabric of the tax system, destroying distinctions between ordinary income and capital gain.” The partner doubts that the courts will accept it, but even if they do, “it is surely mad to allow it,” since it would produce a system “where the rich, who could afford to go into these manipulations, could freely convert ordinary income to capital gain and move income around from year to year as they see fit.”⁹⁰ This would require Congress to respond with legislation to address the situation, which would add to the complexity of the tax system. The partner notes that when he was actively involved in tax practice, “I thought there was some mix in my duty. It was not unalloyed avoidance-seeking, but had at least a measure of allegiance to the fisc and to higher principle. Some things were wrong, even if they worked.”⁹¹

The elite tax bar thus traditionally formulated a conception of the tax advisor’s role that stopped short of the unqualified devotion to the client that characterized the advocate. Elements of the advisor model were neither as explicit nor as categorical as those of the adversarial model, and there was some variation in the intensity with which tax lawyers embraced them in different situations. Nonetheless, there was a relative consensus for most of the twentieth century that the tax advisor occupied a distinct role that involved different responsibilities from those of the advocate. This role required that lawyers rely on a sophisticated understanding of their professional obligations, as well as an understanding that the client was both a taxpayer and a citizen, to determine how far they would go in helping their clients minimize their tax liabilities.

Law Firms under Pressure

Beginning in the late 1970s, increasing competitive pressure on United States businesses from companies abroad and from accelerating technological innovation, compounded by the emergence of hostile corporate takeover activity in the mid-1980s, led to intensified efforts to increase productivity and control costs. Corporate legal expenses had been steadily increasing as business operations became more complex, global, and subject to greater regulation. Companies sought to rationalize their use of legal services by bringing more functions within their legal departments and by increasing the status, responsibilities, and sophistication of inside counsel. Faced with pressure to reduce legal costs, general counsel began to loosen ties with outside law firms, encouraging competition for their company’s legal work.

With these changes, a company was less likely to rely on a single law firm for most of its legal work, and individual law firms had less opportunity to gain intimate familiarity with a company’s operations. This made it less costly for a client to switch from one law firm to another, and easier to consider several firms when deciding who would represent the client on which matters. As firms gradually lost assurance of a steady stream of business from particular clients, they began to lose some of the firm-specific capital that helped tie lawyers to the firm. It became less certain that lawyers at a given firm would be able to rely on the firm for enough work to keep them busy, which made an increasing number of lawyers consider whether another firm might offer more attractive opportunities. The attachment between firm and lawyer weakened even further as general counsel began to claim that their relationships ran between themselves and individual lawyers rather than specific firms. Clients, in other words, had become less institutionalized.

As the relationship between corporate clients and law firms evolved, law firms began to make clear to their lawyers that they were responsible for generating enough work for themselves and the firm. As lawyers became more entrepreneurial, they began to build their own “books of business” that were independent of the particular firm in which they practiced. The result was the emergence of fiercely competitive markets for both clients and lawyers. Most law firms perceived an imperative to grow and diversify to compete in the newly competitive market for corporate legal services. Acquiring partners from other firms or merging with entire firms was the quickest way to increase the scale and scope of services that a firm could provide.

Success in these efforts was dependent on steadily increasing profits per partner, a metric that became the dominant way of evaluating the financial health and prospects of a law firm. High profits per partner gave a firm the opportunity to lure away partners and their clients from firms with lower figures. All this became more feasible with an explosion of financial information about law firms spearheaded by the magazine The American Lawyer beginning in the early 1980s. Increasing mounds of information became available on matters such as revenues, profits, billing rates, partner compensation, and associate salaries as the veil was lifted on aspects of practice that traditionally had been secret and opaque.

As law firms became less insulated from market forces, their internal structure and procedures began to change. The risk of losing partners to other firms, as well as the desire to lure partners from competitors, led most firms to abandon partner compensation based on seniority. Most firms devised compensation systems that gave substantial weight to the revenues that the firm earned from the clients that a lawyer brought in. A growing percentage of partners no longer came from associates who had worked their way up in the firm, but from lateral partners from other firms who brought profitable books of business. The desire to keep profits per partner high also led some firms to “de-equitize” partners who were not generating sufficient revenues so that they no longer were entitled to a share of the firm’s profits.

The scope of the work that law firms performed and the fees that they charged gradually became subject to closer client scrutiny, with many general counsel demanding a larger decision-making role on matters that previously had been the province of outside counsel. Some clients went so far as to hire companies to audit their legal bills, while others were not shy about asking for discounts in return for a certain amount of business. In the early 1990s, the multinational company Dupont launched a “preferred provider” program to contain its legal costs. Reducing its outside firms from about 350 to 40, Dupont required the outside lawyers in the program to collaborate, take measures to minimize litigation costs, consider alternatives to hourly billing, and provide more cost-effective legal services.⁹² Other large corporations soon followed suit. These new arrangements all underscored that corporate law firms no longer had unfettered discretion to decide how to organize, deliver, and bill for legal services based mainly on internal considerations. General counsel made it increasingly clear that they would evaluate law firm services by how much they enhanced corporate clients’ ability to meet business objectives, not simply by professional craft standards.

With law firms subject to increasing competition, a distinct hierarchy of practice areas began to emerge in the last three decades of the twentieth century. This hierarchy reflected the fact that as law firm consultant Joel Henning put it, “different legal services command different market values.”⁹³ Moving up this hierarchy, the stakes for the client were higher and the price of the legal work involved was less important. Moving down, the work became more routine and clients were more sensitive to its price.

At the top of the “services value pyramid” were cutting-edge legal practices customized to the needs of a particular client. This work involved crafting novel transactions, devising creative responses to regulatory requirements, or representing the client in “bet the company” litigation. Clients placed a high value on this kind of work and were willing to pay premium fees for it. The second level on the pyramid was work for clients who “rather than needing the profession’s most creative talent, wanted [. . .] to find a firm that accumulated experience in handling certain types of problems” and didn’t need to start from scratch.⁹⁴ Clients were more sensitive to price here than they were at the top of the service value pyramid, but tended to select firms mainly on the basis of experience and past performance. Finally, the bottom level of the pyramid involved relatively routine work that could be divided into discrete tasks performed according to standard procedures. Clients selected firms for bottom-tier work mainly on the basis of price and reliability. The pyramid thus extended from cutting-edge work at the top to commodity work at the bottom.

As clients began in the 1980s and 1990s to differentiate more aggressively among the types of work that they needed, the legal services market had to respond in kind. Not only did legal work become more segmented, but the types of work that fell into various segments also became less stable. The legal services found at each level of the pyramid continued to change over time, as competitive pressures constantly pushed work downward. The result over the past few decades was a rapidly accelerating life cycle for legal work. Often, what began as cutting-edge, high-margin work done by a small number of firms matured into more standard services that many firms could provide at decreasing cost.

Law firms therefore had to become sensitive to their position on the pyramid, and to consider when and to what extent the services they provide were likely to become commodities. While they responded to this likelihood in different ways, most major firms attempted to increase their proportion of high-end work and reduce the amount that was price-sensitive.

As law firms grew larger and faced more intense competitive pressures as the twentieth century drew to its close, they moved toward more centralized management structures with more formal departments and lines of responsibility. In many firms, the managing partner and executive committee assumed greater authority for making decisions that the full roster of partners had previously made. Firms began to hire professional nonlawyer managers in high-level positions. They often added another layer of management by creating a larger number of practice groups and departments to handle increasingly specialized work.

Firms’ greater reliance on centralized management and more formal organizational features arose in response to loosening, informal norms and weakening peer control. As firms eventually dismantled various discriminatory hiring practices, their lawyers no longer came from a relatively homogeneous, narrow segment of society with a common outlook and experience. In addition, increasing specialization meant that larger numbers of lawyers focused on narrower areas of the law, with less common ground with colleagues who might serve as the basis for informal guidance and review of their work. As an active lateral market arose, lawyers within firms increasingly worked with other lawyers who had grown up in different professional cultures. Firms also moved from general partnerships to limited liability partnerships, which meant that each partner was responsible only for his own actions and those of the lawyers he directly supervised.

At the same time, law firms moved toward promotion and compensation systems that emphasized the need for lawyers to be entrepreneurial in generating revenue. Individual lawyers recognized that their stature and tenure within the firm, as well as their opportunities elsewhere, depended on the book of business they developed. The result was periodic struggles between formal and informal authority systems within firms on a variety of matters, including firm-wide conflict-of-interest policies, the institution of uniform engagement letters, the determination of fees, and the staffing of matters. Many powerful “rainmakers” jealously guarded their authority to set the specific terms of their relationships with clients and often successfully resisted firms’ attempts to impose standard policies that would minimize risk to the firm. As one leading scholar put it, “[A] position of managerial authority in the firm . . . will always be subordinate to the power of the lawyers controlling the largest bloc of clients.”⁹⁵ For all these reasons, law firms had less assurance that lawyers would exercise discretion in uniform ways and in the interests of the firm. The managerial systems they instituted, however, could only partially compensate for the weakening of shared professional norms. Potentially mobile rainmakers with portable books of business comprised an informal power structure that limited managers’ formal authority.⁹⁶

As their relationships with clients loosened in the late twentieth century, law firms were transformed from organizations with substantial firm-specific capital to aggregations of mobile individual capital that could be only imperfectly integrated into the firm. The corporate law firm sought to hold its dynamic parts together with more centralized management, but the practical realities of revenue generation inevitably limited the extent it could do so. As a result, firms became “exquisitely fragile and unstable businesses.”⁹⁷

Tax Practice: The Consensus Erodes

Increasing competitive pressures on law firms left their mark on tax practice. As corporate clients began to devote more attention to managing their taxes like other costs, the nature of what they asked of tax advisors began to change. They began to seek out transactions that took advantage of various provisions in the tax code to reduce taxes, only afterward formulating plausible business purposes for the transactions that might pass muster with the IRS. If lawyers in elite firms failed to give their blessing to a transaction, clients were prepared to shop around to find a lawyer who would. With increasing competition in the market for legal services, the number of lawyers and law firms that were willing to provide an opinion in support of aggressive transactions began to grow. This in turn placed pressure even on lawyers in elite firms, who knew that they were losing business to other firms who were ready to stray from the consensus that had earlier guided the tax bar.

Accounting firms posed an even more significant competitive threat. As they moved more aggressively into tax and consulting services, accounting firms began to increase their market share of tax work at the expense of law firms. By 2001, a tax scholar would write, “Tax work is now much more likely to go to an accountant than a lawyer.”⁹⁸ The orientation in accounting to focus on rules rather than standards made accounting firms receptive to client demand for designing transactions that would reduce taxes by virtue of their compliance with the literal terms of the Internal Revenue Code. Accountants’ professional training tended to make them less burdened than lawyers by concerns about statutory purpose or spirit, an approach reinforced by, as Tanina Rostain put it, “a fundamental lack of fit between the core concepts of accountancy and their counterparts in tax law.” Methods of computing taxable and financial income increasingly diverged since inception of the income tax, “as tax concepts developed to further social and political goals that were foreign to accountancy’s aim of measuring income.”⁹⁹

Accounting firms competed with law firms not only for clients but also for lawyers. They began recruiting heavily at law schools, increasing salaries to make themselves more competitive. They also began to lure away partners from major law firms, with the promise of higher compensation and a client base and organizational infrastructure that made it unnecessary for lawyers to generate business on their own. Vice chairman John Lanning of KPMG wrote in 1999 that the firm hired 175 professionals with law degrees in the previous year, more than a hundred of them right out of law school. Lanning declared that “the commitment of the firm to our new law school hires is seen in the firm’s $125 million annual budget for training and orientation programs.”¹⁰⁰ Even more striking was an arrangement in which Ernst & Young lured three prominent tax partners away from King & Spalding in 1999 to establish a new law firm, McKee Nelson Ernst & Young, that received financial backing and shared office space with the accounting firm in Washington, D.C.¹⁰¹

The complexity of the new wave of tax shelters meant that promoters such as accounting firms needed to enlist the services of members of the elite tax bar. Their pitch to many lawyers with respect to tax shelter work was that tax law was starting to focus on products rather than particular solutions crafted for individual clients and that clients were migrating to large global firms that could provide one-stop shopping for legal, tax, financial, and business advice. In addition, lawyers could avoid increasing client resistance to hourly billing by moving to a practice in which they were compensated based on a percentage of the tax savings that they achieved for clients. Lawyers who failed to heed these trends, they warned, were going to be left behind in the emerging new economics of tax practice.

To the extent that lawyers were inclined at the turn of the century to respond to these competitive pressures by being more receptive to client demands for tax reduction transactions, they could invoke the increasing authority of textualism—in applying a statute, focusing on its terms rather than its underlying purpose—as an interpretive method in law in general and in tax law in particular. In the words of one proponent “strict statutory construction is crucial to achieving the Rule of Law” because it achieves “equality, uniformity, and predictability.”¹⁰² In tax law, the elite of the bar had begun their careers when tax law had fewer rules and practitioners could be generalists. This made them comfortable with looking to standards rather than simply rules as sources of authority. In addition, as tax scholar Joseph Bankman observed, “[t]his group attended law school at a time during which textualism was associated with long-vanquished formalism.”¹⁰³ By contrast, with the resurgence in the academy of strict constructionism, the new generation of tax specialists had imbibed more of a textualist orientation in law school than their predecessors. In addition, junior tax lawyers came into practice when the law had become more specialized and structured around rules. These lawyers confronted the need to “learn and explain rules which their more senior partners hoped to retire without mastering.”¹⁰⁴

As a result of this trend, junior lawyers were more skeptical of judicial doctrines based on contextual standards such as business purpose or economic substance that did not rely on the literal words of legal texts. This trend was reflected in practitioners’ attitudes to ACM Partnership v. Commissioner (1998), which disallowed claimed tax benefits from a transaction even though the transaction complied with the literal terms of the tax code. As Bankman noted in 2001, “[v]irtually everyone I’ve ever heard from or spoken with over the age of 60 supports the government’s position in such cases. The level of support drops directly, and dramatically, with age.”¹⁰⁵ One prominent practitioner and former government tax official noted that when he started practicing law in the 1960s he “really believed that the tax law was a coherent set of rules to help people who were doing real investing—who were working in real business transactions—to decide how to report those transactions for purposes of determining the amount of tax they had to pay.” In the late 1990s, he observed, “you’ve got a group of people that believes it’s just a bunch of rules and if you can figure out a way to satisfy the rules then you can let the rules drive the transaction. [They think] you can sit in your office and read the rules and come up with ways to do things and then go out and convince people to do them, and that’s okay.”

By the end of the twentieth century, two trends in law practice had converged. The first was intensifying competition that led law firm leaders to believe that growth and continuously higher profits per partner were necessary for survival. In this quest, firms coveted high-value services for which the firm could charge a premium fee untethered from hourly rates. The second trend was the erosion of a consensus about the norms of tax practice and the emergence of a division within the elite tax bar concerning where to draw the line between aggressive and improper tax advice. This trend had important implications for judgments about the difference between legitimate and abusive tax shelters.

At this time several forces and events combined that would result in an explosion of abusive tax shelter activity. Monitoring tax shelters was not a priority for the IRS, which was preoccupied with responding to the withering criticism that it had received on Capitol Hill in 1997. Corporate and individual taxpayer demand for shelters increased, while competitive pressures gave professional organizations strong incentives to invest in developing shelters that relied on the interaction of complex financial instruments to eliminate or reduce taxes. These organizations played a crucial role in the wave of abusive tax shelters unleashed in the first years of the new century.