Part IV   The Reckoning

10   Turning the Tide

The Challenge

At the close of Congressional hearings in 1998, the Internal Revenue Service was on the ropes. Its credibility was low, its employees’ morale even lower, and there was skepticism that the agency could competently perform even its basic function of collecting taxes. Its difficulties ran even deeper: the IRS was a tax collection agency in an era in which there was acute hostility toward the very idea that the tax system had legitimacy. The blistering Congressional criticism of the IRS had left it chastened and cautious—just as trends were converging that would dramatically increase efforts to design and market tax shelters. One veteran observer of the agency described the Congressional hearings as akin to a “lynching.”¹ The best course for IRS personnel seemed simply to avoid any activity that might incur the wrath of taxpayers or their elected representatives.

The IRS Reform and Restructuring Act, adopted in May 1998, directed the agency to reorganize its operations to become friendlier to taxpayers. The Act attempted to reinforce this mandate by granting taxpayers greater rights vis-à-vis the IRS, establishing a new oversight board to monitor its operations and imposing new reporting obligations on the agency. In addition, newly appointed IRS Commissioner Charles Rossotti announced that his priority would be to modernize the agency’s basic tax collection functions and to improve its relationship with its taxpayer “customers.” This created an environment in which any attempt to identify and challenge tax shelters would run into both resource constraints and concern about engaging in activity that could anger taxpayers and get the agency hauled before Congress once again.

Even in the best of times, attempting to combat tax shelters was a formidable challenge. The first difficulty was a basic one: how could the IRS know what shelters were out there and who was using them? There are millions of corporate and individual taxpayers in the United States engaged in innumerable business transactions. How could IRS revenue agents comb through all of the returns filed and find the deals that had no economic substance or business purpose? The difficulty was compounded by the format in which transactions are reported on returns. When reviewing tax forms, agents have to work with a series of abstracted categories and numbers; few red flags alert them that further investigation is needed. Losses reported on returns can signal legitimate economic losses as easily as abusive tax shelter activity. And tax shelter promoters made sure to add lots of window dressing so that shelters looked as much as possible like legitimate transactions. To make matters worse, at the time the IRS did not have a system in place to match individual income forms with partnership returns. As a result, agents were unable to cross-check information provided on different returns filed by the same taxpayer.

One way to catch shelters, of course, was to audit tax returns. Historically, however, the IRS has been able to audit only a miniscule portion of returns in any given year. Not surprisingly, in fiscal 1998 the audit rate for all classes of individual taxpayers was the lowest in modern history. The IRS audited less than 0.5 percent of such returns. By contrast, the rate in 1981 had been three times as high. The IRS 1998 audit rate for individuals earning over $100,000 was 1.13 percent, or less than half of what it was in 1992. In 1998 the IRS audited 37 percent of corporations with $250 million or more in assets, compared to 55 percent in 1992. Criminal prosecutions had declined in all but two of the preceding ten years, dropping from 1190 in 1989 to 766 in 1998. In addition, the IRS suffered a 900-person decrease in staffing from 1997 to 1998. Focusing on these figures, the well-respected publication Tax Notes Today asked: “Is this not a major shift away from law enforcement?”²

Catching an abusive transaction was only the first step. In the rare cases in which taxpayers were audited and the IRS agent disallowed the claimed tax benefits taxpayers might be liable at most for the amount of taxes that they owed. They could avoid any additional penalty payment by establishing that they had reasonably relied on a lawyer’s opinion that the shelter more likely than not would be upheld if challenged. In addition, corporations and wealthy individuals had enough resources to impose significant costs and delay on the process so that the agent might be willing to settle for less than what the taxpayer supposedly owed. For those revenue agents who held firm, there was always the risk that their efforts would be undermined by an appeals unit within the IRS, which tended to be more lenient with taxpayers. Even more worrisome was the prospect that an agent might be charged by a taxpayer with harassment, a potentially career-ending blow under the new law.

If a tax dispute ended up in litigation, the agency had found that courts tended to be inconsistent allies. Common law anti-abuse doctrines were vague, and some courts were sympathetic to claims that the doctrines gave taxpayers insufficient guidance about what was and was not permitted. Even a court that regarded the common law as a legitimate dimension of tax law was faced with the difficult task of determining whether complex financial transactions had enough risk or possibility of profit that taxpayers should receive the tax benefits that they claimed. In addition, the stakes of litigation were large for the IRS because of the visibility of the dispute. A loss could embolden shelter promoters and taxpayers to engage in even more aggressive behavior. It also meant that the agency had to decide whether to fight the same or a substantially similar transaction in a different jurisdiction. The result was that the agency might be loath to litigate any case that it was not confident of winning.

In addition to a weakened and underfunded audit process, the IRS had a few other weapons in its arsenal. It had long had the authority to require taxpayers to disclose potentially abusive shelters on their tax returns. During the shelter episode of the 1980s, Congress had granted the IRS the authority to require promoters to register potentially abusive shelters with the agency and maintain lists of clients who bought those shelters.³ Because these laws had been drafted with particular types of shelters in mind, their definition of potentially abusive shelters did not neatly fit the shelters that were coming into vogue in the late 1990s. The 1997 Taxpayer Relief Act expanded the definition of shelters subject to the registration and list maintenance requirements to include transactions entered into by corporate taxpayers that had as a significant purpose the avoidance of taxes, met a minimum fee threshold, and were sold under conditions of confidentiality. Those new requirements did not explicitly apply to shelters purchased by individual taxpayers. Moreover, they did not go into effect until the U.S. Treasury enacted specific regulations applying them. Reeling from the beating it had received at the hands of Congress, the Treasury did not get around to proposing new rules until 2000.

The IRS also had the power to list certain shelters it considered abusive. Listing a shelter put taxpayers on notice that the agency planned to challenge it in court. It also meant that if the IRS disallowed the shelter, taxpayers would not be able to claim that they reasonably relied on a legal opinion in claiming tax benefits from the transaction; they would also be subject to increased penalties for failing to disclose the shelter on tax returns. This required that the agency first learn of a shelter, of course, which might well be after its use had become widespread. Relying on the listing process to combat shelters was like trying to empty the ocean one teaspoon at a time. It might eliminate one shelter as an alternative, but promoters were likely to rush in with new ones that were just different enough to provide an argument that they were not on the list. The IRS was playing a perpetual game of catch up.

Listing a shelter was just a warning shot across the bow. It only meant that if the IRS found the shelter on audit, it would challenge it in court. The IRS still needed to persuade a court that the shelter was abusive. The more widespread a shelter became, the bigger the challenge to convince courts to disallow its benefits. Taxpayers who had bought the shelter transaction and firms promoting it were bound to put up a vigorous fight, requiring the IRS to expend significant resources to combat it.

Traditionally the IRS had been able to rely to some extent on the tax bar to compensate for information barriers and resource limitations. Tax practitioners in law and accounting firms were in a position to constrain their clients by informing them of the acceptable boundaries of aggressiveness and advising them not to venture too close to the line. Conversations in the lawyer’s office thus could have as much or more impact as announcements by the IRS. Beginning in the early 1990s, however, the agency was hearing from knowledgeable tax practitioners that a new wave of tax shelters aimed at corporations was beginning to sweep through boardrooms and management suites. Some lawyers in a company’s tax department or general counsel’s office were being approached directly by a growing number of promoters offering transactions that could sharply reduce a company’s tax liability. Other in-house lawyers were hearing of shelters from management, who wanted them to assess whether the promoters could make good on their promises. Lawyers in law firms were being asked the same questions by their corporate clients. Some of these lawyers were being offered the opportunity by promoters to earn substantial fees for writing a legal opinion saying that the tax treatment of a shelter more likely than not would be upheld in court if challenged by the IRS.

In short, the IRS could no longer be assured that tax practitioners were attempting to constrain aggressive behavior. Events were moving quickly enough that some distinguished tax lawyers in private practice began to urge government officials and members of Congress to address what they regarded as a spreading contagion. And even as the Treasury, Congress, and the public were becoming aware of how widespread corporate tax shelters had become, the contagion was spreading downstream, as accounting and law firms began to market similar shelters to high-wealth individuals.

In the fall of 1998, the IRS received some assistance from another, perhaps unexpected, quarter. Courts had only sporadically elaborated on the concepts of economic substance and business purpose that many saw as originating with the Supreme Court’s 1935 decision in Gregory v. Helvering.⁴ It was not clear whether Helvering had meant these concepts to be equivalent or distinct and, if distinct, whether the government could deny tax benefits if a transaction lacked just one of these characteristics or if it had to lack both. In addition, there was uncertainty about how significant the economic substance or business purpose connected with a transaction had to be to justify the tax treatment that a taxpayer desired. In the fall of 1998, the U.S. Court of Appeals for the Third Circuit provided some clarification on these issues when it largely upheld a 1997 decision by the U.S. Tax Court (mentioned in chapter 4) denying tax benefits resulting from a shelter in ACM Partnership v. Commissioner.⁵

At issue in ACM was a transaction engineered by Merrill Lynch that Colgate-Palmolive had used to offset a gain of $105 million resulting from the 1988 sale of a subsidiary. Colgate-Palmolive used a complicated structure involving a partnership with a foreign corporation that did not pay U.S. taxes and a purchase and installment sale of securities to create a $98 million loss. This loss did not correspond to any economic losses that the company incurred. Colgate-Palmolive claimed that it could use this loss against the gain it earned in the sale of its subsidiary. In March 1997, the tax court sided with the IRS and disallowed the loss. The Third Circuit affirmed this decision, providing substantial guidance on the scope and application of the economic substance doctrine.

The Third Circuit’s decision in ACM made clear that the doctrine retained vitality as a basis to challenge abusive tax shelters that relied on complicated financial instruments and far more complex transactions than promoters had used in the 1970s and 1980s. The court clarified that whether a transaction had a business purpose and economic substance were not “discrete prongs of a ‘rigid two-step analysis,” but were factors that should inform an overall analysis of whether a transaction was created simply to generate tax benefits.⁶ The court held that a nominal nontax financial impact was not sufficient to justify the tax benefits resulting from a transaction and that the costs of participating in the arrangement should be taken into account in determining whether there was any reasonable expectation of profit. The opinion also brought to light the magnitude of the fees that promoters could earn in shelter transactions, which were far greater than many had realized. Merrill Lynch, for instance, had earned $1 million for finding someone to purchase the securities from the partnership shortly after it had acquired them. As the case wended its way through the courts, it also emerged that Colgate-Palmolive was not the only company that had purchased this type of shelter, nor was Merrill Lynch the only financial institution selling them.

The ACM decision signaled that courts were willing to be skeptical, even when it was a major U.S. corporation claiming tax benefits based on a transaction designed by a prestigious financial institution and blessed by a major accounting firm. Colgate-Palmolive tried to suggest outside of court that such deals were presumptively legitimate because they had been approved by some of the biggest names on Wall Street. In an interview with the Wall Street Journal before the court issued its decision, Fred Goldberg, a former IRS Commissioner and the lawyer representing Colgate-Palmolive, wondered if “the court would react to this case differently if the court knew that Goldman Sachs or Bankers Trust or Salomon Brothers had been involved in transactions of this sort . . . or if it knew that four different Big Six accounting firms had concluded that it was appropriate?”⁷ The court was not swayed by the fact that a well-respected bank and accounting firm were involved in the transaction. Its decision demonstrated that it was willing to disallow losses resulting from abusive shelters, regardless of the pedigree of the organizations involved.

In the years following ACM, the IRS would achieve a mixed record of success in the courts. Nonetheless, the decision offered some hope to the agency that if it could muster the resources and the will to challenge corporate shelters, it might receive a sympathetic reception in at least some courtrooms.

Shining Light in Dark Corners

Two months after the ACM decision, a cover article in Forbes entitled “The Hustling of X-Rated Shelters” hit the newsstands. The issue came out during the Christmas holiday lull, but by early the next year it was creating a stir in business circles. In the article, Janet Novack and Laura Saunders described the sale of corporate tax shelters as “a thriving industry that has received scant public notice.” This industry relied on the fact that “neither the tax code nor the IRS can keep up with the exotica of modern corporate finance.” The result was that “respectable accounting firms, law offices and public corporations have lately succumbed to competitive pressures and joined the loophole frenzy.” Tax shelters, in other words, had moved from the margins of economic life in the 1970s and 1980s to invade the mainstream by late in the twentieth century. Relying on “arcane quirks in the tax code,” companies were costing the U.S. Treasury $10 billion a year according to a tentative estimate by Stanford tax law professor Joseph Bankman.⁸ Their ability to do so, Novack and Saunders suggested, reflected reliance on derivatives that could split financial instruments into different cash flows, contingent returns, and tax benefits that were separate from the underlying economics of a deal.

Novack and Saunders described a market for shelters that brought together increasing corporate demand with the supply of sophisticated “products.” For many companies, the tax department had become a separate profit center devoted to minimizing the corporation’s effective tax rate.⁹ Accounting firms, financial institutions, and shelter boutiques were responding by poring over the Internal Revenue Code to find anomalies that could be used to design transactions generating substantial tax losses without significant economic risk. Once they did so, they used extensive distribution networks to engage in mass marketing of the transactions to top executives and board members, “not unlike the armies of pitchmen who sold cattle and railcar tax shelters to individuals in the 1970s and 1980s.” Rather than being paid by the hour, promoters’ fees were based on a percentage of the tax savings that the shelter provided. The journalists pointed to two letters from Deloitte & Touche that offered a tax strategy for a fee of 30 percent of the tax savings, plus expenses. Deloitte promised to defend the strategy in an IRS audit and to refund part of the fee if the agency ultimately did not recognize the tax benefits that the firm promised.

An official from PricewaterhouseCoopers (PwC) was the only accounting firm partner in the article willing to talk on the record about these activities. He was surprisingly candid about the firm’s shelter operations. Fernando Murias, the co-chair of the firm’s Mid-Atlantic and Washington, D.C, Washington National Tax Services (WNTS), explained that PwC had two databases of about a thousand mass-market shelter ideas. Many of these were conventional strategies but others were more aggressive. According to Murias, the firm actively promoted about thirty mass-market products, using “product champions” to coordinate marketing efforts for each. PwC used more than forty recently hired sales personnel to pitch the products to companies that were not current clients. In addition, the firm sold what Murias called “black box” products that were “complex and unique strategies that we do not publicize broadly.”¹⁰ These strategies could save from tens to millions of dollars in taxes and were marketed only to a select group of companies. The firm took care not to “saturate the market” for fear that widespread use would trigger Congressional and IRS attention. “A whale can’t get harpooned unless it surfaces for air,” emphasized Murias.¹¹ PwC’s contingency fees ranged from 8 percent to 30 percent of the customer’s tax savings.

Novack and Saunders’s article depicted a tax shelter industry on steroids. In contrast to the previous wave of shelters two decades earlier, large corporations, not doctors and dentists, were taking advantage of shelters to deprive the U.S. Treasury of hundreds of millions of dollars. These shelters were more complex and difficult to analyze than those that had preceded them. They used exotic financial instruments to create transactions that supposedly provided opportunities for economic gain, even as they hedged any risks associated with pursuing it. Not only promoters on the margins of respectability but also some of the country’s largest accounting firms, law firms, and financial institutions were now intimately involved in propelling the industry. They were catering to a new corporate attitude toward tax obligations, which regarded minimizing taxes as a competitive advantage that a corporation’s tax department was responsible for creating and sustaining.

A few months after the Forbes article, in 1999, a highly respected academic weighed in. Joseph Bankman, a tax professor at Stanford Law School, published an article, “The New Market in Corporate Tax Shelters,” in Tax Notes, a publication widely read by tax practitioners, academics, and tax policy experts. Drawing on conversations with tax lawyers at firms, Bankman was able to describe the rise of new types of shelters that were being marketed to Fortune 500 companies and privately held companies controlled by wealthy individuals.¹² The new shelters, according to Bankman, relied on interpretations of the tax law more aggressive than those offered on behalf of the shelters of the 1970s and 1980s. Indeed, promoters tended to assume that the shelters likely would be shut down if the government discovered them. Despite being expensive to develop, these shelters that typically involved the use of financial instruments were highly lucrative because there was a low probability that the IRS would ever audit the taxpayer and learn about the shelter. Even if it did, the agency likely would invalidate the shelter only prospectively. Once these factors were taken into consideration, Bankman wrote, “the cost benefit analysis leans decidedly in favor of the new corporate tax shelter.”¹³

Bankman described the competitive forces within the legal services market that made providing opinion letters attractive. “‘You break your back for a firm, month after month,’ one partner reports, ‘and the next month the firm is going to ask ‘What have you done for me lately?’ Then a Merrill Lynch comes to you—maybe for the first time—to ask you for an opinion. You know that if you give the client what it wants, there is more work in the future. It’s a real temptation.’”¹⁴

With “the elevation of the tax department to a profit center,” aggressive tax planning had become a “new norm.” Bankman noted that the corporate executive most responsible for Colgate-Palmolive entering into the installment sales shelter the ACM court struck down had been promoted despite the unfavorable legal result and bad publicity because, Bankman was told, “‘management and shareholders thought it was pretty good that the company took such aggressive actions.’” The result was a vicious cycle in which investment banks shopped for firms willing to provide opinion letters, which led to more aggressive opinions, which made it possible to design shelters with even less economic substance, which expanded the development of tax shelter products, which led lawyers to think more positively of shelters and to consider developing their own tax products practice.¹⁵ In the world depicted in Bankman’s article, corporations could come close to selecting the amount of taxes they were willing to pay and respect for the tax system was a quaint anachronism.

On the heels of Bankman’s article, the U.S. Treasury Department weighed in with its report The Problem of Corporate Tax Shelters.¹⁶ The report, issued in July, was intended to elaborate on the Clinton administration’s proposals to address tax shelters in the Fiscal Year 2000 budget, which had been announced in February. Recognizing that obtaining new legislation was an uphill battle, the administration issued a meticulously argued report marshaling all the evidence the IRS had amassed on abusive tax shelters and describing its well-grounded suspicions about as-yet-undiscovered abusive activity.

The report noted the “widespread agreement and concern among tax professionals that the corporate tax shelter problem is large and growing.”¹⁷ Corporate tax payments had lagged behind recent increases in corporate profits and the difference between book income and income for tax purposes had risen sharply in the last few years.¹⁸ The report observed that the growth of sophisticated financial engineering had expanded the number of tax reduction strategies available and that technological advances had made them easier and less expensive to deploy. According to the report, taxpayers also had less reason to fear that their aggressive positions would be discovered because audit rates had been falling. Audit rates for corporations with assets over $100 million had fallen from 77 percent in 1980 to 35 percent in 1997. While this to some extent reflected the impact of real economic growth and inflation, the overall audit rate for corporate tax returns had declined from 2.9 percent in 1992 to 2 percent in 1998.

Finally, the U.S. Treasury report echoed Bankman’s point about a change in corporate norms regarding tax obligations. “Corporations increasingly view their tax departments as profit centers,” said the report, “rather than as general administrative support facilities. Effective tax rates may be viewed as a performance measure, separate from after tax profits. That has put pressure on corporate financial officers to generate tax savings through shelters.”¹⁹ More generally, the report noted, some observers argued that the growth in corporate shelters reflected “more accepting attitudes of tax advisors and corporate executives toward aggressive tax planning. Put another way, the psychic cost of participating in tax-engineered transactions to avoid tax appears to have decreased.”²⁰

Raising the Stakes

Treasury officials were also hearing disquieting rumors suggesting that the abusive shelter problem was on the rise. Tax practitioners, barred from disclosing the confidential information of their clients, would drop hints during informal chats. And every so often, an anonymous manila envelope arrived containing materials describing a shelter currently on the market. In 1999, a group of tax bar leaders, including John “Buck” Chapoton and Ron Pearlman, both former assistant secretaries at the U.S. Treasury, and Stefan Tucker, a highly respected member of the tax bar, began to discuss the problem among themselves. The group formed a subsection of the ABA Tax Section to draft proposals to impose more stringent obligations on lawyers writing opinion letters intended to protect clients from penalties. They also met with members of the Treasury and legislators on the Hill to urge them to take the tax shelter problem seriously and enact new regulation to combat it.

Officials at Treasury knew they had to convince a highly skeptical Congress. Only one year earlier, in 1998, Congress had been persuaded that the IRS was running amok and enacted a landmark bill to rein it in. Now Treasury needed to ask for more resources and new powers to address an enemy that remained largely hidden. The Clinton administration supported legislation that would increase the penalties for understating income, impose new penalties for failure to disclose reportable transactions, sharpen the definition of abusive transactions, and significantly increase the resources available to the IRS to fight tax shelters. As members of the administration began to prepare to leave office, Treasury officials still hoped that they could obtain enforcement tools that would allow them to slow the spread of shelters and leave a regulatory framework in place that would allow their successors to continue to pursue a systemic response.

In seeking stronger legislation, the Clinton administration was up against a formidable adversary. Ken Kies, a brilliant tax expert and forceful advocate, had been, until a year earlier, the chief of staff to the Joint Committee on Taxation and had driven its Republican-leaning agenda. Among his allies, Kies counted Bill Archer (R, Texas), the chair of the House of Representatives’ powerful Ways and Means and Committee. In March 1999, Kies testified before the House Ways and Means Committee against the Clinton administration’s proposals in his capacity as managing director of PricewaterhouseCoopers’s WNTS. In fifty pages of written testimony to the Committee, he made no secret about his strong opposition to the proposals. According to Kies, the recommendations were “overreaching, unnecessary, and at odds with sound tax-policy principles.”²¹ There was no evidence, Kies maintained, that corporations were using tax shelters to erode the tax base. To the contrary, corporate tax revenues were on the rise. There was already a laundry list of statutes and regulations, Kies insisted, which gave the government more than enough tools to combat abusive transactions. In Kies’s strongly voiced opinion, the Clinton administration’s proposed definition of a tax avoidance transaction was excessively vague and would effectively grant broad power to the government that could inhibit the use of legitimate business transactions. Opposing the administration’s proposal, Kies did not hesitate to play on concern about IRS overreaching. Only eight months earlier, Congress had passed broad legislation to curtail the IRS’s power. Kies observed that, if enacted, Treasury’s proposal “would represent one of the broadest grants of authority ever given to the Treasury Department in the promulgation of regulations and, even more troubling, to Service agents in their audits of corporate taxpayers.”²²

Toward the end of the hearing, Representative Lloyd Doggett (D, Texas) took Kies on. “If I understand your written and oral testimony correctly,” he asked, “you oppose every single proposal that the administration has advanced relating to corporate tax shelters?” Kies replied, “That is precisely correct.”²³ Doggett proceeded to grill Kies on the information disclosed in the Forbes article about PwC’s tax shelter practice, most of which Kies denied was true. In response to a question about whether PwC charged contingent fees in connection with tax avoidance schemes, Kies replied, “Mr. Doggett, we don’t advise people on tax avoidance schemes.”²⁴ When Doggett persisted, Kies eventually acknowledged that while he did not know the exact amount, his firm charged contingent fees on tax shelters based on a percentage of the tax loss.²⁵

Stefan Tucker, testifying that day on behalf of the ABA Section of Taxation, urged Congress to take action in the face of a grave threat. “We have witnessed with growing alarm the aggressive use by large corporate taxpayers of tax ‘products’ that have little or no purpose other than reduction of Federal income taxes,” he declared.²⁶ Tucker expressed particular concern that the “lynchpin” of shelter transactions was the tax advisor’s opinion about the likelihood that the tax treatment the taxpayer claimed would be upheld. The role of the advisor in these instances, he said, “often disintegrates into the job of designing or blessing a factual setting” necessary for the transaction to satisfy the requirements of the economic substance and business purpose doctrines.”²⁷ Tucker concurred with the Treasury’s proposal to expand disclosure, increase penalties, and provide additional resources to the IRS to fight shelters. Although recognizing that a broader definition of reportable shelters might give rise to uncertainty, Tucker insisted that “[t]axpayers and their advisors know that relative certainty can easily be achieved in legitimate business transactions by steering a safe course and staying in the middle of the road.”²⁸ Acknowledging that many of the shelter enablers were tax lawyers, Tucker paraphrased the comic strip character Pogo. “We have met the enemy, and sometimes it’s us.”²⁹

A month later, the Senate Finance Committee held hearings dedicated in part to the corporate tax shelter problem. Senator Roth, the committee chair who had spearheaded the hearings on IRS abuses a year earlier, was disinclined to support legislation to expand the power of the agency to combat shelters. Echoing the objections raised by opponents, Roth was concerned that new legislation would subject “legitimate business transactions to tax shelter penalties.”³⁰

If the battle for new legislation was at a standstill, the Treasury had other fronts on which to advance. Much of the shelter activity could be investigated and prosecuted criminally. Unlike other penalties, the threat of criminal sanctions could have meaningful deterrent effects. The IRS’s Criminal Investigation Division (CID), however, had come under withering fire during the Roth hearings.³¹ At the time of the hearings, Commissioner Rossotti had requested that former FBI Director William Webster head an independent investigation of the CID. In April 1999, Webster submitted his report, which broadly exonerated the CID. According to the report, “Generally, CI[D] employs sound methods of investigation and does not routinely violate the constitutional rights of the subjects of its investigations. While isolated and individual incidents of misconduct exist, no evidence was found of systemic abuses by CI[D]agents.”³²

The report did note that the CID had strayed from its core mission of investigating criminal violations of the tax code because it had been drafted by other agencies to help with projects investigating money laundering, narcotics violations, and other activities that called for the CID’s financial expertise. As a result, the percentage of CID investigations based on referrals by the IRS Exam and Collection units had “dropped precipitously.”³³ The report recommended that the Criminal Investigation Division be established as a separate operating division within the IRS, headed by someone who would report directly to the IRS Commissioner and his or her deputies.

In October 1999, Rossotti announced that the IRS would be launching an initiative “to identify—and where appropriate, to stop—transactions which have no real business purpose other than tax savings.”³⁴ Rossotti provided few details beyond indicating that the agency would be bringing together IRS audit and technical resources within its Office of Chief Counsel to address those shelters. While the IRS was getting a late start, the sense was that the agency would finally be turning its attention in earnest to the growth in shelter activity that had occurred in the last several years.

Following up the report’s recommendations, in early October 1999, Rossotti named Mark Matthews, a former assistant to Webster at both the FBI and the CIA, as the new assistant commissioner for Criminal Investigation.³⁵ Matthews, a partner in the Washington law firm of Crowell & Moring, had served as deputy assistant attorney general in the Justice Department’s Tax Division and as deputy chief of the Criminal Division of the U.S. Attorney’s Office in the Southern District of New York. He had won high marks both for his legal skills and his understanding of the dynamics of government agencies. As Matthews debated whether to take the position, it became clear to him that his extensive experience in different prosecutorial settings and his status as an IRS outsider would give credibility to the office. He agreed to come on board.

Matthews undertook several initiatives to reinvigorate CID, including giving agents greater say in the decision to bring criminal charges. He also recognized the importance of using the media to publicize the agency’s renewed emphasis on criminal prosecutions to maximize deterrence. CID began to emphasize that individual cases were part of a larger story about national trends in tax evasion. The office began systematically to use its website, reach out to news outlets, and make special agents available to speak with reporters. When a judge sentenced a doctor to take out a full-page advertisement in a local newspaper, the CID sent a transcript of the sentencing hearing to reporters and the story appeared in Wall Street Journal.

A Manila Envelope and an Early Victory

In mid-fall 1999, an unmarked manila envelope appeared at the U.S. Treasury Department. The envelope contained a complex strategy, known by the acronym BOSS (Bond and Option Sales Strategy), which the accounting firm PwC was marketing to high-wealth individuals. Whoever had sent the envelope, a concerned tax lawyer perhaps, had given the Treasury a big break. The administration now had a detailed roadmap of one of the more abusive shelters on the market.

The timing could not have been better. In November, the House Ways and Means Committee was scheduled to resume its hearings on corporate tax shelters. The hearings had an inauspicious start when chairman Bill Archer opened the hearing by chastising the Treasury for dragging its feet and failing to issue new regulations pursuant to its powers under the 1997 statute. During the hearing, government officials again made the case that a systemic corporate shelter problem existed that needed to be addressed through new Congressional legislation.

Ken Kies was back, too. The PwC representative reprised the arguments he had made several months earlier. There was still no tax shelter problem, according to Kies. If Congress were to rely on the correct economic calculations, it would find that corporate tax revenue had, in fact, gone up since the early 1990s. And the estimate of $10 billion in lost tax revenue, which had been put forward by Bankman the Stanford tax professor, was just a guess from a “part-time” academic.³⁶

Questioning Kies again, Representative Doggett determined what had happened to Fernando Murias, in 1998 the co-chair of PwC’s Mid-Atlantic and WNTS, after he had given his forthright description of the firm’s active tax shelter practice to two Forbes reporters. Although Murias remained a partner, Doggett ascertained that in the previous six months he had been reassigned to a different position at the firm.³⁷

Doggett went on to ask whether the details Murias had provided—during casual cocktail party conversation according to Kies—were accurate. Was PwC promoting thirty mass-marketed shelters? Doggett also wanted to know whether the firm had designated special managers as “product champions” to coordinate sales, and had hired a professional sales force to pitch ideas. Kies insisted that these details were wrong. At most, he conceded, the firm might have a planning strategy that it might bring to more than one client.

Reaching over the table in front of him, Doggett grabbed a thick document. “Let me ask you, sir,” he said, brandishing the document, whether “your company is still promoting the bond and option sales strategy that you call the BOSS plan, a way to circumvent what this Committee did [with a section of the tax code] in June.”³⁸

Kies responded that he was not “even familiar with that transaction” but was “happy to look at it and get back to [Doggett].” “I am sure you would,” Doggett retorted. “It has got PricewaterhouseCoopers on the cover, so I am sure you can find out about it when you get back. Thank you for your responsiveness, Mr. Kies.”³⁹

Within a few weeks, Tax Notes Today had published PricewaterhouseCoopers’s description of BOSS. Soon after, Kies sent a letter to the Ways and Means Committee distancing PwC from BOSS. After inquiring in the firm about the transaction, Kies had learned that “[f]irst, PricewaterhouseCoopers has not been engaged by any client to assist, advise, or otherwise consult on execution of the specific Bond & Option Sales Strategy transaction outlined in the draft opinion letter that Rep. Doggett provided.” But he added: “Second, we did advise clients with respect to transactions similar to the ones describe in the draft. Third, it is the position of my firm that we will not issue an opinion on this transaction or such similar transactions.”⁴⁰

Shortly afterward, the IRS issued Notice 99-59 shutting down BOSS. According to the notice, the agency would not recognize a tax loss from a BOSS shelter or any similar transaction because in the shelter “[t]hrough a series of contrived steps, taxpayers claim tax losses for capital outlays that they have in fact recovered.” Significantly, the notice made clear that the IRS would pursue the range of penalties available to it, including return preparer and promoter penalties. “There will be no Christmas bonus from the ‘BOSS’ this year,” Representative Doggett, announced as he congratulated the Treasury for shutting down the shelter. But he cautioned, “We can’t make a serious dent in tax abuse as long as Treasury and Congress act only on a case-by-case basis; we’ll always be one step behind.”⁴¹

Back at PwC, firm leaders took swift action, launching an internal investigation to determine the scope of its tax shelter activities. After the IRS published Notice 99-59 in December, PwC decided it could not issue any opinion letters for BOSS. As a consequence of its investigation, the firm decided to unwind the BOSS transactions, refunding clients approximately 85 percent of the cash that they had invested in BOSS transactions, including all fees paid to PwC in connection with the shelter. The firm also withdrew from seven FLIP transactions and refunded fees that had been paid for them.⁴²

As Samuel A. DiPiazza, the chair of PwC’s U.S. operations, explained, “The evolving state of the law and the changing environment surrounding tax shelter investments cause the firm to change its view . . . [as a result] the firm believed it would be irresponsible to encourage investors to proceed.”⁴³ Looking back on the episode, PwC acknowledged “The BOSS transaction triggered widespread public attention and controversy in the fall of 1999. As a result, we decided that we had made a regrettable mistake being in this business. Our reputation was hurt; our clients and people were embarrassed.”⁴⁴

By April 2000, the firm had disbanded the group of approximately ten people who were responsible for developing and marketing shelter transactions. Michael Schwartz, who had brought BOSS to PwC from KPMG, left the firm. Schwartz, who apparently had an insatiable appetite for shelter work, soon launched his own firm, Coastal Trading LLC, which continued to participate in client referrals and shelter implementation.⁴⁵

A few years later, when the IRS sought under its statutory authority to obtain the names of investors who had purchased shelters from PwC, the firm complied without a fight. Soon afterward, PwC resolved the IRS’s claims against it arising out of its shelter activity, becoming the first major accounting firm to settle with the IRS. The firm’s decision to get out of promoting shelters and the subsequent settlement showed that sufficient reputational pressures and legal threats could lead one of the Big Five accounting firms to desist from engaging in tax shelter activity, even as other firms were ratcheting up their involvement.

Two Steps Forward

By November 1999 the IRS had won five tax court cases involving corporate tax shelters, a string of victories that Business Week highlighted in an article entitled “Kiss That Tax Shelter Goodbye?”⁴⁶ According to the article, the rulings had left tax professionals “stunned.” Within a few months, the agency would win another important case in the D.C. Circuit of Appeals involving a shelter very similar to the one used by Colgate-Palmolive. While some observers predicted that this trend would lead people to be more careful, using judicial doctrines to attack specific transactions had significant limitations. As one former Treasury official described it, the process was like the game of “whack-a-mole,” where new shelters endlessly arose even as others were knocked down. In this game, the promoter would always be ahead of the government.⁴⁷

In February 2000, Treasury Secretary Lawrence Summers described the multipronged approach the department planned to pursue to go after corporate tax shelters, which he identified as “the most serious compliance issue facing the American tax system.”⁴⁸ Under this approach, the Treasury was issuing new disclosure regulations pursuant to its authority under the Tax Relief Act of 1997. In the meantime, the IRS was being reorganized to focus its resources on identifying potentially abusive transactions. In addition, the Clinton administration would seek new legislation increasing the penalties for abusive shelters and codifying the economic substance doctrine. The Treasury would also focus on strengthening the regulatory standards governing tax practitioners.

The same day as Summers’s speech, the Treasury Department issued temporary proposed regulations. Under the new regulations, corporate taxpayers were required to flag transactions that had multiple tax shelter characteristics on their tax returns so that the IRS could examine these transactions more closely.⁴⁹ The new regulations also required promoters to register with the IRS transactions that bore the indicia of potentially abusive transactions.⁵⁰ In addition, promoters were required to keep lists of investors who purchased such transactions so that the IRS could cross-check taxpayer disclosures against information it obtained from promoters.⁵¹ The new shelter regulations provoked a lively discussion among tax professionals about whether they targeted the right transactions, were overly broad, and could be easily circumvented. Promoters, meanwhile, still took the view that the regulations did not apply to individual taxpayers. By enacting the new regulations, however, the Treasury had at least forestalled one argument made by Kies and other opponents of new legislation that the Treasury had failed to take full advantage of previously granted enforcement powers.

Seeking to use its resources as effectively as possible, the IRS also created a new Office of Tax Shelter Analysis, which would review all disclosures by taxpayers and promoters under the new regulations to identify potentially improper transactions.⁵² It also would serve as a clearinghouse for all information on tax shelters that came to the agency and would help evaluate new transactions so that the IRS could provide guidance on them as early as possible.

Prospects for legislation expanding the enforcement power of the IRS, however, remained dim. But government officials supporting new legislation had won one important new convert. Senator Roth, the chair of the Finance Committee, who only a few years earlier had overseen the hearings that had generated such intense criticism of the IRS, now recognized that shelters posed a serious threat to the integrity of the tax system and was in favor of enacting legislation to address the problem. In the spring of 2000, a coalition of Democratic and Republican members of Congress had drafted a sweeping legislative proposal that sought to strengthen the government’s hand. Representative Archer, the chair of the House’s Ways and Means Committee, remained highly skeptical. Anyone reading the tea leaves knew that without his support, nothing would go forward in Congress.

In the meantime, indications that shelters were moving downstream to individual investors were growing. Evidence was also emerging that some promoters were going so far as to advise investors to report misleading information on their tax returns to hide their involvement in questionable transactions. In August 2000, the IRS announced that it was listing “Son-of-BOSS” shelters as abusive transactions, whose tax benefits it would disallow.⁵³ This type of transaction, of which BLIPS, SOS, and COBRA were examples, relied on the supposedly distinctive tax treatment of certain partnership liabilities. This treatment inflated a taxpayer’s basis producing a tax loss despite the absence of any economic loss. The notice stated that such losses were not allowable as deductions and that any transactions that were the same or similar to these transactions had to be registered under the temporary regulations then in effect.

The notice also described the advice that some promoters were giving taxpayers that enabled them to conceal the amount of their capital losses by using a “grantor trust” to report only the net amount produced by offsetting gains and losses against one another. Tax partners at KPMG and BDO Seidman had given just such advice to clients who were filing their returns. The notice warned that any taxpayer who used this method or any advisor who recommended it was at risk of criminal prosecution. It is not clear how the IRS originally got wind of “Son-of-BOSS” shelters or the grantor trust technique. There was speculation among tax partners at KPMG, who were in the midst of marketing BLIPS and had advised some clients to use grantor trust netting on their tax returns, that someone inside the organization had alerted the IRS about the firm’s tax shelter activities.⁵⁴

The notice caused alarm bells to go off throughout the tax world. It was not just—or even principally—corporations that were engaging in tax shelter activity. As the abusive transaction described in the notice made clear, tax shelters had migrated on a very large scale to wealthy individual taxpayers. “Shelters are going retail,” warned Lee Sheppard, a prolific contributing editor for Tax Notes Today and astute observer of the tax practice world.⁵⁵

Policy experts and politicians have always been somewhat ambivalent about the wisdom of taxing corporations—some argued that it amounted to double taxation, once on the corporation and once on the shareholder who earned income from the corporation.⁵⁶ For a handful of policymakers and government officials, corporate shelters were not cause for serious concern. Shelters were just mechanisms for corporations to avoid the unfairness of a double tax. A growing industry of shelters that were mass marketed to wealthy individuals was an altogether different story. No one doubted that such a market could substantially undermine the legitimacy of the tax regime. The knowledge among average Americans that an increasing number of rich people were getting away with not paying taxes could throw the whole system into crisis, breeding tax evasion on an even larger scale. As Sheppard emphasized, “Retail tax shelters engender a loss of respect for the system, and the belief that the rich don’t have to pay. Even in a system where most of the revenue is collected through wage withholding, those attitudes are unhealthy and dangerous.”⁵⁷ Recognizing the danger from mass-marketed individual tax shelters, in August the Treasury amended its proposed tax shelter regulations so that the requirement to maintain a list of investors in a potentially abusive shelter applied not only to shelters sold to corporate taxpayers but also those sold to individuals.⁵⁸

The fact that the shelter industry was breeding fraudulent tax reporting raised even more serious concerns. When it came to questionable transactions, some commentators believed the shelters were aggressive but not necessarily illegitimate, in that they appeared to comply with the technical requirements of the tax law. Almost everyone agreed, however, that using or recommending a reporting technique to net gains and losses with the intent of hiding the underlying tax shelter was criminal wrongdoing.

In early 2001, the Treasury made good on its earlier promise to strengthen the practice standards that governed tax practitioners, known as Circular 230.⁵⁹ Treasury officials proposed to add a due diligence requirement for more-likely-than-not opinions that were intended to be relied on by taxpayers to avoid penalties. Among other obligations, the opinion author had to “make inquiry as to all relevant facts.” An opinion “could not be based, directly or indirectly, on any unreasonable factual assumptions,” which included “a factual assumption that the practitioner knows or has reason to believe is incorrect, incomplete, inconsistent or implausible” or “a factual assumption that the transaction has a business reason, an assumption with respect to the potential profitability of the transaction apart from tax benefits, or an assumption with respect to a material valuation issue.” Simply put, opinions intended to provide penalty protection could not rely on farfetched factual assumptions about the purpose and profitability of the transaction. More-likely-than-not opinions had to be comprehensive, addressing all of the relevant judicial doctrines and applying them to the relevant facts. Similar requirements applied to opinions being used by third parties to market shelters, which, because they were not obtained from an independent advisor, could not be relied on to avoid penalties.

Reflecting recognition of the importance of organizational structure and climate on tax practice, the regulations required that practitioners who are responsible for a firm’s tax practice “take reasonable steps” to ensure that “the firm has adequate procedures in effect for purposes of ensuring compliance” with tax opinion regulations. The IRS Director of Practice would be authorized to take disciplinary action against any practitioner for failing to do so under certain circumstances when there was a “pattern or practice” in a firm of failing to comply with the regulations.

By January 2001 Some 2,500 transactions had been filed with the IRS as a result of the corporate disclosure regulations and the agency had issued nineteen “soft” letters to promoters requesting additional information. In March 2001, IRS Senior Counselor to the Commissioner Michael Shaheen announced that the number of attorneys in the Office of the Director of Practice would increase from nine to thirty and that the IRS would increase the number of administrative law judge cases that involved tax shelters.⁶⁰ The IRS was ramping up for what it expected to be a larger number of investigations and proceedings. It was also signaling that it was serious about scrutinizing the activities of tax professionals alleged to be involved in shelter activity.

A few months later, the IRS announced its settlement with Merrill Lynch in connection with the 1989 and 1990 installment sales transactions that the firm had failed to register. Courts had upheld the IRS’s denial of tax benefits arising from these shelters in ACM, ASA Investerings, and other cases. Merrill agreed to make a “substantial payment” as part of the settlement, although a Merrill spokesperson said that it was not a “material” amount.⁶¹ The firm agreed to review all of its investment products to ensure that they complied with federal law. The IRS’s hand obviously had been strengthened by court decisions finding these shelters abusive. In light of the twelve years that had transpired between the sale of the shelters and the settlement, however, it was clear the agency couldn’t afford to wait for such vindication before it moved against promoters.

Two Steps Back?

If 2000 had been a good year for the IRS in court, 2001 proved to be a bad one. The summer brought several defeats, as the Eleventh and then the Eighth Circuit Courts of Appeal reversed decisions in which the IRS had successfully argued that features of a tax-advantaged transaction were a sham.⁶² In the fall, the agency lost a district court case involving an installment sales shelter sold by Merrill Lynch.⁶³ These defeats were capped with two more losses in December 2001, as the D.C. and Fifth Circuits reversed tax court decisions that had been favorable to the agency.⁶⁴ Commentators worried that these losses were blowing new winds into the sails of the tax shelter industry. PwC’s Kenneth Kies urged the Treasury to change its policy with regard certain shelters, arguing that the appellate decisions, “cast significant doubt on the economic substance test” relied on by IRS.⁶⁵

In mid-December 2001 the IRS’s Office of Tax Shelter Analysis (OTSA) reported on the information it had received from taxpayer disclosures and promoter registrations since its creation in March of 2000.⁶⁶ OTSA had received fifty-one disclosure statements regarding reportable transactions from twenty-one taxpayers in 2000. The total claimed tax losses from these transactions was $3.7 billion. From the beginning of 2001 until November 30 of that year, OTSA received 272 disclosure statements from ninety-five taxpayers, representing claimed losses of $14.7 billion. OTSA also had received over 3,600 registrations from promoters since its inception. Based on this information, it had issued twenty-eight letters to twenty-two different promoters and was conducting investigations of twelve promoters for failure to file shelter registrations.

As an IRS official acknowledged, the numbers were deceptive. Closer analysis of the OTSA data indicated that about 100 of the 272 transactions disclosed in 2001 were “plain vanilla” leases that an IRS notice had earlier indicated were not abusive. Of the remaining transactions, seventy-two were listed and half of those were contingent liability shelters that the agency had already listed in February of 2001.⁶⁷ In other words, the IRS wasn’t learning much from the disclosures about previously unknown shelters.

Just before Christmas 2001, the IRS announced an initiative that officials hoped would dramatically increase taxpayer disclosure of shelter transactions.⁶⁸ Announcement 2002-2 amounted to an amnesty program for taxpayers who disclosed their participation in any shelter for which they might be subject to an underpayment penalty. These taxpayers would not be subject to the penalty if they came forward by April 23, 2002, and satisfied certain conditions. To take advantage of this offer, a taxpayer was required to provide a description of the shelter and its tax treatment; information about anyone who promoted the shelter and had a financial interest in the taxpayer’s decision to participate, as well as anyone who advised the promoter regarding the shelter; and, if requested, copies of all documents connected with the transaction, including legal opinions and memoranda. The IRS hoped to break the disclosure logjam on shelters by giving taxpayers an incentive to turn over information that the agency could use to pursue promoters, whom it regarded as the root of the problem.

The IRS publicized the initiative to tax practitioners and urged them to advise clients to take advantage of it. Larry Langdon, commissioner of the IRS Large and Mid-Size Business Division (LMSB), spoke to several groups. At a January 18, 2001, meeting of the ABA Section of Taxation Financial Transactions Committee in New Orleans, Langdon said that the disclosure initiative was designed to prompt taxpayers to come forward while knowing that others in their situation were doing the same.⁶⁹ He called it a “once in a lifetime opportunity” that provided for expedited resolution of any issues. One member of the audience said that he couldn’t help but detect “an unmistakable air of revenge” on the part of the IRS toward those who didn’t come forward. Langdon didn’t soft-pedal his response. “That’s why we’re discussing it now,” he said. About a week later, speaking to the Federal Bar Association Tax Section in Washington, D.C., Langdon remarked that the initiative gave taxpayers a choice: “pay me now or pay me later.”⁷⁰ He added, “But if you pay me later, you’ll pay penalties.”

The tax bar expressed concern about the impact of disclosure on the attorney-client privilege since taxpayers were being asked to disclose legal opinions and memoranda as a condition of obtaining amnesty. Its fears were confirmed when Langdon asserted, “We’re in effect asking people to waive appropriate attorney-client privilege.”⁷¹ In an effort to resolve the issue, the IRS announced on February 19, 2002, that it had developed a standard agreement between the agency and a taxpayer making a disclosure under the initiative that addressed the privilege issue. It stated: “This agreement confirms that the Internal Revenue Service will not assert that [Taxpayer’s] production of the document listed below constitutes a subject matter waiver of the attorney-client privilege or the work product doctrine with respect to other documents addressing the same subject matters as those discussed in the listed documents.”⁷² The IRS reserved the right to challenge the assertion of privilege on other grounds. Members of the tax bar were not impressed. Lawrence Hill at White & Case scoffed that the IRS was giving people “ice in the winter.”⁷³ He suggested that the agency could still depose a tax advisor and ask questions about all documents produced under the disclosure initiative. Furthermore, he noted, a court, other agency, or third party was still free to claim, based on traditional court doctrine, that there had been a broad subject matter waiver.

Despite lingering concerns that taxpayers would be broadly waiving the attorney-client privilege, some shelter participants began to disclose. Slow at first, the response began to pick up momentum. In March 2002, the IRS announced that by February, midway through the amnesty period, more than seventy taxpayers had disclosed transactions involving claims of $1.5 billion in tax losses.⁷⁴ Even more striking, in February alone, some twenty-one taxpayers had disclosed more than $1 billion in claimed losses. The number of participating taxpayers had more than tripled in the previous two weeks, observed David Harris, the manager of OTSA. “The volume has been fairly steady,” he emphasized, and more “keep rolling in every day.”⁷⁵ Harris suggested that the $1.5 billion figure for the amount of losses and deductions at stake was “quite understated,” because many disclosures informed the IRS of the transactions but did not specify a dollar amount.⁷⁶ Despite setbacks in the courts, the agency’s tough talk was starting to yield results.

Expanding the Arsenal

Although the amnesty initiative was beginning to bear fruit, many corporate taxpayers and shelter promoters were still not complying with the Treasury’s disclosure regulations. Some officials believed that the complexity of the existing disclosure rules invited creative interpretation, and the penalties for refusing to comply with them were inadequate. Moreover, given the growth of shelter activity among individual taxpayers, imposing a disclosure obligation only on corporate taxpayers was unduly narrow. In late March 2002, the Treasury proposed new regulations that required partnerships, S corporations, trusts, and individuals to disclose reportable transactions.⁷⁷ The new regulations also eliminated defenses to penalties for underpayment, such as relying on a legal opinion, for any reportable transaction that the taxpayer had not disclosed.⁷⁸

Although the new regulations expanded the opportunity to identify potentially abusive transactions, the IRS still lacked the resources to enforce the rules aggressively. The previous spring, IRS Commissioner Rossotti testified before the Senate Finance Committee that the agency was “deeply concerned about the continued drop in audit and collection activity” over the last year.⁷⁹ As Rossotti pointed out, customer service had improved, but at the cost of enforcement. Audit and collection activity had fallen due to a long-term decline in staffing, coupled with a shift of agency personnel from compliance to customer service.

Much of the underenforcement, moreover, was occurring in connection with business filings. Trust and partnership filings had steadily increased since the mid-1990s, but the IRS still lacked the capacity to match these returns with the returns of individual or corporate taxpayers. According to Rossotti, up to 20 percent of income that passed through from entities to their owners was not reported. Unmatched partnership return forms represented approximately $500 billion in pass-through income. “These pass-throughs” Rossotti emphasized, “are not being identified by the IRS and therefore are not available for compliance reviews. Abusive tax shelters are taking advantage of IRS’ inability to match, regulate or analyze this information.”⁸⁰

A year later, the situation had not improved. In testimony before the Senate’s Finance Committee, Rossotti described identifying and combating tax shelters as the IRS’s highest priority.⁸¹ The agency’s resources, however, were stretched to the limit. In testimony during hearings of the Joint Committee of Taxation review of the IRS, James R. White, the director of the independent General Accounting Office, identified “large and pervasive declines across the compliance and collection programs, except for returns processing, between the years 1996–2001.” Among other areas of decreased enforcement and collection activity, White noted declines in audits of individual and corporate tax returns and an increase in deferred collection activity on delinquencies. The drop in overall enforcement activity created a disincentive for voluntary compliance. White observed, “Taxpayers’ willingness to voluntarily comply with the tax laws depends in part on their confidence that their friends, neighbors, and business competitors are paying their share of taxes.”⁸²

These dire figures were replicated in the Joint Committee on Taxation’s report. Levies, liens, and seizures had seen an uptick in 2000 but total enforcement actions were “a fraction of levels in fiscal years 1995 through 1998.”⁸³ The audit rate in 2001 was slightly higher than in the previous year, but overall the audit rate had declined since 1997. Audits of corporations had steadily declined. When it came to pass-through entities, a favorite vehicle to hide tax shelter activity, the IRS only audited one out of 256 returns, a rate equivalent to 0.39 percent. Meanwhile, the IRS had identified the “misuse of trusts and pass-through entities to hide or improperly reduce income” and “the use of complex and abusive corporate tax shelters” as areas of “systemic non-compliance” on which it planned to concentrate its “limited” enforcement resources.⁸⁴ As his five-year term was winding down, Rossotti underscored in speech after speech the need for adequate funding to strengthen the agency’s compliance functions.

For all Commissioner Rossotti’s efforts, there was some skepticism about whether the Bush administration was seriously committed to addressing corporate tax shelters. A Wall Street Journal article portrayed the amnesty program announced in late 2001 as too generous to tax shelter participants and noted that the Bush Treasury, in contrast to the Clinton administration, was slow to shut down individual shelters.⁸⁵ In the previous two years, the Treasury had also been ambivalent about the need to pursue new legislation to address the problem.

The government’s enforcement efforts might have continued to limp along but for the fact that a major corporate scandal was erupting in the news. In late 2001, Enron Corporation was forced into bankruptcy. Only a year earlier the company had been a darling of the business community, listed among the biggest twenty public companies in the world and a poster child for innovative business strategies and management style. On February 1, 2002, William Powers Jr., Dean of the University of Texas School of Law, issued a scathing report on behalf of a special committee of the Enron board, describing the mind-numbingly complex accounting maneuvers that the company had used to make its mounting losses disappear from its books.⁸⁶ As the disclosures emerged, the public was treated to a parade of indictments and guilty pleas, as one high-ranking Enron executive after another came under criminal investigation. It was soon clear that Enron was not the only company that had engaged in large-scale fraud. WorldCom, Tyco, and others joined a growing list of major corporations engaged in massive accounting scandals.

Powers’s report demonstrated that the extent and depth of Enron’s fraud would not have been possible without the complicity of a major accounting firm. The revelations about Arthur Andersen’s role destroyed the accounting firm’s reputation and put to rest the myth that such firms were committed to safeguarding the integrity of the securities market. In the period of a few months, the behavior of several partners at Andersen fell under public scrutiny and the partner in charge of the Enron engagement plead guilty. The firm itself was indicted for obstruction of justice in March 2002.

As the disclosures showed, Enron’s wrongdoing went beyond accounting fraud. The company had also participated in abusive shelters to avoid paying taxes on the revenue it earned. In January 2002, Senator Charles Grassley (R, Iowa), ranking member of the Senate Finance Committee, emphasized that Enron’s tax avoidance strategies underscored the need for new legislation.⁸⁷ In the spring, the Committee held a new round of hearings on abusive shelters. It did not escape notice that the IRS, which had been vilified only four years earlier, was now producing the star witnesses in the proceedings. Senator Grassley, a one-time critic of the IRS, was publicly cheering the agency’s enforcement efforts.⁸⁸ Even as it considered new legislation, the Senate Finance Committee was aggressively negotiating to obtain Enron’s tax records, which the company claimed were privileged under the statutory accounting privilege.⁸⁹

In May 2002, the Washington Post ran a front-page story describing “Enron’s Other Strategy.”⁹⁰ According to Robert Hermann, Enron’s former general tax counsel who was interviewed for the story, the company had been able to produce almost $1 billion in tax savings from engaging in tax avoidance transactions. In 2000, nearly a third of the profit reported by the company came from savings from these one-time transactions. According to Hermann, the tax unit was under intense pressure to produce reportable earnings. Enron’s tax department created a “structured transactions” group, which grew to about twenty employees, who worked with the assistance of King & Spalding, Chase Manhattan Bank, and Bankers Trust to identify and implement transactions. These deals were expected to produce nearly $2 billion dollars in reported revenue by the mid-2000s.

Although Hermann insisted that the transactions were permissible tax avoidance mechanisms, further investigation revealed that many were abusive tax shelters. Lee Sheppard of Tax Notes observed that at least one Enron transaction involved a basis-shifting shelter similar to the shelters that had moved downstream to individual taxpayers.⁹¹ Enron had also used tax havens to avoid paying taxes. Observers hypothesized a connection between Enron’s participation in abusive shelter activities and its accounting fraud. As tax professor Alice Abreu noted, if line crossing in tax compliance led to pushing the envelope in other areas, then “corporate tax shelters would be like cancer—bad not just because it damages an organ but because it spreads.”⁹²

The widespread attention to tax abuses prompted by Enron’s collapse lit a fire under the Senate. By summer, several senators had proposed separate bills to address the issue. In a surprise move, meanwhile, the Appropriations Committee gave the IRS $10 million more than the Bush administration had requested in its budget to fight tax shelters.⁹³ Representative Doggett, for his part, sponsored a bill that would yield an estimated $16.5 billion in tax revenue, otherwise lost to corporate shelters, over ten years. Still the Republican-controlled House was not eager to move quickly to enact legislation to curb tax shelters and the use of tax havens to shield income. While the push for new legislation was stalled again, no one expected that this would be the last attempt to address abusive shelters through Congressional action.

By 2002, it was clear that the issue of abusive tax shelters had become an important topic of public debate. Publicity in the press about shelters, court decisions affirming the use of anti-abuse doctrines, and Congressional hearings had moved the Treasury Department to issue a report on corporate shelters and to stiffen regulations. The IRS had listed two major shelters as abusive and had enacted an initiative to encourage taxpayers who had used shelters to come forward. A new IRS Office of Tax Shelter Analysis was beginning to gather more information about questionable tax avoidance transactions. From this point forward, government efforts would gain momentum. Over time, these efforts slowly tightened the noose around the accounting firms and law firms that had helped perpetrate a major assault on the United States income tax system.