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Update on Ray Lane's Tax Shelter

As noted in an earlier post focusing on the way intimidation of the IRS tends to lead to more tax avoidance and even tax evasion through promoted "shelters", Hewlett-Packard official Ray Lane engaged in a phony tax shelter back in 2004.  He got caught and has apparently settled the $100 million tax bill.  See, e.g., Reuters, H-P Board member Ray Lane Settles long-running tax bill (June 6, 2013);  Tax Prof listing of assorted stories.

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The Boom and Bust Cycle of Tax Shelters and Intimidation of the IRS

[edited 6/9/13 to correct some glaring typos :) ]

In response to concern about taxpayer rights and potentially abusive tax collection activities, Congress passed two "taxpayer bill of rights" laws, in 1988 and again in 1996.  Together, these laws protect taxpayers with further notice and information, shift the burden of proof to the government in many cases, and create an office of taxpayer advocate that reports directly to Congress, among many other provisions.  The 1988 law (consolidating five different proposed bills into an "omnibus" bill under HR 4333) included provisions that sharply restricted IRS' employees' ability to ferret out tax evasion for fear of potentially violating the law. See summary of HR 2190,  "the IRS Administration Reform and Taxpayer Protection Act of 1987", incorporated in the 1988 legislation passed as HR 4333.  The 1996 law, HR 2337/ Public Law 104-506, beefed up the Taxpayer Advocate office, modified various penalty and collection provisions, and required an annual report to Congress on IRS employee misconduct.  While these laws provided important new protections for taxpayers and noteworthy additions to the law governing collection authority, some were  overgenerous to taxpayers and at the least made enforcing the tax laws more difficult for IRS employees.

It was only a short while after the 1996 law was enacted when the Senate Finance Committee held an elaborate series of hearings looking into alleged "abuses" of "innocent" taxpayers by the agency in collecting taxes and investigating potential criminal evasion of taxes:   hearings on IRS practice and procedures, Sept. 23-25, 1997;  hearings on IRS restructuring, Jan. 28-29, Feb. 5, 11, and 25, 1998; and hearings on IRS oversight, May 28-30 and June 1, 1998. Let it be clear: these  hearings targeted the IRS with an apparent objective of changing the agency's focus from enforcement and collection of taxes to "nice-guy" relations with taxpayers.  They included "sob stories" about harassment by the IRS from a priest, a divorced mother, a restauranteur and others, and alleged abuses in the collection and investigatory processes within the agency.  

Much of the inflammatory testimony in those late 90s hearings was just that--stories, hand-picked to highlight purported problems, with the result that they inflamed the citizenry against the agency.  The selected testimony was anything but balanced, in that it ignored myriad examples of just the opposite and included made-up tales of abuse.  Danshera Cords, in an article discussing the 1998 Act, describes the restaurant owner's testimony and its lack of truthfulness as follows:

John Colaprete, owner of the Jewish Mother restaurants, "told the Finance Committee that IRS agents and other law enforcement personnel forced children to the floor at gunpoint, leered at scantily clad teenage girls, and generally violated his Fourth Amendment rights against illegal search and seizure, all on the word of his felonious bookkeeper." Ryan J. Donmoyer, Judge May Dismiss Jewish Mother Lawsuit, 83 TAX NOTES 1696, 1696 (1999). Mr. Colaprete testified before the Finance Committee that, while attending his son’s first Holy Communion, "[a]rmed agents, accompanied by drug-sniffing dogs, stormed my restaurants during breakfast, ordered patrons out of the restaurant, and began interrogating my employees." IRS Oversight: Hearings Before the Senate Comm. on Finance, 105th Cong. 75–79 (1998); ROTH & NIXON, supra note 5, at 189.

Danshera Cords, How Much Process is Due? IRC Section 6320 and 6330 Collection Due Process Hearings, 29 Vermont L. Rev. 51, 52 note 7.

That sounds atrocious, until you find out that Colaprete later recanted the whole thing, when it was found that he was actually out of the country at the time it was claimed to have happened.  Id.

There were two later reviews of the testimony--the Webster Commission and a GAO study (both cited in Cords' article).  The Webster Commission found isolated abuses but no pattern of misconduct by the criminal investigation division.  Criminal Investigation Div. Review Task Force, IRS, Review of the IRS's Criminal Investigation Division (1999).  The GAO study found no evidence supporting the allegations that tax assessments were improperly handled or criminal investigations inappropriately undertaken. GAO, Tax Administration: Investigation of Allegations of Taxpayer Abuse and Employee Misconduct Raised at Senate Finance Committee's IRS Oversight Hearings (reprinted in 2000 Tax Notes Today 80-13 (Apr. 25, 2000)). David Cay Johnston, in his highly regarded book on the tax shelter business, describes those hearings as "going after the IRS".  Perfectly Legal (2003).  Bryan T. Camp describes Congress as seeing tax administration as an "inquisitorial" process.  Bryan T. Camp, Tax Administration as Inquisitorial Process and the Partial Paradigm Shift in the IRS Restructuring and Reform Act of 1998, 56 Fla. L. Rev. 1 (2004) (describing the hearings at 78-86).

The  Senate Finance hearings enabled the passage of additional legislation in 1998, the Internal Revenus Service Restructuring and Reform Act of 1998. The law reorganized the IRS, the main agency to enforce the law, into "units serving particular groups of taxpayers with similar needs"--i.e., changing its focus from law enforcement to "serving taxpayers".  It  "significantly limited" the agency's "historically broad powers".  Id. (Cords, at 51).  It created a collection due process hearing requirement before the IRS can proceed to collect on taxes due; a bureaucratic (red-tape) approval process for levies, liens and seizures; and severe limitations on examination and audit techniques and impositions of penalties.  The agency suffered not only from increased disrespect (from media attention to the inflammatory hearings) that facilitated the right's mission to spread the Reagan mantra that "government is the problem," but also from underfunding, strict limitations on methodologies, and effective intimidation that made it harder to enforce the tax laws and collect unpaid taxes, thus encouraging tax evasion and even tax fraud. Stress, time and resource constraints, and understaffing, got worse, even while Congress dumped more and more administrative responsibilities on the agency.

The always innovative tax practitioners (attorneys and CPAs) noticed.  Corporations and their high-wealth CEOs and majority shareholders were already engaging in more tax avoidance with the help of crafty lawyers finding loopholes in the interstices of the tax law and the more restrictive 1988 and 1996 laws that made it harder to enforce or collect.  Many now took advantage of the newly flourishing tax shelter schemes from the late 1990s to mid 2000s.  These were often promoted by big-money law partners at law firms like Donna Guerin at (now shut down) Jenkens & Gilchrist or Raymond Ruble at Brown & Wood (later Sidley Austin) and financed by investment banks like Deutsche Bank and others eager to profit from derivatives that made deals appear to move money around while essentially leaving it in place, with avid assistance (and sometimes design) by accounting firms like Arthur Anderson, KPMG, and BDO Seidman. The shelters usually had fancy acronyms like "COBRA" and "FLIPs."  They frequently involved invented (phantom) losses or phony deductions.  Many used purported federal income tax partnership structures to selectively pass gains to tax-exempt or tax-indifferent parties so (phantom) losses could be passed to parties that "needed" a tax loss to offset a large, expected, and real gain. 

Hitting the news today is yet another story about a top CEO who engaged in those phantom-loss- generating partnership tax shelters.  Zajac & Drucker, Ray Lane Rode Tech-Boom Tax Shelter Wave Broken by IRS, Bloomberg.com (June 7, 2013). Lane, former president of Oracle and current chair of Hewlett-Packard, used a shelter involving partnerships with long and short positions called "POPS"--put together by Sidley & Austin, Deutsche Bank, and BDO Seidman--to shield $250 million from taxation. Id.  As Chris Rizek, a tax lawyer at DC's Caplin & Drysdale told Bloomberg, the IRS slacked off on enforcement in those years after the series of bills restricting tax administration because "they were intimidated." Id.  "They could be cowed again," Rizek said, given the focus in Congress this month.

We seem to have a "boom or bust" cycle in terms of attitudes towards the IRS as the primary agency for enforcing our tax laws.  And that's unfortunate, because a country that cannot force wealthy and corporate taxpayers to pay their share of the tax burden is a country that will fail.

This history should serve as an important warning to Congress, the mainstream media, and citizens as hearings exploiting anti-IRS sentiments spread cries of alleged abuses (seemingly with as little evidentiary support for widespread patterns of abuse as the 1998 hearings) that may again lead to overly restrictive legislation.  

While any agency should avoid wasting money on unnecessary travel (and certainly luxury suites is a waste for any government employee), IRS employees should not be restricted from participating in important activities like attending and speaking at the ABA Tax Section's three annual meetings.  And while it is important to ensure that there isn't a corrupt abuse of agency power, the hearings so far into the 501(c)(4) selection of various groups (conservative and liberal) for greater scrutiny bear too strong a resemblance to the hyped-up hearings by the Finance Committee in 1997-98, which inappropriately intimidated IRS employees from doing their jobs.  Congress should not prevent the IRS from taking forceful actions to fight violations of the tax laws, such as appropriately screening applicants for 501(c)(3) and (c)(4) tax-exempt status.

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Moving in the right direction: US, UK, Aussies to share tax info

One of the (many) ways by which rich, sophisticated taxpayers who are also ultra-greedy have managed to avoid paying their fair share of taxes is to move money offshore through trusts and "companies" set up in various no-tax/lo-tax, hi-sun jurisdictions like the Cayman Islands, British Virgin Islands, Cook Islands, Singapore, etc.  I suppose for many years this scheme served multiple objectives--it stashed the cash beyond the reach of the US government, it provided a nice place to visit the cash, and it had the cachet of belonging to the exclusive jet set behind it.

That's becoming less so as the US continues to pursue tax cheats with unreported offshore accounts.  The dam started bursting with the revelation of the way Swiss bankers groveled at their American clients' feet, from smuggling diamonds into the country in toothpaste tubes to secreting gold in deep, hidden vaults to setting up sham companies in the Phillipines or other countries.  Over the last half decade, more people have participated in voluntary disclosure and more have been identified for more serious penalty programs (including criminal prosecution).  Each voluntary disclosure included full information about those who facilitated the offshoring--bankers' names, other involved lawyers, accountants, and bankers, other entities.  That groundswell of information facilitated identification of even more tax cheats, and those identifications yielded a new trove of relational data--those who had assisted them.  That finally seemed to begin to put some teeth into enforcement efforts and some gnashing of teeth into the lives of the otherwise obliviously happy tax evaders.

But various commentators (including my colleague at Wayne Law, Professor Michael McIntyre) have been concerned that the offshore gambit can't be cleaned up until countries begin more automatic sharing of the tax information they have without requiring the requesting country to have already identified the accountholder well enough to ask for information specifically about that person.  If they can ask specifically, of course, it means they have already been found, which makes for a catch-22 that has made pursuing secret bank account holders an overly arduous task. 

That makes the IRS's announcement today of a new coordinated effort among the U.S., U.K, and Australia heartening news.  They have agreed to share information about trusts and companies holding assets in tax havens like the British Virgin Islands, the Cayman Islands, and Singapore.  See IRS news release IR-2013-48 (May 9, 2013).   With the cache of information each country has gleaned from the recent efforts, coordination will allow them all to benefit from each one's effort.  That should accelerate the effort to catch the tax cheats.

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Baucus Will Not Run in 2014 (yay!)

Max Baucus announced to his fellow Senators today that he will not seek re-election to the Senate in 2014.  He has been the top Democrat on the Finance Committee since 2001.  See Senate Finance Chairman Max Baucus Won't Run Again in 2014, Bloomberg.net (Apr. 23, 2013).

As someone who thinks that Baucus has been a hindrance to progressive reform of the tax code and financial regulation, I must admit that I do not find his retirement a loss.  His chairmanship of the Finance Committee has been marked by a failure to understand the most important issues related to federal income and estate taxation and by adoption of positions that are too favorable to Big Money and Big Business (especially Big Banks).  He has been tone-deaf, in other words, to the class warfare waged by the right against the middle class and the resulting growth in inequality in the country that has been worsened by the current tax provisions that support redistribution upwards to the very wealthiest owners of financial assets and businesses.  In particular, he has failed to use his position to push for reasonable reform of the capital gains preference and the wealth-favoring versions of the estate tax passed by the Bush administration.  He has refused to consider a reasonable financial transactions tax. In fact, Baucus was too willing to go along with the initial passage of the Bush tax agenda in 2001-2004, and he did nothing to ensure that the Bush tax cuts would fade into oblivion on the sunset date.  In fact, he worked to make permanent almost all the Bush tax cuts and supported the corporate-friendly "extension" of the broad menu of corporate tax cut provisions (including a retroactive extension of the R&D credit, which cannot possibly serve the purpose it is claimed to serve when enacted retroactively).  The tradeoff provided only token items on the progressive menu. 

Of course, the Republicans will cast Baucus' choice to retire as a reflection of problems for Democrats.  See the Bloomberg News article cited above, in which Rob Collins of the National Republican Senatorial Committee says as much.  I suspect that Baucus knew he would be targeted by liberal Democrats for his failure to vote for gun control and for his failure to support progressive tax policies. 

That said, he remains as Finance Chair through 2014, and he has said he intends to produce a rewrite of the tax code.  He is the wrong person to do that, and so it is important that other Democrats relegate him to a position of less influence in order to come up with more progressive changes than he would support.

Is Ron Wyden (who would become the most senior member of the Finance Committee when Baucus leaves) capable of carrying the banner of progressivism?  His emphasis on "tax simplification" is worrisome, because it suggests that he does not understand the relationship between complexity in the tax code and sophistication of taxpayers to whom the complexity applies.  The main reasons for complexity are two-fold:  (i) existing tax rules are expanded to cover abusive schemes developed by sophisticated tax advisers (attorneys and accountants), and (ii) existing tax rules are riddled with exceptions to provide subsidies (tax expenditures) favoring industries represented by heavy lobbying.  To the extent that tax simplification reduces the anti-abuse rules needed to prevent various tax scams and manipulation, simplication is a policy mistake.  To the extent that simplication results in changes to the tax expenditures, it can be useful  but it is often also mistaken, because the easiest way to "simplify" such rules is to expand them to cover even more of heavily lobbied-for industries.  Wyden needs to expand his understanding of the relationship between simplification as a goal and fair allocation of resources to the extent that resource allocation is handled through tax expenditures in the Code, reasonable rules to ensure that the most sophisticated taxpayers pay their fair share, and fair distribution of the tax burden.  Baucus did not serve the publci well in regards to these issues.  Let's hope that Wyden does better.

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Doggett fighting for fairness on Tax Day!

Baucus

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Doggett fighting for fairness on Tax Day!

On Monday, Congressman Lloyd Doggett, a long-time member of the House Ways and Means Committee, releases a GAO report showing the continued advance of corporate tax expenditures that allow corporations to pay little or no taxes year after year. 

 “Of the many Americans who are right now getting their taxes ready to file, I doubt there are very many that think they will be able to pay a mere nickel on the dollar.  But there are many of America’s largest corporations that continue lobbying the Administration, and this Congress to let them pay a nickel on the dollar in taxes on a significant portion of their earnings.  Over a three-year period, 30 Fortune 500 companies devoted more of their monies to lobbying this Congress than they did in paying taxes to the Treasury. Some have a negative tax rate. Many of our largest corporations are paying effective rates that are single digits.

On Monday, he will again propose legislation to deal with the way corporations can so easily avoid tax liabilities in the US. A press release from Doggett's office lists the following pieces of legislation to be introduced:

• The Stop Tax Haven Abuse Act aims to close several different loopholes by deterring the use of tax havens for tax evasion and strengthening the enforcement of our tax laws.  The bill would also require SEC-registered corporations to report annually on the number of employees, sales, financing, tax obligations, and tax payments on a country-by-country basis, shedding more light on the extent of use of tax havens.  This bill also provides for additional penalties for failing to disclose offshore holdings and for promoting abusive tax shelters.

 

• The International Tax Competitiveness Act addresses a large and growing area of tax abuse: the practice of developing a trademark, patent, or copyright in the U.S. and then transferring that intellectual property abroad to avoid taxes on the vast income it generates.  This bill would treat income from the U.S. intellectual property as U.S. income and tax it accordingly.    

 

• The Fairness in International Taxation Act would end the current practice of treaty shopping to avoid U.S. taxes.  The United States has tax treaties with a number of trading partners that reduce the amount of taxes that a U.S. based entity owes on interest and royalties paid to a foreign parent.  Since many of these foreign parent companies are set up in tax havens, these companies now bypass U.S. taxes by routing the payment through a tax-treaty country that then just transfers the funds to the tax-haven parent.  This bill would end that legal fiction and say that you only get the tax-treaty discount if the parent company is actually located in a tax-treaty country. 

 Doggett has tried to get Congress to act on corporate loopholes for more than a decade.  The lobbying money has enormous influence.  Just as in the gun control arena, where a majority of Americans want stronger gun controls but the manufacturer of weapons want lax provisions, most Americans think that corporations ought to pay a larger share of taxes but Congress is heavily influenced by lobbyists who wine and dine staffers and provide numerous purported "educational" briefings on what Big Business wants.

 Each of these legislative proposals has merit.  Of particular interest is the "international competitiveness" provision, which would finally make some inroads in corporations' ability to move intangible properties developed in the US into tax haven countries in order to eliminate taxes.  We have for too long relied on an outdated transfer pricing mechanism for this kind of transfer.  It doesn't work, since no company would ever actually sell intellectual property that is the core of the company's business.  These cross-border transfers of IP are shams, and we should finally legislate to prevent this .

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Jenkins & Gilchrist attorney sentenced to 8 years for tax shelter work

In the late 90s and early 2000s, Jenkins & Gilchrist (J&G) made lots of money promoting bogus tax shelters, often using derivatives and partnerships, to generate phantom losses to offset real (economic) income or to defer recognition of income.  The highly promoted but secretive deals had catchy names, like "SOS" (for "short options strategy"), and generated very high fees (based on a percentage of the tax loss generated by the shelters!) from the wealthy individual clients that considered themselves above the (tax) law.  In return for the fees, the law firms promoting the shelters assisted the clients in all stages of the shelters, including setting up bank accounts and sham corporations and partnerships as needed, topping it off with a "more likely than not"  "get out of jail free" tax opinion.  Download Guerin Donna Sentencing PR.

As the press release notes, one such shelter, sold between 1994 and 1999 to almost 300 wealthy individuals, generated about $2.6 billion in fake tax losses.  The SOS shelter, sold between 1998 and 2000 to more than 500 wealthy individuals, generated at least $3.9 billion in fake tax losses.  And so on. 

Donna Guerin, one of the partners at J&G (and earlier at Altheimer & Gray) during that period, was instrumental in the design and marketing of the shelters.  She was originally convicted in May 2011 in a jury trial, but juror misconduct led to the scheduling of a new trial for March 2013.  Guerin pled guilty instead of facing trial and was sentenced last Friday to eight years of jail time on conspiracy and tax evasion charges.  She was also ordered to pay restitution of $190 million. Not only did she participate in the marketing and implementation of the tax shelters, but Guerin also "took part in the illegal back-dating of certain tax shelter transactions," making more than $17 million between 1998 and 2002 from her illegal activities.  Op. Cit. 

 Congratulations are due to Assistant US Attorneys Stanley Okula, Jr. and Jason P. Hernancez, as well as DOJ Tax Division Assistant Chief Nanette Davis, who handled the prosecution of these tax frauds.  These promoted shelters reveal the lengths to which wealthy American--and, too often, also their advisers--will go to avoid their personal responsibilities and duties to We the People.  Hopefully, attorneys will pay more attention to their duties to the integrity of the courts going forward.   And this should be a reminder to all those who claim that "the 47%" don't care about personal responsibility that there is a good deal of evidence about the 1% being negligent of their public responsibilities .

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Hedge Fund Tax Avoidance Schemes--using (purported) offshore reinsurers

It seems that billionaires think they are entitled to it all and think they should be able to run their speculative games without paying much of anything at all in taxes to the government they depend on. And none of this is good for the economy or good for the taxpayers not in "the 1%".

Case in point--John Paulson, the notorious hedge fund manager who got a CDO built to his desires with a bunch of iffy subprime mortgages and then took the short side of the bet, making a fortune off the bet against subprimes in the mortgage crashes underlying the 2007-8 Great Recession.  See, e.g., Zuckerman, Trader Made Billions on Subprime, Wall St. J. (Jan. 15, 2008). 

What has Paulson done?  He established a new "reinsurance company" in Bermuda in April, that turned around in June and put the money invested in it  back into Paulson's hedge funds in New York, as a portfolio of insurance "reserves" to be held to pay off insurance risks that go bad.   The result is tax deferment for Paulson and other executives of his hedge fund along with recharacterization of ordinary compensation income as preferentially taxed capital gains.

For a discussion of the hedge fund reinsurer gambit, see , e.g., any of the following.  The story at Bloomberg has reinvigorated media attention to this issue.

• Zachery Mider, Paulson Leads Funds to Bermuda Tax Dodge Aiding Billionaire, Bloomberg.com (Feb. 19, 2013);
• Andy Barile looks at hedge fund-backed reinsurance, World Risk and Insurance News (Feb 11-15, 2013) 

Barile notes that these hedge funds are using reinsurance premiums and investing in a very aggressive way, compared to traditional reinsurers".  This aggressive position produces a downside if there are low investment returns, especially if there are catastrophes for which they have to pay claims when their investment strategies have produced losses.  He says that "it remains to be seen" whether hedge-fund reinsurers are in it for the long haul, since they have a shorter time frame on making greater returns on their money.

• Baker, The Bank For International Settlements: Evolution and Evaluation (Greenwood Publishing 2002), at 235-237

Looking at this as a global concern, Baker ultimately suggests that the Basle Capital Accord rules should be extended to hedge fund reinsurer operations,  "Another area in which the BIS should take a leadership position," he says, "is the role in which reinsurance firms play in hedge fund operations.  The tax implications of hedge funds using reinsurance firms in their funds for tax advantages points to the need for more government regulation of this activity."

He describes the basic problem as follows:  "wealthy individuals invest in private placement offerings of offshore reinsurance companies.  These companies, many headquartered in Bermuda, buy insurance policies written by name-brand insurers...and "may then invest its stock issue returns in a hedge fund.  ...[That reinsurer] pays no taxes on the trading profits until it sells the fund shares and then the reinsurer is taxed at a lower capital gains tax.  The tax savings are passed on to the individual investor.

He goes on to say that "The problem ... is that insurers are exempt from registering as investment companies....These reinsurers do not have to make annual distribution of profits as mutual funds do and they are not taxed by the Internal Revenue Service as investment vehicles.  ...In short, the activity ... is a method for wealthy investors to reduce their tax burden as a result of a tax loophole.  Since these insurance companies are mixing insurance business with investment business, they need more supervision. 

This is especially true when hedge funds are involved.  "[H]edge funds work with reinsurers to reduce tax liabilities for their wealthy clients.  ...U.S. hedge fund managers and investors form a tax-advantaged reinsurance company offshore in...Bermuda, which has no corporate income tax.  The Bermuda-based reinsurer sends investment assets to the hedge fund to invest.  Investors return to the United States with shares of the reinsurer and pay no taxes until the company goes public.  At that time, investors [and managers] sell their shares in the reinsurer company and are taxed at a lower capital gains rate. 

These schemes are worrisome from both tax and insurer regulatory perspectives.  "Aside from the tax loophole problem, the real issue in these cases is the added underwriting risk incurred in the process. ... [Hedge funds acting as reinsurance companies] have insufficient insurance expertise.... Much of this activity has stemmed from financial engineering and deal making of the 1990s. ... [W]ithout the bailout of LTCM [Long-term Capital Management hedge fund] by national bank regulatory authorities, many banks and reinsurers might have collapsed as well."

So why do it and how does the hedge fund reinsurer gambit work?  Remember that these hedge fund execs get a ridiculous amount in compensation in the form of a "fee" (usually 2% of assets under management) and a "carry" (usually 20% of the profits).  (The fee and carry are often represented as 2 and 20, but can be much higher for some firms with status, rising to as much as 5 and 50.)  Without more, hedge fund managers don't get as much benefit from the claimed treatment of a "profits" partner as private equity fund managers do.  Though the managers claim classification as "profits" partners whose taxation is based on their share of the partnership's gains and ordinary income and not as payments of (ordinary) compensation, hedges mainly yield ordinary income so don't act directly as "converter" entities.   Private equity fund managers also claim they are "profits" partners whose income should not be classed as compensation but as pass-through shares of the  partnership items:  in their case, most of the private equity fund's gains will be deferred anyway (for several years at least until the partnership sells the leveraged company) and they claim those deferred gains should be characterized as pass-throughs characterized by the partnership rather than being characterized as ordinary compensation income to them.   

So for hedge fund managers,  gaining deferment (of what is clearly in substance their compensation as managers) can achieve  minimal current tax.  If the money is cycled through an offshore corporation that pays no taxes, that's even better because it gets preferential rates as well.  The deferrment is achieved by waiting to sell the stock, and the sale of the stock is reported as a capital gain.  Thus what is really current compensation income is recharacterized, through the reinsurer "conduit" scam, as a deferred capital gain.   So hedge fund and private equity managers ultimately both claim to get the best of all possible worlds--their wages from work are not currently taxed as wages at ordinary income rates, they pay no payroll taxes on their compensation, and their compensation is deferred and taxed at preferential capital gains rates. 

This is so obviously unfair to the vast majority of ordinary taxpayers who pay taxes on their compensation income even before the end of the tax year through the withholding mechanism that Congress should step in with legislation.   It seems hard to justify a "profits" interest in a partnership at all: it has been created by the "Wall Street Rule" that gains credence because big-money people claim it is correct.  As usual, tax administration eventually mostly went along with it (Rev. Proc. 93-27) and a few court cases (Diamond, Hale) mostly treat the notion of a profits partner who pays no taxes on his compensation as reasonable.  Congress could easily legislate away the profits interest and define partner in a partnership for tax purposes as someone who has made a genuine at-risk equity contribution of cash or property to the partnership. There really should be no such thing as a services partner with a "profits" interest who hasn't contributed up front for a capital interest.  And all compensation shares to what are currently treated as profits partners could be treated as ordinary income --i.e., compensation currently subject to the income tax and to payroll (Social Security/Medicare) taxation.

This use of reinsurers by hedge funds is itself a tax dodge that has been around a decade or so.  In 2007, the Senate Finance Committee held a hearing on Offshore Tax Issues: Reinsurance and Hedge Funds (S. Hrg. 110-875, Sept. 26, 2007) (179 pages).  In his introduction, Baucus described insurance tax avoidance schemes as follows:

Insurance companies make a living by doing two things: they assess premiums based on the prediction of the likelihood of events against which they insure—that is called underwriting—and they also make money by investing the premiums that they collect until they have to pay out claims. If they are good at those two jobs, they  make a profit.

Customers buy insurance from insurance companies to guard against the risk of fire, disaster, or some other calamity. In exchange for paying premiums, the customers shift some of their risk to the insurance companies. Insurance companies also buy insurance. Property and casualty insurance companies pay premiums to reinsurance companies in exchange for shifting some of their risk to the reinsurance company. Sometimes the reinsurance company is also the parent company of the property and casualty insurance company. In that case, the property and casualty insurance company shifts risk to their parent reinsurance company at something less than an arm’s length transaction.

Here is where the tax avoidance comes in. Some parent insurance companies set their headquarters in low-tax jurisdictions, like Bermuda. Subsidiary property and casualty insurance companies shift risk to the Bermuda parent. Because of Bermuda’s low tax burden, the Bermuda parent can get a greater after-tax return on their investment activities. As a result, subsidiary property and casualty insurance companies can charge lower premiums for their insurance. They get a competitive advantage over insurance companies doing business in jurisdictions that tax investments.

The second setting that we will examine today involves hedge funds. Foundations and other nonprofits are some of the largest investors in the world. The law requires a nonprofit investor that invests directly in hedge fund partnerships to pay the unrealized business income tax, otherwise known as UBIT. The policy behind the law is that tax-exempt entities should not be able to have an unfair advantage over taxpaying entities doing the same thing. To avoid UBIT, nonprofit investors sometimes invest in hedge funds through offshore entities incorporated in lowor no-tax jurisdictions, such as the Cayman Islands or Bermuda. These offshore entities are called blockers.

The third setting we will examine today is the compensation of hedge fund managers. Hedge fund managers receive fees from offshore blocker corporations used by nonprofits and foreign investors.Some hedge fund managers elect to defer their income, and deferring income means you pay taxes later, which is the same as a significanttax savings.

 The IRS has already noted that offshore arrangements using reinsurers for hedge fund managers may be shams that are subject to challenge on audit.  See Notice 2003-34 (indicating that "Treasury and the Internal Revenue Service have become aware of arrangements, described below, that are being used by taxpayers to defer recognition of ordinary income or to characterize ordinary income as a capital gain.  The arrangements involve an investment in a purported insurance company that is organized offshore which invests in hedge funds or investments in which hedge funds typically invest.")  Although the notice says that these purported insurers may be challenged as not insurers because they are not using their capital and efforts "primarily in earning income from the issuance of insurance", and although it states that such arrangements will be subject to close scrutiny that could result in the application of the PFIC rules (leading to current taxation), it has apparently not bothered to challenge any of the big hedge funds' reinsurer companies.

Again, why would they be subject to challenge?  On the basis that they are not real reinsurers, since the low amount of reinsurance that many provide is the less risky part of the business and provides a buffer to the very high reserves that they retain, sometimes invested solely in a single promoter's hedge funds.  And if they are not insurers, they are at the least "passive foreign investment companies" (PFICs) on which shareholders are subject to current taxation on profits.  (Or perhaps the IRS might go further and recharacterize the arrangement as a sham , causing the hedge fund executive to have current ordinary compensation income.)    In other words, there is good cause to think that for many of these, the tax haven corporation is acting as an offshore tax-avoidance pocketbook for the hedge fund executive, and not really as an insurer.

By the way, if you think these hedge fund managers who are making multi-millions and billions from managing other people's assets and hardly paying any U.S. taxes on those huge compensation payments are incredibly smart people who add to the economy's well-being and therefore merit that kind of out-sized pay or because of the returns they bring to people that then invest them in needed projects in the good ole US of A, you need to rethink that. Hedge funds typically pay out very poor returns, when all the expenses and profits to managers are taken into account. 

Roughly speaking, if the typical fund manager worked for free, and if the investment firms didn’t charge, these masters of the universe would still have underperformed a balanced index since 2003, by roughly 2.5 per cent per year. Andrew Hallam, Think you're smarter than a hedge fund manager?, The Globe and Mail (Feb. 19, 2013) (emphasis added).

 

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UBS Snare Continues to Catch--Florida Widow Faces Potential 6 Year Jail Sentence

A Taxing Matter has reported frequently on the scandals of offshore banks aiding and abetting US taxpayers in avoiding tax due on income from their capital held overseas.  The opening of the UBS case cracked open a vast network of mostly wealthy US taxpayers who had held money overseas and avoided tax.  With the exposure of the bank's role in assisting tax avoidance, and the requirement that taxpayers "come clean" about the particular bankers and banks that assisted them, the government began to create a web of information leading to tax evaders, even those who thought they had moved Swiss accounts to Liechtenstein banks to avoid capture.  That web has already led to the demise of one of the oldest Swiss banks--Wegelin.  See Robert Wood, FATCA Cliff: Tax Evasion Guilty Plea and Death for Oldest Swiss Bank, Forbes.com (Jan 3. 2013);  Swiss Bank's Demise: Glass Half Empty or Half Full?, Jan 9, 2013.

The IRS offered a number of voluntary disclosure programs with slightly escalating penalties but, importantly, no criminal prosecution, for people who would come forward before their names/accounts turned up in the ongoing chase after tax avoiders.  (There is considerable suspicion that one of the reasons Mitt Romney refused to release the usual number of tax returns is that he may well have been a participant in that voluntary disclosure program.) 

For those who don't come forward soon enough and are caught by the IRS, the statutory penalties and potential for criminal punishment are very real.  The statute in effect allows the government to collect amounts that could well exceed the amount left in the account, and criminal punishment for filing falsified tax returns can well mean jail time.

Mary Estelle Curran fell into that trap when she choose not to report the Swiss accounts her husband had established after he died, from 2001 through 2007, using foundations in Liechtenstein and Panama.  By the time she tried to participate in the voluntary disclosure program, it was too late, because she was one of the Americans revealed by UBS in its deal to defer US prosecution. The taxes she evaded amounted to about $667,000, but the penalty under the law for this type of willful evasion is quite severe, allowing the government to take 50% of the highest account balance for each failure to report.  Forbes notes that "[b]y 2007, the accounts totaled over $42 million. Her penalty? 50% of the highest balance: $21,666,929, and that’s not all. She has not yet been sentenced but faces a potential prison term up to six years." Florida Widow Guilty + $21M penalty for Inherited Swiss + Liechtenstein Accounts, Forbes.com (Jan. 8, 2013).

The crackdown has led to charges or indictments for "more than four dozen American clients of Swiss and Swiss-style banks."  Mary Estelle Curran, 79-year-old ex-UBS client, facing 6 years in prison over tax evasion, HuffPost (Jan 8, 2013).

The moral of this tale--if you have money sequestered offshore on which you haven't filed the required FBAR reports or paid taxes, you'd better 'fess up before you get discovered in this continuing sweep.  And next time, go on and pay your fair share.  You really owe those taxes, you know.....

 

 

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Former UBS client In Florida pleads guilty to tax evasion

Goggle's Bermuda hideaway/HSBC's too-big status: time to rein in the corporations!

If you are a company that depends on IP for a lot of your revenue, you may be able to avoid considerable taxes by funnelling profits from subsidiaries in high-tax countries into a Bermuda shell company.  Google avoided about $2 billion in worldwide income taxes in 2011 by shifting about 80% of its total pretax profits-- $9.8 billion -- into Bermuda.  See Jesse Drucker, Google Royalties Sheltered in No-Tax Bermuda Soar to Nearly $10 Billion, Bloomberg.com (Dec. 10, 2012).

Meanwhile, the US decided not to take action against HSBC for its fraudulent behavior because it was considered so big that it could damage the financial system (again) to interfere with its continuing corporate existence.  See  Glenn Greenwald, HSBC, too big to jail, is the new poster child for US two-tiered justice system, guaradian.co.uk (Dec. 12, 2012) (noting that "one of the world's largest banks, HSBC, spent years committing serious crimes, involving money laundering for terrorists; 'facilitating money laundering by Mexican drug cartels'; and 'moving tainted money for Saudi banks tied to terrorist groups' " but US officials decided "not to prosecute HSBC for accepting the tainted money of rogue states and drug lorgds on Tuesday, insisting that a $1.9bn fine for a litany of offences was preferable to the 'collateral consequences' of taking the baqnk to court").

Maybe this kind of information will finally incense governments against corporate tax dodging.  What we need are laws that refuse to recognize shell companies set up in tax-haven countries to siphon profits from the countries where they originate.  What we need are fewer possibilities for companies to expand through tax-free mergers and acquisitions that allow them to get so big that they become immune to ruin when they commit major crimes. 

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Romney and Private Equity's Questionable Schemes for Paying Very Little Tax

Presumably any American who wants to be informed is aware that GOP presidential candidate Mitt Romney's claim to business acumen resides in his experience at a private equity firm that made much of its money by ramping up debt at purchased firms and using that debt to repay whatever (usually relatively small) investment the equity firm partners made in what has come to be known as "LBO" deals (for "leveraged buyout").  In LBOs, the equity firm investors almost always do well to exceedingly well, using mostly other people's money. 

Not so generally for the workers in the bought-out company.  The "rent" profits of the equity firm are often on the back of the workers, who may get fired in favor of outsourcing their jobs or get stuck in a rut, as productivity gains go to the new managers and owners and not to the workers.  At the least, the high debt load makes it very difficult for the company to succeed and certainly difficult for it to give its workers a fair shake.   Remember that one of Romney's gaffs was to admit that he enjoys firing workers.

Why anybody thinks this kind of winner-take-all, leverage-'em-up mentality of private equity firms suggests the kind of leader desirable for a democracy that purports to provide genuine opportunity for all classes of citizens to live a decent life is beyond me. 

But even if the very nature of the business and the common tools of over-leverage and "rent" profits for a very few already at the top don't give voters cause for pause, then there are the many ways that private equity firm partners manage to avoid paying their fair share of taxes, which ensures that more of the tax burden falls on the less-well-off, that are worthy of consideration, even if candidate Romney has not (as his campaign claims) benefited from them personally.  That is because if Romney is elected president, his views on the acceptability of aggressive tax strategies of questionable legality will matter.  We should know what kinds of tax schemes are routine in the business that he touts as good evidence of his ability to serve as president of this nation--especially if some of them are obviously poor policy (the carried interest treatment) or highly questionable tax avoidance schemes (the management fee conversion waiver scheme).

I. Carried Interest

The best known way private equity firm partners reduce taxes is by earning their compensation in the form of "carried interest" and claiming that such profits should be treated the same way a real capital investment in a partnership is treated, even though it is awarded as compensation for their purported management expertise and work and not as a return on an actual investment made.   That is, they claim they are profits partners in the firm and that their compensation is a distribution of the partnership's profits (usually from gains on sales, and hence eligible for preferential capital gains) to them rather than compensation income.  As such they benefit from the extraordinarily preferential rate for capital gains in the current law as enacted under the Bush administration (generally 15%).  Carried interest is the primary reason that candidate Romney has to pay such a very low rate of taxes on his income from his business.

The Internal Revenue Code (the codification of the federal statutes governing the federal income tax) does not include a specific provision governing profits interests and indicating that such "profits" partners should be treated as actual partners in a partnership (without that partnership interest itself being subject to tax as compensation) entitled to receive capital gains distributions.  Accordingly, as one partnership tax treatise puts it, the tax treatment of a transfer to a "service partner" of a "profits interest" for services "has been uncertain" because "[n]o provision of the Code specifically exempts from taxation the receipt of any partnership interest in exchange for services."  Willis & Postlewaite, Partnership Taxation, 6th ed, at 4-124.    There is some caselaw about profits interests, but those cases made it even less clear how and when such interests should be taxed. 

Finally, the Service resolved the issue with administrative authority (heavily lobbied for in the interests of equity partners and real estate profit partners, in particular) in Rev. Proc. 93-27 (and later proposed regs and other items) that does not treat the issuance of a compensatory "profits interest" as  a taxable event in most instances.  The main reason for the treatment may well be the so-called "Wall Street Rule"--once incredibly wealthy taxpayers hire sophisticated, high-priced lawyers to produce opinons supportive of a taxpayer-favorable interpretation and then operate as though the Code blesses a particular activity, it is hard for tax administrators to issue regulatory authority that treats that activity differently.

2, Management Fee Conversion Waivers

But there is another lesser-known aspect to the compensation that private equity fund partners earn for their services in their private equity firms--the management fee.  Most explanations describe this as  compensation paid for services that is subject to taxation at the ordinary rate (just like a secretary's wages would be).  But that disregards a practice that exists among a significant number of equity firms (the Times article linked below says about 40% in 2009) that are willing to take aggressive positions to avoid paying taxes and can afford to pay the tax professionals to provide a way to do it--the management fee waiver conversion scheme. 

The conversion of management fees from ordinary income to capital gains is purportedly accomplished by "waiving" the fees (not necessarily across-the-board throughout the life of the firm, but often selectively and on a quarter-by-quarter basis),  Instead of getting fees, the partner claims they are "converted" to a share of related profits --i.e., they become an additional carried interest--and hence eligible for treatment as (deferred) capital gains from the firm.  

Some tax professionals think this conversion waiver works.  Much of this is again the "Wall Street Rule"--the claim that lots do it, the IRS has known about it, and oh it should be justifiable because now the "fee" is (sort of, maybe, kinda) at risk.  It is not really at risk in the way we ordinarily think of investment risk, since these are pre-tax dollars -- the managers are not putting after-tax dollars at risk like any other investor is doing.  And as Vic Fleischer commented to the gothamist blog, "there is a tension between economic risk and tax risk .... The way Bain set it up there's not much risk at all, so it's hard to see how this income should receive capital gains treatment."  Christopher Robbins, NY AG: Bain Capital and others may have skirted tax law, the Gothamist (Sept. 2, 2012).  

I'd guess  that most professionals do not think the conversion scheme works, at least not in most instances.  This would be especially true for those who consider that interpretations of the law should further coherent bodies of law that work as fairly as possible.  And even more tax professionals likely think that the partnership rules should be adjusted to ensure that it doesn't work, since otherwise we are perpetuating inequities in the tax system that favor the already incredibly rich.

The conversion waiver issue has come to the attention of the public now because the New York State attorney general is investigating private equity firms who may have engaged in this conversion waiver practice.  See Nichnolas Confessore et al, Inquiry on Tax Strategy Adds to Scrutiny of Finance Firms, New York Times (Sept. 1, 2012) (noting that the AG's subpoenas, issued by the AG's Taxpayer Protection Bureau, cover firms like Kohlberg Kravis, TPG Capital, Apollo Global, Silver Lake and Bain, and that Bain partners may have saved more than $200 million in federal income taxes, $20 million in Medicare taxes). 

It's not clear on what grounds the New York AG is investigating this issue, which appears on the surface to be primarily a federal income tax issue.  It could be some sort of state-law fraud claim but it could also be a claim that underpayment of state taxes routinely results from the filing posture taken,  Equity partners in firms using the conversion waiver would presumably be able to save on state income taxes through either rate preferences and/or deferral, depending on the state and how much the state's laws build on the federal filing.  Though New York State does not have a preferential rate for capital gains, if the timing of reporting the income is set by the conversion waiver, the deferral would amount to a significant state tax savings that deprives New York of needed revenues. 

[Aside:  By the way, some of the information about the management fee conversion waiver first came to broad public attention in connection with Bain and the trove of documents released at Gawker.com.  See John Cook, The Bain Files: Inside Mitt Romney's Tax-Dodging Cayman Schemes, Gawker.com (Aug. 23, 2012) (noting that the huge cache of Bain financial documents "shed a great deal of light on those finances, and on the tax-dodging tricks available to the hyper-rich that [Romney] has used to keep his effectie tax rate at roughly 13% over the last decade").   These documents, and the further analysis articles available at the Gawker.com site, are worth considering for their own revelation of what Romney's real business is like and how that does (or doesn't) suggest he can help our economy as president--it is a business where "opaque complexity" allows the "preposterously wealthy" to engage in "exotic tax-avoidance schemes", according to the Gawker.com article.  (I have not yet personally perused much of the 950 page trove on Gawker.)  That said, Romney's campaign issued a statement indicating that the candidate has not benefited from the conversion waiver practice.  We have not, of course, seen enough of Romney's tax returns and supporting information to be able to judge this matter independently.  The focus on the conversion waiver thus provides yet another reason why candidate Romney should release 10 years of tax returns as other candidates have done.]

There are two additional readable pieces on this conversion waiver issue, plus a scholarly article that anyone wanting to better understand the details can peruse.  Vic Fleischer, a tax prof at Colorado who made his original contribution to academe by writing about carried interest, has an article that sets out the issues well, with an example contrasting the significant difference in after-tax results for a real investor compared to a profits-interest purported investor.  See Victor Fleischer, What's at issue in the private equity tax inquiry, DealBook, New York Times (Sept. 4, 2012). See also Brian Beutler, Did Bain Capital Execs Break the Law Using a Common Tax Avoidance Strategy? Talkingpointsmemo.com (Sept. 3, 2012). The academic piece is Gregg Polsky, Private Equity Management Fee Conversions (Nov. 4, 2008).  The following two paragraphs are from the conclusion to that piece.

In fact, there are strong arguments that it is not. While managers argue that the safe harbor in Rev. Proc. 93-27 applies to the additional carried interest, there are both technical and conceptual claims to the contrary. Without the protection afforded by Rev. Proc. 93-27, the additional carried interest would be taxable upon receipt if it has a market value capable of determination. Both the context in which the additional carried interest is issued and the specific design features of the typical additional carried interest support the view that additional carried interests are significantly easier to value than prototypical profits interests.Under existing caselaw, this would mean that the additional carried interest is taxable upon receipt as ordinary income to the extent of its fair market value.

The IRS also has strong arguments under section 707(a)(2)(A), which recasts transactions that are artificially designed as partnership transactions in order to obtain tax benefits, such as character conversion. In the context of fee conversions, the most critical fact that favors section 707(a)(2)(A) recharacterization is the manager’s very limited exposure to risk. As a result, section 707(a)(2)(A) likely applies to fee conversions. If so, the manager’s attempt to convert the character of their management fee income would be thwarted.