A Tough New Stance On Tax Shelters

Recent legislation provides the IRS with a series of enforcement tools to use against abusers of tax shelters.

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In recent years, Congress has passed a string of tax bills built around several different themes: revising the tax code, spurring the economy, slashing revenues, and, with last summer's Tax Equity and Fiscal Responsibility Act, "revenue enhancement." But whatever larger policy goals these bills were meant to accomplish, at least one common theme has endured: The rules governing tax-shelter investments are getting tighter.

For investors, the dangers in participating in outlandish tax-shelter schemes have never been greater. While this new climate shouldn't necessarily rule out all imaginative and aggressive deals that create tax losses, it does mean that those intriguing sheltered investments that lack any real chance of turning a profit could backfire. At the very least, an investor's mere participation may invite time onsuming and costly challenges from the Internal Revenue Service. And if a tax shelter is disallowed, the potential penalties and interest charges can far outweigh whatever economic benefits investors might have hoped to achieve.

In the past, the IRS had a tough time cracking down on questionable tax shelters -- those deals whose only apparent motive is the creation of tax losses for limited partners. Because the IRS was required to track down and file suit against each partner, the process was often drawn out for years by legal appeals. But provisions in the tax acts of 1981 and 1982 have given the IRS sharper teeth -- and more of them. Significantly, the burden of identifying each partner separately has been eliminated; it is now possible for the IRS to take administrative action against an entire partnership, and a successful claim becomes binding on each investor.

Among the other noteworthy developments, attorneys and accountants involved in assembling deals now must attest to the likelihood that the deal can withstand IRS attack, making these advisers potentially accountable to investors. Congress last summer also sanctioned specific penalties for investors in, and, for the first time, the promoters of, "abusive" tax shelters.

The new penalties and the IRS's "get tough" attitude aren't just theoretical. In only three months of 1982, according to Roscoe L. Egger, commissioner of Internal Revenue, the IRS's Criminal Investigation Division was preparing criminal proceedings against more than 80 tax-shelter promoters and brokers who had sold questionable limited partnerships to some 13,000 investors. At stake in these cases alone is some $2.6 billion in tax revenues that the IRS hopes to collect.

The fundamental attractions of tax shelters to those in a 50% tax bracket should hardly be a mystery. The major benefit is deferral of taxes. So for every dollar of ordinary losses from the partnership, the investor saves 50 cents from the current year's tax bill. However, in many cases the investor may be able to limit taxes on the gain to the lower capital gains rate of 20% upon sale of the investment property.

Yet even if the investment itself doesn't appreciate over time, it is possible to make a return on the investment simply on the basis of the spread between the 50% rate a high-bracket taxpayer might normally pay and the 20% long-term capital gains rate. Moreover, in those instances where such long-term capital gains treatment isn't possible, the investor can still achieve a profit, as long as the deal is properly structured, by earning interest on deferred tax payments without incurring a penalty or interest liability.

However straightforward these principles may be, most difficulties arise when promoters of tax shelters devise schemes that have little if any economic value other than the creation of tax losses. While examples of "creative" tax shelters abound, a case cited by IRS commissioner Egger in recent congressional testimony involved a master recording that was sold to a record production company and then syndicated to investors. The company agreed to pay $250,000 -- 100 times the record producer's cost -- but only 1% of the amount was to be in cash, with the remainder payable in a 12-year note.

The tax shelter, as it was devised, hinged on the leasing of the master recordings on a nonexclusive basis to limited partners, who then sought a share of the investment tax credit based on the entire $250,000. What is more, the investors went on to claim not only deductions and tax credits for the current tax year but also special tax treatment to carry back unused losses and credits to previous years. According to the IRS, some 5,200 investors participated in master recording schemes, claiming investment tax eredits totaling about $60 million. The IRS is seeking to reclaim this money from investors on the premise that the value of the master recording was vastly overstated, resulting in excessive depreciation and investment tax credits.

While the problems with this deal are easy to identify, investors should be aware that the IRS isn't focusing strictly on exotic tax shelters. Indeed, investments based on real estate, oil and gas, equipment leasing, and movies, which inflate the value of the partnership's property to achieve substantial depreciation deductions or investment tax credits, are also being subjected to careful scrutiny.

Perhaps the most potent new weapon with which Congress has armed the IRS is the ability to penalize investors when they participate in partnerships that inflate the value of investment property. When the value claimed is more than 150% of what the IRS's valuution supports, the Tax Act of 1981 says the IRS can impose penalties ranging from 10% to 30% of the underpaid tax bill. Previously, the sole weapon in this area was a 5% penalty when the IRS proved negligence on the part of any investor.

In addition to the overvaluation penalty, the 1982 tax act allows the IRS to impose substantially higher interest fees and extra penalties on investors who understate their tax liability for any reason. Until last year, the interest rate the IRS charged on amounts taxpayers underpaid was so low that it was often viewed as a loan at below-market rates. However, rates now are being set twice a year on the basis of the average prime rate for the preceding six months. Thus, when rates are declining, "borrowing" from the IRS would be significantly more-expensive than a floating rate loan from a commercial bank. Furthermore, if an investor's understatement is greater than $5,000 or 10% of what is determined to be due, whichever is greater, a nndeductible surcharge of 10% will be added to whatever additional tax is levied.

Now that the IRS has won much of the artillery it has been lobbying for, the message to tax-shelter investors should be clear. Investors and their advisers should always analyze prospective investments with caution, remembering that the deals that seem to offer something for nothing may be questionable.