Qa: William Brennan On Tax Shelters

New rules for tax shelters, What to do when you sell a business

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Tax shelters -- or tax-advantaged investments, as the promoters like to call them -- have a way of making people nervous. If you have never invested in one, you may be wondering how to separate legitimate shelters from those that bring down the wrath of the Internal Revenue Service. If you already have a shelter or two in your portfolio, you may regard the prospect of an IRS audit with rather less equanimity than otherwise.

Recently, such worries have only increased. The Tax Reform Act of 1984 included provisions designed to crack down on abusive shelters, and the IRS has announced tough new programs aimed at thwarting aggressive shelter promoters before they can sign up their first customers.

What is a high-bracket taxpayer to do? For an expert's perspective, INC. staff writer Lisa R. Sheeran spoke with William Brennan, editor and publisher of The Brennan Report, a monthly newsletter on tax planning and tax shelter investments. INC.: These days, tax shelters are cropping up everywhere, and most of them are sold pretty aggressively. How much income should you have before you take shelters seriously?

Brennan: Sponsors often want to bring in lower-bracket investors because it broadens their market base, especially since we've seen a dramatic reduction in tax rates in the past three years. Just a few years ago, a taxpayer earning $60,000 might have been in the 50% bracket. Today, that same taxpayer is in a 38% bracket. You have to earn over $160,000 to make the 50% bracket.

In general, a married taxpayer with $60,000 in annual taxable income is at the bottom of the scale for investing in tax shelters -- and he or she should stick to low-risk shelters like a low-leveraged public real estate program. People in the 50% bracket can start looking at riskier investments because the government is picking up more of the cost.

INC.: The new crackdowns are supposed to be concentrating on "abusive" tax shelters. Is there a simple definition of the term?

Brennan: There is no simple definition. But the major giveaway is usually in the offering materials. They dwell on the tax benefits without discussing the economics at all.

Take a simple example: An income-oriented investor might buy a duplex for $150,000 in cash with no financing. That provides some tax benefits -- the building can be depreciated -- but there's no leverage and no interest deduction.

The tax-oriented investor buys that same duplex by investing $30,000 in cash and financing $120,000. He has reduced the straight economics, because now part of the rental income must go to pay off the debt. But he has invested only $30,000, so depreciation and interest deductions will be high relative to the initial outlay.

The abusive sponsor buys the same duplex for $150,000 and sells it to a limited partnership for $250,000. He asks investors for only $30,000 in cash, then finances a $220,000 mortgage. Now all rental income goes to debt service, but the investors get to depreciate $250,000 worth of building. The promoter, meanwhile, finances the $220,000 loan at 18%, versus the 13% a bank might charge, so investors can write that off, too. Instead of writing off $30,000 over five years, the investors might write off $90,000.

INC.: The economics don't hold water in this deal.

Brennan: There are none. The rental income will never provide enough money to pay off the $220,000 debt, and the building is unlikely to appreciate beyond its inflated value, so the investors will never make any money directly. All the promoter has given the investors is the tax benefits. In the past, he could even say, "Even though I'm charging you 18% interest, you only have to pay me 7% interest annually and the remaining 11% will be accrued." The investors deducted that interest even though they hadn't paid it.

INC.: The new tax law put a stop to this kind of operation?

Brennan: It did eliminate the abusive financing that I just described. Under the "original issue discount rule," as it is known, the seller and the buyer have to report interest as an expense and as income simultaneously -- whether money has actually been paid or not. The new law also eliminated gimmicks like the so-called two-tiered partnership, under which a new partnership would buy into an existing one that had a lot of expenses, and the existing one would allocate all losses to the new partners. Now you can't pay for an expense unless you were part of a partnership when the expense was incurred.

INC.: What did the law not do? Insiders were expecting some changes that never saw the light of day.

Brennan: The new tax act did not have the dramatic impact that Congress once implied it would. The change in real estate depreciation from 15 to 18 years, for example, will not significantly change how real estate partnerships are managed, nor will it affect their popularity. And Congress backed off from eliminating deductions for prepaid expenses, a change that would have threatened oil and gas drilling programs.

INC.: Did it affect research and development partnerships?

Brennan: I don't know if research and development is ever going to be a big tax shelter area. The risk is too high. And it doesn't have much to do with the new tax law. Just go through the history of R&D.

The first partnership offered on a large scale was De Lorean's automobile partnership -- no reason to discuss that. Then there was the Lear prop-jet program, which opened on a national scale, I understand that program never got off the ground at all. Shortly after that, Gene Amdahl formed his Trilogy partnership, offered through Merrill Lynch. The products Trilogy tried to develop have been complete failures -- and failures for investors as well. The next big sponsor was a company called Storage Technology, a New York Stock Exchange company. Storage Technology offered many limited partnerships throughout the years. Everyone, myself included, thought that if anyone can make it with R&D, it's Storage Technology. Several months ago, Storage announced that the products they were trying to develop were being discontinued. Now I hear there are huge investor suits against the company.

INC.: The new Tax law zeroes in on sponsors and investors involved in any tax shelter promising at least a two-to-one write-off. Both groups must register with the IRS. How much impact will this have on the field?

Brennan: I though this requirement would give the IRS an opportunity to attack abusive tax shelters. But the IRS has broadened the definition of deductions so much that almost any investment falls under its criteria.

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