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.

INC.: How did this bit of irrationality come about?

Brennan: When Congress first passed the provisions about registering tax shelters, it said that tax shelters with a write-off equal to twice the investment over five years had to be registered with the IRS. But when the IRS issued regulations interpreting the law, it defined write-offs as gross deductions, not offset by income from the investment. Say you invested $10,000 in a real estate venture that produced $50,000 in rental income and $40,000 of expenses. So far, the investment isn't even a tax shelter: You're reporting $10,000 in profits. But the IRS regulations ignore the rental income and only look at the expenses. And these are four times the investment.

One major accounting firm is campaigning against this change. They use an illustration of five partners investing more than $250,000 to set up a public accounting firm. As of late September, the partners didn't have to count receipts, and the business would have had big losses -- and would have had to register as a tax shelter.

INC.: Surely the IRS must be correcting this situation.

Brennan: On October 1, the IRS announced that it plans to review the criteria for registration.

INC.: Are so-called exotic shelters always abusive in the IRS's eyes?

Brennan: Many of the exotic shelters are built around artwork, and most have never been formed for any reason other than tax avoidance. One such shelter was promoted in booths at some of the seminars I have regularly attended. The offering materials -- for a master stamp plate from some small islands off Scotland -- described the tax benefits in detail, a four-to-one tax write-off. But I couldn't find out what the business intent was behind the investment. There was no effort to distribute the stamps.

Another example: A few years ago, a sponsor was raising $1 million from limited partners to buy the rights to several books. Of the $1 million, $300,000 -- 30% -- went to attorneys, accountants, and salespeople. Only 70% went to buy book rights from the promoter. The promoter, however, bought the rights from the authors for just $200,000, pocketing a $500,000 profit. The investors also gave the sponsor $13 million in notes payable out of profits from exploiting the book rights. How could these book rights worth $200,000 now be worth $13.7 million? That provided an awful lot of tax benefits -- on paper. Of course the IRS didn't buy it.

INC.: Are such deals still being peddled?

Brennan: It used to happen all the time. I'd like to say the promoters won't get away with it anymore. When the tax laws were changed in 1976, people thought the number of exotics would be cut down. I thought the same thing in '78, '81, and '82.I'm convinced now that even after '84 there will be high tax-write-off promoters like this.

INC.: Like master recordings, for instance?

Brennan: Anyone making a decent amount of money has probably been approached by a salesman hawking a master-recording shelter. These programs are closed down -- or will be soon. The new tax law affected these investments, and the IRS is both seeking and obtaining injunctions against the promoters.

INC.: Will any exotics sneak through the cracks?

Brennan: Master recordings will disappear because the IRS pressure is so heavy on them now. Promoters of video-cassette shelters, however, may still be offering high write-off tax shelters.

INC.: How do these work?

Brennan: A typical example of a video-cassette shelter involves a videotape of medical instruction distributed to doctors. The investor buys the master, and the promoter presumably markets the tapes at a profit. I say presumably because in most high-write-off shelters, the investor signs a distribution agreement but nothing is ever distributed. The investor, therefore, gets a large tax write-off on an investment with no economic basis.

INC.: Once the abusive promoter is stopped, what's the verdict for investors? Are they in danger with the IRS, too?

Brennan: The investor is pretty much protected. If there were severe, publicized fraud penalties brought against investors, they would think twice about investing in abusive shelters. But in most cases, sponsors are sharp enough to protect investors by obtaining a clean tax opinion from their law firms. They'll also get an appraisal of the assets stating that they are worth what the sponsors say they are. This technically prevents the investor from committing fraud. Personally, I can't imagine any attorney or accountant believing there is a profit motive for the investors.

INC.: What's your advice to investors who get audited by the IRS?

Brennan: If the tax shelter is sound, you don't have a lot to worry about. If deductions are challenged, normally the partnership will handle it. If the tax shelter is exotic or abusive, explore with your accountant or attorney the probability of the IRS's success. If it appears that the IRS is going to be successful, particularly with an exotic shelter, I would ask for a deduction equal to the amount I invested, and settle it.

INC.: What's your best advice to investors in general?

Brennan: A tax shelter's primary objective should be to make a profit; the tax benefits should flow naturally. Concentrate on the economics and pay less attention to the tax side. And don't do anything that will cause you to lose a good night's sleep.

PLANNING FOR THE WINDFALL

You are about to sell your business, and the deal will bring you a lot of money. You -- along with your accountant, your lawyer, and anyone else you choose to work with -- have the pleasant job of figuring out what to do with the proceeds.

If, that is, you are sure you want to sell.

"A preliminary step should be to examine yourself," says William Katz, tax partner in the New York City office of Ernst & Whinney, the accounting firm. "Can you be an employee after having been a boss? Could you emotionally survive the trauma of selling the baby you nurtured to prosperous adulthood? Is your plan to retire early realistic?"

Katz tells of three clients who came in to discuss a $4-million offer they had received for their garment business.

"These men -- in their mid-forties to early fifties -- were talking enthusiastically about the joys of being able to do whatever they wanted. They'd made it," says Katz. As the discussion progressed, however, doubts began to surface. "Finally, they agreed they'd probably get restless and look for other things to do. With that, we discussed what it would be like if they didn't sell, and they went on and on about what could and should be done with the business.

"In the end," Katz continues, "they rejected the offer. Five years later, the business was worth nearly four times the offering price."

In another situation -- related by Bruce Mac Corkindale, an accountant with Arthur Andersen & Co. in New York City -- the owner of a consulting firm backed out of a $2-million sale because the buyer refused to retain a key employee.

If you have made up your mind to sell, however, there are some critical decisions to be made. One potential buyer, for example, might want you to remain with the company for several years, to provide management continuity and the benefit of your experience. Another might require the exact opposite: not only that you leave, but that you agree not to compete for a set period of time.

Among the most important financial questions confronting the seller of a business are: one, how to take the money, and two, how to minimize the tax bite on the proceeds.

You will doubtless want to sell for cash if you are planning on an immediate investment in another business.Otherwise, an installment plan might sweeten the deal.Richard J. Berry, a partner in the Norfolk, Va., office of Price Waterhouse, tells of a client who quite happily accepted an installment arrangement. In the $2-million sale of his small manufacturing company, he agreed to take $1.5 million up front and the rest over five years. In return, the seller required that the buyer pay him an annual noncompetition fee of $60,000 for 10 years instead of the 6 years originally proposed.

If the acquirer is a publicly traded company whose stock is attractive, you may want to take your payment in the buyer's securities. If the deal is properly structured, you thereby postpone tax liability on the capital gain realized from the sale of your company. And in the meantime, you have all of those pretax dollars working for you. Mac Corkindale, for example, told of a client who accepted stock in the sale of a specialty-steel business. If he had taken his $1.5-million share of the proceeds in cash, he would have had to pay more than $300,000 in federal and state capital-gains taxes. As it was, he postponed that obligation -- and the stock he accepted instead paid $120,000 a year in dividends and subsequently grew in market value.

If your company is publicly held, points out Barry Salzberg, director of personal tax services in the New York region for Deloitte, Haskins & Sells, you may have a special problem created by the 1984 Tax Reform Act: the "golden parachute" tax. One of Salzberg's clients, for example, will leave his company with about $1.5 million when it is merged into a multinational conglomerate in a few months. The package includes stock options worth $400,000. Since the executive would have to borrow to exercise them now, he had planned to let the acquiring company buy them at closing.

However, if he had done that, he might have had to pay a 20% excise tax, because the Internal Revenue Service would have considered the options to be part of a golden-parachute agreement made in contemplation of the transaction. The IRS's criteria: The options were issued within a year of the merger and the income generated is more than three times the executive's average income over the past five years.

Faced with that prospect, says Salzberg, the client chose to exercise the options now. The loan he had to take out was a lot less costly than the golden-parachute tax.

The sale of a privately held company can also generate monumental tax problems, particularly if you have built the company (and thus the value of your shares) up from nothing. One way to ease the tax bite is to distribute some of the proceeds among your family members.

Before the sale, you can transfer shares in your company to your children. If they have little or no other income, the tax on their gains when the company is sold may be nominal. The Virginian who sold his manufacturing company, for example, gave stock to each of his five children 18 months before the sale. When the deal was closed, the kids got $30,000 apiece, with another $10,000 each spaced out over five years.

Even after the sale, you can save on both income and estate taxes by transferring assets to family members. If you take your payment in stock, no capital gains taxes are due on shares you give away or leave to your heirs. But even many cash transfers can escape gift and estate taxes. Under the Economic Recovery Tax Act of 1981, you can give your spouse as much as you wish without incurring a tax, and you can make tax-free gifts each year of up to $10,000 to as many people as you wish. If your spouse joins in the giving, the limit is $20,000.

The 1981 act also provides a unified estate and gift tax credit that applies to gifts given during your lifetime (in addition to the annual tax-free gifts) and to bequests. The credit this year is sufficient to allow a transfer of up to $325,000 to escape taxes; by 1987, the tax-free transfer will rise to $600,000. Under the so-called unified credit trust, you can pass along assets up to the credit limit to the second generation. Meanwhile, a surviving spouse gets the trust's income and can draw on the principal if necessary.

How much can all this save? If the principal in the trust was the 1987 maximum of $600,000, the estate-tax saving would be at least $192,800 -- the amount that would otherwise be due at your spouse's death. In larger estates -- in which you and your spouse's assets exceed $1.2 million (thus using up both your unified credit and his or her own) -- the tax saving could be as much as $330,000 because of the pregressive tax rate, which climbs as high as 55%.

Another estate-planning device is the so-called Q-Tip trust. It gives a surviving spouse a qualified, terminable interest in the property," which usually is annual income for life, but deprives the survivor of ultimate control over the property. On that spouse's death, the principal goes to the beneficiaries the first spouse has designated.

The Q-Tip is not as advantageous as the unified-credit trust: The money you put into it qualifies for the marital deduction on your death, but it will be included in your spouse's estate for tax purposes. So most people use it only after they have set up a unified-credit trust.

Published on: Dec 1, 1984