Why didn't the IRS and Treasury do more about aggressive tax planning techniques of the sort that Romney appears to have used extensively?

As I’ve noted in prior posts (and many others have noted as well), there is strong if indirect evidence supporting the surmise that Romney – wearing his Bain hat, rather than acting as a lone wolf – may have engaged in a lot of aggressive and legally questionable tax planning in recent years, including (1) aggressive structuring to convert ordinary income management fees into capital gain shortly before they accrued, (2) using total return equity swaps to avoid the U.S. withholding tax on dividends paid to Caymans entities, (3) mysteriously acquiring a huge gob of foreign tax credits in 2008, and (4) using aggressive under-valuation to transfer valuable assets to his sons and his IRA without getting hit by gift taxes or contribution limits.

Keeping in mind that the practices here were widespread among high-flying financial sector people, I’ve gotten the question: Why did the IRS allow this stuff to happen, given that often (albeit depending on the particular facts) it was so legally questionable?

There are several likely answers to this.  When it comes to these sorts of things, the IRS and Treasury are under-staffed, often are behind the curve regarding what is happening on Wall Street, may be subject to political influence regarding overall audit and regulatory priorities, and also may very reasonably have concluded that they had higher-priority fires to put out first.  For example, there is no doubt that the IRS and Treasury, albeit initially slow off the mark, eventually put a great deal of effort into addressing abusive tax shelters that involved ginning up huge fake losses with little or no economic substance, through marketed deals that typically had nothing to do with the taxpayer’s actual business.  This was not only relatively easy to do (both in terms of getting taxpayer lists and winning the actual cases) but was an urgent high priority.  By contrast, even once the government understood what sorts of games people on Wall Street were playing to minimize tax liability, attacking it was bound to be hard work with only a more limited payoff.  For example, these techniques really were limited to people at the top, whereas marketed tax shelters can extend much further down, and each case might turn on its particular facts and circumstances (whereas, say, Son-of-BOSS cases were generally all the same).

Of course, this is not to let the IRS and Treasury entirely off the hook.  They probably should have been much more active in issuing shot-across-the-bow notices and rulings, giving examples of aggressive tax planning transactions that do not work.  (An example is the 2010 ruling about total return swaps that I mentioned in a prior blog post, which ought to have been issued years earlier.)  Once something becomes common practice and has not been challenged over a period of years, putting the toothpaste back in the tube can be quite difficult.

But to be sure, all this is easy for me to say, sitting at my law school desk in 2012.  The press of daily events and the “fog of war” can make it more difficult in real time.

Plus, of course, the “audit lottery” is inevitably pervasive. Even for that tiny percentage of taxpayers that actually does face at least a minimal audit, the IRS may frequently fall short of spotting all or even many of the key issues that full knowledge would have suggested pursuing.

What do we learn from the standpoint of tax law design?  Although I consider the foreign tax credit over-generous, and although capital gains do indeed get a lower tax rate than ordinary income (reflecting that taxpayers often find it easy not to realize them), the tax planning at issue here generally has less to do with the enactment of special tax preferences by Congress than with basic structural soft spots in the body of our income tax system.  For example, the questions of who owns a particular asset, what exactly is its value at a given point in time, and whether a given transaction has economic substance and/or is subject to meaningful downside economic risk – all variously at the heart of the four tax planning tricks that I referenced above – are inherently hard to answer, especially given taxpayers’ inevitable information advantages regarding their own detailed circumstances.

Neither presidential campaign has proposals out there that would address these basic problems (although one side might be less unlikely – albeit very far from certain – to countenance expanded enforcement with regard to the financial sector’s tax planning fun and games).  The issue here is less tax reform, in the standard sense of broadening the base, than either shifting to a progressive consumption tax or else, perhaps, having a much more mark-to-market-based income tax.