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

 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, KBMG, 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 Sheloter 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.l

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.