Health Care Reform bill contains heat-seeking missile against tax shelters

(To my knowledge, this is the first post about this anywhere. Please distribute widely. Feedback and collaboration welcome.)

The HCR bill contains a rider that, by codifying and unifying recent case law, makes it much harder for tax shelters to avoid taxes. This may well explain why there is such fierce opposition to HCR from corporate interests. Their pet cash cows are getting gored. It has nothing to do with health care.

Some background. Selling tax shelters is big business. Shelters with more than a few participants must be registered with the IRS, but “customized” plans do not require registration and are often not disclosed. They are designed to generate paper “tax losses” for corporations while involving little or no actual economic risk or cash outlay. Designing and marketing these schemes generate millions in fees for investment banks, attorneys, and accounting firms. This is very big money indeed and goes deep into the heart of corporate America.

The new law provides “that, in the case of any transaction to which the economic substance doctrine is relevant” [.i.e a tax shelter],”the transaction shall be treated as having economic substance only if (i) the transaction changes in a meaningful way (apart from Federal income tax effects) the taxpayer’s economic position, and (ii) the taxpayer has a substantial purpose (apart from Federal income tax effects) for entering into the transaction.”

The IRS has now codified the economic substance doctrine into a two-pronged test across the country which supersedes the varying previous interpretations in different federal circuits.

So, a tax shelter now *must* have economic substance. It must have a purpose other than federal tax reduction. Further, the IRS will challenge taxpayers who try to slide in under the old interpretations. Also, penalties have been increased from 20% to 40% for underpayment of tax liability.

This is a heat-seeking missile into tax shelters. I can hear the fat cats yowling from here, can’t you? Imagine the effrontery of the government to say that tax shelters must do something else besides dodge taxes. Why, why, that’s socialism isn’t it?

The ABA has requested clarification from the IRS (PDF).

This legislation changes the playing field significantly by mandating the two-prong test and imposing a strict liability penalty. Despite the detailed consideration of the legislation over the years, the 2010 Act did not resolve major pre-existing ambiguities in the economic substance doctrine (e.g., what counts as a substantial business purpose) and brings to the fore a number of other ambiguities, most particularly the question of when the doctrine is relevant.

Translation. We’ve had a swell gravy train going for a while helping corporations evade billions in taxes and this new statute is mucking things up. Please make your law less broad so we can wriggle around it.

The IRS answers (PDF)

Section 7701(o)(5)(A) states that the term “economic substance doctrine” means the common law doctrine under which tax benefits under subtitle A with respect to a transaction are not allowable if the transaction does not have economic substance or lacks a business purpose.

Translation: we need a big net for big fish — you won’t be getting a pass.

Make no mistake. This is a big deal, serious anti-tax shelter tightening. Is it extreme to conclude that if corporations (who don’t care whether or not we buy health insurance coverage) can get the little people foaming at the mouth about HCR — if they can persuade us to repeal the bill in its entirety — then maybe big business will be able eliminate that noxious anti-tax shelter rider while no one is paying attention? And the Tea Party will have then been played, as will the rest of us.

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  • Gonna pass this around, but I think I might have read something on this before.

    In some ways I can see what the ABA means by ambiguous and I will not be surprised to see them getting the corporate owned courts to agree to the corporate parsing of “is”, where “is” is “substance”. If ya get my meaning?

    • I’m sure they will try. But the IRS regs are crystal clear. The shelter must meet the two-pronged rule.

  • DJ

    There is actually a great deal of ambiguity in the law, and it will no doubt take years of litigation to resolve it. Simple tax matters are rarely simple. Begin with the IRS’s response that “the term “economic substance doctrine” means the common law doctrine under which tax benefits under subtitle A with respect to a transaction are not allowable if the transaction does not have economic substance…” That’s a circular definition.

    Here’s a real world example of how a seemingly simple question can become complex: A taxpayer purchases a lot and decides to build a home and sell it. Capital gain, or ordinary income? The answer depends on a variety of factors. Now suppose that the taxpayer, who was short of cash after purchasing the land, decided to go into partnership as a silent partner with the General Contractor rather than hire him. Capital or ordinary? You’ve just delved into an area of law on which even the various appeals courts do not agree.

    The question of what constitutes a trade or business (and is therefore entitled to deduct its various expenses) seems simple enough, but has been litigated extensively – in some cases all the way to the Supreme Court. In one particular case, a man who supported himself through gambling argued that he was in business as a gambler. The IRS disagreed. SCOTUS sided with the taxpayer.

    Tax shelters do indeed cost this country a great deal in tax dollars. But nothing in the tax world is ever simple. If our Senators and Congresspeople, with their own deep pockets to protect, permit this rule to stand, you can bet it contains plenty of wiggle room.

    • I think it’s less what type of transaction it is and more is the shelter only used to to avoid taxes. See the Son of Boss post today. The entire purpose of that tax shelter was to book losses that weren’t really losses. But say, owning a house in a tax shelter where you collect rent, do improvements, then sell it has “economic substance.”

      • DJ

        I think you’ve just caught the gist of the complexities – because if that’s what’s required to make it work, corporate attorneys will have their clients buying houses through the tax shelter. Voila! – another round of audits and litigation, another few billion in taxes avoided.

        Of course, it’s not really that simple, which is why our ridiculous tax code (and the body of case law supporting it) makes my head hurt, and attorneys’ mouths water.

        • From what I can tell the IRS would be fine with that. They just don’t want tax shelters that server no purpose except to book losses that aren’t actually losses.

          • DJ

            Actually, the IRS prefers ambiguity – it gives them more leeway. Take for example the issue of compensation for S Corporation officer/owners, which Congress attempted to legislate last year (badly I might add, thank God they failed). All the IRS has to do is issue a guideline, and the problem goes away. But IRS won’t issue a guideline because then they would have to follow it, limiting their ability to say what they think is right or wrong in any particular instance. So many Americans operate with no clear idea of whether, of they get audited, they will owe more tax or not!

            Hello, litigation!

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