The Daugerdas Indictment - Part #3 - The Shelters

The tax shelters alleged in the indictment are of two generic types.

1. The first is the contingent liability / Helmer type of shelter. (Indictment ¶¶ 26-31.) This type of shelter was employed by other tax shelter promoters, including KPMG (e.g., the indictment of the KPMG related individuals including BLIPS and SOS, both of which were this type of shelter.) Three of the four shelters involved used this strategy - Short Sale, Short Option Strategy ("SOS") and Swaps. The tax play in this genre of shelter is based on cases, exemplified by Helmer v. Commissioner, 34 T.C.M. (CCH) 727 (1975) that treated some types of debt as contingent debt that is not characterized by tax rules dealing with true debt. To illustrate, If individual A borrows $1 and contributes the $1 cash borrowed and the offsetting debt to a newly-created partnership in which he is a 99% partner (with no special allocations), A will take his partnership with basis calculated by the cash contributed $1 and the debt deemed shifted to another partner -- i.e., $ .01, and so has a $ .99 basis in the partnership. Suffice it to say for present purposes that, in that scenario, any way the debt gets resolved or A leaves the partnership holding the debt, A will get no free losses -- losses he has not paid hard dollars to achieve. However, if in making the calculations, the debt contribution to the partnership is not treated as debt at all (let's call it contingent debt and therefore not true debt because the calculations take into account only true debt), A can take a full $1.00 basis in the partnership interest, A never has to account for the fact that economically he shifted $1 of offsetting debt to the partnership, and A will have $1 basis in his partnership interest which he can, at least theoretically, claim as a loss even though economically A has paid nothing for the partnership interest (i.e., he put in $1 cash and $1 debt characterized for tax purposes as contingent but economically an offsetting position making his economic contribution $0). As presented in this simple example, the arrangement is a pure tax play, having no business or nontax purpose which is required in order to sustain the loss that appears to arise from the transaction. Pomoters peddling this type of shelter inserted various investment gambits, of various cosmetic opaqueness, that were intended to put some business or nontax purpose flavor to the transaction (at least enough, they hoped, to deflect the IRS's attention or even be sustained by a court). Thus, for example, in the SOS strategy long and short paired offsetting options would form the portfolio -- the long option position would be substantially paid for with the proceeds realized upon selling the short option position and the economic risks and opportunities of the offsetting positions would balance effectively to zero. Both positions would be transferred to the partnership with the short position being treated as a contingent debt that did not have to be accounted for in tax calculations. Economically, it is the equivalent of the example of borrowing $1 and obligating to pay with something that will be treated for tax purposes of a contingent obligation to repay. The net effect, the taxpayers and promoters hoped, is to leave the taxpayer with a very large artificial basis (very large because much more nominal dollars than $1 were involved) that the taxpayer never paid for and will never pay for, to claim as a very large (albeit very artificial) tax loss. That artificial tax loss would be reported on the tax returns as an offset the taxpayer's very real taxable gains.

2. The HOMER Shelter. The HOMER shelter is described in Indictment ¶¶ 32-34. I am unusure precisely what the tax play was, but the bottom-line, the indictment alleges, was the same as the other shelters -- the parties' liabilities and risks were eliminated through offsetting investment positions, the "tax losses purportedly created by the tax shelter vastly exceeded any actual economic loss suffered by the client[, and] the reporting of the tax shelter's tax benefits on the client's tax returns substantially reduced or eliminated the amount of taxes owed by the client." (Indictment ¶¶ 34.)

The economic effect of these shelters is that the very larlge tax liabilities that taxpayers otherwise would have paid on the their very real gain disappears, with the Government holding the bag and the promoters sharing in the amount the Government lost. What economically motivated person would not be willing to pay $1 to save $4 of taxes? (That might not be the right ratio, but that is the concept.) But the question as to the promoters / enablers indicted in the Daugerdas indictment is not just the economic motivation, but whether that economic motivation drove them to do something the law (or jury) has called or will call criminal.

JAT Comment on the tax aspects of the Helmer play. I believe that the promoters' hopes for the Helmer play was off balance in a tax accounting sense. Those hopes assume the ability under general tax principles to achieve a cost-free cost basis. The counter to that is that tax books don't balance with a cost-free basis. Alright, I know that Gitlitz says perhaps not in the S Corporation context, but that was a special case and it appears to have slipped into tax history without affecting much in its wake and certainly not affecting general rules that look for tax books to balance. I think the more pertinent authority is Tufts where the Supreme Court forced the tax books to balance (and it really did not take much forcing, just a healthy dose of solid logic). Focus on the simple example above where the taxpayer gets $1 cash by undertaking a debt somewhat artificially labeled for tax purposes as contingent debt. If the debt were real, noncontingent debt, the taxpayer's tax books will balance and be consistent with the economic results, with perhaps only some interperiod differences that ultimately resolve. But, if it is contingent debt (whatever precisely that is) and the taxpayer never resolves that debt, the promoters claim he has achieved a cost free $1 basis asset (originally the cash but a partnership interest if he contributes it to a partnership) and his books can't balance unless he pays for it either with phantom income (not unlike Tufts) to match the phantom basis (analogous to the debt driven cost basis in Tufts). A tax event not unlike Tufts to balance the books would have fixed the problem in the shelters relying upon Helmer. The opinion letters I read on the subject pretty much ignored the issue. I guess, if the writers spotted the issue at all, they ignored it in hopes that it would go away. It has since the IRS has prevailed, both civilly and, based the instructions in the Larson case, criminally with a more blunderbuss approach in the economic substance doctrine.