Random thoughts on Ethics, Tax Opinions and A Tax Lawyer’s Life at a Big Law Firm (3/27/13)

An anonymous reader of this blog offered comments on a recent blog entry, Ethicist Question About Tax Professionals Exploiting Loopholes (3/24/13), here.  The anonymous reader's comments were good, so I requested that he expand or revise them to be presented as a blog entry rather than a comment to another blog.  The reader prefers to remain anonymous, and I honor that preference.  Please note that all of the balance of this blog entry are the reader's comments (as revised).  I do not indent because it is not necessary to show the reader's authorship:

I worked on the Street for many years as a tax lawyer for a “top-10” major law firm. During that time, I worked on a number of highly tax-driven deals, which were technically not tax shelters in the sense that they were not mass-marketed and liberally replicated for different "taxpayers." No, they were much more subtle than that (tax shelters nonetheless) involving tailor-made solutions for particular “tax problems” (almost always how to evade tax payments on excess cash build-up) experienced by large corporate enterprises (see Google, Dell, Apple, Facebook, for current examples), for which legal opinions were designed to fend off an IRS investigation (I will come back to that aspect of things). Technically, our “client” for many of the transactions was a large investment bank no longer with us since 2008 (yep, that one) who had a huge "tax" servicing business, comprised of fixing its clients’ tax issues using its massive balance sheet to do.

I, and, more importantly, my direct supervising tax partner, knew that most (if not all, my memory is hazy) did not work in the sense that if any particular scheme were thoroughly and competently reviewed, it would fail that scrutiny. Typically, we dressed the structure up to resemble a complicated machine (a Rube Goldberg type contraption) that would be difficult, perhaps well-nigh impossible, to decipher. (Since then, I suspiciously view over-complicated legal structures as a badge of fraud; I have yet to be proven incorrect, though I live in vain hope).

A transaction’s elements would be fragmented in various ways to make them difficult to detect in the larger corporate enterprise. We liberally interspersed partnerships, corporations, trusts, nominee arrangements and different offshore entities in a bewildering constellation of obfuscation and deliberately confusing "business structures" to make the scheme difficult to decipher if it was discovered. Always, we had a deliberately obvious tax error (the “head feint”) for concession if there was a good IRS reviewer (a bone for the dog as it were--that's the crass expression that was used). (And the liberal churning of legal hours was staggering, overstaffing and useless research projects the norm, but that's another tale, so it is not detailed here: the NYT has an interesting story on “churning,” which, in my experience, greatly understates the level of egregious over-billing at big law and accounting firms: http://dealbook.nytimes.com/2013/03/25/suit-offers-a-peek-at-the-practice-of-padding-a-legal-bill/)

And coming back to the opinions: well those were easy. We would ask the client to supply us with complicated representation letters that represented the key facts (we, of course, prepared those after we had devised the transaction and come up with the final product). No legal issues either: all the legal analysis stood up if the pieces were looked at in isolation and making assumptions regarding the business purpose.  How easy it was to achieve a “more likely than not opinion”:  my blind grandmother could drive a coach and four through that one on a foggy day! This kept the firm’s insurance carrier happy though, for there was really no legal liability for the law firm, or so my supervising partner thought.

The ethical issues were simple: if there were no analytical legal issues, then there were no ethical issues at all to consider, particularly if the bill was going to be big. To digress a little, as an associate, I once questioned the partner to whom I reported in front of the client whether we should be giving what I considered a suspect legal opinion for a very large transaction (one you would have read about in the financial media). I got a call from the chairman of the firm at home at approximately 12:30 PM after he couldn’t reach me at the office (the client had called him to “straighten me out” he told me afterwards). He praised my work on the transaction, larded me with platitudes, and told me in clear terms I shouldn’t worry about giving the opinion because that was the business we were in and the difficulty of the opinion rendered would be reflected in the final bill (the firm ultimately got a $2.5 Million premium which the chairman attributed to my “stellar” work), and to “just do it.” (Actually, I had forgotten to do it, but, in the blizzard of paper at the closing, the missing “opinion” wasn’t noticed, raising another ethical dilemma for me, one I had forgotten about until I wrote this piece for Jack! Should I have produced a clearly incorrect opinion in order to ethically comply with the firm’s commitment to deliver that opinion? The amount of taxable income in play was about $800M of compensation income, as I recollect. You decide.)

The firm at which I worked was a commercial firm running a commercial enterprise (that’s what large law firms are) and the issue was never whether what we were doing was ethical or not; rather, it was always a risk/reward determination— for any transaction, “is this particular candle worth the light in pieces of George Washington.” Please read the NYT piece noted above for the same approach at a different big firm (“churn baby churn”).  Read the comments to the article: many are more concerned with the stupidity of putting those “churn” thoughts in email correspondence rather than the substantive wrong that obviously occurred! Ethical concerns were viewed as for the “little people” who cannot marshal enormous assets to defend themselves, or who leave a paper trail! Ethics? Right! Dream on!

Getting back to the narrative, all the time we knew full well the IRS would not be able to marshal internally the different pockets of expertise necessary to figure out the transaction—the IRS works in “silos” so to speak, which, in general, do not work cooperatively with each other, as most battle-hardened tax professionals know quite well. And the proof of the pudding is that, in 15 years I worked in that transactional environment, to the best of my knowledge, none of the subject schemes were overturned by the IRS even though many were examined by it. In one astounding example, the IRS examiner started asking the right questions and even solicited the right documents, triggering a fair amount of panic. However, he then abandoned the concerning issue for a smaller one involving entertainment expenses for some corporate parties. The amount involved for the entertainment was about $75,000 (and even at that was just shifting the expense from one year to another, if I remember correctly--the “real” issue carried a tax bill of at least $240M (for recognition of a compensatory option relating to a successful offshore insurance company). That latter issue was just too complicated to pursue for the two agents assigned to the corporate examination. Now, I must say reluctantly that this wasn’t luck, but incompetence on the part of the IRS, and I suppose a deep cunning on the part of the corporate tax director who handled the audit for the corporate client.

I do not want to appear harsh in my criticism of the IRS (in fact, I have tremendous respect for the institution and most within it), but they were (and are) hopelessly outgunned and outmaneuvered, in my not so humble opinion! Just look at the tax prosecutions roster: they pick on the small and relatively defenseless, while big fish seem to swim away—certainly, few bigger fish are to be found in the roster of criminal tax prosecutions and that speaks volumes.

What's the solution? I don't know. As I get older, my questions become simpler and finer, but as I simplify I realize I understand less and less. Here's an attempt at an answer, or at least at getting a discussion going, for doing nothing should not be acceptable at this point—we don’t want to be Cyprus do we and I respectfully suggest we all collectively focus on righting the ship before it’s too late. My solutions focus on attacking the economics of the underlying situation, and undermining the current regime accordingly. My cynical view from what I have seen is that only those who are ethical at core will follow ethical rules, while those who are not will take advantage, which is precisely the current situation.

It’s in all our interests (the ordinary people of America) that all pay their fair share of taxes, which is clearly not the case now, with employees/workers bearing a disproportionate burden, at least based on the IRS stats I reviewed.

The IRS Whistleblower Program is very promising, because it would bring firepower to the IRS that it needs and does not possess, and contrary media impressions aside, the IRS seems to be embracing it based on my direct experience. Properly implemented that would substantially increase the IRS’s firepower and allow selective actions for reported cases. A substantial improvement to that program would be actively involving whistleblowers in IRS investigations prompted by the whistleblower’s information.

Another tripartite solution would be as follows: (i) make "planners" secondarily liable, or perhaps jointly and severally liable, for taxes they have helped others evade/avoid, (ii) extend statutes of limitation for a longer period, say 10 years (3-6 years is simply not long enough for effective enforcement in my opinion), (iii) eliminate the categories of opinion like “reasonable basis,” “more likely than not,” etc; have two categories as other jurisdictions for tax opinions: (1) “it works,” (2) “it doesn’t work,” and (iv)  require a legal opinion for large transactions (or obtain IRS pre-approval for it) to avoid massive penalty.

If the opinion is ultimately wrong (i.e., the court overturns the reasoning for (1)), see first sentence of previous paragraph. This would, at a stroke, eliminate much of the “shelters” and aggressive tax planning. Why? One reason: because the insurance carriers would charge massive premiums for insuring the judgment of tax lawyers rendering tax opinions on large transactions; for, in effect, they would be underwriting loss to the Fisc.

Any thoughts anyone?

PS        For the record, I have not been involved in IRS transactional work of the sort described above for many years now, and much happier for that decision. Yes, I was part of the problem for those active years, but now, in a small (and undescribed) way, I think I have become part of the solution. 

Addendum on 3/29/13:

Related to lawyers' churning billable hours, see:  Steven J. Harper, The Tyranny of the Billable Hour (NYT Op-Ed 3/28/13), here.