Note. Tax Shelters and Economic Substance

• Pages: 511-522
• Author: Marvin A. Chirelstein,Lawrence Zelenak

511

Note

TAX SHELTERS AND

ECONOMIC SUBSTANCE

In the 1 990s and early 2000s, the tax system suffered from a

plague of tax shelter devices promoted by major accounting and

investment banking firms, often with the active support of some of

the best-known law firms in the nation.

1

The plague seems now to

have ended—not for any one reason, but for a rather complicated

combination of reasons (described below). While the tax shelter

phenomenon lasted, the cost to the Treasury—tha t is, to the rest of

us—in taxes never collected was horrendous.

These tax shelters were intended to shield the taxpayer from

paying tax, otherwise due and payable, on income from unrelated

sources.

2

Typical would be income in the form of executive

compensation—perhaps resulting from the exercise of non-statutory

stock options, as in the Lo Bue case (19.01)—or gain from the sale of

a closely held business. In one case the authors are aware of, stock

options exercised by an executive generated $200 million of ordinary

compensation income; in another, the sale of a computer company

produced capital gain of twice that amount for family stockholders.

The taxpayers in both cases were willing, eager and easily persuaded

to pay fees (in the millions) to promoters who assured them that their

regular tax obligations could—legally and without financial risk—be

eliminated or reduced to a minimum through investment in a tax

shelter devised by the promoters themselves.

From the taxpayer’s standpoint there was little to lose (apart

from fees) by investing in a tax shelter scheme provided that the only

consequence, if the scheme unraveled, was payment of taxes that

would have had to be paid anyway (plus interest on those taxes). So

why not give it a try? The outlook would have been a lot more

chancy—often prohibitively so—if the t axpayer also h ad to confront

the risk of civil penalties for understating his income, penalties that

might, depe nding on circumstances, run as high as 75% of the tax

1

For a very readable in-depth account of the tax shelter phenomenon, from

inside some of the most deeply involved law and accounting firms, see Rostain &

Regan, Confidence Games: Lawyers, Accountants, and the Tax Return Industry (2014).

2

We may be tempting fate by describing tax shelters in the past tense. The tax

shelter industry appeared dead after the enactment of the passive loss rules (13.02) in

1986, but it returned with a vengeance only a few years later. We are not quite

convinced that tax shelters are (in the words of the Munchkin coroner) “really most

sincerely dead” this time either.