Chapter 15: Tax Shelters
What is a “tax shelter”? That question is a difficult one on which there is no broad agreement.
Nevertheless, I think it helpful to think of tax shelters as generally falling within two categories:
(1) the mismeasurement of SHS wealth increases and decreases or (2) an attempted conversion of
high-taxed ordinary income or gain into low-taxed capital gain (or other manipulation of the
applicable tax rate).
In each category, in turn, there are three types of response: (1) clearly intended by Congress
and permissible because of an economic, social policy, or administrative reason, i.e., they are tax
expenditures, (2) not intended by Congress and comprising a common pattern that lends itself well
to statutory amendment to address it, or (3) not intended by Congress and a one-off or idiosyncratic
transaction more efficiently addressed through individual adjudication and application of the
substance over form doctrine and its progeny, including the step transaction doctrine, sham debt,
tax ownership, the business purpose doctrine, and the economic substance doctrine.1 Sometimes
certain tax shelters are first addressed through common law adjudication but then result in statutory
amendment, particularly if the shelter becomes common and clogs up the courts with expensive
and inefficient case-by-case litigation. Even the economic substance doctrine, itself, has been
codified, though the chief effect of its codification lies in the application of a strict liability penalty,
as described below. Part A. will explore the various common law doctrines that are used in
common law adjudication, and Part B. will consider a few of the more important statutory
responses to tax shelter activity.
You learned in Chapter 1 that SHS income comprises wealth increases less wealth
reductions but only if the wealth reduction does not represent personal consumption.
Moreover, you learned that a wealth reduction in the SHS sense means—in particular—an
outlay or loss of previously or concurrently taxed dollars, i.e., of after-tax dollars, to ensure
that the same taxpayer does not enjoy a double tax benefit (both exclusion and deduction)
for the same dollars.
You have already studied numerous provisions that deviate from these core concepts, but these
deviations are clearly intended tax expenditures (whether wise or unwise). Simple examples are
contributions to § 401(k) plans, IRAs, and other qualified pension plans, which are accorded
consumption tax treatment, as described in Chapter 2. Some personal consumption expenses
(which would be nondeductible under either a pure income or pure consumption tax) are permitted
to be deducted under current law, such as qualified residence interest, charitable contributions, and
state and local income and real propert y taxes—all examined in Chapter 17. Similarly, the amount
of wages received in the form of employer-provided health insurance is excludable from Gross
Income, also discussed in Chapter 17, notwithstanding the Old Colony Trust two-step (under which
the compensation in the form of employer-provided health care costs would be includable in Gross
Income under § 61(a)(1) and the individual’s deemed payment of the health care costs would be
nondeductible under § 262(a) as a personal expenses). The receipt of a substantial gift or bequest
1 In my view, each of these common law doctrines can be viewed as simply a variant of the substance over form
doctrine, but courts often treat them as separately identifiable doctrines. Because of the recent codification of the
economic substance doctrine and a strict-liability penalty that applies if the transaction is held to lack economic
substance, discussed infra, the treatment of these doctrines as separate and independent doctrines has significance.
Chapter 15 Tax Shelters Chapter 15
represents a wealth increase evidencing ability to pay but is nevertheless fully excludable under §
102, as you learned in Chapter 7. Property appreciation represents a wealth increase under SHS
principles, but (except for those properties required to be marked to market each year under §§
475 and 1256) this appreciation is not included in Gross Income until a realization event occurs
and, moreover, is completely forgiven at death. You learned in Chapter 11 that untaxed borrowed
principal can create basis immediately under Crane that can generate depreciation deductions of
before-tax (rather than after-tax) dollars—thus allowing a double tax benefit for the same dollars
to the same taxpayer (both exclusion and deduction) between the time that the deductions are taken
and the principal is repaid with after-tax dollars. You also learned in Chapter 13 that statutory
depreciation under current law is allowed at a rate that is much faster than economic depreciation.
Each of these examples represents a p ermissible mismeasurement of SHS income, in the sense that
it is clearly intended by Congress.
But even though these deviations are intended in isolation, the attempted combination of the
last three in particular (the realization requirement which ignores property appreciation during
ownership, the deduction of pre-tax dollars when borrowed funds generate expense and
depreciation deductions before principal repayment, and the front-loading of depreciation) has
often resulted in deduction of significant non-economic losses, resulting in both common law
challenges and statutory amendment.
As with some forms of mismeasurement of SHS wealth increases and decreases, some forms
of tax rate manipulation are clearly permissible (in the sense that they are intended by Congress).
You have already learned, for example, of several instances in which a return on labor is
permissibly treated as capital gain rather than (high-taxed) labor income. In Chapter 14, for
example, you learned that the music composer can elect, if she wishes, to have the gain realized
on the sale of the composition treated as capital gain under § 1221(b)(3), but that the painter,
sculptor, and author are out of luck under § 1221(a)(3)(A). (Go figure ….) We can now add
additional examples to our list.
The gain realized by an entrepreneur who sells founders shares with a zero basis at a large gain
(while paying himself a low salary until then) reflects much of his personal work effort. Yet, the
sale gain is entirely capital gain.
Another example that has been much in the popular press in recent years is the taxation of so-
called carried interest earned by private equity fund managers, who earn a return for their
management skills in picking and managing investments purchased almost entirely with other
people’s money (the fund’s investors), with only a nominal capital contribution by the managers.
Their arrangements with the funds (organized as partnerships) typically provide that their return
should be measured by two components (often referred to as “two and twenty”): (1) an amount
equal to 2% of the funds under management each year and (2) an amount equal to 20% of any
increase in the value of the fund assets each year (after a preferred return to the fund investors).
While these managers include the portion described in (1) as ordinary income under § 61(a)(1)
each year, they include the am ount described in (2) as net capital gain or qual ified dividend income
(taxed at 15% or 20%) to the extent that the income earned by the fund consists of such income2—
notwithstanding that both components are used mainly as benchmarks in valuing the services that
they perform for the fund. In contrast, a corporate executive whose bonus is determined by how
much the corporation’s share price increases realizes ordinary income (whether paid in cash or in
2 They also can often defer the inclusion until future years.