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How to avoid buying an abusive tax shelter

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How to avoid buying an abusive tax shelter

By Kay Bell • Bankrate.com

The deal sounded sweet. The investments would save tons of tax dollars and were recommended by a highly respected international accounting firm. Hundreds of investors confidently signed up for the KPMG tax shelters.

It didn't sound so sweet, however, after a ruling from the Internal Revenue Service that the arrangements didn't meet tax-law muster. The investments were, according to the IRS, abusive shelters that deprived the U.S. Treasury of billions in evaded taxes.

KPMG has acknowledged wrongdoing and agreed to pay $456 million in a settlement that defers any criminal prosecution. The entire investigation certainly put accountants and investment firms on notice, but it also raises an important issue for individual investors:

How can you tell if a proposed tax-saving arrangement is really an abusive tax shelter?

Questioning conventional wisdom

Conventional wisdom used to be that as long as you stuck with a reputable company with solid and long-standing financial and tax experience, you were OK. The KPMG incident, however, turned conventional wisdom on its head.

"That's one of the dilemmas here," says Mark Luscombe, principal federal tax analyst with CCH, a provider of tax and accounting information and software. "A lot of things in the tax world are subject to interpretation. You hire some clever accountant or tax lawyer to take a careful reading of the tax code and come up with something that works under the letter of the law. Then the IRS comes along with a different interpretation.

"I'm not sure it pays to be too clever."

Those might be good words to heed since the IRS is making it clear that it is looking more closely at tax shelters nowadays. Tax law provisions that took effect late last year give the agency more latitude in tracking down and penalizing those involved in abusive shelters. So what exactly is the IRS looking for?

An abusive tax shelter is a marketing scheme that involves tax transactions with little or no economic value, says Michael C. Provine, managing director of Tradition Capital Management in Summit, N.J. "It is often marketed in terms of how much you can write off against tax on your tax return, in relation to how much you invest."

"Some shelters are advertised as you're not going to get all your money back, but you'll more than make up for it with tax savings," says Bob D. Scharin, editor of Warren, Gorham & Lamont/RIA's monthly tax journal "Practical Tax Strategies." "For example, you invest $10,000 and lose it but will get $50,000 in tax breaks that will make up for the loss."

Expect that type of investment to get IRS attention since its examiners look at whether you would enter into the transaction if it didn't promise tax savings. In the eyes of the IRS, a legitimate shelter is one you invested in expecting to make a few bucks and the tax savings just made it even better.

Investment intentions matter

That's why it's important, says Provine, for an investor to consider whether the proposal can stand on its own as a money-making investment without the tax consequences. Can you make money by investing in the arrangement?

You also need to look at the flip side, he says: Will you lose money? Are you creating some kind of loss?

Then consider your answers to these two questions together.

"Basically, you want to determine whether the benefit is disproportional to the dollars you're placing in the shelter," says Provine. "Or do the tax benefits multiply beyond the dollars that you're putting into the shelter. Are you getting a lot of tax benefits for nothing?"

If the answer to that last question is yes, you could have a problem.

Get it in writing

Scharin says it's a good idea to get written information on any tax shelter proposal.

Reputable firms obtain opinion letters, documents written by a CPA or tax attorney, that discuss what the tax considerations and issues of the plan are or should be. "With the latest IRS scrutiny," says Scharin, "practitioners should be more concerned about what they're putting in these letters."

Some KPMG offices apparently provided letters that overstated the shelters' benefits, says Scharin. That's why you also want to try to determine what kind of affiliation the opinion's author has with the company offering the investment.

"The person writing the letter will get a fee for research and writing the letter, but you would not want someone who also is selling the product and getting a commission," says Scharin. And since the IRS is cracking down on the quality of written advice, he says you also want to make sure that the opinion writer considered and researched the shelter's relevant issues.

Luscombe says questionable support of shelters was more of a problem in the late 1990s, the tax shelter's heyday. "It wasn't just the marketers behind these things," he says. "Corporations were attracted to these things, too, and a lot of pressure was applied to those who were asked to evaluate and verify their credibility.

"People would go to a third party and say 'KPMG has this deal. What do you think?' If you told them it was a little questionable and you wouldn't do it, you were likely to be ignored if the person or company really wanted to go ahead. There were lots of lawyers willing to issue a favorable opinion. There was pressure on third parties to go along to avoid losing clients and favor.

"That's changed 180 degrees now. You can pretty much rely on an independent third party to give you an honest and unbiased evaluation."

Get your own evaluation

The key here, everyone agrees, is that the evaluation be objective. To guarantee that, take the proposed shelter information to your own tax adviser.

"If the [shelter promoter] will not let you take anything off premises, that a signal," says Scharin.

Some shelter sellers ask that you sign a confidentiality agreement or promise you won't tell anyone about this tax-saving deal. Their argument: The shelter is such a great arrangement, they don't want someone else to steal the idea. Don't buy that pitch or the shelter.

When investments are marketed under such cloaks of confidentiality, it is sometimes an effort to discourage you from checking with your own tax experts, says Luscombe. A seller who is simply concerned about safeguarding a proprietary investment plan should not have a problem with your advisers looking it over as long as they also agree to restrictions on discussing it with others.

"Always get a second opinion, whether it's medical or financial," says Provine. "Think of it as a souped-up car that has lots of bells and whistles, lots of options. You really have to understand that, while the vehicle might be pitched as going fast, it could be an accident waiting to happen."

To forestall a financial crash, take the time you need to ensure that any investment vehicle meets your safety standards.

Know exactly what you're buying

You also need to employ what Scharin calls the common-sense tests: Can you understand the nature of the deal? Does it seem sound? How am I going to benefit from this? Is it designed only for the tax savings or is my money going to be used to make money?

Provine says ideally you'll want to have a good enough understanding of how the shelter works so that you can explain it to someone else.

Certainly, tax laws are complex and there are some legitimate tax-shelter transactions that are so convoluted that most of us don't understand them. But the more complex the arrangement is, Scharin says, the more chance for the IRS to challenge it as lacking a business purpose.

"What has to happen is: The expert [proposing the shelter] has to be very conversant in what's going to happen to inform the client of the [investment's] upside and downside," says Provine.

The price of abusive shelters

When the IRS does decide that a shelter is abusive, it's going to cost you. Not only did KPMG pay a hefty price for marketing the disallowed plans, so did investors who bought them.

"Basically you would be looking at a reversal of the tax strategy that you used in your return," says Luscombe. "You'll face some additional income tax and because of the time that usually passes between the filing and the disallowance, you're probably looking at interest charges associated with it, as well as penalties -- failure to pay and possibly some abusive penalties -- associated with it."

Some of KPMG's customers will get help in paying what they now owe to the IRS. In addition to the criminal fines, the accounting firm also agreed to pay $195 million to settle the civil claims of almost 300 investors.

However, even after these investors have put the KPMG shelters behind them, their tax worries might not be over.

"The key issue for a taxpayer," says Provine, "is once the IRS opens a tax return and makes some judgment regarding some specific issue on that return, your entire return is open for audit, so you could have other areas open to examination.

"They don't divulge their auditing methods, but if you have large transactions with large deductions and large offsets, they clearly want to go in and find out why."

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