Do Only Fools Pay Taxes?

By Daniel L. Simmons

“Don’t tax you
Don’t tax me
Tax that fellow behind the tree.”
— Former Sen. Russell Long

Taxes and government—we need them both. We rely on government for national defense, homeland security and law enforcement. It provides our air transportation network and our highways. We depend on federal, state and local government for public education, including, to a large extent, this university. Government also is necessary for the creation and regulation of dependable financial markets. Events of the past year demonstrated that the absence of governmental regulation and lax enforcement contribute to economic disruptions like the California energy crisis (born from manipulation of flawed deregulation) and the bankruptcies of Enron and WorldCom.

Government costs money—lots of money. Taxes are the way citizens and residents, including U.S. corporations, finance the governmental benefits on which we depend. Tax law allocates the burden of financing our government among segments of our society. Income tax systems are based on the proposition that the burden of government finance should be allocated according to ability to pay, which is measured by income with adjustments for family size and various personal circumstances such as extraordinary medical expenses. The allocation of the tax burden also is affected by congressionally enacted subsidies to favored activities such as home ownership, business investment in equipment, and retirement savings, each of which, while justifiable in its own right, shifts the tax burden to others who cannot take advantage of the subsidy.

Amazingly, our tax system depends on a system of self-reporting. We trust citizens to pay their fair share. Cheating by failing to report income, claiming inappropriate deductions or employing questionable transactions shifts the burden of government finance from the tax cheat to the rest of us. And today, that’s increasingly what’s happening.

Justice Learned Hand once wrote, “Anyone may so arrange his affairs that his taxes shall be as low as possible; he is not bound to choose that pattern which will best pay the Treasury; there is not even a patriotic duty to increase one’s taxes.” In that same case, however, Justice Hand made it clear that a transaction must have economic substance and business purpose beyond merely tax reduction. Business activity undertaken solely for tax reduction is not acceptable.

Financial advisers and accounting firms (for a percentage cut themselves) have been devising for large taxpayers tax-avoidance strategies with no economic benefit beyond tax avoidance. These strategies are costing the U.S. government millions of dollars of lost revenue. A few of these transactions have been identified by the Internal Revenue Service and litigated through the courts. The transactions that have recently come to light through litigation are striking.

One example: In the late 1980s and early 1990s the insurance industry marketed a product called “corporate-owned life insurance” (COLI) under which employers purchased life insurance policies on employees. For example, Winn-Dixie Stores purchased life insurance on 36,000 employees. The policies were structured to permit the corporate purchaser to borrow back all of the cash value. The policies provided no benefits to the corporate employer or the employees except for tax deductions for interest resulting in millions of dollars of tax savings. Indeed, in one case, CM Holdings Inc. (Camelot Music Inc.) v. United States, the policies purchased on 1,430 employees mistakenly produced a positive death benefit to the corporate purchaser, which was quickly corrected through adjustments in the premium structure. The courts rejected these transactions as being entirely without economic substance or business purpose except for producing tax benefits. Congress subsequently enacted legislation blocking the device. But all of this was at great cost to the government in terms of litigation and lost revenue from corporations that used the strategy and were not discovered by the IRS.

In another set of transactions, Merrill Lynch marketed a deal involving foreign partnerships that permitted U.S. corporations such as Colgate-Palmolive, Allied Signal, Brunswick and American Home Products (now Wyeth) to reduce their tax liability by shifting capital gains to foreign partners who were not subject to tax on the transactions and claiming large tax losses. The courts uniformly rejected these tax benefits (with the exception of one district court judge in Washington, D.C., who was recently reversed) on the grounds that the transactions lacked economic substance and were devoid of non-tax business purpose. Merrill Lynch recently settled with the IRS in a case brought against it for promoting tax-avoidance transactions.

In litigation that came to haunt recent California gubernatorial candidate Bill Simon, KPMG, one of the major accounting firms, is being pressed by the IRS to disclose its tax-shelter clients and tax-avoidance transactions.

Some marketed tax-avoidance transactions have been more successful. A scheme promoted by Twenty-First Securities Corp., an investment banker, involving foreign tax withholding on dividends and the U.S. tax credit, and sold to Compaq Computer Corp., was rejected by the Tax Court as being without economic substance, but approved by the 5th Circuit Court of Appeals. The same transaction sold to IES Industries, also rejected by the Tax Court, was approved by the 11th Circuit Court of Appeals. Compaq derived an after-tax profit of $1.2 million, while the deal cost the United States $2.7 million in lost revenue. The U.S. Treasury would have been better off simply making a $1.2 million gift to Compaq. Congress has enacted legislation to bar that particular transaction in the future, but only after considerable loss of revenue.

Again reversing the Tax Court, the 11th Circuit Court of Appeals also accepted a transaction structured by United Parcel Service to shelter substantial income generated by excess damage insurance on goods shipped by it. The income was shifted to an off-shore subsidiary where it was outside the jurisdiction of the U.S. tax law. Some U.S. corporations, including Tyco, Ingersoll-Rand and McDermott, have reincorporated their parent corporations outside the United States to avoid U.S. tax on income earned in other countries. After substantial adverse publicity, Stanley Tools abandoned plans to undertake this arrangement.

The deception isn’t limited to corporations, of course. Individuals have used offshore bank accounts to hide income from the U.S. government. To bring the money into the United States without detection, they have used credit cards issued by the foreign bank that holds the offshore income. The IRS is attempting to identify these taxpayers by issuing subpoenas to credit card companies. But the government’s ability to identify this hidden income and prevent it is limited.

In fact, the IRS has only been weakened in recent years. After highly publicized hearings in the Senate Finance Committee in 1998 that alleged several instances of IRS abuse of individual taxpayers, Congress enacted legislation that restricted the ability of the service to audit returns and collect revenue due. Subsequent investigation establishing that the allegations of IRS abuse were unfounded received little publicity. Meanwhile, Congress underfunds the IRS and enacts provisions that make the tax system increasingly difficult to understand by taxpayers or to enforce by the government. (The IRS’ ability to audit tax returns has declined to about 1 percent of all returns filed.)

Given weakening enforcement and corporate tax sidestepping, is the average person foolish not to engage in a little self-help tax sheltering and fudging on the tax return? Is the same person foolish not to steal a candy bar at the grocery store check-out because someone else did? If everyone steals a little from the local grocery store, it goes out of business. The proliferation of tax avoidance schemes may also affect the way that government does its business. The result might be higher tax rates or increasing governmental deficits.

The maintenance of a sound system of taxation, fairly applied, remains critical to the high standard of living that we enjoy in the United States. Congress should be reminded that we expect a fair system of taxation with adequate enforcement to stop the tax cheats.

Law professor Daniel Simmons ’68, J.D. ’71, is an expert on tax law and author of numerous books and journal articles on federal income taxation. In 1978 he served as a task force leader for the California Commission on Governmental Reform, and in 1986–87 he served as professor in residence with the IRS’ Office of Chief Counsel.