KPMG, Ernst & Young Made Clients' Taxes Vanish, so IRS Appeared
By Ed Leefeldt and Jack Duffy
New York, March 14 (Bloomberg) -- Peter Loftin accepted KPMG LLP's word when the accounting firm promised he could avoid taxes on a $30 million gain with the right offshore investments. The Internal Revenue Service says the plan was too good to be true.
The agency is auditing Loftin, chairman of Raleigh, North Carolina-based BTI Telecom Corp., a closely held provider of telephone and Internet service. Loftin's lawyer declined to say whether he'd received a bill yet from the IRS, adding that his client expects to pay a ``substantial'' settlement.
That puts Loftin among many wealthy individuals who made the mistake of investing in so-called basis-shifting tax shelters marketed by U.S. accounting firms in the late 1990s. The firms promoted the idea -- discredited by the IRS two years after the Loftin transaction -- that they had found ways for one investor to count another investor's costs, or basis, as his own to create capital losses.
``All the big accounting firms had similar products,'' said Joseph Bankman, professor of law and business at Stanford University Law School and co-author of ``Federal Income Taxation,'' a legal reference. ``While they could do it, the fees were quite lucrative.''
Accounting firms often charged as much as $1 million just to explain a tax shelter strategy under a confidentiality agreement and millions more to execute it.
New York lawyer Blair Fensterstock is suing Ernst & Young LLP on behalf of four Indianapolis-based business partners who say they paid $1 million to learn about a shelter and total fees of $7 million to the firm, their banks and lawyers. Fensterstock's suit claims the tax shelter was ``unlawful and unregistered.''
Assurances
Ernst & Young spokesman Larry Parnell said the fourth-largest accounting firm has shut down a group that sold tax strategies for wealthy individuals. He said the firm continues to devise strategies for corporate clients but won't do transactions whose only purpose is tax avoidance.
Through his lawyers, Loftin declined to comment on his suit against KPMG, the third-largest U.S. accounting firm.
``He was assured the strategy complied with tax rules,'' said Steven Shulman, a New York attorney representing Loftin in the lawsuit against KPMG. The suit, filed in the U.S. District Court for the Southern District of Florida, claims that KPMG pushed a high-risk strategy without describing its dangers.
KPMG spokesman Tim Connolly declined to comment on Loftin's case or on specific tax shelter strategies.
``KPMG doesn't offer abusive tax shelters,'' Connolly said. ``As a matter of policy we do not offer transactions listed by the IRS.'' Listed transactions are those the IRS deems abusive.
Shelters Boomed
Tax shelters were thrust into the spotlight in January after Sprint Corp. forced two top executives, Chief Executive William Esrey and President Ronald LeMay, to step down.
Ernst & Young, which served as Sprint's auditor, also provided tax advice to Sprint executives. Both men followed Ernst & Young's counsel in using a shelter to slash tax bills on more than $100 million in stock option profits. The IRS challenged the shelters, and Esrey said he faces back taxes that would wipe out his assets.
Shelters like those used by Sprint executives proliferated in the late 1990s as the economy boomed and the Nasdaq Composite Index gained more than 400 percent in the last half of the decade. Unlike past tax-avoidance strategies where taxpayers invested in tangible assets such as real estate, these shelters bought and sold stocks, currencies and other financial instruments.
The IRS is now disallowing many of them. After the agency offered amnesty from penalties, 1,206 taxpayers reported they had participated in basis shifting and other strategies, claiming losses of $30 billion.
Retail Market
``The shelter market went retail in the late 1990s and became a problem of much greater magnitude because of the sheer number and variety of the transactions,'' said David Weisbach, a University of Chicago Law School professor who was an attorney in the Office of the Tax Legislative Counsel at the Treasury Department under President Bill Clinton.
Basis shifting became a common strategy. Under the tax code, the basis is the price of buying an asset plus the cost of the transaction and serves as a starting point for calculating gains and losses when the asset is sold.
The IRS permits one taxpayer to assume another's basis under limited circumstances, accountants and tax experts said. They cited, for example, corporations owned by married couples. There, the tax code allows one spouse to sell shares in a family-owned business back to the corporation, report the income as a dividend and pass the shares' basis to the other spouse.
Offshore Strategy
``It's a rule for very special situations,'' said Bankman. ``Like most tax shelters, it was seized upon by clever promoters and made into something totally different.''
According to Emily Parker, deputy chief counsel for operations at the IRS, accountants tried to apply principles that cover married co-owners of a business to taxpayers who were making offshore investments. IRS spokesman Ken Hubenak said the agency does not comment on individual cases.
A typical strategy involved having a client purchase a controlling interest in a Cayman Islands corporation. The client and the corporation would then buy and sell shares of a foreign bank that was outside the U.S. tax jurisdiction, often using the bank to finance and execute the transactions.
The corporation would count the proceeds of the share sales as dividends, which are untaxed in the Caymans, and shift its basis in the investments to the client. The client would then reduce his tax bill by claiming the corporation's stock purchase costs on his U.S. return, according to tax experts who have studied the deals.
Creating Losses
Loftin, who founded BTI in 1983 at the age of 24, sold his stake in FiberSouth, a fiber optic network, for a $30 million gain in 1997. The tax shelter designed by KPMG worked as follows, according to his suit:
On Sept. 16, 1997, Loftin bought a warrant for 4,250 shares in Larkhaven Capital Inc., a company chartered in the Caymans, for $2.1 million. The purchase gave him a controlling interest in Larkhaven. That same day, Loftin also bought 1,408 shares of Union Bank of Switzerland, now part of UBS AG, establishing an investment with a basis of about $1.5 million.
Also on Sept. 16, Larkhaven bought 28,392 Union Bank shares, creating a basis of more than $29 million. Larkhaven financed the purchase with a UBS loan and sold the bank an option allowing it to repurchase the shares by Nov. 5, 1997.
On Nov. 5, Larkhaven started the process of shifting its basis to Loftin. The corporation sold its shares back to UBS for more than $29 million and repaid its loan. Larkhaven would count the proceeds of the sale as a dividend, which would not be taxed in the Caymans, according to Bankman and other tax experts. On the same day, Loftin bought call options giving him the right to acquire the same number of UBS shares.
Sounding Retreat
About a month later, Loftin sold his UBS stake for about $1.8 million, liquidated his Larkhaven warrants and left behind an unexercised option on UBS shares. He also assumed Larkhaven's $29 million basis and used it to claim $27.4 million in capital losses, wiping out most of his gain from the FiberSouth sale.
``Larkhaven gets the dividend and the basis flows to Loftin,'' said Bankman. ``In the end he sells everything and roughly breaks even, but reports a $27 million dollar loss because he got a bump-up in his basis.''
Union Bank, which in 1998 merged with Swiss Bank Corp. to form UBS AG, is not named as a defendant in the suit. UBS spokeswoman Monika Dunant declined to comment, citing client confidentiality.
Accounting firms retreated from selling tax shelters as the IRS began disallowing losses and sued shelter promoters to get names of clients.
Lawsuits
PricewaterhouseCoopers, the largest accounting firm, stopped developing ``mass-marketed, one-size-fits-all tax products'' in 1999, two years before the IRS ruled that basis-shifting shelters were disallowed, spokesman Steven Silber said.
Deloitte & Touche LLP, the second-largest accounting firm, would not discuss any aspect of its tax practice, according to spokeswoman Deborah Harrington.
Some taxpayers who invested in basis-shifting shelters only to be audited later by the IRS are suing the accounting firms that structured them.
James Gilreath, who heads a Greenville, South Carolina-based law firm, said he has filed two lawsuits against KPMG and is in talks with other former clients of the accounting firm to file a number of additional suits.
Gilreath is representing six members of two North Carolina families -- the Colemans and Thorpes -- who faced tax bills after reaping gains in 1998. The Colemans sold the Asheville Mall in Asheville, North Carolina, while the Thorpes liquidated a stock portfolio owned by their company, Thorpe & Co.
IRS Crackdown
``This was an off-the-shelf product sold in the same way to the same types of people all across the country,'' Gilreath said.
Fensterstock, the New York lawyer who is suing Ernst & Young, represents business partners Henry Camferdam, Jeffrey Adams, Jay Michener and Carol Trigilio.
The four sold an Indianapolis-based mainframe computer business in 1999 for a $70 million gain and invested in a tax shelter that used trading in foreign currency options to create capital losses. Their suit, filed in the U.S. District Court for the Southern District of New York, claims that 47 Ernst & Young clients paid the firm a total of $50 million to make similar investments.
The IRS began a tax-shelter crackdown in 1999, outlawing a shelter that created losses through a foreign-owned corporation. In September 2000, the agency disallowed losses from ``inflated partnership basis transactions'' and added basis-shifting transactions to its list of abusive shelters in August 2001.
Rules Revised
The IRS also began to track down taxpayers who had used the strategies and the firms that had promoted them.
``We recognized that the marketing had shifted from corporations to individuals,'' said Pamela Olson, Treasury assistant secretary for tax policy. ``One scheme promoted by a tax shelter network led to 600 tax returns and 580 were individuals.''
The IRS issued revised rules Feb. 27 aimed at ferreting out tax shelters. They require taxpayers and accountants to report transactions to the IRS if they are marketed under conditions of confidentiality; generate losses above certain amounts; involve assets owned for brief periods; or have been previously identified by the IRS as a tax shelter.
B. John Williams, the IRS's top lawyer, said the moves are having an effect. ``We are seeing strong anecdotal evidence that the investments are dropping off,'' he said at a press conference Feb. 27. |
