A Taxing Blog

Friday, July 11, 2003
From the comment box on econprof Brad DeLong's blog, following his snip on the Myron Scholes / LTCM tax shelter trial:

The mind-bending part is that the $900,000 spent on the legal opinions that stated the transaction had economic substance in the IRS sense, may have actually stripped the transaction of economic substance. Perversely, the more time the lawyers billed, the less the opinion was worth.

Posted by Sequoia at July 10, 2003 02:15 PM

Brilliant observation.

Thursday, July 10, 2003
Update on applying economic substance  
A practitioner from a nyc firm notes that if the proposal to codify the economic substance doctrine is enacted, it would make clear that transaction costs are to be deducted first from the calculation of pretax profits. She notes that this is consistent with current law: "In general, for there to be an expectation of pre-tax profit for the purposes of determining whether there was economic substance in a transaction, there must be a reasonable expectation that nontax benefits will meet or exceed transaction costs. See, e.g., Yosha v. Commissioner, 861 F.2d 494, 498 (7th Cir. 1988)."

I would add that by stating that the nontax benefits must "meet or exceed transaction costs" (rather than just "exceed" or "significantly exceed"), the Yosha court could be read as suggesting that a peppercorn of nontax profit --- which would "meet" transaction costs --- might be enough. Other courts have suggested that modest profits relative to substantial tax benefits might not be enough.

The Daily Saga of Myron Scholes  
More from the NYT on the testimony of Myron Scholes regarding a tax shelter entered into by LTCM.
Then Mr. Hurley shifted tactics. He eased up in his style and began taking apart various dimensions of the potential profits and risks in the tax shelter, all the while pacing back and forth at the lectern, his suit coat buttoned, his right hand deep in his pocket.

Again and again his line of questions ended with Dr. Scholes confirming that the tax shelter had to make a profit apart from the tax benefits. He urged Dr. Scholes to put a figure of $900,000, maybe $1 million, on the potential profits apart from the tax benefits.

Mr. Hurley's endgame began to emerge when he started asking about fees for opinion letters from lawyers saying that the tax shelter should survive an audit. The letters, by the Shearman & Sterling law firm in New York and King & Spaulding in Washington, cost more than $900,000.

Then there was the bonus to one Long-Term executive, somewhere from $50,000 to $100,000, Dr. Scholes confirmed.

And finally there was the big question, though it was asked so subtly that the first time Dr. Scholes answered without much argument. Yes, he testified, he had asked for and received a multimillion-dollar bonus from the other partners in Long-Term Capital for finding the tax shelter and strengthening it.

Between the opinion letter fees and the bonus for the one executive, the tax shelter could only, barely, show a profit. Add in the millions paid as a bonus to Dr. Scholes and the shelter could not show a profit apart from the tax benefits.

Interesting question -- under the economic substance doctrine, I don't think there is any clear law on how much potential profit a deal must have --- is 10% enough? 1% enough? a penny? And what happens if the potential profit is eaten up by transaction costs?

The DOJ will clearly be arguing that one must deduct professional fees before making this calculation, as Scholes admitted that there was no potential profit if one deducts the fees and bonuses off the top. Is anyone aware of any law on point?

Wednesday, July 09, 2003
Scholes and Tax Shelters  
David Cay Johnston has another NYT article on tax shelters, this time discussing the testimony of the economist Myron Scholes, who was a principal in Long Term Capital Management. (LTCM, for those of you who may not recall, was the hedge fund that needed to get bailed out a few years ago. LTCM was apparently also into some shady tax deals.)

The article also discusses the testimony of a Shearman partner, who acknowledged on the stand that he never checked the assumptions of the parties, and yet he relied on those assumptions in rendering the tax opinion. Absurd as this sounds, it is a common practice. I've always wondered at what point the opinion writer has a duty to investigate questionable assumptions, e.g. as to the valuation of property contributed to a partnership.

Also interesting to me is the involvement of Scholes in this tax shelter. Scholes & Wolfson have the leading textbook on tax planning, "Taxes and Business Strategy." Used mainly in B-schools, it is gaining attention in law schools as well. One could argue that the textbook implicitly suggests that legal rules are just another friction to be circumvented in pursuing the highest after-tax return on investment --- in other words, that there is nothing unethical about entering into convoluted deals for no other purpose than to reduce a firm's overall taxes. Someday soon I hope to write an article on the impact of Scholes and Wolfson on modern tax planning.

Tuesday, July 08, 2003
Tax Shelter Opinions  
On the subject of tax shelter opinions, the following description in the June edition of the American Lawyer (no link available) of an Enron tax shelter opinion written by Bill McKee (one of the best-known and highest-paid tax lawyers in the country) caught my eye. The quote is from John "Buck" Chapoton, former Assistant Secretary to the Treasury for Tax Policy, and it describes a McKee opinion for which King & Spalding (then McKee's firm) was paid $1 million as follows: "It's just such bullshit. It's ludicrous on its face. Nobody who was getting paid by the hour, who was charging the same whether or not they approved the deal, would give that opinion."

NYT article on Tax Shelter strategy  
Here's a NYT article by David Cay Johnston on the IRS's "general deterrence strategy towards tax shelters. The basic idea is that, like speeding, it's impossible to catch everyone, but that a well-placed cop pulling someone over on the shoulder slows everyone else down too.

Chris Bergin of Tax Notes has an interesting quote in the article:
"Christopher Bergin, the chief executive of the nonprofit organization Tax Analysts, which publishes the journal Tax Notes, said, 'Everyone, and I really do mean everyone, in the tax business knows that these letters are worthless and that a few guys are getting incredibly rich off of them.'
Mr. Bergin also faulted the government for not moving against any tax lawyers or law firms through Circular 230.
'The government has not made one lawyer who wrote one of these letters, for which they charge up to a million dollars, a copy walk the plank,' he said. 'They need to make an example of someone, a big someone, so the next guy says to himself that he had better not misbehave.'"

Easier said than done, I suspect.

Search WWW Search taxpolicy.blogspot.com