+ What is a tax shelter?

University of Texas law professor Calvin H. Johnson has written about the various definition of a tax shelter. "My favorite definition of a tax shelter is that it is an investment that is worth more after tax than before tax," he says. "A tax shelter saves the investor tax that would otherwise be paid on consumed amounts or other outside income. A tax shelter has a higher rate of return because Uncle Sam tries to run a tax system than it would have if Uncle Sam let the taxpayer go."

+ What's the difference between legitimate and illegitimate tax shelters?

Many people take advantage of legitimate tax shelters, such as Roth IRA accounts, deductions for home mortgage interest or small business R&D investments. These are deductions sanctioned by Congress, often for social purposes.

Illegitimate tax shelters, however, often arise when sections of the tax code, or multiple sections of the code, are used for purposes not originally intended by Congress or the IRS. In that way, illegitimate shelters may conform "technically" with the code, and yet violate the "spirit" of the code. As the tax code has become more and more complex, "technical" manipulation of the code has become more and more problematic.

A 1999 Treasury Department white paper identified common characteristics of illegitimate tax shelters as:

• A lack of economic substance (see explanation below) or business purpose

• Inconsistent financial accounting and tax treatments (see book v. tax income below)

• The participation of "tax-indifferent parties," such as foreign or tax-exempt entities that receive a substantial fee to enter into the shelter transaction

• Marketing activity -- in other words, a shelter that is designed to be used by multiple participants, as opposed to an individual shelter designed to meet the needs of a particular client

• Secrecy -- Many of the 1990s tax shelter promoters required the investor to sign non-disclosure agreements to keep the transaction from their competitors or the IRS

• A fee structure based on the tax savings of the client

• High transaction costs

Some offer a more simple explanation. Yale Professor Michael Graetz describes an illegitimate or abusive shelter as "a deal done by very smart people that, absent tax considerations, would be very stupid."

+ What is "economic substance"?

The economic substance doctrine says that a transaction must have a meaningful economic purpose or investor risk to be legitimate. A correlation to the economic substance doctrine is the business purpose doctrine, which says a shelter should have a legitimate business purpose outside of the tax savings. The question of whether to codify -- or write into law -- an "economic substance rule" is at the heart of the current controversy over legislative efforts to address the abusive tax shelter problem.

+ How big is the problem of abusive tax shelters?

Estimating how much abusive tax shelters cost the U.S. Treasury is very difficult. Some estimate the cost is in the tens of billions every year and a few deem it as high as $50 billion a year. Others suggest that the abusive shelter problem has largely abated -- a victim of the recession, increased regulatory requirements (such as the Sarbanes-Oxley legislation regulating the accounting industry) and post-Enron sensitivity to good corporate governance. Former IRS Commissioner Charles Rossotti believes, however, that the "fundamental drivers" behind the shelter problem remain present and that abusive shelters will rebound as the economy improves.

In October 2003, the General Accounting Office (GAO) released a report, "Challenges Remain in Combating Abusive Tax Shelters" that notes, "Although they do not have a reliable measure of the size of the abusive shelter problem, Treasury and IRS believe that tens of billions of dollars of taxes are being improperly avoided and the potential for proliferation of abusive shelters is strong."

According to the GAO report, the IRS estimates that $33 billion was lost to the abusive shelter problem between 1993 and Sept. 30, 2003, but the GAO notes that that figure only includes transactions the IRS had uncovered.

Whatever the actual cost, former IRS Commissioner Rossotti says that abusive tax shelters are the "biggest single source" of a larger problem -- the gap between taxes owed and taxes collected. The total uncollected tax gap, Rossotti says, is somewhere in the range of $250 to $300 billion per year -- which, he says, is the equivalent of a 15 percent surtax on the honest taxpayer.

+ What's the difference between what happened with tax shelters in the 1990s vs. the 1970s and 1980s?

In the 1970s and 1980s, illegitimate tax shelters tended to be based on exploiting a specific loophole in the tax code.

In the 1990s, however, as the bull market exploded, companies came under increasing pressure to keep their profits and stock prices up. One favored means was to drive down the tax line of their corporate returns. According to Harold Handler, former chair of the Tax Section of the New York State Bar, "What changed in the '90s was that the tax line of the financial statement became a profit center for many corporations."

The other big change was in how tax shelters were marketed. Tax firms that previously responded to client needs, (i.e., reviewing business transactions to help minimize the tax implications) turned to pushing tax products that had no connection with the client's business needs. "That's bothersome," says Handler, "because it changes the dynamic of what you're doing. You're no longer doing real things, but you're doing artificial transactions for the purpose of reducing tax only." Buck Chapoton, a treasury official in the Reagan administration, says many of the shelters of the 1990s were "sham transactions. … They simply were financial mechanisms for creating tax losses."

+ How did concern about abusive tax shelters emerge?

Under U.S. law, corporations are allowed to keep two sets of books -- a bullish book income report released publicly to shareholders and a lowball tax income report provided to the IRS. Schedule M on the corporate tax return is where companies reconcile differences between what is reported to Wall Street and what is reported to the IRS.

In the late 1990's, officials at the Treasury Department noticed that the gap between book and tax income -- known as "Schedule M gap" -- was widening. "There's always been a gap, but the gap gapped," says former Treasury Secretary Lawrence Summers. "There was discontinuity. The income to shareholders went up rapidly. The taxable income reported to the IRS stayed the same, and in some years, actually declined. It was pretty obvious that the reason had to be more shelter[s] and activity of various kinds."

+ How has sheltering affected corporate tax revenues?

In October 2000, Robert McIntyre, director of the Institute on Taxation and Economic Policy, released a study that looked at the tax rates of 250 large U.S. corporations between 1996 and 1998. The study found that in 1998, the average effective tax rate companies were paying was 20 percent -- in contrast to the corporate tax rate of 35 percent. "Lately, we think the rate is down to about 15 [percent]," McIntyre says. "In other words, companies are paying less than half of what they're supposed to."

It should be noted that McIntyre's study does not identify how corporations reduced their effective tax rates or to what extent illegitimate tax shelters may have contributed. But, McIntyre believes that the effective rates were much lower because "there are so many [tax code] loopholes, so many shelters."

As effective corporate tax rates have dropped, so too has the total share of the tax burden shouldered by corporations. Over the past 50 years, says McIntyre, corporate tax revenues have averaged about 17 percent of the total tax take. But now, he says, corporate tax revenues account for 7 percent of all tax revenues collected by the government -- the second lowest level since the Great Depression.

+ What is the IRS doing about the problem of abusive tax shelters?

The IRS tries to discourage the use of illegitimate tax shelters by identifying and publishing transactions that it believes are "abusive." The process, called "listing," is intended to put taxpayers on notice that the IRS will not recognize, or allow, certain types of transactions. The IRS has published a list of more than 25 transactions that it has determined to be abusive or illegal. That list can be found on the IRS Web site.

In addition, the IRS is going after tax shelter promoters, trying to enforce requirements that promoters register all shelter products and maintain lists of clients who use these products. The Department of Justice, on behalf of the IRS, has brought several cases against promoters -- including KPMG -- for failing to register their products and/or provide client lists when requested. Some promoters have settled with the government. Others, continue to fight the legal proceedings.

The IRS also offers periodic amnesties to investors to try and get them to come forward with information about shelter promoters and transactions. In these cases, the IRS will lessen the penalties on the investors to induce them to come forward.

According to IRS Commissioner Mark Everson, the agency currently has 100 active investigations of tax shelter promoters underway.

+ What are Congress and the Bush administration doing to resolve the problem of abusive tax shelters?

Both the Senate and the House of Representatives have held hearings over the past few years examining the tax shelter problem. Several lawmakers have introduced bills to address the problem. Most bills include provisions that would increase penalties on shelter promoters for failing to register their products. The Senate has passed broad shelter reform legislation that includes both increased penalties and codification of the "economic substance" doctrine. But, similar legislation has repeatedly stalled in the House Ways and Means Committee.

The Bush administration has included several provisions relating to abusive tax shelters in its budget for Fiscal Year 2005. The administration's proposals include an increase in promoter penalties and an increase in the IRS enforcement budget, but the administration opposes efforts to turn "economic substance" into a statutory standard. They believe a legislative standard would be difficult to interpret and enforce and that determining "economic substance" should be left to the courts.

Former IRS Commissioner Charles Rossotti and former Treasury Secretary Lawrence Summers, however, believe that Congress should pass a broad rule that outlaws any transaction lacking economic substance.

Read more about the debate over economic substance