Case: KPMG’s Tax Shelter Business
In the 1990s, KPMG, one of the “big four” accounting firms, began offering tax shelters to corporations and wealthy investors. In addition to standard audit and consulting ser- vices, KPMG aggressively developed and marketed a number of innovative ways for clients to avoid taxes. Not only did individuals and businesses reduce taxes on billions of dollars of gains, but also KPMG partners pocketed many millions for their assistance.
Acting like any business developing a new product, KPMG established a “Tax Innovation Center” to generate ideas and to research the accounting, financial, and legal issues.66 Previously, tax shelters had been individualized for particular clients, but the new ones were intended to be generic, mass-marketed products. Once a strategy was approved, it was energetically promoted to likely clients by the firm’s sales force. KPMG tax professionals were turned into salespeople. They were given revenue targets and urged to use telemarketing and the firm’s own confidential records to locate clients. The strategies—which bore such acronyms as OPIS, BLIPS, FLIP, and SOS—generally involved complicated investments with cooperating foreign and offshore banks that generated phantom losses that could be used to offset capital gains or income from other investments. The shelters were accompanied by opinion letters from law firms that assessed their legality. The gain to KPMG and its clients and the loss to the
U.S. Treasury were significant. The four main tax shelters marketed by the firm generated over $11 billion in tax deductions for clients, which yielded at least $115 million in fees for KPMG and cost the government $2.5 billion in lost tax revenue.67
During the period in which the KPMG tax shelters were sold, no court or Internal Revenue Service (IRS) ruling had declared them illegal. However, KPMG had failed to register the shelters with the IRS as required by law. Registration alerts the tax authorities to the use of the shelters and permits them to investigate their legality. One KPMG partner attributed this failure to a lack of specific guidance by the IRS on the rules for registration and the agency’s lack of interest in enforcing the registration requirement.68 Furthermore, this partner calculated that for OPIS, the firm would pay a penalty of only $31,000 if the failure to register were discovered. This amount was more than outweighed by the fees of $360,000 for each shelter sold.69
Until a court or Congress explicitly outlaws a tax shelter, the line between legal and illegal tax strategies is often difficult to draw. The IRS typically employs the “economic substance” test:
Do the transactions involved in a tax shelter serve a legitimate investment objective or is their only effect to reduce taxes?
A tax shelter that offers no return beyond a tax saving is abusive in the view of the IRS. However, an IRS ruling is not legally binding until it is upheld by the courts, and the courts have occasionally held some shelters to be legal even if they do not involve any risk or potential return. One rea- son for such decisions is that tax shelters typically involve legitimate transactions combined in unusual ways. As one observer notes, “Most abusive shelters are based on legal tax-planning techniques—but carried to extremes. That makes it hard to draw sharp lines between legitimate tax planning and illicit shelters.”70 Even when a shelter like those sold by KPMG is found to be legal, a tax savings is almost always the only outcome. According to an IRS com- missioner, “The only purpose of these abusive deals was to further enrich the already wealthy and to line the pockets of KPMG partners.”71
When a tax shelter is found by the court to be abusive, the usual outcome is simply a loss of the tax advantage so that the client pays what would be owed otherwise plus any penalties. The issuer is seldom sanctioned. KPMG and other marketers of tax shelters generally protect them- selves, first, by having the client sign a statement affirming that he or she understands the structure of the transaction and believes that it serves a legitimate business purpose. This makes it more difficult for the client to sue the firm. KPMG also sent all related documents to its lawyers in order to protect them from disclosure by claiming lawyer– client privilege.
Although some partners at KPMG thought that the tax shelters were illegal and raised objections, others argued for their legality—and, in any event, their shelters were an immensely profitable part of the firm’s business. Aside from the huge fees, the motivation to market the Welfare shelters came from the KPMG culture, which New York Times business reporter Floyd Norris characterized as that of a “proud old lion.” He writes, “Of all the major accounting firms, it was the one with the strongest sense that it alone should determine . . . the rules it would follow. Proud and confident, it brooked no criticism from regulators.”
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