A fundamental objective of the federal tax law is to raise revenues to cover the cost of government operations. Ordinarily, Congress will set annual budgets, based on anticipated revenues, to plan expenditures and create a balanced budget. Until recently, the last balanced budget was in 1969. Beginning in 1970, there were 28 straight years of deficits. The budget was again balanced from 1998 through 2001, but, since 2002, the federal budget has run at a deficit—in fact, the largest in the nation’s history.
The internal revenue code (IRC) comprises numerous code sections, complete with abrupt twists and sudden stops. It has been a complaint of U.S. taxpayers that the tax code is too complicated, often defying logic. Even trained professionals can be baffled by the complexity of a tax return. Recently, the Internal Revenue Service (IRS), the governmental body charged with collecting taxes and auditing tax returns for compliance, has stated that its mission is to simplify the tax code. However, ask any tax professional, and he or she will tell you that, to date, simplifying the tax code has seemingly resulted in three additional binders of tax code.
The IRS distributes more than 650 types of tax forms, schedules, and instructions (Hoff man et al. 2009). That being said, there often is a reason behind every oddity that occurs in the tax code, whether it is an economic, social, or political reason. An example is how the federal government has tried to encourage charitable giving to nonprofit organizations. An individual’s ability to deduct charitable contributions from his or her taxes is a social practice that Congress has encouraged through tax deductions. Another example is research and development credits, which are given to encourage organizations to develop innovative ideas and processes.
II. What Is a Tax Shelter?
III. Why Tax Shelters Are Harmful
IV. Why Tax Shelters Can Be Beneficial
V. Solutions to Abusive Corporate Tax Shelters
During the thriving 1990s, business in the United States was growing at unprecedented levels, breaking many corporate earning records. Between 1988 and 1998, corporate revenues grew 127 percent, from $292.5 billion to $666.4 billion. The surge also had a positive impact on the U.S. Treasury. Throughout this time period, reported corporate taxable income increased by 99 percent, or from $94.5 billion to $188.7 billion (Crenshaw 1999). So why did corporate taxes not keep pace with corporate revenues? Experts say that this was due to the emergence of complicated tax shelter plans.
During the 1990s, a peculiar situation developed where, by strict application of the IRC, tax professionals were able to create paper losses that a corporation would be able to use to offset income. This strange phenomenon caught the eye of the IRS in the late 1990s as it began discover the flourishing industry of marketed tax planning packages that enabled corporations to lower their total taxable income and, ultimately, pay less in taxes. In 1999, Stanford law professor Joseph Bankman projected the cost to the U.S. Treasury to be at $10 billion (Stratton 1999). It is reasonable to expect the current cost to have grown greater since that time.
Total corporate taxes paid as a percentage of the entire amount of taxes collected by the IRS have fallen significantly over the past two decades as corporations have found and exploited loopholes in the IRC. These loopholes allow them to reduce their total tax bill, usually by concealing revenues or accumulating additional expenses. For example, a corporation is taxed on its net income, which is generally calculated by taking total revenues received less total expenses incurred to generate the income. By lowering revenues or amassing additional expenses, you can lower your net income and, effectively, your total tax due. These loopholes manipulate the IRC in ways that were never intended by Congress. Tax sheltering methods can be legitimate or illegitimate. Naturally, there are two sides to this debate. On one hand, if a given transaction follows the letter of the law, then how can it be considered abusive or unethical? Conversely, it is justifiable to deem transactions that contain no economic gain, aside from lowering an entity’s tax liability, as fraudulent tax reporting?
What Is a Tax Shelter?
There is no clear definition that characterizes all tax shelters. The purpose of a tax shelter is “to reduce or eliminate the tax liability for the tax shelter user” (Committee on Governmental Affairs 2005, 1). The definition of a tax shelter would include both legitimate and illegitimate actions. The controversy centers on what is considered tax planning and what is considered abusive tax sheltering.
There are many instances written into the IRC that allow a company to structure a transaction that will reduce the tax liability of the organization. It is reasonable for a person to plan his or her affairs so as to achieve the lowest tax liability. Judge Learned Hand is cited as saying, “There is not even a patriotic duty to increase one’s taxes” (Gregory v. Helvering 1934). It is reasonable to believe that if these taxpayers follow the IRC, they should be rewarded for their proper planning and work. For years, tax minimization tactics have been used and have afforded taxpayers the ability to properly plan transactions to achieve the least tax consequences. However, it should be noted that these minimization tactics have been done using acceptable, practical procedures. The argument next focuses on whether these transactions ordinarily contain substance and motivation on some economic level to justify performing the transaction.
Abusive tax shelters can be categorized as financial mechanisms with the sole purpose of creating losses to deduct for tax purposes (Smith 2004). These complex transactions produce significant tax benefits in ways that were never intended by the tax code. These benefits were never expected by the underlying tax logic in effect and, in essence, are transactions used only to avoid or evade tax liability.
Since there is no firm differentiation between legitimate and illegitimate tax planning, it is hard to tell where the line is. A working definition of an abusive tax shelter is a “corporate transaction involving energetic paper shuffling aimed at having favorable tax consequences along with no, or next to no, economic consequences other than the tax consequences” (Shaviro 2004, 11). The purpose of these types of transactions is to create transactions that will generate tax losses that can be off set against other taxable income. There is no economic sense to these transactions except to generate these losses and reduce the total tax liability.
At its core, the IRS is the agency exclusively responsible for detecting any transaction with the sole purpose of eliminating or avoiding taxes. The IRS, through audits of filed returns, and the U.S. Treasury have begun to spot and publish legal regulations on transactions they consider abusive. These mandates warn taxpayers that use of such listed transactions may lead to an audit and assessment of back taxes, interest, and penalties for using an illegal tax shelter.
The IRS requires that, under certain circumstances certain transactions be reported and disclosed to the IRS as potentially illegal tax shelter transactions. A listed transaction is one that the IRS has determined to have a potential for tax avoidance or evasion. In addition, transactions that are similar in their purpose to the listed transactions require similar disclosure. The IRS uses several distinctive judicial doctrines to determine whether a transaction is legitimate or abusive in nature.
Why Tax Shelters Are Harmful
When enacting changes to the tax code, Congress is often directed by the concept of revenue neutrality. Revenue neutrality is the idea that new legislation will neither increase nor decrease the net revenues produced under existing laws and regulations. In other words, the total revenues raised after new tax laws are passed should be consistent with revenues generated under the prior tax laws. One taxpayer will experience a decrease in tax liability, however, at another taxpayer’s expense.
When corporations engage in illegitimate tax sheltering schemes, they, in essence, steal from the U.S. Treasury. Over the years, billions of tax dollars have been lost. Recently, the IRS and Congress have taken a firm position with legislation to impede tax shelters that have been identified. It is estimated that legislation to prohibit certain shelter transactions, specifically lease-in lease-out shelters and liquidating real estate investment trust transactions, have saved taxpayers $10.2 and $34 billion, respectively (Summers 2000).
When corporate taxpayers do not pay their respective tax liabilities, the result is lower revenues for the U.S. Treasury, which ultimately causes or escalates a government’s deficit. Congress, the U.S. Treasury, and individual U.S. taxpayers are dependent on corporations paying their fair share of the tax bill to maintain government operations. Shortages in tax revenues can make fiscal planning difficult when budgeted income falls short of what was anticipated and pledged for various governmental programs.
To maintain tax revenue collections, Congress has only a couple of options: raise corporate taxes or raise individual taxes. Buried deep in the corporate tax shelter controversy is their effect on individual taxpayers. A side effect of a corporation engaging in fraudulent tax practices is that the federal government redistributes the tax burden, ordinarily, back onto the remaining taxpayers, who would otherwise enjoy a tax reduction. To say it differently, the rest of the population picks up the tab for the use of abusive corporate tax shelters.
Why Tax Shelters Can Be Beneficial
In the 1980s, President Ronald Reagan cut corporate tax rates as part of his monetary policy. The United States was a leader worldwide in lowering its tax burdens on corporations as a way to facilitate economic growth, and, during the mid-1980s, the United States’ tax rates were the lowest around the world. However, this started a sequence of events where many industrialized countries around the world began cutting their tax rates by an average of 30 percent in response, according to the Organisation for Economic Co-operation and Development (OECD), a group of 30 countries that works to address economic and social issues.
Twenty-five years later, many counties around the globe have surpassed the United States in its tax-cutting policies. Federal and state corporate taxes average 39.3 percent, approximately 10 percentage points higher than the OECD average (“Let’s Make a Deal” 2005). To look at it from a different angle, a corporation in the United States has Uncle Sam as more than a one-third shareholder.
Indeed, of the 30 wealthiest countries in the world, the United States now levies one of the highest corporate income tax rates on its businesses (along with Japan, Canada, Germany, and Spain). In 1996, these 30 countries’ average corporate tax rate was 38–30 percent that in the mid-2000s. Overall, global corporate tax rates fell over 20 percent during this time period (Edwards and Mitchell 2008). Although U.S. individual tax rates decreased during this time period, corporate tax rates have remained unchanged.
Furthermore, the effects tax rates have on U.S. businesses go beyond cutting the tax piece of the profits out of a corporation’s net income. The world has become a global marketplace, where executives and managers compete against not only their rivals next door but on the other side of the world. Higher corporate tax rates place U.S. companies at a competitive disadvantage when compared to their foreign counterparts. Higher tax rates produce increased pressure to maintain or lower costs.
Imagine two identical corporations located in the United States and Ireland. Ireland’s corporate tax rate is 12.5 percent. These two companies have the same gross sales and administrative costs and, with all other factors being the same, report the same net income. However, the corporation in Ireland is allowed to keep an additional 27.5 percent of its income in comparison to the one located in the United States (40 percent versus 12.5 percent tax rates). This additional income can be used for additional research and development costs, higher employee wages, or greater dividend payouts for stockholders. To gain greater market share, the Irish corporation is better situated to compete on price and can still produce the same net income after taxes as the U.S. corporation with lower prices.
Having one of the highest tax rates in the world is self-defeating because it encourages U.S. corporations to engage in questionable tax practices as a means of staying competitive globally. Many legal and accounting firms are hired primarily for the purpose of creating arrangements that enable the company to pay little or no tax. With real tax benefits achieved by moving operations to countries like the Cayman Islands, Bermuda, and other international tax havens, many CEOs and boards of directors feel that it is their duty to get involved with these practices.
Solutions to Abusive Corporate Tax Shelters
With high tax rates versus foreign competitors, a potential solution would be to lower the corporate tax rate imposed on U.S. corporations. If a primary reason to engage in questionable tax practices is to become more competitive versus global competition, a tax rate that is more in line with other similar industrial countries could alleviate the pressure that causes corporation managers to investigate these practices. A lower fl at tax rate for all industries could not only benefit corporations, but also their employees, who would work for more competitive organizations. A result would be more jobs and job security. In addition, with the need for tax shelters removed, decreasing the use of phony transactions and bringing into the United States income that was held off shore would create a windfall of revenue for the U.S. Treasury.
When President Reagan first initiated corporate tax cuts as part of the Tax Reform Act of 1985, other countries responded by lowering their tax rates. It is reasonable to expect this same activity to occur again should the United States lower its corporate tax rates, but it probably cannot afford to lower them much more. Only a tax-free situation would ensure that corporations would not find motivation to investigate tax shelter activities.
Another option, the one preferred by President Barack Obama, would be to require that a corporation’s book income be equal to its tax income. Corporations are allowed to maintain two sets of books: book and tax. Book income is what is reported to shareholders, while tax income is what is reported to the IRS for taxation purposes. Many transactions deductible for book purposes are not deductible for tax and vice versa. An example of this is the depreciation expense. Differing methods are required to be used when computing depreciation expenses for book and tax purposes. Generally, tax depreciation allows you to write off the value of an asset much quicker than book. This generates a higher book income and a lower tax income. These types of differences occur quite frequently because book and tax income do not agree.
This encourages managers to perform transactions that show a lower tax income, and therefore a lower tax liability, while still reporting the higher book income to the shareholders. In other words, they are able to realize the best of both worlds. To remedy this problem, making tax income equal to book income would once again deter tax departments from creating loopholes in the tax code designed specifically to maintain book income but lower tax income. The Obama administration has sought to apply this strategy to companies operating out of the Cayman Islands. The administration also worked with the government of Switzerland to revise its tax laws in order to allow the U.S. government to levy taxes on certain U.S. holders of Swiss bank accounts.
Embedded in the IRC are numerous tax-planning possibilities for taxpayers. Many corporations have taken tax planning a step too far, infringing on what may be out of bounds in the field of tax planning. Arguments can be made on both sides of the debate as to why corporations should or should not engage in such activities, but the fundamental reason that abusive tax sheltering is detrimental is its redistribution of the tax burden. In addition, tax-sheltering methods should be considered abusive and rejected in their entirety when they offer a benefit that is inconsistent with the purpose of the tax code.
Keith C. Farrell
- Committee on Governmental Affairs, The Role of Professional Firms in the U.S. Tax Shelter Industry. Washington, DC: U.S. Government Printing Office, 2005.
- Crenshaw, Albert B., “When Shelters Aren’t Aboveboard: IRS, Hill Step Up Efforts as Improper Deals to Help Firms Cut Taxes Rise.” Washington Post (November 23, 1999): E01.
- Edwards, Chris, and Daniel J. Mitchell, Global Tax Revolution: The Rise of Tax Competition and the Battle to Defend It. Washington, DC: Cato Institute, 2008.
- Gregory v. Helvering, 69 F.2d 809, 810 (2nd Cir. 1934), aff ’d, 293 U.S. 465 (1935).
- Hoff man, William H., et al., South-Western Federal Taxation: Corporations, Partnerships, Estates and Trusts. Belmont, CA: Thomson South-Western, 2009.
- “Let’s Make a Deal.” Wall Street Journal (December 28, 2005): A14.
- Rostain, Tanina, “Sheltering Lawyers: The Organized Tax Bar and the Tax Shelter Industry.” Yale Journal on Regulation 23 (2006): 77.
- Shaviro, Daniel N., Corporate Tax Shelters in a Global Economy. Washington, DC: AEI Press, 2004.
- Slemrod, Joel, Taxing Ourselves: A Citizen’s Guide to the Debate over Taxes, 4th ed. Cambridge, MA: MIT Press, 2008.
- Smith, Hedrick, Tax Me If You Can. Documentary. Boston: PBS (a Frontline coproduction with Hendrick Smith Productions), 2004.
- Stratton, Sherly, “Treasury Responds to Critics of Corporate Tax Shelter Proposals.” Tax Notes 84 (1999): 17.
- Summers, Lawrence H., Tackling the Growth of Corporate Tax Shelters. Washington, DC: Office of Public Affairs, Department of the Treasury, 2000.