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Saturday, November 19, 2005

Johnson on IRS Settlement Initiative Creates a Perfect Environment for Tax Shelters

Tax_analysts_182Johnson_calvin Calvin H. Johnson (Texas) has published IRS Settlement Initiative:  A Perfect Environment for Tax Shelters, 109 Tax Notes 929 (Nov. 14, 2005), also available on the Tax Analysts' web site as Doc 2005-22783, 2005 TNT 219-36.  Here is a taste:

On the straight percentages, massive, abusive counterfeit shelters will survive and thrive under the settlement initiative. Let's look at the odds. A taxpayer who pays his due tax, without a shelter, pays 100 percent of tax (t). To justify buying a shelter, the expected cost of the shelter must be less than 100% * t. With the shelter, the purchaser has some percentage chance (x%) of paying no tax and thus (1-x%) of having to pay the tax plus the maximum 20 percent penalty for 120 percent of t. The shelter's value, before fees, is x% of 0*t + (1-x%) * (120% t).

Fees and transaction costs must be paid to the promoters and lawyers, assume at f% of tax avoided. With the deduction allowed under the settlement initiative, the after-tax cost of fees in a 35 percent tax bracket is (1-35%)*f%*t.

The break-even point by the straight percentages in the decision as to whether to pay tax or buy the shelter is described by the following equation:

(1A) Pay tax = expected value from shelter (1B) 100% t = x% * 0 + (1-x%) * (120% t) + (1-35%) * f% * t.

From (1B), it follows that an amoral investor will buy a shelter if the chance of success is greater than x% where

(1C) x% = (20% + 65% * f%) divided by 120%

Chart 1 graphs (1C) and x%, the required chance of success for the investor to buy the shelter, for a range of fees charged:

Required Chance of Success

Johnson_chart [click to enlarge]

 

With a 20% cap on penalties, the investor does not need a very big chance of the shelter's success to make the shelter look attractive. With low fees as a percentage of tax saved, a shelter becomes rational on the straight percentages if there is just above a one-sixth chance of success in evading tax. With deductible fees of 30% of the tax the promoter is erasing for you, there needs to be a 33% chance of success.

The graph makes it look like greater fees will force shelters to be more reliable to be attractive. Overall, however, fees have more effect in subsidizing than in restraining shelters. Fees operate not only as a disincentive for the shelterer but also as an incentive to the promoter to invent more shelters and learn how to hide them better from the IRS. Shelter promoters are increasing their chances of avoiding tax not just with a smarter product but also with sneakier tricks camouflaging the shelter to avoid clear IRS perceptions of the issues....

The terrible state of affairs is not the IRS's fault. Taxpayers come in with a war chest of $1 million per shelter to spend on defense lawyers. When you are facing litigation against opponents with that large a defense fund, there are hazards of litigation. Still, the 20% cap is not an occasion for self-congratulations or happy talk. An environment of 20% maximum penalty allows very ugly abusive shelters to arise and prosper. This settlement initiative will induce -- not end -- those festering wounds to our tax base.

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