Before 2002, accounting firms would provide multiple services to the same firm.

Hired by the shareholders, they would audit the financial statements that were prepared by management while also providing consulting services to those same managers. Some would provide tax advice to the managers of audit clients. However, the Sarbanes-Oxley Act (SOX) of 2002 restricted the type and the intensity of consulting services that could be provided to the management of audit clients because it might compromise the objectivity of the auditor when auditing the financial statements prepared by management on behalf of the shareholders. Nevertheless, both before and after the passage of SOX, Ernst

& Young (E&Y) and KPMG were offering very aggressive tax shelters to wealthy taxpayers as well as to the senior managers of audit clients.

E&Y In the 1990s, E&Y had created four tax shelters that they were selling to wealthy individuals. One of them, called E.C.S., for Equity Compensation Strategy, resulted in little or no tax liability for the taxpayer. The complicated tax plan was a means of delaying, for up to thirty years, paying taxes on the profits from exercising employee stock options that would otherwise be payable in the year in which the stock options were exercised. E&Y charged a fee of 3% of the amount that the taxpayer invested in the tax shelter, plus \($50,000\) to a law firm for a legal opinion that said that it was “more likely than not” that the shelter would survive a tax audit.

E&Y had long been the auditor for Sprint Corporation. They also took on as clients William Esrey and Ronald LeMay, the top executives at Sprint. In 2000, E&Y received the following:

• \($2.5\) million for the audit of Sprint

• \($2.6\) million for other services related to the audit

• \($63.8\) million for information technology and other consulting services

• \($5.8\) million from Esrey and LeMay for tax advice In 1999, Esrey announced a planned merger of Sprint with WorldCom that potentially would have made the combined organization the largest telecommunications company in the world. The deal was not consummated because it failed to obtain regulatory approval. Nevertheless, Esrey and LeMay were awarded stock options worth about \($311\) million.

E&Y sold an E.C.S. to each of Esrey and LeMay. In the three years from 1998 to 2000, the options profits for Esrey were

\($159\) million and the tax that would have been payable had he not bought the tax shelter amounted to about \($63\) million. The options profits for LeMay were \($152.2\) million and the tax thereon about \($60.3\) million.

Subsequently, the Internal Revenue Service

(IRS) rejected the tax shelter of each man. Sprint then asked the two executives to resign, which they did. Sprint also dismissed E&Y as the company’s auditor.

On July 2, 2003, E&Y reached a \($15\) million settlement with the IRS regarding their aggressive marketing of tax shelters.

Then, in 2007, four E&Y partners were charged with tax fraud. These four partners worked for an E&Y unit called VIPER,

“value ideas produce extraordinary results,”

later renamed SISG, “strategic individual solutions group.” Its purpose was to aggressively market tax shelters, known as Cobra, Pico, CDS, and CDS Add-Ons, to wealthy individuals, many of whom acquired their fortunes in technology-related businesses.

These four products were sold to about 400 wealthy taxpayers from 1999 to 2001 and generated fees of approximately \($121\) million. The government claims that the tax shelters were bogus and taxpayers were reassessed for taxes owing as well as penalties and interest.

KPMG On August 26, 2005, KPMG agreed to pay a fine of \($456\) million for selling tax shelters from 1996 through 2003 that fraudulently generated \($11\) billion in fictitious tax losses that cost the government at least \($2.5\) billion in lost taxes. The four tax shelters went by the acronyms FLIP, OPIS, BLIPS, and SOS. Under the Bond Linked Premium Issue Structure (BLIPS), for example, the taxpayer would borrow money from an offshore bank and invest in a joint venture that would buy foreign currencies from that same offshore bank. About two months later, the joint venture would then sell the foreign currency back to the bank, creating a tax loss. The taxpayer would then declare a loss for tax purposes on the BLIPS investment. The way that the BLIPS were structured, the taxpayer had to pay only \($1.4\) million in order to declare a

\($20\) million loss for tax purposes. They were targeted at wealthy executives who would normally pay between \($10\) million and \($20\) million in taxes. Buying a BLIPS, however, effectively reduced the investor’s taxable income to zero. They were sold to 186 wealthy individuals and generated at least \($5\) billion in tax losses. The FLIP and OPIS involved investment swaps through the Cayman Islands, and SOS was a currency swap similar to the BLIPS.

The government contended that these were sham transactions since the loans and investments were risk free. Their sole purpose was to artificially reduce taxes.

Some argued that the KPMG tax shelters were so egregious that the accounting firm should be put out of business. However, Arthur Andersen had collapsed in 2002, and if KPMG failed, then there would be only three large accounting firms remaining:

Deloitte, PricewaterhouseCoopers, and E&Y. KPMG Chairman, Timothy Flynn, said “the firm regretted taking part in the deals and sent a message to employees calling the conduct ‘inexcusable.’”1 KPMG remains in business, but the firm was fined almost a half billion dollars.

Questions:-

1. What differentiates very aggressive tax shelters from reasonable tax shelters?
2. As a result of the E&Y and KPMG tax fiascos, the large accounting firms have become wary of marketing very aggressive tax shelters. Now, most shelters are being sold by tax “boutiques” that operate on a much smaller scale and so are less likely to be investigated by the IRS. Is it right that accountants market aggressive tax shelter plans?
Are tax shelter plans in the public interest?