Tax Shelters and the Exposure to Professionals
O&B Insurance Advisory
October 5, 2004

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In the aftermath of Enron and WorldCom, and against the backdrop of continuing corporate insecurity, governmental authorities have turned their attention to improper tax shelters.¹ In the 1990's, the use of tax shelters increased as investors and businessmen reaped large capital gains as a result of the bull market.² Indeed, the use of tax shelters became widespread and are now being used by an array of small companies, wealthy individuals, and even the middle class.³ During the decade before the turn of the century, the burgeoning technology sector and increasing salaries for company executives provided the economic climate sufficient to allow accounting firms to promote aggressive tax strategies in the form of tax shelters.⁴ Waning revenue from auditing, coupled with a change in the accounting profession's rules allowing accountants to charge performance based fees⁵ (as opposed to traditional hourly rates), also provided impetus for accounting firms to push new tax strategies.⁶ In the end, it is estimated that the federal government was denied tens of billions of tax dollars.⁷

We provide this brief summary of the substance underlying these lawsuits not only to allow a better understanding of the relevant provisions of the applicable statutes and regulations for those handling claims involving these allegations, but also to alert underwriters to these issues as they renew or are presented new risks.

According to the IRS, tax shelter promoters, organizers or sellers⁸ must register tax shelters that may be potentially abusive with the IRS and keep lists of their clients.⁹ To be sure, 26 U.S.C. § 6111 requires that any tax shelter organizer shall register a potentially abusive tax shelter with the IRS not later than the day on which the first offering for sale of interests in such a tax shelter occurs.¹⁰ A potentially abusive tax shelter is defined in 26 CFR § 301.6112-1 as any transaction that is required to be registered under 26 U.S.C. § 6111, regardless of whether or not it is registered, or that constitutes a transaction that has a potential for tax avoidance or evasion. Under 26 U.S.C. § 6112(a) any person who "organizes any potentially abusive tax shelter, or (2) sells any interest in such a shelter" must "maintain . . . a list identifying each person who was sold an interest in such a shelter." A person is an organizer of, or a seller of an interest in, a transaction that is a potentially abusive tax shelter if that person is a material adviser with respect to that transaction.¹¹ A material adviser, in turn, is a person required to register the transaction under § 6111, or the person receives or expects to receive at least a minimum fee with respect to the transaction.¹² Those required to maintain a list must make it available to the IRS.¹³ Additionally, in order to further the policies of the foregoing statutes, the Secretary of Treasury promulgated regulations that authorize the IRS to publish a list of tax strategies that it considers to be subject to registration or disclosure.¹⁴ The IRS has since published numerous notices requiring certain types of transactions to be registered.

Generally, according to complaints filed against those involved in promoting the tax shelters, representatives from accounting firms ("accounting reps" or "accountants"), attorneys, financial institutions ("banks") and investment advisers marketed tax shelters as a team effort.¹⁵ Both banks and accounting reps were in good positions to identify candidates that would benefit from tax shelters as banks were able to recognize clients that made large deposits, while accountants identified possible candidates when they audited or prepared tax returns for their clients.¹⁶ Consequently, accountants and banks contacted wealthy individuals, including company executives, about the tax shelters.¹⁷ Typically, after accountants or banks first contacted a client, a meeting was arranged to discuss how the bank or accountant with the help of investment advisers could save the client millions of dollars in taxes.¹⁸

At the meeting, accounting reps (in some cases, accompanied by bank representatives) presented the client with a plan that would save the client most, if not all, of the money that would have to be paid to the government, usually in the form of federal capital gains taxes.¹⁹ However, the accounting reps first required the client to sign a confidentiality agreement, in order to ensure that other firms would not profit from the strategy.²⁰ Likewise, attorneys marketing tax shelters also protected the tax strategies they sold and had clients sign confidentiality agreements.²¹ Once the client signed the confidentiality agreement, accounting reps would give a presentation outlining a complex tax avoidance²² strategy that promised to save the client most or all of its tax liability ("tax shelter").

What is more, those touting the tax shelters took the position that the tax shelters would not have to be registered with the IRS, even though the shelters were similar to specific transactions²³ the IRS announced as listed transactions. Indeed, in at least one case, an accounting firm determined that registration of potentially abusive tax shelters was not warranted after weighing the firm's potential exposure to minimal IRS penalties against the significant competitive disadvantages that would result from registration.²⁴

Accounting reps also informed the client that they would receive a legal opinion from a leading law firm endorsing the tax shelter in the event that the client was audited.²⁵ Both the law firms and the accounting firms collaborated in writing favorable legal opinions for the clients with regard to the tax shelters.²⁶ If the client decided to go forward with the tax shelter, he would pay fees to the accounting and law firms, both of whom issued opinions that the tax strategy would "more likely than not" be considered proper.²⁷ The bank would perform all the transactions involved in the tax shelter such as setting up new entities and transferring funds for which they would receive substantial fees.²⁸ In some cases, the accounting firm would also insist upon retaining an investment adviser firm.²⁹ When the presentation concluded, those in charge of the meeting did not allow the client to take the marketing materials in order to further investigate the transaction.³⁰ Pursuant to the confidentiality agreement, the client was also prohibited from consulting outside counsel.³¹ In at least one case, the individuals and entities making the presentation pressured the client to act quickly.³² Accounting firms even required the clients to sign an agreement releasing the former from any liability for its role in the tax shelter. Many clients, relying on the expertise and reputation of both the accounting and law firms, went ahead with the tax strategies.

In 1999, 2000 and 2001, however, the IRS began issuing notices that certain tax shelters were abusive, invalid and illegal.³³ In addition, the IRS concluded that any similar transactions should have been registered as tax shelters.³⁴ After the IRS received tax shelter promotion materials from anonymous senders, they began serving subpoenas on investment banks, accounting firms and law firms in order to determine whether they were complying with registration procedures and to determine the identity of clients who entered into these listed transactions.³⁵ At least one government agency went so far as to subpoena insurance companies in order to obtain lists of those people for whom the insurance company provided tax liability policies.³⁶ Law firms, as well as the clients themselves, attempted to block the IRS from discovering the lists of those clients that used tax shelters, arguing that the IRS was not entitled to discovery of such lists on privilege grounds.³⁷ The courts found those arguments unpersuasive, stating that the privilege did not apply because the privilege protects communications that a client makes to his attorney, and a client's identity is not a communication.³⁸ Additionally, one court noted that a client may not buy a privilege by retaining an attorney to sell the client a generic tax advantaged structure because a non-lawyer could accomplish the same task.³⁹

The foregoing disclosures of client lists resulted in a significant number of audits of those clients that used the tax shelters. Thus far, IRS audits revealed that the tax shelters that accounting and law firms proposed, and for which investment banks conducted the financial transactions, were considered abusive tax shelters.⁴⁰ Consequently, the promised tax benefits from the elaborate tax strategies have been or will be disallowed, leaving the client with a large tax bill upon which interest and penalties are assessed. The clients, in turn, have begun filing lawsuits against the investment banks and advisers, accounting and law firms alleging, inter alia , RICO violations, fraud, breach of fiduciary duty, negligent misrepresentation and malpractice (against accountants and attorneys).⁴¹ Clients sought recovery of the assessed interest and penalties as well as the substantial fees paid to the banks, accounting firms, investment advisers and law firms. The accounting and law firms' fees were substantial. In some cases, accounting firms charged clients $1 million simply to hear a sales pitch.⁴² In at least one case, the fees exceeded $3 million, and one accounting firm has stated that it earned $124 million.⁴³

Although some of the lawsuits have been dismissed as premature,⁴⁴ underwriters need to make sufficient inquiries regarding this conduct when presented with a request for new coverage or renewal of coverage from a financial adviser, financial institution, and/or professional such as an accountant or lawyer where the malpractice policies may be called on to cover those participating in the sale of potentially abusive tax shelters. In underwriting the errors and omissions coverage, the underwriter should keep in mind the following considerations and recommendations when negotiating, renewing or re-negotiating the insureds' policies.

First, the underwriter should recognize that the former clients who are likely to commence litigations against professionals are wealthy individuals who enjoy a high amount of disposable income that can be spent on litigation costs. Thus, the clients will exhibit no reluctance to incur the costs necessary to protect and leave untarnished their reputations. Likewise, the potential insureds who are exposed include large investment institutions, wealthy investment advisers, accounting firms, and law firms that will have significant interest in, and concern for, their business reputation, thereby leading to significant exposure on defense costs alone.

Thus, underwriters, in assessing whether to renew or offer first-time coverage for these professionals, must not only specifically probe the potential involvement of the individuals and entities in these tax shelters, but must also consider a number of methodologies to protect coverage from this exposure. The specific inquiry must focus on whether the insured or potential insured has engaged in any actions that qualify as an organizer or seller, as defined in 26 CFR § 301.6112-1, or material adviser, as defined under 26 U.S.C. § 6111 or 26 CFR § 301.6112-1. Likewise, inquiry should be made concerning the professionals' involvement in abusive tax shelters, including the potential receipt of significant fees.

Appropriate protections to be included can, for instance, include larger self-insured retentions, modification of the policy's definition of Loss to protect against fines and penalties that the IRS may assess against clients, which fines and penalties the clients will turn to insureds for. To the extent the Insuring Clause utilizes the term "Professional Services," the definition of that term can likewise be modified to exclude acts as an organizer or seller within the scope of 26 CFR § 301.6112-1, or a material adviser, as defined in 26 U.S.C. § 6111 or 26 CFR § 301.6112-1. Finally, exclusionary language can be specifically crafted to eliminate coverage for such abusive tax shelters.

The foregoing analysis is not meant to be exhaustive of the techniques that the underwriter may use in order to protect itself from Claims involving abusive tax shelters. Instead, in the interest of brevity, we have chosen to focus on the foregoing in order to introduce the claims and underwriting departments to current issues of coverage and shed some light on legal doctrines involved and techniques that the underwriter may want to employ in order to protect the Company's policies from claims involving abusive tax shelters.

1. The Senate Permanent Subcommittee on Investigations defines improper tax shelters as complex transactions used to incur large tax benefits that Congress did not intend to provide. Rick Rothaker, Firms Caught in Tax Shelter Fallout: Wachovia, Accountants KPMG are Being Sued by Former Clients Suits, Senate Report Allege Firms Made Lucrative Fees By Pushing Schemes , The Charlotte Observer, January 11, 2004. However, American legal doctrines consider tax shelters improper when they lack economic substance and a non-tax business purpose. A tax shelter lacks economic substance when it lacks an investment risk; therefore, if there is no chance that an investor will lose his investment, the tax shelter is improper. Paul Braverman, Helter Shelter , The American Lawyer, Dec . 2003.

2. Rothaker, supra n ote 1.

3. Braverman, supra n ote 1.

4. Ken Brown & John D. McKlinnon, Leading the News: IRS Later Opposed Tax Strategies Sold by Auditor , The Wall Street Journal, Feb . 6 , 2003, at A3. See also Rothaker, supra n ote 1; Cassell Bryan-Low, Unhappy Returns: Accounting Firms Face Backlash Over the Tax Shelters They Sold, Suits by Users Being Audited Are Multiplying, and IRS Steps Up Its Regulation , The Wall Street Journal, Feb . 7, 2003 , at A1.

5. Performance based fees are calculated as a percentage of taxes saved.

6. Bryan-Low, supra n ote 4.

7. Lynnley Browning, KPMG Wrote New Versions of Shelters Ruled Illegal, The New York Times, August 24, 2004. Jonathan Weil, Ernst & Young Faces Tax-Shelter Inquiry , The Wall Street Journal, May 24, 2004, at C1.

8. The IRS loosely defines promoters, or organizers as those who participate in the organization management or sale of a questionable tax shelter, or any person connected to the organizer. Lynnley Browning, A Spotlight on Deutsche Bank's Tax Shelter Role , The New York Times, Feb . 1, 2004.

9. Braverman, supra n ote 1; The American Lawyer, December 2003; Bryan-Low, supra n ote 4.

10. U.S. Department of Justice, Justice Releases Petition in Presidio Enforcement Action—Exhibit A3 Loftin Complaint , Tax Notes Today, Nov . 5, 2003.

11. 26 CFR § 301.6112-1

12. Id .

13. 26 U.S.C. § 6112

14. U.S. Department of Justice, supra note 10.

15. In 1998, Jeff Stein, an attorney at KPMG, identified R.J. Ruble of Sidley, Austin, Brown & Wood as a member of a working group who was involved in creating new tax shelters for clients. Paul Braverman, Still in the Shadows , The American Lawyer, Oct . 2003.

16. Browning, supra n ote 8; Rothaker, supra note 1; Dan Christensen, Tycoon Sues KPMG, Bank Over Tax Woes , Miami Daily Business Review, Jan . 17, 2003.

17. Christensen, supra n ote 16; See also Browning, supra n ote 8.

18. Bryan-Low, supra n ote 4; See also Braverman, supra n ote 1.

19. Id . See also Christensen, supra n ote 16.

20. Id . See also U.S. Department of Justice, supra n ote 10.

21. Clients Denied Preliminary Injunction Against Banks' Disclosure to the IRS , Tax Notes Today, June 27, 2003.

22. The tax avoidance strategies went by many different acronyms: FLIPS (Foreign Leveraged Investment Program Strategy), OPIS (Offshore Portfolio Investment Strategy), BOSS (Bond and Options Sales Strategy), COBRA (Currency Options Bring Reward Alternatives), CARDS (Custom Adjustable Rate Debt Structure) and BLIPS (Bond Linked Investment Premium Strategy, also known as "Son of BOSS").

23. Bryan-Low, supra n ote 4; Christensen, supra n ote 16.

24. U.S. Department of Justice, supra n ote 10.

25. Braverman, supra n ote 1.

26. Paul Braverman, Evicted From the Shelter , The American Lawyer, Jan . 2004.

27. Loftin v. KPMG, LLP , 02 CV 81166, 2002 U.S. Dist. LEXIS 26909 , at *7 (S.D. Fla. Dec . 10, 2002).

28. Bryan-Low, supra n ote 4.

29. U.S. Department of Justice, supra n ote 10.

30. Braverman, supra n ote 1 .

31. Id .

32. Christensen, supra n ote 16.

33. In 1999 and 2000, the IRS issued notices that BOSS shelters and "son of BOSS" shelters were abusive and invalid. Braverman, supra n ote 1. Additionally, in or around 1999, the IRS found that the COBRA tax shelter was also illegal. David Cay Johnson, Wealthy Suing Accountants Over Rejected Tax Shelters , The New York Times, Feb . 7, 2003. Also, in 2001, the IRS stated that OPIS was an illegal shelter. U.S. Department of Justice, supra n ote 10; Browning, supra n ote 7.

34. Braverman, supra n ote 1.

35. Id .

36. Informa Publishing Group Ltd., U.S. Insurers Receive Subpoenas For Covering Abusive Tax Shelters , Insurance Day, Apr . 14, 2004; A.M. Best Co. Inc., Insurance Companies Questioned in California Tax Cheat Probe , BestWire. According to the article entitled, Insurance Companies Questioned in California Tax Cheat Probe , the names of the insurance companies that were the targets of the subpoenas were not released and would only be released if they failed to comply with the order.

37. See generally Clients Denied Preliminary Injunction Against Banks' Disclosure to the IRS , Tax Notes Today, June 27, 2003.

38. See generally United States v. Jenkens & Gilchrest , 03 CV 5693, 2004 U.S. Dist. LEXIS 6919 (N.D. Ill . May 13, 2004); United States v. Sidley Austin Brown & Wood , 03 CV 9355, 2004 U.S. Dist. LEXIS 7355 (N.D. Ill . Apr. 28, 2004); United States v. Jenkens & Gilchrest , 03 CV 5693, 2004 U.S. Dist. LEXIS 6919 (N.D. Ill . Apr. 20, 2004); United States v. Sidley Austin Brown & Wood , 03 CV 9355, 2004 U.S. Dist. LEXIS 6452 (N.D. Ill . Apr. 15, 2004).

39. Clients Denied Preliminary Injunction Against Banks' Disclosure to the IRS , supra n ote 37.

40. See, Browning, supra n ote 8.

41. Jacoboni v. KPMG , 02 CV 510, 2004 U.S. Dist. LEXIS 4096 (M.D. Fla. Mar . 11, 2004); Loftin v. KPMG , 2002 U.S. Dist. LEXIS 26909.

42. Johnson, supra n ote 33.

43. Id . See also Brownin g, supra n ote 7.

44. At least one plaintiff has been allowed to re-file.