The Internal Revenue Service's tough stance on settling the "Son of Boss" tax shelters matches the call by the IRS Oversight Board for increased compliance funding, as well as the tax gap findings of the National Research Program. Together, they signal a sea change from the kinder, gentler, post-1998 hearings IRS.
The 1998 hearings led to a decline in IRS enforcement activity, resulting in a shelter-friendly climate that encouraged taxpayers to test the waters, according to observers.
"Some of the allegations were overblown," said IRS Commissioner Mark W. Everson. "That doesn't mean that there weren't any problems that needed to be addressed, but the hangover from the hearings was damaging to the IRS. We're correcting this now and bringing things back into balance."
Taxpayers participating in the Son of Boss tax shelter settlement have so far paid in more than $3.2 billion, a figure that should top $3.5 billion when the project concludes in the coming months.
"This was a particularly bad shelter, and we're glad so many chose to get right with the government," said Everson. "Despite the tough terms we offered, two thirds of Son of Boss participants have come forward and paid up."
The settlement initiative required taxpayers to concede 100 percent of the claimed tax losses and pay a penalty of either 10 percent or 20 percent, unless they had previous disclosed the transactions to the IRS.
Son of Boss, an offshoot of an earlier shelter that was called Boss (for Bond and Option Sales Strategy), was an abusive transaction aggressively marketed in the late 1990s and 2000 primarily to wealthy individuals.
Son of Boss sheltered capital gains with paper tax losses from foreign currency options, spread transactions, European digital foreign currency options, investment transactions, or option partnership strategy transactions.
Based on disclosures from promoter investigations and from investor lists from Justice Department litigation, the IRS estimates that over 1,800 people participated in Son of Boss.
"For those who didn't come forward, we know who they are," Everson said. "We are going after them."
However, getting the remainder won't necessarily be easy, say some observers.
"Given the fact that 1,165 individuals are participating in the settlement initiative, that still leaves more than 400 - or one out of four - that have declined," observed Martin Tittle, a Detroit-based international tax attorney. "It's unlikely that they're all crazy. And the IRS hasn't always prevailed in the past when they've gone after transactions that they say have no business purpose or economic substance. Look at the ADR shelters of the early 1990s."
"The American Depository Receipt shelter generated dividend income that was sheltered in part by foreign tax credits and capital losses," he explained. "But both the Fifth and Eighth Circuits upheld the transactions, despite minimal risk on the part of the taxpayer."
However, IRS chief counsel Don Korb believes that the courts will uphold the IRS view. "The IRS's legal position on this abusive transaction is strong," he said. "It's our belief that taxpayers who did not participate in the settlement will rue the day they made that decision."
"This is essentially a tax shelter post mortem," agreed Simon Schneebalg, a tax analyst at RIA. "The life cycle of a shelter begins with the people who plan and sell it. Next, people take the positions on their returns. Then the IRS finds out about it and issues a notice saying, 'This is bad, don't go into it.' It's over when the IRS issues a settlement initiative."
"The autopsy," said Schneebalg, "will be either when cases come down upholding the IRS position or legislation addresses the type of transaction covered by the shelter."
The big picture
The Son of Boss initiative is part of a broader enforcement effort at the IRS, including eradicating abusive tax shelter deals and cracking down on those who promoted them. This effort includes increased audit activity of taxpayers and promoters; expanded criminal investigations; a new focus on professional ethics and responsibility through the IRS Office of Professional Responsibility; designating appropriate tax cases for litigation; and offering targeted settlement initiatives.
Following the Son of Boss initiative, a settlement program involving an abusive transaction of stock option transfers by executives to family-controlled entities was announced in February. Taxpayers have until May 23, 2005, to participate in that initiative.
The focus on compliance reflects the call by the IRS Oversight Board - the body charged with overseeing the IRS - for even stronger measures. The board released a report requesting an additional $11.6 billion in funding for fiscal year 2006, a 9 percent increase over the administration's recommendation. President George W. Bush is required to submit the board's request, without revision, to Congress, along with his own request.
"One of the board's roles is to provide a private sector perspective," observed board chairman Raymond T. Wagner Jr. "And from this vantage point, it makes perfect sense to make the additional investments in enforcement that will pay for themselves many times over. IRS and administration estimates show that every dollar invested in enforcement generates four dollars in increased revenues."
The board estimated that an additional $435 million for enforcement would result in $1.74 billion in additional tax revenue.
Increased enforcement is supported by taxpayers, according to the board. Those surveyed in its annual tax compliance survey called for additional funding for the IRS - 62 percent favored more funding for enforcement and 64 percent favored more taxpayer assistance.
Meanwhile, the first study of taxpayer compliance since 1988 shows that the vast majority of American taxpayers pay their taxes on time and accurately, but that the nation still has a significant tax gap.
The National Research Program, launched in 2001, randomly selected about 46,000 returns for review and examination from 2001 to 2004. The return selection process included an oversampling of high-income returns to enable researchers to draw valid conclusions about important sub-categories of taxpayers.
The preliminary findings show that the gross tax gap - the difference between what taxpayers should pay and what they actually pay on a timely basis - exceeds $300 billion per year. IRS enforcement activities, coupled with late payments, recover about $55 billion of the tax gap, leaving a net tax gap of between $257 billion and $298 billion.
The study found that underreporting of income is the largest component of the tax gap, accounting for more than 80 percent of the total, with non-filing and underpayment at about 10 percent each. Individual income tax is the single largest source of the annual tax gap, accounting for about two thirds of the total. For individual underreporting, more than 80 percent comes from understated income, not overstated deductions, and most of the understated income comes from business activities, not wages or investment income.
Everson said that the study confirms two key points involving tax enforcement and simplification. "The IRS needs to enforce the law so that when Americans pay their taxes, they are confident that neighbors and business competitors are doing the same," he said. "At the same time, this research underscores the president's call for tax reform. Complexity obscures understanding. Complexity in the tax code compromises both the service and enforcement missions of the IRS."
"Those who try to follow the law but cannot understand their tax obligations may make inadvertent errors or ultimately throw up their hands and say, 'Why bother?'" the commissioner continued. "Meanwhile, individuals who seek to pay less than what they owe often hide behind the Tax Code's complexity in order to escape detection by the IRS and pay less than their fare share."
