US Efforts To Thwart Tax Shelters Receive Court Setback

by Mike Godfrey, Tax-News.com, Washington

24 July 2006

The US authorities' campaign against aggressive tax shelters was dealt a blow last week after a Texas judge ruled that the government exceeded its power by outlawing a shelter known as 'Son of Boss'.

In a 28-page judgement released last Thursday, Judge T. John Ward of the US District Court for the Eastern District of Texas wrote that regulations issued by the IRS in 2000 did not apply to taxpayers who used the tax shelter prior to this date. According to Judge Ward, the government's retroactive application of these rules was an "abuse of discretion"./p>

The civil case was brought by two Texas lawyers, Harold W. Nix and C. Cary Patterson, who sued the Internal Revenue Service in 2004 after the agency denied deductions resulting from the use of the tax shelter four years previously.

The ruling is expected to be only a minor setback for the government in its prosecution of tax shelter cases, as it does not come from a precedent-setting court. However, it is possible that it will have a bearing on the case against 16 former KPMG executives which is due to go to trial next January - believed to be the largest ever criminal case pursued by the government. It is alleged that the former KPMG employees defrauded the Treasury to the tune of billions of dollars by selling a variety of similar tax shelters, including Son of Boss, to wealthy clients in the 1990s.

Son of Boss evolved from an earlier scheme known as ‘Boss’ (bond and option sales strategy). The scheme utilises a complex set of derivative transactions to reduce tax liability and was commonly used in the late 1990s to offset large one-off gains such as the sale of a business.

The government argues that such schemes have no economic substance other than to evade taxes and are therefore illegal. However, defense lawyers in the KPMG case have pointed out that this has never been established in a court of law. This will be decided when the civil case involving Nix and Patterson goes to trial in October.

IRS Chief Counsel Donald L. Korb has commented that the agency is still studying the ruling, although he stated that the decision affects "one part of the government's case".

Last year, the IRS released the results of its Son of Boss settlement offer, a 2004 initiative which offered users of the shelter improved settlement terms in a limited amnesty. More than 1,200 taxpayers qualified to participate in this offer, and the IRS collected some $3.8 billion in taxes and penalties. However, about 600 investors did not come forward, with some instead electing to challenge the IRS in court.

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