Although IRS has no single, authoritative definition of abusive shelters, IRS generally characterizes abusive shelters as very complicated transactions that sophisticated tax professionals promote to corporations and wealthy individuals, exploiting tax loopholes and reaping large and unintended tax benefits. As the Joint Committee on Taxation has said, “taxpayers and tax administrators have struggled in determining the line between legitimate ‘tax planning’ and unacceptable ‘tax shelters.’” Even though, it continued, “there is no uniform standard as to what constitutes a tax shelter … there are statutory provisions, judicial doctrines, and administrative guidance that attempt to limit or identify transactions in which a significant purpose is the avoidance or evasion of income tax.” Abusive shelters have been promoted by some accounting firms, law firms, and investment banks. Investors in these abusive shelters range from large and small corporations to wealthy individuals. IRS approaches the tax shelter enforcement problem from both the promoter and investor perspectives. IRS promoter investigations are designed to learn (1) what abusive shelters have been promoted, if the shelters are registered, and possibly how much they cost investors, (2) who purchased the shelters and what tax savings the investors expect, and (3) whether promoters should pay penalties for their activities. IRS examines investor and other tax returns to see if income, expenses, taxes, and credits are accurately reported. In a June 2002 letter, Treasury responded to congressional questions about whether Treasury had a comprehensive strategy for combating tax avoidance. In his letter to the then Ranking Member of the Committee on Finance, then Secretary of the Treasury O’Neill addressed the actions being taken to combat abusive shelters, referring to Treasury’s March 20, 2002, enforcement proposals on the topic. The proposals said that IRS had made significant organizational improvements to coordinate its response to ongoing abusive tax shelters. Treasury, all of IRS’s operating divisions, and IRS’s Office of Chief Counsel are involved in combating abusive shelter activity. Within IRS, LMSB has primary responsibility for combating abusive tax shelter activity. LMSB’s OTSA was created in February 2000 to centralize and coordinate the IRS response nationwide. As shown in figure 1, OTSA is the focal point for IRS shelter activities, overseeing promoter tax shelter registrations; taxpayer disclosures of tax shelters; hotline tip analysis and referral; and issue coordination and interface between the Office of Chief Counsel, Treasury, the Tax Shelter Committee, the 6700 Committee (referring to section 6700 of the Internal Revenue Code), and external stakeholders. The Tax Shelter Committee oversees LMSB’s tax shelter program. The committee is composed of the Commissioner and Deputy Commissioner of LMSB, the Director of Pre-Filing and Technical Guidance, LMSB Division Counsel, five Industry Directors, the Director of International, and the Directors of Field Specialists and Research and Program Planning. The 6700 Committee serves under the Tax Shelter Committee and approves all LMSB tax shelter promoter activities. The financial services’ industry director chairs this committee. IRS’s appeals function receives and evaluates taxpayer objections to IRS examination determinations and may agree with those determinations or reduce or eliminate changes to tax returns resulting from them. The Office of Chief Counsel plays an integral role in combating shelters through summons enforcement and targeted litigation. By litigating, IRS establishes case law supporting IRS enforcement programs and aims to diminish the incentives taxpayers find for investing in tax avoidance transactions by increasing the risks and costs of IRS discovery. Abusive shelters are complex transactions that manipulate many parts of the tax code or regulations and are typically buried among “legitimate” transactions reported on tax returns. Because these transactions are often composed of many pieces located in several parts of a complex tax return, they are essentially hidden from plain sight, which contributes to the difficulty of determining the scope of the abusive shelter problem. Often lacking economic substance or a business purpose other than generating tax benefits, abusive shelters are promoted by some tax professionals, often in confidence, for significant fees, sometimes with the participation of tax-indifferent parties, such as foreign or tax-exempt entities. They may involve unnecessary steps and flow-through entities, such as partnerships, which make detection of these transactions more difficult. When a transaction has certain abusive characteristics defined by section 6111 of the Internal Revenue Code, the promoter or other tax shelter organizer is required to register it, describing the transaction and its tax benefits to the Secretary of the Treasury. This registration requirement enables Treasury and IRS to identify and evaluate questionable transactions. Under recently issued Treasury regulations, effective February 28, 2003, there are six categories of transactions for which promoters must maintain lists of investors who have entered into the transactions, and investors must disclose the transactions into which they have entered. The rules are designed to allow IRS to use information from investors to identify promoters who do not register transactions and to use promoter registrations and investor lists to identify investors who fail to disclose transactions. The six categories are transactions offered under conditions of confidentiality, transactions including contractual protections to the investor, transactions resulting in specific amounts of tax losses, transactions generating a tax benefit when the underlying asset is held transactions generating differences between financial accounts and tax accounts greater than $10 million, and “listed transactions.” A “listed transaction” is a transaction that is the same as or similar to one of the types of transactions IRS has determined to be a tax avoidance transaction. For a transaction to be a listed transaction, IRS must issue a notice, regulation, or other form of published guidance informing taxpayers of the details of the transaction. As of mid-August 2003, IRS had listed 27 kinds of abusive tax shelter transactions, a number that, as figure 2 shows, has grown more quickly in recent years than it had grown earlier. Disputes between IRS and taxpayers about the abusive nature of a transaction may be litigated. In some, but not all, cases, the courts have upheld the government position. The following cases illustrate features of abusive shelters: In 1993, a corporation began a company-owned life insurance (COLI) program in which the company purchased whole-life insurance on 36,000 employees for which the company was the sole beneficiary. The company then borrowed money against the policies at interest rates that averaged 11 percent and deducted the interest expense and administrative fees from income on its tax returns. Over 60 years, the interest costs and administrative fees would have exceeded the cash surrender value of the policies and benefits paid by several billion dollars. IRS disallowed the deductions and the case was litigated. Despite the fact that the money the company made on this arrangement may have been used to fund the company’s benefits program, or for other business purposes, the court found that the function of the program itself was only to generate tax deductions. As a result, the Tax Court sustained the IRS disallowance of deductions and concluded that the COLI program was a sham.The Eleventh Circuit Court of Appeals affirmed the Tax Court’s decision. A company had a sizable gain from the sale of a subsidiary and wanted to avoid or minimize paying tax on the gain. An investment bank proposed forming an offshore partnership with a foreign corporation (a tax-indifferent party) for the express purpose of sheltering the capital gains of its corporate client. The partnership purchased and quickly resold notes in a contingent installment sale transaction. The partnership earned a large capital gain, most of which it allocated to the foreign corporate partner. Later, related losses were allocated to the U.S. corporation, generating an approximate $100 million capital loss for the investment bank’s client. The corporation used this capital loss to shelter its U.S.-based capital gains. Both the Tax Court and the Third Circuit Court of Appeals ruled that the transaction lacked economic substance. The Third Circuit, in addition to requiring economic substance, held that a transaction must have a subjective nontax business motive to be respected for tax purposes. For this transaction, the investment bank was to earn a fee of $2 million. This was one of 11 such partnerships formed over a 1-year period from 1989 to 1990 by the investment bank. IRS has information that suggests the scope of abusive shelters totaled tens of billions of dollars over about a decade, but those estimates are based on limited data. This information comes from an OTSA database, examinations of large corporations, and a contractor study. Information contained in the OTSA database includes transactions disclosed to or discovered by IRS and estimates of potential tax losses. The tax loss estimates vary from being IRS officials’ recommended taxes based on examining some transactions to taxpayer judgments regarding potential losses in cases where examinations have not been done. In addition to being based on judgments, the database does not include any reductions resulting from examination, appeal, litigation, or other sources. Information from examinations of the largest corporations, which may overlap information in the OTSA database, shows proposed income adjustments in the tens of billions of dollars before reductions, but data were not available from IRS on the results of examinations of smaller corporations, partnerships, trusts, S corporations, or individuals. Information from IRS’s contractor study estimates an annual tax gap due to abusive shelters but has data and methodological limitations. As shown in table 1, as of September 30, 2003, an OTSA database included estimated potential tax losses of about $33 billion from investments in listed transactions, before considering any reductions resulting from examination, appeal, litigation, or other sources and another $52 billion in potential tax losses from nonlisted transactions with some characteristics of abusive shelters. This database contains information on promoters and investors and the amount of potential tax savings resulting from listed and nonlisted transactions. Nonlisted transactions are transactions that needed to be registered because they have some characteristics of abusive shelters but were not, at least yet, determined to be abusive. According to an IRS official, IRS was studying nonlisted transactions with about $12 billion in potential tax losses for possible listing. The database only includes information on abusive or possibly abusive transactions that had been disclosed to or discovered by IRS.