"Anyone may so arrange his affairs so that his taxes shall be as low as possible. He is not bound to choose that pattern which best pays the Treasury. There is not even a patriotic duty to increase one's taxes."
-- Judge Learned Hand
The breakdown of the financial oversight system led to billions in losses for investors, tens of thousands of unemployment checks for workers, and a crisis of confidence in our capital-markets system.
It has become apparent that many of the corporate bankruptcies of the past couple of years were caused, at least in part, by the voluntary nature of our tax-compliance system. Simply put, the system is based on individuals and businesses paying their "fair share" of tax liability.
Given that loosely policed honor system, it's fair to ask what role tax professionals are playing, or perhaps more importantly, what role they should play. But there's little consensus among government officials, consumer advocates, journalists, professional organizations, and tax preparers from both small and large firms, about what the extent and nature of that role is.
To explore, here are two hypothetical questions we posed to a number of people involved in the tax process:
Scenario No. 1: Taxpayers bring in their information to a tax professional. When they get to the section on itemized deductions, should the tax professional:
A. Request documented support for every deduction;
B. Input whatever the taxpayers give them;
C. Ask the taxpayers about common deductions they may have forgotten;
D. Pull out their list of average itemized deductions for various income levels and suggest to their clients that they could increase their deductions with very little risk of being audited?
There was a general consensus that answer A isn't required, answer B is neither helpful nor diligent, answer C is what most taxpayers want, and answer D steps over the line. Yet we didn't get such agreement when we asked about a similar situation involving corporate tax.
Scenario No. 2: When assisting business clients in determining the proper structure for their company, tax professionals should:
A. Tell their clients to see their corporate attorney;
B. Recommend the type of entity that they feel most comfortable with;
C. Discuss with their clients the pros and cons of various business entity structures;
D. Offer a prepackaged plan to both clients and non-clients that will eliminate all business taxes, but has little economic substance (cost $2-$3 million in fees)?
Several tax professionals we spoke with said they felt it was their responsibility to minimize their client's taxes as long as it wasn't illegal, with one even saying "anything that is not illegal is fair game."
In the past year, the Internal Revenue Service, Congress, and the Treasury Department have focused on the problems of abusive tax shelters. Three international accounting firms have been in the center of the controversy -- KPMG, BDO Seidman, and Ernst & Young (see related article .)
But the skepticism continues among ordinary investors.
"How can the public possibly have any confidence in the accounting profession when they read about the 'tax shelters' that are being created by the major accounting firms and sold to clients for fees, in some cases equal to 25% of the tax savings," one reader wrote to us. "What they're doing is instructing their clients [on how] to create fictitious transactions resulting in so-called losses which they then use to offset taxable income. Arthur Andersen's involvement in the Enron case is innocent child's play by comparison to what these accounting firms are doing."
We took that question to tax professionals, and several of them admitted that many tax shelters being offered to clients went way beyond the "limits of acceptability." Some schemes preyed on the inability of the IRS to match income reported on partnership K-1 forms to individual and corporate tax returns. In effect, taxpayers were playing the "audit lottery," hoping to fly under the radar of the understaffed IRS.
However, many voiced concern that legitimate tax-savings techniques have been caught in the government's web, because the IRS was frustrated over its inability to make a serious dent in the tax-shelter business. (Certain taxpayers clearly felt the frustration when the IRS released the names of tax-shelter participants, though the IRS later apologized for the disclosure.) They wanted to make sure we knew there is a difference between tax avoidance and tax evasion (a k a tax cheating).
How Big Is the Problem?
That is a tough one to answer. Barbara Kaplan, tax litigator for Greenberg Traurig, LLP told us "the tax-shelter bubble has burst." She also said that inversions, the use of a foreign holding company to own a U.S. company, are on the downtrend. "It has become politically unpopular."
Others suggested that any changes were temporary and the problems can only be solved with an Enron/Andersen type solution, a frightening eventuality, to say the least. Hopefully the accounting profession can solve the issue before a bankruptcy of a Fortune 500 company, the failure of another major accounting firm, or Sarbanes-Oxley type legislation does it for them.
Who Is Responsible?
If there is a problem, we want to know who is responsible. What we heard sounded more like a cat fight. Tax attorneys blamed aggressive accounting firms for promoting abusive tax shelters. Accountants blamed lawyers who provide tax opinions based on little substance. If the tax-shelter bubble has burst, there still seems to be plenty of name-calling among the professional organizations.
On a Positive Note
Tax professionals offer value like never before. Added complexities like the alternative minimum tax -- which applies to more taxpayers than ever -- state taxes that no longer piggyback federal tax laws, and the wide variety of education tax preferences are just a few of the reasons more and more taxpayers need trained professionals. In response to the need, tax professionals are spending more and more time educating themselves to earn back the trust of their clients.
We also heard positive words from the government. Assistant U.S. Treasury Secretary Pamela Olson, in a recent speech to the New York Tax Executives Institute, focused on the goal of striking an appropriate balance between enforcement and fairness. She openly discussed controversial topics including international tax rules, inversions, and tax shelters and noted that the government recognizes the need for a tax system that doesn't deter individuals from savings and investing and encourages businesses to invest and grow.
We repeatedly heard two solutions that unfortunately may be a long way off -- more resources and simplification. The IRS and the U.S. Treasury need more staff and more funding to police the system. Similar to the issues facing the SEC, there simply aren't enough resources to meet the demands of enforcing compliance with the tax code. In addition, complying with the code, even for those who want to, has become so complex that it may be beyond the ability of most taxpayers.
The American Institute of Certified Public Accountants' Code of Professional Conduct includes a statement that their members have a responsibility not only to their clients, but to the tax system as well. Having learned the lesson the hard way through dubious corporate financial statement disclosures, we can only hope that taxpayers and tax professionals will heed the dangers of unethical behavior and take this opportunity to restore an important balance in the tax-preparation process.