Image: Esrey
Sprint Corp. Chairman and CEO Bill Esrey holds a Sanyo phone at last year's Consumer Electronics Show in Las Vegas. Sprint ousted Esrey and another top executive after the IRS questioned their efforts to shelter stock options from taxes.
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msnbc.com

It’s been 17 years since Congress overhauled the tax code with the aim of closing loopholes that allowed wealthy taxpayers to avoid paying their fair share. Recent reports about Sprint and Tyco executives trying to cut their tax bills demonstrate that these tax schemes haven’t lost any of their popularity — and some may even still work. But tax experts says that, once these tax shelters show up on the front page and the Internal Revenue Service takes a closer look, the game is usually over — and the IRS wins.

Nobody likes paying taxes. And there’s nothing illegal about trying to be clever and creative about using the rules to pay as little as you have to. But evading taxes lands you in jail. Navigating that legal gray area — between avoiding and evading — has produced a lucrative business for accountants and lawyers offering to help clients cut their tax bills.

“Shelters have become more common as accounting firms have begun to truly market them — just like a mutual fund company markets mutual funds” said Edward Lyon, a tax consultant and financial planner. “They’re a great source of fee revenues because the fee the accounting firm charges really bears no relation to the cost of providing the service. What it takes is one creative accountant or attorney to come up with the idea and it’s off to the races.”

That creativity spawned a host of strategies for executives sitting on lucrative stock options, which promised to generate piles of income during the historic market boom of the late 1990s. A scheme used by two top Sprint executives, and sanctioned by the company’s accountants, recently landed them in hot water with the Internal Revenue Service and cost them their jobs. Former Tyco Corp. executives reportedly set up similar complex transactions to shield their stock options from taxes.

It’s difficult to estimate how widespread these strategies have become — largely because they rely on secrecy to fly under IRS radar. That’s why many firms selling tax shelters require clients to sign a confidentiality agreement.

“Once the idea hits the public and everyone’s heard about it, it gets notoriety,” said Paul Bochner, an accounting professor at Fordham University’s Graduate School of Business. “And then either the (Internal Revenue) Service through rules, or Congress through the law, curtails that kind of activity.”

To try to shield the tax bite on their clients’ historic stock option gains, the accounting industry came up with various schemes executives sitting on potential windfalls.

“In the old days they were called tax shelters,” said Bochner. “Today they’re called products.”

But these “products” are hardly new. In the 1980s, tax shelters got such a bad name that Congress turned the tax code upside down to try to close the loopholes in the law that made them possible. Comprehensive tax reform shut down the most common schemes in 1986. But it didn’t eliminate them.

And with the huge stock market gains of the late 1990s, wealthy taxpayers once again had piles of income to try to shelter. One common strategy involved transferring those gains to another entity (like a trust or family member) that would be subject to lower taxes —- or none at all.

Ordinarily, transferring stock options to a family member or independent trust “wouldn’t be allowable,” according to Mike Blackburn,” a financial advisor at A.G. Edwards who specializes in stock options. “Some plans allow transfer of options, but not many. It’s not something we see very frequently.”

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But there are all sorts of ways to interpret the rules and stretch legal definitions, say tax experts. Rather than transferring options, you could transfer an option on the option — giving the new owner the right to exercise it later.

Or you could set up a shelter using long-term transactions — like currency trades — that would generate huge short-term losses to offset stock option gains while paying gains years later. If you can figure out a way to convert your stock option windfall to capital gains, which are taxed at a lower rate than ordinary income, you can cut your tax bill in half.

But no matter what method you use, you have to convince the IRS that the deal has a purpose other than avoiding taxes.

“A tax shelter, by definition, is a transaction entered into primarily for tax benefits,” said Lyon. “If the transaction has no economic benefit other than the tax advantages, they will eventually get shut down.”

Congress is taking a fresh look at the tax code to try to close loopholes that have crept back into the system since 1986. But it may take awhile.

“The government is always a couple of years behind,” said Douglas Stives, a CPA with the Churchin Group, an accounting firm in Red Bank, N.J. “Right now, the IRS is auditing 2000 returns. It’ll take them a year or two to teach their people how to find [a specific tax shelter.] And even if someone has done this today and is put on notice, it’ll be a couple of years before we get a final ruling out of the court system.”

In the meantime, if you’ve set up one of these tax schemes, you get to keep using the money you would have otherwise had to pay in taxes.

Unless you’re a high roller, don’t expect your accountant to suggest setting up one of these schemes. To avoid penalties, you’ll need a letter from a lawyer saying the plan is legal. And that’s expensive.

“If you or I were faced with this,” said Stives, “we could get it to a law firm and it probably would start at $50,000 for an opinion of this magnitude. Most of my clients would say, ‘I’ll just pay the tax and get it over with.’”

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