Financial Alchemy: How Tax Shelter Promoters Use Financial Products to Bedevil the IRS (and How the IRS Helps Them)

Abstract

In 2012, taxpayers who participated in the Son of Boss tax shelter received a $1 billion windfall from the government, based on the U.S. Supreme Court ruling in United States v. Home Concrete & Supply, LLC (“Home Concrete”). In the last ten years, by the Internal Revenue Service’s (“IRS”) own estimate, Son of Boss generated over $6 billion in improper tax benefits. While many taxpayers who participated in the Son of Bosstransaction settled their cases with the IRS, the effect of entering into the transaction was often a net positive for those who settled. Among those who chose not to settle, based on the government’s loss in Home Concrete, taxpayers were allowed to keep the roughly $1 billion in tax benefits generated from those taxpayers’ transactions.

The Son of Boss shelter, at its core, was derived from a financial strategy called a “short against the box,” which, since the 1930s, has allowed taxpayers to avoid paying billions of dollars in capital gains taxes. The government shut down the original form of the short against the box transaction in the mid-1990s and later shut down the Son of Boss transaction in the mid-2000s. Despite those government actions, however, numerous tax shelters derived from the short against the box strategy have robbed the U.S. Treasury of billions of dollars of tax revenue. Those shelters, and the government’s response to them, are discussed herein.

Taxpayers and the IRS have long engaged in a battle over tax shelters. After the Internal Revenue Code (“Code”) was amended substantially in1986, numerous large-scale tax shelters became obsolete. What emerged after the 1986 amendment, however, was a cottage industry of tax professionals creating more targeted tax shelters for corporations and high net worth taxpayers.

Many of these modern tax shelters are structured to take advantage of gaps in the law or regulations, particularly with respect to the taxation of combined financial products. Two of the largest such tax shelters, the Son of Boss and the Contingent Deferred Swap (“CDS”) transactions, used combined financial products to turn the Code on its head, generating billions of dollars of tax benefits for transactions largely devoid of substance.

Keywords: tax shelter, Son of Boss tax shelter, box transaction