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Tax shelters turn to millstones

The Washington Post

WASHINGTON — The Internal Revenue Service’s campaign against abusive tax shelters is driving a wedge between shelter marketers and their clients and a growing number of unhappy taxpayers are seeking damages from the accounting and law firms that have devised these strategies.

Corporations and executives who find their shelters under fire stand to lose vast sums, should the IRS prevail. This week’s disclosure that Sprint chief executive William T. Esrey and Chief Operating Officer Ronald T. LeMay could face a $123 million tax bill illustrates the stakes involved.

Many of the cases involve technology companies, their founders and employees who saw the value of their holdings skyrocket in the boom of the late 1990s. Accountants and advisers told them their potential tax bills could be minimized, deferred or avoided.

But the IRS, under pressure from Congress and elsewhere, has had other ideas, and many of its challenges have been successful in court. As a result, some unhappy taxpayers are seeking redress against the accounting firms that sold them the shelters and against the law firms that wrote “comfort letters” assuring them that the strategies had a better-than-even chance of surviving an IRS challenge.

Already, accounting firms Ernst & Young, KPMG and others are defendants in damage suits, as are a number of law firms, including Dallas-based Jenkens & Gilchrist. None of the defendants responded to requests for comment.

In one case, the founders of a computer distribution company in Indiana are suing E & Y, accusing the accounting firm of “luring” them into a scheme called COBRA (Currency Options Bring Reward Alternatives), designed to shelter a $70 million capital gain that the founders had realized in 1999 from sale of their company.

According to the suit, the gist of COBRA is to create a paper capital loss to offset a real capital gain by simultaneously buying and selling long and short currency options, a process known as a straddle. The holdings are then transferred to a partnership. After a number of other transactions, the owners end up with a paper loss that cancels out their real gain.

The IRS has disallowed these losses, according to the suit, which asks $40 million in compensatory damages and $1 billion in punitive damages from E & Y. According to the lawsuit, “upon plaintiffs’ filing of amended tax returns, the IRS, along with the state tax authorities, will require plaintiffs to pay the capital gains taxes supposedly sheltered by COBRA and may impose statutory interest and penalties, amounting to many millions of dollars.”

E & Y, which is also the firm that advised Esrey, LeMay and others at Sprint, did not respond to a request for comment.

The firm did say, in a statement regarding the Sprint situation, “Ernst & Young’s long-established policy is to provide tax planning for its clients that is appropriate and has the highest probability of being approved if reviewed by the IRS. Because this policy was strictly adhered to in the case of the Sprint executives, we stand by the tax advice and counsel we provided. Ernst & Young will not comment further on this matter because of our policy not to publicly address client matters. Ernst & Young stands by the tax advice and counsel it provided.”

In the Sprint case, Esrey and others held stock options that would have triggered millions of dollars in taxes when exercised. E&Y, Sprint’s auditor, sold the executives on an arrangement that apparently involved contributing the options to family limited partnerships or trusts, and combining the options exercise with other transactions that would postpone the tax liability for years.