Chances are, if you've ever itemized deductions on your income tax returns, you may have already played a small-stakes version of "audit roulette," in which you consider the likelihood of being audited against the value of the deduction.

For example, when you decide to take that "borderline" deduction for your newspaper subscription or for that birthday party business clients attended, you may have placed your bet on the low probability of your return being audited.

Putting aside moral factors, if audit risk is weighed against the chance of the deduction being sustained, there are often rational economic reasons to take aggressive tax positions.

For some time now, high-stakes tax audit roulette has been packaged and sold to business owners, executives and in-house tax managers in the form of "proprietary tax plans" (also known as tax shelters) marketed by investment banks, Big 5 accounting firms and others.

Typically, legal opinions from the promoters or third-party outside lawyers are included to support the tax treatment being proposed. This gives the shelter buyer a fighting chance at avoiding the 20 percent penalties assessed on negligent or substantial tax underpayments. The legal opinions often quantify with a percentage the likelihood of prevailing if the matter ever came to court.

However, a legal opinion ordinarily will not take into account what is arguably the key economic factor the likelihood of an audit of the return that reports the transaction. This key economic consideration audit risk is left to the buyer of the tax product.

It seems many are taking the risk. The latest statistics show the country's corporate book profits are at all-time highs, while corporate tax receipts, as a percentage of book profits, are in rapid decline.

Many in Congress, at the Treasury and elsewhere believe this drop in corporate tax receipts is attributable to the widening use of these marketed tax plans. The Treasury has, in fact, recently adopted regulations that heighten the tax return disclosure requirements for corporations that use the plans.

Other recent regulations require the promoters of the plans to maintain lists of customers (which could then be discovered by the IRS through the use of a "John Doe" summons).

These requirements have resulted in a turn to greater marketing of these tax plans to individuals. Sophisticated buyers of these tax products should consider the following factors:

  • The percentage probability of being audited;
  • The percentage of taxes and interest that the IRS and Franchise Tax Board would assert;
  • An estimate of legal and accounting fees in defending an audit. Often, when these factors are considered, taxpayers will conclude that they come out ahead with a tax product (rather than paying the taxes on a given transaction up front). Of course, optimistic assumptions about these factors increase the attractiveness of the plan, while more conservative assumptions could tip the economic scales against use of a plan. Those giving them serious consideration should run the numbers with an array of different reasonable variables. Taxpayers sometimes place a low estimate on audit risk because the marketed tax plans often come with suggestions for "artful" reporting of the loss or deduction-generating transactions. Under rational economic analysis, as the audit risk percentage drops, the attractiveness of the plans grows. Also, with higher stakes, audit defense fees as a percentage of these stakes, are likely to be lower, thus explaining why these plans are most often marketed to those at the highest end of the economic spectrum. Though we are not endorsing the use of marketed tax plans, we suggest the following for those who are considering them:
  • Opinion review, which considers the likelihood of settlement of taxes, interest and penalties, if an audit occurs. Have independent tax counsel review the promoter's legal opinion to advise you as to its soundness, as a matter of substantive tax law. Also seek a supporting opinion from independent counsel. When you are considering several plans, counsel may be able to recommend one over another based on the relative quality of the promoters' opinions. Keep in mind that just because a promoter's opinion estimates the likelihood of a tax position being sustained at greater than 50 percent does not necessarily justify placing a low estimate on the settlement of tax, interest and penalty percentages, if an audit were to occur.
  • Reporting review, which relates to audit risk. Have independent tax counsel review any suggested reporting of the underlying transaction to confirm that this stacks up with procedural tax law. Counsel may be able to suggest better alternatives under procedural tax law.
  • Preparation for possible audit. Consult with tax counsel about their strategies for handling controversies arising out of audits of these types of plans. Keep in mind that in view of the recent trend in court cases and possible legislative or regulatory responses to these plans, the best end game strategy in this context may be to seek an efficient settlement, rather than potentially protracted and difficult litigation.
Menasche Nass and Andrew Bernknopf are attorneys with De Castro, West, Chodorow, Glickfeld & Nass Inc. The authors can be reached at mnass@dwclaw.com and abernknopf@dwclaw.com.


Entrepreneur's Notebook is a regular column contributed by EC2, The Annenberg Incubator Project, a center for multimedia and electronic communications at the University of Southern California. Contact James Klein at (213) 743-1759 with feedback and topic suggestions.

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