Long-Term Capital Case Puts Tax Shelters on Trial

By Ben White

Washington Post Staff Writer

Wednesday, July 23, 2003; Page E01

NEW YORK, July 22 -- Testimony concluded today in a closely watched trial that shows how difficult it is for the federal government to rein in corporate tax shelters.

Justice Department lawyers, in a case being heard in U.S. District Court in New Haven, Conn., are seeking $75 million in taxes, penalties and interest from Long-Term Capital Management L.P., the huge investment fund that nearly went bust in 1998 and required a $3.6 billion Wall Street bailout. The tax case centers on the previous year, however, when the fund carried out a series of coordinated, complex transactions that resulted in a total of $106 million in tax deductions.

When the government goes up against corporate America in tax-shelter cases, it faces a bevy of high-priced lawyers, investment bankers and accountants who attempt to explain why the tax shelters they devised serve legitimate business purposes and are, therefore, not abusive to the tax laws. In the Long-Term Capital Management case, government tax lawyers Charles P. Hurley and Nicole Bielawski had to contend not only with the regular lineup of sharp minds, but also with two Nobel Prize-winning economists, Myron S. Scholes and Robert C. Merton, and the famous bond trader John W. Meriwether, all of whom were founding partners of the investment fund.

To help bolster its case, the government called to testify a Nobel Prize-winning economist of its own, Joseph E. Stiglitz, a professor at Columbia University who was chairman of the White House Council of Economic Advisers in the Clinton administration.

U.S. District Judge Janet Bond Arterton's ruling in the case, which may not come for several weeks, will be important to the government's crusade against what it considers to be abusive corporate and individual tax shelters.

It's unclear how much money the government loses to shelters. The Senate Finance Committee has estimated the loss at $10 billion to $14 billion a year. Many experts believe it is more than that.

Government officials could not say how much money was recovered by the government in tax-shelter settlements or courtroom victories in recent years. Several academic experts who follow tax-shelter cases say such figures have not been tabulated.

IRS spokesman Don Roberts referred to the number of cases in progress.

Roberts said that since the beginning of 2002, the IRS has completed 207 tax-shelter examinations. He said more than 3,850 are either in progress or scheduled. In the IRS's large and mid-size corporations division, 129 people are working on cases involving the "promoters" of tax shelters -- mostly investment bankers, lawyers and accountants. The IRS counsel's office has 72 more people working on tax shelters and 268 summonses have been issued to promoters to secure lists of tax-shelter investors.

On the New Haven courthouse steps one recent afternoon, Hurley declined to comment on where his case fits in the overall war on shelters. "I'm not sure how much coordination there is, given how much the leadership always changes," he joked. "All I know is they told me I better win this thing."

The bar for the government is high. It will not have "won," tax lawyers said, unless the government recovers both the tax and penalties.

There is little reason for individuals and business not to go to great lengths to wipe out taxes, lawyers said The worst thing that generally happens is a settlement with the IRS for a portion of the contested tax, or a courtroom loss requiring full repayment but no penalties. Taxpayers can usually avoid penalties if they demonstrate that they relied on sound legal advice that a tax shelter was legitimate.

In the current case, the government has argued that because the Long-Term Capital partners were so sophisticated, they should have known that the deductions would be disallowed. The government has also argued that Long-Term Capital relied on opinions from two law firms that would benefit from the transactions and, therefore, had clear conflicts of interest. The question of whether the partners of Long-Term Capital should have known better created one of the more colorful moments in a mostly dry legal proceeding. At the outset of his cross-examination, Hurley, the lead Justice Department lawyer, sought to portray Scholes as a tax expert.

"Am I correct that yesterday you described yourself as a lay person in regard to taxes?" Hurley asked.

"No, if I remember correctly, I said I was not an expert in regard to taxes," Scholes replied.

Hurley then picked up a fat book.

"Okay," he said. "You did, in fact, write this book, though, 'Taxes and Corporate Strategy'? . . . And am I correct that you used this book as a textbook for courses that you taught at Stanford?"

"That is correct."

Scholes repeatedly said he relied on the advice of two law firms to determine whether the tax deductions would be approved by the IRS.

The transactions, designed by San Francisco investment banking firm Babcock & Brown, worked roughly this way:

Three British investors, not subject to U.S. taxes, inserted themselves into a series of leasing transactions with, among other companies, General Electric Capital Computer Leasing. The transactions, commonly known as "lease stripping," produced about $375 million in tax deductions. The British investors could not use the deductions themselves, so they transferred them to several American investors in return for preferred shares of stock, which supposedly were worth $375 million.

The British investors contributed the preferred shares to Long-Term Capital in exchange for a stake in the fund. Long-Term Capital later sold the shares and claimed a loss of $371 million.

On its 1997 tax return, Long-Term Capital applied $106 million of that loss to offset capital gains. The IRS disallowed the loss, saying the value of the preferred stock sold by Long Term Capital was artificially inflated.

Long-Term Capital sued in 2001, putting the $40 million in contested taxes on deposit. If it had simply refused to pay, the case would have been heard in federal tax court in Washington, which is considered friendly to the government and hostile to taxpayers.

During his cross-examination, Scholes repeatedly asserted that all parties to the series of transactions took risks and had real expectations of profit. The government, supported by Stiglitz and other experts, argued that the transactions were financial gymnastics with no true business purpose.

"You don't think getting $100 million in tax deductions for something you paid $1 million for is a tax shelter?" Hurley said to Scholes with a sneer last week.

Scholes, who generally responded to simple yes-or-no questions with long, discursive answers, demurred.

"I prefer not to get into definitions like that," he said. "It was a mitigation of taxes."

© 2003 The Washington Post Company