Tax shelters; Public limited partnerships
This used to be the time of year for tax panic: Your accountant had discovered that you owed the Internal Revenue Service (IRS) a small fortune.Skip to next paragraph
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His cousin, however, had a tax shelter, involving coal or maybe lithographs, which would not only wipe out your tax liability, but maybe make you - or more likely his cousin - rich, as well.
That was the way some tax shelters used to work.
However, in the 1980s, many of the folks selling limited partnerships are going to have to clean up their act.
This year, Congress passed the Tax Equity and Fiscal Responsibility Act. According to Robert A. Stanger, who heads up the Stanger Report, which analyzes tax shelters, the legislation is ''perhaps the most important change in partnership-tax proceedings in a decade.''
Among other things, this tax act gave the IRS the ammunition it needed to crack down on what it considers ''abusive'' tax shelters. Investors' main reason for investing in these tax shelters is to obtain extremely generous write-offs to avoid paying taxes. Accountants and professionals call these ''exotic'' investments, since they often deal with coal royalties, lithographs, or some other unusual limited partnership.
Now, the IRS, instead of pursuing cases on an individual basis, can go after all the investors in a shelter at once. In other words, the IRS can challenge whole shelters, not just individuals. The result is that, ''If you flirt with the grey areas of the law, you better do so with your eyes open,'' says Mr. Stanger in his recent book, ''Tax Shelters, the Bottom Line'' (Fair Haven, N.J., Robert A. Stanger & Co., $32.50.). It sometimes used to pay financially to cheat on your taxes. The penalty, if you got caught with a deduction that was disallowed, was paying the tax due plus 6 percent interest.
Now the IRS charges interest rates based on the prime rate. The rate currently charged is 20 percent, and on Jan. 1, it will fall to 16 percent. According to Jerome Seidman, an accountant with the firm of Seidman & Seidman, the 20 percent interest rate ''made a major impact'' on cutting down on questionable deductions. In addition, the IRS now can impose a 10 percent nondeductible penalty on what it considers a ''substantial understatement'' of income tax.
The IRS has significantly changed the rules so that an individual now must be able to prove that he thought he would be successful in making the deductions. Thus, it's likely the investor will need a letter from a law or accounting firm indicating that he had been advised that the deductions would hold up under IRS scrutiny. The penalty for a law firm that commonly gives bad advice is that it cannot practice before the tax court - a potential loss of income.
And, if the IRS considers a taxpayer ''negligent,'' it can add a penalty as high as 50 percent of the interest due on the unpaid tax. Furthermore, the agency has programmed its computers to greatly increase the probability that an individual using multiple write-offs (more than $1 deducted for every dollar invested), will have his whole return audited.
Does this sound like the IRS means business?
You bet it does.
''Any savvy investor is going to know the game is over for the old-style tax shelters,'' says John A. Tomassini, an E.F. Hutton vice-president dealing with tax shelters. Adds George (Woody) Frank, a Merrill Lynch & Co. vice-president, ''The government is slowly but surely making the tax-shelter business into the tax-investment business.''
In addition, investors are going to find that limited partnerships are less alluring than they had been, because of the change last year in the maximum tax rate from 70 percent to 50 percent. In the past, ''When you were in the 70 percent tax bracket, tax shelters made sense in terms of tax dollars,'' says Thomas W. Spear, a vice-president at Asset Management Group, a financial counseling firm located in Englewood, Colo. At the 50 percent rate, factors other than taxes will have greater weight in the decision.
Assume that John Q. Taxpayer in 1980 was in the highest marginal tax bracket - 70 percent. Also, assume he puts $10,000 in a tax shelter investing in landfill projects in Hoboken, N.J. He receives a conservative depreciation write-off from his income taxes of $1 for every $1 he invests. Thus, he can deduct $10,000 from his taxable income. In his tax bracket, his tax savings is $ 7,000. Since he invested $10,000, his out-of-pocket expense is $3,000. Assume there is an after-tax cash flow of 6 percent a year from the investment. Thus, his average annual after-tax return is 20 percent (6 percent of $10,000 is $600, divided by the out-of-pocket expense of $3,000, which equals a 20 percent annual after-tax return).
By way of comparsion, Mr. Taxpayer could have invested in municipal bonds yielding 12 percent. Thus, his ''risk premium'' for investing in the tax shelter was 8 percent. This is considered a good premium.