New York — 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.
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.
On the other hand, now that Congress has lowered Mr. Taxpayer's maximum tax to 50 percent, the economics of an investment in the garbage dump change. Assume he still invests $10,000 and receives a one-for-one write off. The tax savings is $5,000. Assuming the same pre-tax return as before, his after-tax return is now 12 percent ($600 divided by $5,000.) There is no risk premium over municipal bonds. Thus, the investor has no incentive to buy that tax shelter since the economics do not justify it.
The tax act also changed the way limited partnerships can figure depreciation - a change that George Wilson of Stanger & Co. calls ''extremely important.''
This doesn't mean the end of the road for legitimate limited partnerships. Partnerships will continue to be used to raise money for oil and gas drilling, real estate ventures, low-income housing, research and development projects, and other legitimate investments. Limited partnerships, as accountants and lawyers point out, are attractive because they limit the legal and financial liability of the investor limited partners. The general partners, in a limited partnership , most of the time take on legal and additional expenses.
But, as Mr. Spear notes, a lot more emphasis will be placed on whether the deal can stand on its own - without the tax considerations. Investors have already started to ask these questions. Last year, Mr. Stanger estimates, $2.9 billion was invested in public oil and gas partnerships. This year, with oil prices depressed, these partnerships are down by half. And with real estate prices dampened by high interest rates, real estate partnerships, which had $1.6 billion invested in them in 1981, are up by only 5 to 10 percent.
To entice investors, brokers are changing the nature of the deals. Mr. Tomassini says an increasing number of limited partnership deals brought out by E. F. Hutton are now geared towards capital appreciation.
For example, E. F. Hutton recently completed a deal with Apache Oil & Gas in which investors anted up $65 million to buy producing oil and gas wells. Investors were assured of a cash flow of 15 to 20 percent - with the only tax aspect involving a depletion allowance. And it is hoped that the oil and gas will appreciate in line with inflation.
Another Hutton deal involved raising $40 million from investors who bought an interest in some multifamily housing. The residences are to be rented out for three to five years before being converted into condominums and sold.
''This is purely a play for capital appreciation,'' Mr. Tomassini says.
This trend towards raising equity through limited partnerships should continue, says Steve Puleo, tax partner in charge at the Coopers & Lybrand Boston office. ''This an attractive approach in a tight-money situation.''
He says that a high technology company called Storage Technology recently raised $90 million in two research and development limited partnerships. The investors, as part of their reward if the venture is successful, received options and warrants for the company's common stock - thus giving them some equity in the company. From the businessman's point of view, there is some appeal to this approach. From the investor's standpoint, Mr. Puleo of Coopers & Lybrand says he thinks this trend toward giving limited partnerships some equity should make them more attractive as investments. ''As an investment vehicle these things are limited to sophisticated investors,'' he says. ''They can say, 'Hopefully the equity will pay back some handsome rewards, and I've got Uncle Sam to underwrite some of the risk.' Even though there can be a lot of risk, the investor is rewarded with tax benefits he or she dosen't normally get and the possibility of a high multiple payback.''
This is not to say that investors will find themselves making more money than they did in the past. In order for the IRS to agree that the partnership is a legitimate tax shelter, there must be money at risk.
In the past, investors in limited partnerships have had mixed results. According to a Stanger study of $3 billion of oil and gas drilling programs, the average partnership returned 10 to 13 percent after taxes over the life of the program.
''For an illiquid investment, you should get a few points better than municipal bonds,'' Mr. Wilson says.
On average, real estate funds have done much better. Stephen E. Roulac, president of Questor Associates in California, says a recent study by his organization found that some 71 programs launched between 1970 and 1976 returned 22 percent on an after-tax basis.
Sales of limited partnerships (Billions of dollars) 1981 1982 (9 months) Oil and gas limited partnerships Oil and gas drilling funds $2.0 $.798 Income funds .81 .862 Completion, royalty, and others .098 .009 Total $2.91 $1.67 Real estate partnerships $1.6 $1.43 Equipment leasing partnerships .2 .109 Other partnerships $4.91 $3.46 Total public limited partnerships $4.91 $3.46 Source: Robert A. Stanger & Co.