Most experienced CFE’s are familiar with financial fraud cases involving the overhanging liabilities represented by artfully constructed schemes to avoid income taxes since multiple ACFE training courses over the years have focused on the topic in detail. But for those new to fraud examination and to the Central Virginia Chapter, a little history. Before 2002, accounting firms would provide multiple services to the same firm. Hired by the shareholders, they would audit the financial statements that were prepared by management, while also providing consulting services to those same managers. Some would also provide tax advice to the managers of audit clients. However, the Sarbanes-Oxley Act of 2002 (SOX) restricted the type and the intensity of consulting services that could be provided to the management of audit clients because the provision of such services might compromise the objectivity of the auditor when auditing the financial statements prepared by client management on behalf of the shareholders. Nevertheless, both before and after the passage of SOX, as subsequently reported in the financial press, both the major accounting firms Ernst & Young (E&Y) and KPMG were offering very aggressive tax shelters to wealthy taxpayers as well as to the senior managers of their audit clients.
In the 1990s, E&Y had created four tax shelters that they were selling to wealthy individuals. One Of them, called E.C.S., for Equity Compensation Strategy, resulted in little or no tax liability for the taxpayer. The complicated tax plan was a means of delaying, for up to thirty years, paying taxes on the profits from exercising employee stock options that would otherwise be payable in the year in which the stock options were exercised. E&Y charged a fee of 3 percent of the amount that the taxpayer invested in the tax shelter, plus $50,000 to a law firm for a legal opinion that said that it was “more likely than not” that the shelter would survive a tax audit. E&Y had long been the auditor for Sprint Corporation. They also took on as clients William Esrey and Ronald LeMay, the top executives at Sprint. In 2000 E&Y received:
- $2.5 million for the audit of Sprint,
- $2.6 million for other services related to the audit;
- $63.8 million for information technology and other consulting services, and
- $5.8 million from Esrey and LeMay for tax advice.
In 1999 Esrey announced a planned merger of Sprint with WorldCom that potentially would have made the combined organization the largest telecommunications company in the world. The deal was not consummated because it failed to obtain regulatory approval. Nevertheless, Esrey and LeMay were awarded stock options worth about $3ll million. E&Y sold an E.C.S. to each of the two executives. In the three years from 1998 to 2000, the options profits for Esrey were $159 million and the tax that would have been payable had he not bought the tax shelter amounted to about $63 million. The options profits for LeMay were $152.2 million and the tax thereon about $60.3 million.
Subsequently, the Internal Revenue Service rejected the E&Y tax shelter of each man. Sprint then asked the two executives to resign, which they did. Sprint also dismissed E&Y as the company’s auditor. On July 2, 2003, E&Y reached a $15 million settlement with the IRS regarding their aggressive marketing of tax shelters. Then, in 2007, four E&Y partners were charged with tax fraud. These four partners worked for an E&Y unit called VIPER, “value ideas produce extraordinary results,” later renamed SISG, “strategic individual solutions group.” Its purpose was to aggressively market tax shelters, known as Cobra, Pico, CDS, and CDS Add-Ons, to wealthy individuals, many of whom acquired their fortunes in technology-related businesses. These four products were sold to about 400 wealthy taxpayers from 1999 to 2001 and generated fees of approximately $121 million. The government claims that the tax shelters were bogus and taxpayers were reassessed for taxes owed as well as for related penalties and interest.
On August 26, 2005, KPMG in turn agreed pay a fine of $456 million for selling tax shelters from 1996 through 2003 that fraudulently generated $11 billion in fictitious tax losses that cost the government at least $2.5 billion in lost taxes. The four tax shelters went by the acronyms FLIP, OPIS, BLIPS, and SOS. Under the Bond Linked Premium Issue Structure (BLIPS), for example, the taxpayer would borrow money from an offshore bank and invest in a joint venture that would buy foreign currencies from that same offshore bank. About two months later, the joint venture would then sell the foreign currency back to the bank, creating a tax loss. The taxpayer would then declare. a loss for tax purposes on the BLIPS investment. The way that BLIPS were structured, the taxpayer only had to pay $1.4 million to declare a $20 million loss for tax purposes. BLIPS were targeted at wealthy executives who would normally pay between $10 million and $20 million in taxes.
Buying a BLIPS, however, effectively reduced the investor’s taxable income to zero. They were sold to 186 wealthy individuals and generated at least $5 billion in tax losses. The FLIP and OPIS involved investment swaps through the Cayman Islands, and SOS was a currency swap like the BLIPS. The government contended that these were sham transactions since the loans and investments were risk-free. Their sole purpose was to artificially reduce taxes. Some argued that the KPMG tax shelters were so egregious that the accounting firm should be put out of business. However, Arthur Andersen had collapsed in 2002, and if KPMG failed, then there would be only three large accounting firms remaining: Deloitte, PricewaterhouseCoopers, and Ernst & Young. KPMG Chairman, Timothy Flynn, said “the firm regretted taking part in the deals and sent a message to employees calling the conduct inexcusable. KPMG remained in business, but the firm was fined almost a half billion dollars.
Because of the Ernst & Young and KPMG tax fiascos, the large accounting firms have become wary of marketing very aggressive tax shelters. Now, most shelters are being sold by tax “boutiques” that operate on a much smaller scale and so are less likely to be investigated by the IRS. The question that remains, however, is to what extent should professional accountants be selling services that directly or indirectly abet even lawful tax avoidance which, as the ACFE tells us, can so easily shade into what the IRS calls tax evasion?