The Tax Man Cometh

The federal government looks to eliminate abusive tax shelters, and it may cost San Francisco tens of millions of dollars

When it comes to money, I'm not ordinarily a prescient man. I first got wind of this insufficiency in 1995, when, while working for Dow Jones Newswires, I tut-tutted investors who had made leveraged purchases of Mexican government bonds while that country teetered near financial collapse. In a span of weeks, the investors multiplied their money tenfold. Moving to San Francisco in 1997, I scoffed at those willing to buy Bay Area houses in the wake of the Asian currency crisis; didn't they know we were part of the Pacific Rim? That was the year local house prices began a sharp, sustained rise. Later, I envied people with dot-com jobs, what with the free Snapple, back rubs, and money.

It was thus with simultaneous twinges of satisfaction and regret that I realized I may have finally gotten one right. A year and a half ago, I wrote an article saying the city government stood to lose millions of dollars in connection with a tax shelter San Francisco's Municipal Railway sold to a group of private investors. Last week, statements from the U.S. Treasury Department and the chairman of the U.S. Senate Finance Committee dramatically increased the likelihood that such a costly scenario will play out.

Specifically, important federal officials are describing as "illicit" and "abusive" a type of transaction completed by Muni in 2002, when the agency received $43 million in a complex "lease/lease-back" deal that allowed private investors to depreciate (that is, to write off the wear and tear suffered by) 118 rail cars for federal income tax purposes. Muni paid out $10 million to lawyers and financial consultants to prepare the deal, and kept $33 million. The investors gained a tax advantage that presumably was valued far in excess of the $43 million that Muni received, but they have rigorously refused to say how much they stand to reap over the life of the quarter-century deal.

The U.S. Treasury Department last week said it has every intention of eliminating precisely the corporate tax breaks created in lease/lease-back deals such as Muni's. There was nothing generic about the Treasury announcement; it directly targeted transit authority tax shelters.

"Taxpayers increasingly have used purported leasing transactions to 'acquire' significant tax benefits from a tax-indifferent party, such as a municipal transit authority," the Jan. 12 Treasury Department press release said. "These transactions do not involve any useful economic activity, such as the acquisition or financing of business assets, and instead simply move a tax benefit, including depreciation, from a party that cannot use it (the municipality) to a party that can (the taxpayer). The Administration's proposal would sharply limit the tax benefits claimed by the taxpayer in these transactions."

The "useful economic activity" language is a specific reference to transactions such as the 2002 Muni deal, which was presented to government officials as the cash sale of a tax shelter, and then portrayed to the IRS as an ordinary business transaction.

San Francisco is not alone in selling corporations the right to deduct wear and tear from public infrastructure. New York City has plans to turn its huge, underground water delivery tunnels into tax shelters. BART has done several such deals, selling its trains and switching systems as corporate tax dodges. But San Francisco's deal may have been unusual -- and unusually stupid -- in the way that it guaranteed investors that the deal would always pass muster with the IRS.

In light of the recent government announcements, a side agreement associated with the deal seems particularly dangerous. In entering the tax-shelter deal, Muni signed a contract that, as interpreted by a tax expert I spoke with, would make San Francisco responsible for the benefits of the tax break to the private investors for the 25-year life of the deal, should the IRS ever disallow the shelter.

In a press conference Tuesday, Assistant Treasury Secretary Pamela Olson said the department would seek to halt such deals retroactive to Jan. 1, 2004, a ban that would not affect the San Francisco deal. But Olson added that the IRS would also audit existing deals, a policy that could potentially imperil Muni's tax shelter. A call to a Treasury Department spokeswoman seeking information about how Olson's plans might specifically affect earlier deals, including Muni's, had not been returned by press time.

Olson used unusually strong language in condemning transactions like San Francisco's, creating the impression among tax experts that the Treasury Department might make good on its threat. According to news accounts of the press conference, Olson characterized the deals as shams in which "nothing happens" except the divvying up of bogus tax deductions. San Francisco's deal certainly seems to meet this definition; when I asked in 2002 for them to provide evidence that the deal had economic merit beyond its role as a tax dodge, both Muni and lawyers for the private investors refused.

The Treasury announcement has been months in coming. Last fall, Senate Finance Committee Chairman Charles Grassley (R-Iowa) held hearings condemning San Francisco-style municipal lease-back tax shelters as illicit shams. "My hearing was held to examine abusive tax shelters and ended up uncovering a gross breach of ethics, where greed and green trumps all else, including a decaying moral code of professional conduct," Grassley said in a press release last October. "Witnesses at my hearing exposed tax lawyers and accountants not just stretching tax law to find loopholes, but twisting facts to fit those loopholes. It showed companies leasing subway systems and other public works." Last Wednesday, Grassley described the Treasury Department announcement as confirmation of his findings.

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