Accounting Firms Face Backlash
Over the Tax Shelters They Sold

INDIANAPOLIS -- A number of things struck Henry Camferdam as unusual when he sat down in late 1999 with tax experts from Ernst & Young LLP. He and three colleagues had just sold their computer business. The meeting, at the accounting firm's downtown office here, was called to show them how they could legally shield their $70 million in profit from federal income taxes.

But first they had to sign papers agreeing not to tell anyone how the strategy worked. Only then, Mr. Camferdam says in an interview, did two Ernst & Young tax partners give a 40-minute presentation outlining the complex deal. The tax partners said the deal would be hidden from the Internal Revenue Service, according to Mr. Camferdam.

He says he didn't quite understand the plan -- and wasn't allowed to take the marketing materials with him to study later. But he says he signed on, relying on the firm's reputation and the advice of his auditor and accountant who also worked for Ernst. Mr. Camferdam and his associates paid about $7 million in fees for a strategy that put their taxes at close to zero.

Now the move is beginning to look costly, both for them and for Ernst. The IRS is auditing the Ernst tax strategy, meaning that the four clients potentially face back taxes, penalties and interest of more than $20 million. They have sued Ernst in federal court in New York, alleging that the firm exploited its position as a trusted adviser, fraudulently luring them into "an illegitimate tax sham." Ernst has declined to discuss specifics of the suit, which it is fighting it court, but terms it "frivolous" and "without merit."

The dispute is just one part of a new wave of scandal hitting the accounting business. Ernst, along with nearly every other major accounting firm, is under attack for tax advice given to individuals, many of them highfliers now being pressed by the IRS to pay significant sums to cover taxes they avoided at the firms' advice. Clients are suing accountants in a sour aftermath to the profession's push in the 1990s for new markets that paid better than auditing work.

Simmering in boardrooms and courthouses for months, the issue broke into prominence this week as Sprint Corp. asked its chief executive, William Esrey, and its president, Ronald LeMay, to step down over tax-shelter deals they had gotten into. They have said they did nothing wrong and blame Ernst for providing bad advice. The accounting firm has issued a statement standing by its advice.

STORMY SHELTERS See an IRS petition1 against KPMG over tax shelters, by arrangement with FindLaw (http://www.findlaw.com/2).

The IRS also is cracking down. It has pledged to close the tax loophole used by the Sprint executives and others. Last year the agency sued to force Arthur Andersen, KPMG LLP and BDO Seidman LLP to turn over shelter-related documents. The government accused the firms of flouting tax laws to help hundreds of companies and individuals avoid billions of dollars of taxes through improper shelters. The IRS has identified dozens of clients it says KPMG sold questionable tax shelters to, including former chairman of Global Crossing Ltd. Chairman Gary Winnick, Guess? Inc. Chief Executive Maurice Marciano, and New Line Cinema Chairman Robert K. Shaye. All declined to comment.

'Tidal Wave'

Accounting firms "are now facing a tidal wave of lawsuits over tax shelters that could do tremendous damage," says Lynn Turner, a former chief accountant at the Securities and Exchange Commission. He says this seriously threatens their credibility with clients, including wealthy executives, who may decide the advice they're getting is misleading.

The scope of the tax-avoidance problem has reached huge proportions. During 2002, the IRS got information suggesting that a million taxpayers could have been using one scheme alone -- anonymous offshore bank accounts that allow them to hide money away yet gain access to it through credit or debit cards. The IRS confronts 82,100 cases of abusive devices a year, though it doesn't have the staff to pursue all of them, former IRS Commissioner Charles Rossotti wrote in a report late last year.

A federal clampdown in the 1980s on tax shelters marketed by accountants and others prompted some investors to sue their advisers. What distinguishes the recent wave of activity is the energy that large accounting firms have devoted to devising strategies themselves, as well as the scale of their marketing efforts and the size of fees earned.

The 1990s boom produced a large pool of rich potential clients, most unfamiliar with tax-law complexities. At the same time, accounting firms were looking for new revenue as that from audits flagged. A 1991 change in the profession's rules provided a helping hand: Accountants could now charge performance-based fees just like investment bankers, as opposed to the traditional hourly rate.

So big accounting firms formed teams dedicated to promoting high-margin tax strategies. Fees to the accounting firm ranged from 10% to 40% of taxes saved. The individual tax salesmen who snagged deals could get up to 10% of this. At Deloitte & Touche LLP, a large group of salesman informally known among some members as the "Predator" group hunted clients armed with a long list of creative tax ideas. Deloitte says it does have dedicated sales team but says it has no knowledge of that name.

"The pressure became to sell things that would be in your best interest rather than the clients'," says Robert Verzi, a former Deloitte tax partner in Atlanta who left in 2000 to join a regional firm. A Deloite spokesman said he didn't "want to dignify such an incorrect assertion with a response."

BDO Seidman had a tax-sales team known in-house as the "wolf pack." It generated shelter sales of more than $100 million in 2000 -- more than half of the firm's tax revenue -- according to documents filed in Chicago federal court as part of a July enforcement action.

Audit firms offered big pay packages to compete with law firms for top talent. Some tax experts moved between government posts and the accounting firms' Washington tax offices. There they ruled on tricky tax issues, interacted with regulators and often devised the strategies. Training for tax partners began to include a heavy dose of salesmanship -- with coaching in voice-projection and how to make presentations.

"The pressure on the partner group to sell became severe, it became a monster that needed to be fed," says Donald M. Griswold, a former KPMG tax partner who left in 2001 and now works at a Washington law firm.

Mr. Camferdam says he saw a taste of this in his dealings with Ernst. The strategy it sold him created paper losses to offset capital gains through a complex series of transactions. They included the purchase and sale of long and short currency options, transferring them and other assets to a newly created partnership, and other steps that inflated the value of the assets before they were sold.

All of which seemed fine until one day in December, when the IRS sent him a large white hand-addressed envelope informing him he was under audit. Mr. Camferdam contends Ernst abused its position of trust. "It's like having a policeman there with you, you don't think you're committing a crime," he says in an interview.

The case shows how well these deals paid, not only for accountants but also for the lawyers and bankers brought in for their help. For accountants and lawyers, Mr. Camferdam and his three colleagues paid a fee of 4.5% of capital losses that the shelter created to shield capital gains from taxes. About one-third of that, or $1.06 million, went to Ernst.

About two-thirds of the fee, or $2.04 million, went to the law firm of Jenkens & Gilchrist, which the suit says helped develop the deal and provided a legal blessing. So-called opinion letters from law firms are vital to tax-shelter sales. The four entrepreneurs also paid lawyers Brown & Wood, now part of Sidley Austin Brown & Wood LLP, $75,000 for a second legal opinion. The opinon letters may help taxpayers who are challenged by the IRS to avoid penalties, although they're no guarantee.

Jenkens & Gilchrist declined to comment on the fees or the Camferdam suit, in which the law firm is a defendant. Sidley Austin, also a defendant, has called the lawsuit without merit.

Beyond those fees, the clients paid Deutsche Bank $3.52 million for conducting the transactions involved in the shelter. Officials of the bank, which isn't a defendant, couldn't be reached for comment.

One reason the tax maneuvers are lucrative for accounting firms is that once devised, they can be marketed to potentially thousands of clients, both corporate and individual. In the case of the Ernst shelter sold to Mr. Camferdam, at least 47 other individuals used the same transaction, generating $50 million in fees, according to his and his colleagues' suit. Their lawyer, Blair Fensterstock, of Fensterstock & Partners LLP, says he has been contacted by a dozen other Ernst clients who say they received similar pitches.

BLIPS

KPMG partners sold a tax strategy, dubbed BLIPS, to at least 186 clients during 1999 and 2000, according to documents the IRS filed in a federal court as part of its enforcement action against the firm in July. The documents claim the strategy deprived the Treasury of about $1.28 billion in taxes. The suit says KPMG sold another strategy, known by the acronyms FLIP and OPIS, to at least 160 clients. The IRS has identified both as potentially "abusive" shelters. KPMG has maintained that the tax advice it marketed was appropriate.

Among those who bought the FLIP/OPIS strategy was Joseph J. Jacoboni, a software entrepreneur from Lake Mary, Fla. Now under IRS audit, he has accused KPMG of fraudulently misrepresenting the risks associated with the deal. In a suit in federal court in Orlando, Fla., Mr. Jacoboni contends KPMG officials assured him the strategy was bullet-proof and strictly complied with IRS rules, but told him that for reasons of confidentiality he couldn't get an independent legal review.

Mr. Jacoboni had generated $28 million in capital gains in 1997 by selling a stake in his technology company. His suit says KPMG told him it could save him millions of dollars in taxes. Mr. Jacoboni claims in the suit that he didn't understand the complex deal but went along, somewhat reluctantly, relying on the accounting firm's "blue chip" reputation.

Four years later, he learned that the IRS was auditing his 1997 tax return. In a phone call in the summer of 2001, he says in his suit, a KPMG partner told him that the firm had known for at least two years prior to the call that the IRS was challenging investments similar to the one conducted for him. His suit says this partner suggested he settle with the IRS, which he says he has since agreed to do.

The suit also alleges a "pattern of racketeering" by KPMG, naming more than 20 others that it contends were defrauded in a similar manner in 1997 and 1998. KPMG "aggressively marketed its tax strategies" through such techniques as a "Wealth Management" seminar it sponsored in Phoenix, says the suit.

KPMG say it doesn't comment on the work it performs for clients. The accounting firm has been fighting the Jacoboni lawsuit, contesting its specific allegations in court.

Tax experts at PricewaterhouseCoopers were busy designing their own deals, but in 1999, a big marketing push blew up in their face. The Treasury forced the firm to back away from a strategy known by the acronym BOSS that could have produced tens of millions of dollars in deductions.

Pricewaterhouse has scaled back its tax-shelter operations, partners say, and last summer paid about $1 million to the IRS to settle matters relating to tax-shelter registration. IRS rules require promoters to register shelters that the agency has identified as potentially abusive and to keep lists of investors; those can face stiff penalties of up to 1% of all sheltered funds. PwC says it doesn't currently sell any transactions the IRS lists as potentially abusive.

The IRS, knowing it can be years before audits identify a new type of abusive shelter, has focused increasingly on the promoters of the strategies. In a flurry of activity last year, the IRS sought tax-shelter-related information from 20 auditors and other promoters, issuing roughly 200 summonses. It has filed enforcement action against several accounting firms, including KPMG, BDO Seidman and Andersen, to force them to hand over documents -- which the firms consider privileged -- relating to transactions dating back to as early as 1995.

At Andersen, the agency identified at least 48 clients that invested in "potentially abusive tax-shelter transactions" with claimed deductions ranging from $10 million to $1.6 billion, according to the agency's September enforcement action against that firm in federal court in Chicago. A federal district judge in November ordered Andersen to give the IRS the documents, a potential boon to its efforts to obtain similar documents from KPMG and BDO. Both those cases are awaiting final rulings.

Write to: Cassell Bryan-Low at mailto:cassell.bryan%20low@wsj.com³

Updated February 7, 2003 10:06 a.m. EST