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Introduction

There is an aggressive effort underfoot in Washington to catch purported tax cheats. President Obama's fiscal 2010 budget proposes to double the IRS enforcement budget for the current year and quadruple it by 2015.[1] Senate Finance Committee Chair Max Baucus, D-Mont., has undertaken a widely publicized campaign to solve the tax gap--which has been estimated by the IRS to have exceeded $345 billion in 2001—in part by pursuing policies to identify and stop abusive tax shelters. Meanwhile, the IRS is fully engaged in pursing an aggressive audit strategy with the resources it already has. While no one likes a cheat, properly distinguishing one from the simply business-smart or lucky is a difficult task and can involve the IRS sweeping up the good with the bad. This article discusses the trade-offs surrounding tax efficiency and economic uncertainty through a case study discussion of Southgate Master Fund v. United States, [2] a case involving the tax treatment of a distressed asset debt (DAD) transaction in 2002, and a legislative change to that treatment enacted prospectively in the American Jobs Creation Act of 2004 (Jobs Act).

Former IRS Chief Counsel Donald Korb remarked in a 2005 speech, "One of the most serious problems that the IRS has had to face over the last 10 years is the proliferation of abusive tax shelters." [3] Nearly four years later, he commented, "I believe that someday we will look back on the past 48 months as a rather historic period where many courts overwhelmingly sustained the Service's use of the various judicial doctrines (substance over form and economic substance) in a number of tax shelter cases."[4] Striking the appropriate balance between legislative action and IRS enforcement, however, presents a challenge for policymakers. Giving broad discretion to the IRS to challenge suspected tax evaders is one way to address the tax gap, but to do so substantially amplifies the economic frictions involved with doing business because the compliance costs and risks for taxpayers engaged in legal, business-motivated transactions will increase.

This case study illustrates the issues and challenges involved in balancing the competing forces between tax collection and economic efficiency. First, Southgate offers evidence that advocating a broad judicial interpretation of the economic substance doctrine--a sniff test for tax shelters whereby tax benefits are disallowed simply because they do not look or feel right or fair--is unnecessary and in fact undesirable. Second, waiting to enact the statutory change disallowing loss partnership transfers and enacting the change prospectively did not impede the government's ability to pursue suspected tax evaders. Rather, a careful, precise, fact-based approach that judiciously employs common-law doctrine should be sufficient to achieve proper tax enforcement without creating undue uncertainty for all other taxpayers.

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Alex Brill is a research fellow at AEI.

Photo credit: iStockphoto/Brandon Rose