As I write this, it isn’t known whether the Department of Justice will arrange for KPMG Peat Marwick to be indicted. It is known that the firm will have to grovel for any mercy that may be extended. Already the apologies and promises of future amendment flow copiously and abjectly. They may or may not be sufficient to avert another Andersen-like collapse. That will be decided not by what clients want but by whether the depth of humiliation and fervor of repentance satisfy federal lawyers and state accounting regulators.
As Andersen’s fate showed, the White Queen’s “sentence first, verdict later” is the rule for professional firms, and guilt by association is adequate grounds for capital punishment. Andersen was associated with Enron. KPMG’s fatal association is with a more nebulous wrongdoer: “illegal tax shelters”. By that phrase the DoJ’s publicists do not mean schemes that violate clear principles of tax law or that courts have condemned. They refer to complex financial transactions that, in the opinion of the IRS, lack economic substance and therefore are to be disregarded for tax purposes. There is usually room for argument. The parties to a carefully designed shelter typically buy or sell assets, borrow money and engage in other financial dealings that individually have tangible economic effects and collectively produce a large tax deduction. The question, often hard to resolve, is whether the flurry of transactions reflected real economic activity or was a sham undertaken for no purpose but the generation of tax benefits.
Various KPMG partners played leading roles in devising “shelters”, dubbed with acronyms like “FLIP” and “BLIPS” and “OPIS”, and touting them to clients. They backed up their sales pitches with tax opinions, which analyzed the applicable law and concluded that it supported the purported tax consequences. These opinions frequently had to delve into hazy areas of the law, including the definition of “economic substance” itself, where little light was shed by any available authority. The Justice Department’s criminal case against KPMG rests on the theory that these analyses were not good enough, that more acute reasoning would have revealed that the courts were not likely to rule in favor of the techniques and that a conscientious tax advisor could not recommend their use. (There are also, inevitably, “cover-up” allegations, which aren’t my subject here, though they give the appearance of being based on no more than the accused’s refusal to turn documents over to investigators until ordered by a judge and otherwise defending itself too vigorously.)
If KPMG was wrong about tax law, one might suppose that the government had a simple remedy: Disallow the claimed deductions, and let their validity be decided by the courts. That is how tax disputes are ordinarily handled. Since all of the taxpayers that adopted KPMG’s schemes were wealthy and sophisticated, the government could be confident that a few court victories would lead to the extinction of any shelter found to be truly illegal. What is the point, then, of invoking criminal sanctions against taxpayers’ advisors?
A useful comparative case is that of marketers of phony tax avoidance trusts for less-than-sophisticated individuals. The courts have repeatedly agreed with the IRS that these devices do not legitimately reduce tax liability, but the nature of the target market is such that legal defeats don’t hobble the sales pitches. The only way to put those shelters out of business is to send the promoters, whose persistence in the face of adverse court decisions evidences either bad faith or invincible stupidity, to prison.
Was KPMG similarly culpable? Its legal argumentation was good enough to attract clients with first-rate internal tax expertise and had not been disapproved by any court; to a great extent, it has not been judicially tested to this day. Yet the Justice Department intimates that the firm’s techniques were so clearly fraudulent that selling them was a crime – not just on the part of the individuals who did the promoting but of KPMG itself.
A successful prosecution of the firm is virtually unimaginable. Also unimaginable, though, is a successful future for it following an indictment. In effect, if the government proceeds with this case, it will create a new, incredibly vague crime by executive fiat and punish it without trial. This from an Administration that is continually accused of excessive solicitude for business interests!
DoJ lawyers may, I realize, disagree with my assessment of the strength of their case. Fine. They have a ready course of action that will penalize any actual criminal activity without risking injustice: Indict one of the individual partners who promoted KPMG’s products, and bring him to a speedy trial. After he is convicted, if he is, is the time to think about sanctions against the firm as an entity.
The government won’t follow that strategy for two reasons: First, it isn’t likely to succeed. Even if the defendant’s weighing of tax authorities is proved to be negligent, more than negligence is needed to establish that he committed a crime.
Second, the not particularly concealed purpose of the exercise is not the punish past wrongdoing but to shape future tax advice. The IRS has learned over the decades that the Gorghemghast-like Internal Revenue Code and its baroque trellises of regulations foster expertise in discovering and exploiting oddities in their structure. There are too many rules, and their interaction is too predictable. Slowly the IRS is giving up the effort to struggle for revenue on a loophole-by-loophole basis. Its new idea is to make tax inventiveness so risky that advisors will shy away from it and content themselves with routine compliance chores. Right now, tax law has a reputation as a place where really bright people congregate. The IRS’s implicit goal is to increase the proportion of dullards. Ideal would be a world in which “tax strategy” was an obsolete concept and no business or wealthy individual planned for tax consequences.
Such a world has obvious attractions for tax bureaucrats, for their word would be the final authority among risk-intolerant return preparers. It is possible, too, that a species of self-censorship would lead to higher revenues, as taxpayers faced with alternatives grew into the habit of automatically selecting the “safest” and most expensive.
I doubt, however, that self-interest will ever grow so weak as to let that IRS ideal come into existence. As the cadre of intellectual tax experts dwindles, tax schemes won’t disappear; they will simply become the province of lower quality specialists and of individual taxpayers’ amateur imaginations. Certainly they will remain just as great a nuisance as before.
The current anti-tax shelter strategy is on a par with spraying pesticide on roaches while leaving food scattered around the house. Getting rid of the pests requires eliminating favorable conditions for their proliferation. The conditions that favor tax scheming are high tax rates and complicated rules that try to micromanage the economy rather than produce revenue in a simple, consistent fashion. Until and unless Congress develops the will to clean up the Internal Revenue Code, hanging a hundred KPMG Peat Marwicks will accomplish nothing worthwhile.