Tax shelters in the 1990s; rumors of the death of tax shelters may be greatly exaggerated.

KEN MILANI, CPA, Phd, is professor of accountancy in the College of Business Administration, the University of Notre Dame, Notre Dame, Indiana. He is a menber of the American Institute of CPAs.JOHN J. CONNORS, CPA, LLM, is associate professor, director of tax research and coordinator of tax programs at Bryant College in Smithfield, Rhode Island. He is a ember of the AICPA.

Rumors of the death of tax shelters may be greatly exaggerated.

There's little question tax shelters took a beating during the 1980s. A primary source of this punishment was the changes in the tax laws that made many shelters unattractive by reducing, restricting or repealing certain key tax benefits. As a result, not much has been written about tax shelters in the last few years.

However, tax shelters do still exist. Those who look favorably on them describe shelters as investment opportunities that provide substantial tax benefits. Others look askance and claim shelters are "loopholes" in the Internal Revenue Code that siphon away revenues needed to reduce the national debt. This article covers the tax and nontax benefits, risks and other aspects of tax shelters in today's complex economic environment.

TAX REFORM ACT OF 1986

The Tax Reform Act of 1986 took dead aim at tax shelters and restricted several benefits that had been available for many years. Tax shelter opportunities are still available, however. A common organizational vehicle for such investments is the limited partnership. This structure appeals to certain investors; it is especially attractive to investors lacking the time or expertise to pursue opportunities that (1) yield special tax advantages, (2) limit liability and (3) are economically feasible relative to the risk involved. Other shelter formats, such as S corporations and individual investments, also are available, but currently the limited partnership represents the most common structure. Exhibit 1, page 42, lists some of the most common limited partnership tax shelter investments.

When examining a potential tax shelter opportunity, there are several actions investors and their advisers should take:

* Identify the risks.

* Detail the tax benefits and burdens.

* Analyze the shelter's income, loss and profit projections.

* Determine how appropriate the investment is, given the needs and circumstances of the potential investor. For a more complete discussion of how to evaluate a tax shelter, see the sidebar on page 43.

BENEFITS OF A TAX SHELTER

A tax shelter must be an economically sound investment. If the venture is otherwise viable, tax benefits will only add to its value. But if tax benefits are essential to make the shelter an attractive investment, this raises questions about the overall soundness of the shelter. Some of the more important benefits tax shelters offer are described below.

Leverage. Leverage enables investors to make a relatively low cash outlay to garner substantial gains and other tax benefits. The benefits of leveraging occur, for example, when an investment of only a modest down payment in real estate triggers depreciation or tax credits. Regular or non-recourse debt (in the case of real estate) is used to finance the balance of the transaction. When recourse financing is involved, investors carry personal and unlimited liability for the debt, while non-recourse financing limits personal liability to the specific assets acquired. The short-run benefits include

* Positive cash flow.

* Tax losses that can be applied against other income.

* Tax credits.

Exhibit 2, page 44, illustrates the benefits of leverage in a limited partnership.

Leverage continues to be an attractive feature of many tax shelters, even in the face of changes in the tax laws. Consider, for example, what happened with the Revenue Reconciliation Act of 1990. Ordinary tax rates were increased from 28% to 31% for some taxpayers. The phaseout of itemized deductions and exemptions makes the actual effective tax rate for some individuals more than 31% on ordinary income. In contrast, the top rate on capital gains is now locked in at 28%. This makes the idea of tax sheltering more attractive.

Of course, there are several negative outcomes to consider in analyzing a leveraged shelter. For example, a larger down payment may be required or the lending institution may mandate a balloon payment of principal. This balloon payment might coincide with the anticipated sale date of the property (such as after five years in the Parsons project in exhibit 2). In addition, the projected time of sale or estimated sale price may be optimistic.

Tax deferral. This benefit was integral to the Parsons project illustrated in exhibit 2. Its attraction-early losses-is enhanced if income is expected in future years. Exhibit 3, page 44, illustrates the "classic" tax deferral shelter scenario (writeoffs generating tax savings followed by gains).

Certain tax shelters provide tax deferral by mismatching revenue and expenses. These shelters are characterized by significant deductions allowed even though the revenue generated is modest or nonexistent. The most common mismatch occurs in oil and gas tax shelters, in which deductions for intangible drilling costs, the oil depletion allowance and depreciation are recognized as losses when revenue generation is just getting under way. Other shelters that create a mismatch include agriculture, real estate and equipment leasing.

The last can produce sizable depreciation deductions in the early years, especially if the assets being leased are in the five-year depreciation category (which includes light trucks and qualified technological equipment). Exhibit 4, page 46, illustrates the impact of depreciation writeoffs.

Permanent reduction in taxes. The tax credits generated by a shelter reduce investors' tax liability. If the recapture provisions can be avoided, this reduction is permanent. Shelters that feature credits for building rehabilitation, research and development, targeted jobs and low-income housing serve a dual purpose; they are attractive to investors seeking tax benefits while providing capital to ventures that may have social implications. Investors in these types of shelters typically will be considered passive investors and can use the credits generated only to offset tax liability from passive income.

One important exception to this general rule took effect for tax years beginning after December 31, 1989. Investors in low-income housing credit projects, regardless of their level of adjusted gross income (AGI), can use up to $25,000 of deduction equivalents to offset any portion of their tax liabilities. All types of income can be offset by the deduction equivalent (the measure of what the credit is worth given the investors' marginal tax brackets). Exhibit 5, page 48, illustrates the treatment of credits created by a shelter (part A) and the application of the $25,000 deduction equivalent (part B) for credits generated by low-income housing projects.

In building rehabilitation projects and low-income housing ventures, investors like Whitlock in exhibit 5 are automatically considered active for purposes of the $25,000 active rental real estate exception, regardless of the amount of the investment. Investors' AGIs are no longer a potential limiting factor in using this exception when low-income housing is involved.

Another way of bringing about a permanent reduction in taxes is to invest in a shelter with losses that can be written off in high marginal tax bracket years while any gain is reported in lower bracket years. This so-called bracket break is illustrated in exhibit 6, page 48.

Other benefits. Some tax shelters enable taxpayers to convert gains from ordinary to capital. This is typically accomplished by the sale or exchange of the shelter interest. Because capital gains are taxed at lower rates than ordinary income, the conversion can be even more beneficial if there are capital loss carryforwards available to offset the capital gains. Accordingly, investors may be able to generate current year capital losses from other investments to offset all or part of the tax shelter gain. Although depreciation recapture may diminish this benefit, it's worth considering.

The availability of a particular tax break can reduce the risk involved in a shelter and may increase the expected return. The tax advantage should not, however, be the shelter's most substantial appeal. Other attributes, such as potential appreciation and cash flow, are the foundations of an attractive investment.

RISKS INVOLVED IN A TAX SHELTER

One of the major risks in any tax shelter investment is its lack of economic substance. While this was one of the targets of the Internal Revenue Service's attack on shelters in the 1980s, there are still some shelters based entirely on the merits of projected tax benefits. Such shelters are bad news for investors because of personal liability on recourse loans, potential for audits and tax litigation and loss of all or a portion of the investment. There is little good news; the returns are not attractive, considering the risks involved.

Tax status. A poorly structured or implemented shelter-even though marketed as a partnership--can result in the IRS'S taxing it as a corporation. Such an outcome negates the tax benefits on which many shelters are built, since the income, losses or credits that were to flow through to investors remain with the shelter. Investors seeking promised tax benefits will find them unavailable, and later profits may be subject to double taxation, at the corporate level and again at the investor level if they are distributed to investors.

The characteristics most likely to place a partnership's tax status in jeopardy are continuity of life, centralization of management, free marketability of interests and limited liability. If any three of these traits are found in a shelter's business operation, it may be classified by the IRS as an association and taxed as a corporation. Often, the prospectus or offering memorandum for a shelter will include a statement the venture "will be treated as a partnership for federal income tax purposes. " This is an opinion and as such is not binding on the IRS, which will still examine the shelter for the characteristics listed above.

Turnaround or crossover. The turnaround or crossover point occurs when a shelter begins to generate taxable income greater than its cash flow. This point typically is reached when (1) the majority of depreciation allowances has already been taken or (2) debt-reduction payments are reducing principal. The term "burned out" often is used to describe shelters that have reached this point. When shelter projections focus only on the early years, potential investors should lengthen the time horizon as they evaluate the investment. This enables investors to determine if and when burnout will occur.

The negative connotations of burnout may be overstated. When a taxpayer has excessive passive losses or deductions, the burned-out shelter may offer solace as a passive income generator. Shelters that generate taxable income in excess of cash flow may prove attractive if this is reflected in the purchase price.

The shelter's load. A tax shelter's load represents the costs carried by investors representing support for someone else, usually the promoter or syndicate marketing the shelter. Elements of the load include sales commissions, professional and manangement fees and other direct and indirect costs. A "front-end" or "spread" load reduces the amount of money the partnership will have available for the acquisition of assets because it is paid before any assets are acquired. For example, one tax shelter prospectus included the following:

Gross proceeds to partnership             100%
Less:
   Selling commissions             8%
   Estimated organization
     and selling expenses          4%
   Acquisition fees                1%
Total front-end fees                       13%
Amount available for investment
   and working capital                     87%

This means if an individual invested $10,000 in a real estate limited partnership with these front-end costs, only $8,700 of the investment would actually be used to purchase property.

Other risks. At the outset, shelters carry a certain amount of risk when a promoter or syndicate is involved, since these parties have the authority to make crucial decisions about the operation of the shelter. Later, there may be a recapture of tax benefits as specific triggering transactions such as a sale, taxable exchange or involuntary conversion occur.

SPECIFIC TAX PROVISIONS AFFECTING SHELTERS

Several tax laws were developed specifically to address perceived distortions caused by tax shelters. These provisions were designed to restrict benefits, add tax burdens or detract from the attractiveness of a shelter. The basic elements of these provisions are described below.

Passive activity limitations (PALS). Although lengthy coverage of PALS is beyond the scope of this article, a summary of their impact is appropriate. These limitations introduced by the 1986 act had a dramatic impact on an investor's ability to use tax losses and/or credits generated by a shelter. For some investors, the PALS virtually eliminated the use of loss writeoff strategies. According to the limitation rules, passive losses are allowed only to offset passive income. Some exceptions, such as active rental real estate, are available, but the PAL rules have restricted rampant writeoffs previously available from shelter investments.

Credits generated from a passive investment also are subject to regstrictions: Only the tax on passive income greater than its cash flow. This point typically is reached when (1) the majority of depreciation allowances has already been taken or (2) debt-reduction payments are reducing principal. The term "burned out" often is used to describe shelters that have reached this point. When shelter projections focus only on the early years, potential investors should lengthen the time horizon as they evaluate the investment. This enables investors to determine if and when burnout will occur.

The negative connotations of burnout may be overstated. When a taxpayer has excessive passive losses or deductions, the burned-out shelter may offer solace as a passive income generator. Shelters that generate taxable income in excess of cash flow may prove attractive if this is reflected in the purchase price.

The shelter's load. A tax shelter's load represents the costs carried by investors representing support for someone else, usually the promoter or syndicate marketing the shelter. Elements of the load include sales commissions, professional and manangement fees and other direct and indirect costs. A "front-end" or "spread" load reduces the amount of money the partnership will have available for the acquisition of assets because it is paid before any assets are acquired. For example, one tax shelter prospectus included the following:

Gross proceeds to partnership             100%
Less:
   Selling commissions             8%
   Estimated organization
     and selling expenses          4%
   Acquisition fees                1%
Total front-end fees                       13%
Amount available for investment
   and working capital                     87%

This means if an individual invested $10,000 in a real estate limited partnership with these front-end costs, only $8,700 of the investment would actually be used to purchase property.

Other risks. At the outset, shelters carry a certain amount of risk when a promoter or syndicate is involved, since these parties have the authority to make crucial decisions about the operation of the shelter. Later, there may be a recapture of tax benefits as specific triggering transactions such as a sale, taxable exchange or involuntary conversion occur.

SPECIFIC TAX PROVISIONS AFFECTING SHELTERS

Several tax laws were developed specifically to address perceived distortions caused by tax shelters. These provisions were designed to restrict benefits, add tax burdens or detract from the attractiveness of a shelter. The basic elements of these provisions are described below.

Passive activity limitations (PALS). Although lengthy coverage of PALS is beyond the scope of this article, a summary of their impact is appropriate. These limitations introduced by the 1986 act had a dramatic impact on an investor's ability to use tax losses and/or credits generated by a shelter. For some investors, the PALS virtually eliminated the use of loss writeoff strategies. According to the limitation rules, passive losses are allowed only to offset passive income. Some exceptions, such as active rental real estate, are available, but the PAL rules have restricted rampant writeoffs previously available from shelter investments. Credits generated from a passive investment also are subject to registrictions: Only the tax on passive income can be offset by passive credits, with some exceptions.

At-risk rules. These focus on the ability to deduct losses. Investors' deductions are restricted based on the amount at risk, which covers

* Cash contributions to the shelter.

* Adjusted basis of other contributions.

* Borrowed funds acquired in a way that does not restrict their ability to be included in the at-risk amount.

Any money borrowed should be obtained from someone other than the promoter of the shelter, and the debt should be recourse-unless real estate is involved. Accounting practitioners should realize that at-risk rules take precedence over PAL provisions and other loss-limiting rules. Use of credits generated by a tax shelter also is restricted by the amount at risk. The at-risk rules will continue to play an important role in the development and marketing of tax shelters in the 1990s.

Other provisions. Several other tax provisions also were directed at tax shelters:

* The alternative minimum tax base was considerably broadened and the rate increased to 24% by the 1990 act. This could increase the tax bill of many investors.

* The interest expense limitation was trimmed: A taxpayer must have sufficient investment income to cover the interest deducted.

* Deductions for intangible drilling costs, depletion and depreciation were affected in a manner that deferred and/or decreased the writeoff amount. Intangible drilling and development costs incurred outside the United States must be capitalized by producers and amortized over 60 months.

THE FUTURE OF TAX SHELTERS

Tax shelters have received considerable attention from the IRS over the last few years and have generated much controversy, particularly for unhappy investors. This article has attempted to provide an overview of the benefits and burdens facing these tax shelter investors. It is unlikely the 1990s will produce a plethora of tax shelters. However, as long as there are investors willing to take a risk to generate a reward, as well as taxpayers seeking passive income, there will be tax shelters.

EXHIBIT 6 Benefits of "bracket-break"

Jordan is in a combined 36% tax bracket (31 % federal and 5% state). He owns an interest in a partnership that generated losses of $80,000 applicable to and written off by Jordan. The tax saving tied to this writeoff is $28,800 (36% x $80,000). After moving to a state with no income tax and while he is in the marginal 28% tax bracket, Jordan sells his interest in the partnership at a gain of $100,000, paying a tax of $28,000. Since Jordan was allowed to write off the losses at a 36% rate, his permanent tax reduction is $6,400:

Tax on $80,000 at 36%            $28,800
Less: Tax on $80,000 at 28%       (22,400)
Permanent tax reduction              6,400

EXHIBIT5

Tax credits

Part A Whitlock acquires an interest in Hoosier Enterprises, a limited partnership. Whitlock reports the following for the current year: Gross income:

Active or portfolio income         220,000
Passive activity income            20,000
                                   240,000
Nonpassive deductions              20,000
Passive deductions                 10,000
Taxable income

Credits:

Targeted jobs credit f rom passive activity 5,000

For the current year, the amount by which Whitlock's passive income exceeds passive deductions from Hoosier Enterprises is $10,000. Whitlock's regular tax liability allocable to passive activities for the current year is 2,800, determined as follows:

Regular tax liability based on taxable
income of $210,000                   $59,374
Tax liability based on $200,000 of income
(not including passive income and
deductions)                        $56,574
Passive tax liability              $2,800

Whitlock may offset up to $2,800 of her total liability with the $5,000 credit generated from her investment in Hoosier Enterprises. The remaining $3,200 credit will be carried over.

Part B

The facts are the same as in part A, except Hoosier Enterprises is a limited partnership that constructs low-income housing and offers it for rent. Whitlock (a 28% marginal bracket taxpayer) could use the entire $5,000 credit to offset her tax liability. The first $2,800 is handled using the same calculations as in part A. The remaining $3,200 is converted into a deduction equivalent of $11,428.57 (that is, $3,200 divided by 28%) since the credit is a low-income housing credit.

* CHANGES IN THE TAX LAWS in recent years, limiting tax benefits, have made tax shelters unattractive to many investors. Tax shelters do, however, still exist and will continue to provide investment opportunities.

* MOST TAX SHELTERS are organized as limited partnerships, which offer investors a pass-through of tax benefits and limited liability.

* TAX SHELTERS OFFER investors other benefits in the form of leverage, tax deferral, a permanent reduction in taxes and the ability to convert gains from ordinary to capital.

* A CONSIDERATION of the risks involved is important to the evaluation of any tax shelter. One of the major risks is the shelter lacks economic substance. The IRS may attempt to treat and tax the partnership as a corporation.

* A NUMBER OF TAX LAW provisions including the passive activity limitations and the at-risk rules were passed by Congress in an attempt to curb abusive tax shelters.

* FUTURE TAX SHELTER opportunities are likely to concentrate less on tax benefits and more on the opportunity to make a profit.

EXHIBIT 1

Limited partnership tax shelter investments

* Aircraft leasing

* Building rehabilitation credit properties

* Cable television

* Commodity operations

* Computer equipment leasing

* Film and media ventures

* Industrial warehouses

* Low-income housing credit properties

* Miniwarehouses

* Net lease properties

* Oil and gas

* Real estate

* Research and development credit projects

EVALUATING A TAX SHELTER

Although each tax shelter has its own unique characteristics, there are several basic activities practitioners should perform in an evaluation of them.

Check credentials. Carefully consider the credentials of those involved in the shelter. Obviously, the promoter or syndicate should be evaluated. Any individual or organization that provides an opinion about the shelter (for example, the venture will be taxed using subchapter K [partnership] provisions) should also be checked out. Other investors should be scrutinized as well.

Determine economic substance. Several documents should be examined when developing an opinion about the economic substance of a shelter. Projections, appraisals, valuation reports and other forecasts or predictions should be subjected to reality testing." For example, Argonaut Acres, a shelter involving the rental of vacation property, projects 1,900 rental weeks per year. Since the property will be a rental attraction only during the summer, this projection should be examined to determine if it is realistic. One hundred units are available for rental; the 13 weeks of summer generate a maximum of 1,300 rental weeks. This brings the 1,900 rental weeks forecast into question. An estimate of 1,100 rental weeks would likely be considered reasonable.

Other items that might be reviewed while determining the economic substance of a shelter include the partnership agreement, insurance, management and other contracts and agreements (rental, purchase, default, etc.).

Identify risks. In addition to the risks discussed in the article, such as possible burnout or treatment as a corporation, other risks might be considered. External risks in the form of competition, changeable weather patterns or other circumstances should be identified. In the case of Argonaut Acres, for example, weather might have an impact on the number of rental weeks (would a severe cold snap in July cause cancellations; does a rainy May mean a late start in rentals). Investors also might want to inquire about other factors, such as economic conditions, that could affect the ability to rent units at the anticipated level.

Internal risks also might be uncovered as investors investigate the management and administration of the shelter. For instance, an inexperienced team of managers should cause some reservations about the shelter's ability to produce promised results.

Determine if the shelter meets investor needs. Do investors know what they are seeking from the shelter? The investors' needs must be identified and compared with the shelter's projected results. Investors may be seeking cash flow, long-term appreciation, immediate tax savings or a combination of these benefits. Does this particular shelter meet those needs? Do the passive activity limitation rules pose a problem or present an opportunity for investors?

EXHIBIT2

Benefits of leverage

The Parsons project is a hypothetical limited partnership marketed to taxpayers in a 31 % marginal tax bracket seeking passive income generators. The partnership will construct a waste treatment facility in Allentown, Pennsylvania, for $3,024,000. The cash investment will be $624,000; the remaining $2,400,000 will be borrowed from a qualified lender. The 12% nonrecourse loan provides for payment of interest only for the first five years.

Assuming the property can be leased to a county government, operating projections indicate net income of $300,000 per year not including annual depreciation of $96,000 (the $3,024,000 cost depreciated on a straight-line basis over 31.5 years) or the interest expense on the loan. After five years, the facility will be sold at an expected price of $5 million. A financial summary of this investment reveals

  Annual income tax impact
        Operating income (net)            $300,000
        Less: Interest expense  @ 12%      (288,000)
               Depreciation                (96,000)
        Taxable loss                       (84,000)
        Multiplied by marginal tax rate     x.31
        Annual tax savings                 $26,040
        Cash flow analysis
        Tax savings ($26,040 x 5 years)    $130,200
        initial investment                  (624,000)
        Operating income ($300,000 x 5)      1,500,000
        Interest payments ($288,000 x 5)    (1,440,000)
        Sale of property                    (5,000,000
        Repayment of debt                   (2,400,000)
        Tax on gain*                        (761,360)
        Net cash flow (after 5 years)       1,404,846
        *Expected sales price               5,000,000
        Less: Adjusted basis net of depreciation  (2,544,000)
        Equals: Expected gain               2,456,000
        Multiplied by marginal tax rate     x .31
        Equals: Tax on gain                 $761,360

EXHIBIT3

Benefits of tax deferral

Rose and Ruth form, and are material participants in, an equal general partner-Major Music Machine (MMM). They each invest $250,000 cash in the venture, and MMM receives a $1,500,000 recourse loan from Wings Bank. MMM reports a loss of $750,000 in 19X1 and a loss of $1,200,000 in 19X2. Since the partners have a beginning basis of $1 million each $250,006 cash pl us 50% of the $1,500,000 loon), each can report her appropriate share of MMM losses ($375,000 and $600,000) as reductions in adjusted gross income. The tax basis drops to $25,000 for each partner who, at this point, has deducted losses of $975,000 (well in excess of the cash investment of $250,000). Because this is a general partnership and Rose and Ruth are personally liable for MMM'S recourse loan, they are permitted to deduct losses in excess of their cash investment.

If Rose was in the 28% tax bracket, the tax savings from this shelter investment would be $105,000 in 19Xl and $168,000 in 19X2. The total tax savings of $273,000 is greater than Rose's investment of $250,000. Assuming MMM operations are successful in 19X3 and 19X4 (with net incomes of $60,000 and $250,000, respectively), Rose and Ruth must report the following incomes-$30,000 for 19X3 and $125,000 for 19X4. Accordingly, each will have her basis in MMM increase to $180,000 ($25,000 beginning balance in 19X3, increased by $30,000 and $125,000).

EXHIBIT4

Impact of depreciation

In January of the current year, the Pacer partnership purchased $100,000 of equipment with a $5,000 down payment and a $95,000 10-year loan at 12 1/2% interest. The partnership leased the equipment to Cruise Corporation in February. The 10-year lease stipulated payments of $1,400 per month, which equals the monthly payments of principal and interest on the note. The marginal tax bracket of the individuals involved in the partnership is expected to be 33% this year and 28% next year. An analysis of the net cash flow for this year and next assuming depreciation of $20,000 and $32,000 and interest expense of $10,900 and $8,000, reveals

  Current year      Next year
Rental income     (15,400 (11 months) $16,800 (12 months)
   Depreciation   (20,000)               (32,000)
  Interest expense(,900)
     Tax loss     (500)
Tax savings      (5,115*                $ 6,496f
Rental income    (15,400                 16,800
Down payment     (5,000)                   0
-Note payments    (15,400)               (16,800)
  Net cash flow  (115                 $ 6,496
*$15,500 x 33%.
t$23,200 x 28%.