NEW YORK — When two executives of accounting giant KPMG came calling on Los Angeles pension officials in 1999, they pitched what sounded like a cost-free way to fatten the city's retirement kitty.
Larry Manth and Doug Duncan, then partners in KPMG's Los Angeles office, were helping to run a nationwide rollout of an innovative tax shelter that promised to shave millions of dollars off the personal tax bills of wealthy private business owners.
The complex plan required the businesses to make temporary charitable donations of corporate stock. But for the shelter to work, KPMG needed to find a tax-exempt institution willing to cooperate by accepting the donations -- and that's where the Los Angeles Fire and Police Pension System came in.
That KPMG was paying a visit to L.A. pension officials at all was a vivid indication of how, by the late 1990s, the mass-marketing of "tax solutions" had evolved into a powerful sideline for the blue-chip accounting firm. Indeed, it was a faster-growing field than KPMG's traditional, green-eyeshade business of auditing the books of Fortune 500 corporations.
The shelters were the product of some of the sharpest minds in American tax avoidance, marketed to the wealthy in high-pressure sales blitzes under odd names -- BLIPS, FLIPS, OPIS, SC2 -- that only hinted at their complexity. KPMG told clients that its shelters would save them so much money that the service would be well worth fees of $1 million or more.
Instead, several of the shelters blew up when they were identified as abusive by the Internal Revenue Service, and the IRS began going after KPMG's tax-shelter clients for interest, back taxes and, sometimes, penalties. Meanwhile, Senate investigators estimated that the shelters cost the federal government $1.4 billion in taxes, minus whatever the IRS is able to recover.
The fallout has left KPMG reeling. In the wake of a Senate probe of tax shelters that was highly critical of KPMG, the firm is facing lawsuits from former tax-shelter clients who are being pursued by the IRS. It also is negotiating with federal prosecutors to resolve a criminal probe and avoid the fate that befell accounting firm Arthur Andersen, which collapsed in 2002 after being convicted of obstruction of justice for its role in the Enron Corp. debacle.
In mid-June, apparently hoping to appease prosecutors, KPMG issued a public apology, saying in part: "KPMG takes full responsibility for the unlawful conduct by former KPMG partners during that period, and we regret that it occurred."
KPMG's dealings with the Los Angeles Fire and Police Pension System provide a window into the bewilderingly complex world of tax shelters.
The quasi-municipal agency, known in the trade press by the rakish nickname "L.A. Guns & Hoses," manages the $12-billion pension fund for city fire fighters and police officers.
Chief Investment Officer Tom Lopez, in a statement submitted to a Senate committee in November 2003, said he took the initial phone call from KPMG's Manth and Duncan, who said they had clients who were interested in making donations to the fund.
"This was the first time that we had ever heard from them or KPMG," Lopez said in his statement.
In a subsequent meeting, the KPMG executives laid out a description of the tax shelter known as the S Corporation Charitable Contribution Strategy, or SC2, according to Lopez' statement. It would eventually become one of KPMG's top-selling shelters, generating more than $26 million in fees for the firm over two years, according to Senate investigators.
In an S Corporation (named for a subchapter of the U.S. tax code), profits from the business are passed directly to the shareholders, avoiding corporate income tax while retaining other benefits of incorporation. It has been popular with family-owned businesses and other private firms with a handful of shareholders, such as car dealerships and construction companies.
Each year, the shareholders must declare the profits as ordinary personal income, whether the profits are actually distributed to them or are retained by the company for reinvestment in the business or other purposes.
The goal of SC2 was to turn that personal income -- the shareholders' profits -- into long-term capital gains, which in the late '90s were taxed at a much lower rate. The method devised by KPMG was for S Corporation shareholders to issue nonvoting stock, donate it to a tax-exempt entity and buy it back after a couple of years -- time enough to qualify as "long-term" under the tax code.
In a simplified example, suppose an S Corporation has 100 shares. Under the SC2 plan, it issues 900 new, nonvoting shares and donates them to a tax-exempt institution, generating a charitable tax deduction for the corporate shareholders.