Contrary to what may be considered common wisdom, tax law is not set in stone. It is updated on a regular basis as taxpayers and professionals struggle to keep up with it. Likewise, tax shelters are not illegal but can be legitimate ways to mitigate the impact of taxes upon a company's bottom line or on an individual taxpayer's bank account.
Recently one of those tax shelters was disallowed by a California judge. The Internal Revenue Service calls the tax shelter the distressed asset/debt or DAD shelter.
The way that a DAD shelter works is that a U.S. taxpayer buys junk foreign debt for pennies on the dollar and then claims significant tax losses. The taxpayer buys the debt through a partnership, and the losses are real, although they were losses sustained by a foreign lender and not by the taxpayer.
The problem with the DAD shelter is that it used to be allowed, and has since been made illegal and is not allowed.
The billionaire in question claimed significant losses for the tax years of 2002 and 2003. The law passed by Congress to make the DAD illegal passed in 2004. The billionaire paid $6.2 million for $303 million worth of nonperforming Chinese and Korean loans. The $6.2 million investment claimed as a loss would save about $78 million in taxes according to the IRS.
The IRS denied the losses claimed for the tax years of 2002 through 2004 and as a result the billionaire sued in district court stating that those losses were necessary to diversify his portfolio and reduce its volatility.
The California district court judge dismissed the lawsuits and the case was ended without a trial. The billionaire who used the tax shelter has indicated that he will appeal.
Source: Forbes, "Judge Shoots Down Another Forbes 400 Member's Tax Shelter," Janet Novack, Sept. 25, 2012
At our San Francisco law office, we represent clients with tax issues including those dealing with tax shelters and IRS disputes such as those mentioned in this post.