By David Cay Johnston

Merrill Lynch saved AlliedSignal $180 million. A division in Merrill's army of bankers, lawyers and accountants known as the financial engineers had invented a way for AlliedSignal to escape taxes it owed the federal government on the sale of an oil business.

The scheme worked this way: the company transferred the taxable profit on the sale to a newly created partnership with a foreign company, which turned around and returned the same amount to AlliedSignal in a way that made it no longer count as taxable profits. For their efforts, Merrill and its associates got a cut of the savings $25 million, or more than 13 cents on every dollar rescued from the government.

For decades, accountants and lawyers charged by the hour for advising corporations on how to arrange deals to legally avoid as much tax as possible. But the business has changed in two significant ways. First, Merrill and others decided they could create business deals that existed only on paper and could wipe out enormous tax bills. Second, they could demand a cut of the savings for devising the techniques that make the deal look real. The bigger the savings, the higher the fee. As companies have discovered how much money these deals can save them, Wall Street bankers, lawyers and accountants have rushed in to serve them. All of the Big Five accounting firms — PricewaterhouseCoopers, Ernst & Young, Deloitte & Touche, KPMG and Arthur Andersen — now charge corporations a fee based on the savings from tax shelters they design and sell. So do big investment houses, notably Merrill Lynch, Goldman, Sachs and Bear, Stearns.

Some of their colleagues in these fields are appalled. They say that many of these tax shelters are illegal because they have no business purpose; they exist only to avoid taxes. They say that such shelters would be much less likely to be approved by advisers who are not compromised by the possibility of profiting handsomely from work that requires strikingly little time. Indeed, the United States Tax Court ruled the AlliedSignal deal, struck in 1990, was a sham, and an appeals court upheld that decision earlier this year. AlliedSignal, now called Honeywell and planning to merge with General Electric, is appealing. Merrill Lynch sold a similar shelter to 10 other companies.

But few tax shelters are uncovered by an Internal Revenue Service whose resources have been significantly reduced in recent years. And even if one is discovered, penalties are rare. Criminal prosecution is almost unheard of. And, as in the AlliedSignal case, the Treasury is still without the money while appeals drag on for years. In short, the money to be made can seem well worth the very small risk of being caught. That is why the tax shelter business is thriving to an extent that worries even some people in the field.

Paul J. Sax, former chairman of the American Bar Association's tax section and a partner at the law firm of Orrick, Herrington & Sutcliffe in San Francisco, used simple math to explain why tax shelters are so attractive — "if you are willing to turn a blind eye to whether a deal really works or is a sham." He cited a case he knows about on the condition that he not identify the participants. It involved a $7 million fee for a tax shelter that will save a company $100 million. "I have a chance of being hit by the I.R.S. with a 20 percent penalty" for false reporting — $20 million on top of the $100 million owed, Mr. Sax said. "Based on my experience I calculate that chance to be one in 50 because the likelihood of the I.R.S. detecting this transaction in my very large tax return is small, the chance of them pursuing it correctly is small, the chance of them pursuing through to litigation is small, the chance a judge will uphold a penalty is small." What that means, he said, is that "once I get past `I know I am doing something wrong here,' the arithmetic settles it for me." "What is $7 million for at least an 80 percent chance at $100 million?"

He noted that the recent weakness of the I.R.S. because of budget cuts and new restraints imposed by Congress has only emboldened corporations. They "could not pick a better time to exploit the inability of the I.R.S. to deal with this under present law, under present funding and under the present demoralized state of the auditors." Promoters of tax shelters are eager to play because of the dazzling payoff. "To think up a shelter, work out the details and then put it down on paper so you can sell it to others takes, maybe, 100 hours," said Peter L. Faber, a tax partner at McDermott, Will & Emery in New York who wants a crackdown on abusive tax shelters. "Then you take that idea to the biggest companies and tell them your fee is $10 million. Where else can you earn that kind of money?"

Lawyers asked to render opinions on whether a shelter was legal can also be intoxicated by the chance to profit handsomely. Buck Chapoton, a tax lawyer at Vinson & Elkins in Washington and a former tax policy chief for President Ronald Reagan, said he had been offered hundreds of thousands of dollars to write a letter characterizing as legitimate a tax- avoidance plan he considered a sham. Mr. Chapoton said another top tax lawyer told him that he had turned down more than $1 million to write such a letter.

"For those kinds of fees, the purveyors are not buying your professional advice," Mr. Chapoton said. "They are buying your good name and, sadly, at those prices there are lawyers and law firms that will sell." Some corporations, including Ford Motor, say they refuse to participate in questionable tax shelters. But others have participated. Colgate-Palmolive, United Parcel Service, Winn- Dixie Stores and the advertising agency Foote, Cone & Belding, now part of True North Communications, have all engaged in tax shelters that the courts held were shams. Each of these rulings is now being appealed. But the great majority of shams go undetected, Treasury Secretary Lawrence H. Summers says. His aides have said that audits uncover perhaps one of every 10 illegitimate shelters.

Indeed, the Treasury Department has identified corporate tax evasion as the nation's biggest tax enforcement problem, and such shelters are at the core of it. Over the next decade, illegitimate tax shelters will short the government tens of billions of dollars, Mr. Summers said, adding that this official estimate is conservative because audits uncover "just the tip of the iceberg." The Treasury Department has learned of some tax shelters through anonymous mailings of tax shelter documents, presumably sent by participants who found them improper but could not stop them. In recent weeks the department has proposed regulations intended to shut down tax shelters with names like Captain Sandy's, the Guam Residence Trust and, earlier this year, BOSS and Baby BOSS.

The Guam Residence Trust, first disclosed in the journal Tax Notes, relied on an opinion by Daniel M. Berman of the Washington office of the law firm of Sutherland Asbill & Brennan. Mr. Berman has been a tax official both with the Treasury Department and the Joint Committee on Taxation. Mr. Chapoton and Mr. Sax said they were angry and saddened that Mr. Berman wrote an opinion letter for a trust that Mr. Chapoton said "doesn't even pass the smell test." Mr. Berman denied there was anything improper and said, "I am not in the tax shelter business."

The Fees

The More You Save,

The More You Pay

Charging a fee based on a percentage of the taxes avoided is prohibited by ethics rules of the accounting industry and is widely frowned upon by other tax professionals. The more subtle, and widely accepted, variation is called value pricing, in which the sellers of tax shelters set their price based not on hourly fees but on how much a client would be willing to pay to save a lot more on taxes. In some cases that amount is half the savings. The sellers assert that this more fairly compensates them for the value of the techniques that they invented.