Global Policy Forum

By David Cay Johnston

Some wealthy Americans who paid millions in fees to two of the Big Four accounting firms to set up tax shelters are suing the firms after the Internal Revenue Service denied the tax savings that they had been promised.

Although only a few lawsuits have been filed, tax experts and lawyers handling these cases said they expected a flood of similar cases as the I.R.S. stepped up its hunt for tax cheating by hundreds and perhaps thousands of executives, business owners, athletes and entertainers with big incomes.

Two firms being sued, Ernst & Young and KPMG, offered shelters that they said would make taxes on salaries, stock option profits and capital gains from the sale of a business either shrink to pennies on the dollar or disappear.

The fees and savings on taxes can be enormous. Ernst & Young charged some clients $1 million just to hear a sales pitch, according to court papers. And the firms made millions from the sale of each shelter. The shelters allowed accounting firms, their clients and the law firms that blessed the deals to share money that otherwise would have gone to the government.

The plaintiffs in the suits say that the accounting firms should have known that the tax shelters would be disallowed and that the firms put their own financial interests ahead of those of their clients. The accounting firms say that they gave sound advice, that they fully informed clients of the risks and that the clients acknowledged these risks in writing.

The threat that one tax shelter will be demolished in an audit has already meant that the top two executives at Sprint could owe more than $100 million in taxes. William T. Esrey, the departing Sprint chief executive, and Ronald T. LeMay, the company president, bought shelters that Ernst & Young said would let them take stock option profits immediately, but delay taxes for 30 years. Mr. Esrey disclosed Wednesday that he was being audited and could lose his entire fortune. Mr. Esrey said he was depending on Ernst & Young to defend him if the I.R.S. disallowed his arrangement; Ernst & Young said it stood by its tax advice.

Lawyers whose clients have sued Ernst & Young and KPMG in New York, North Carolina and Florida described several common elements in the unrelated cases. In all of the cases, large fees were charged; the customers were not allowed to seek independent legal advice on the shelters or to disclose the arrangements; the deals were pitched as virtually sure things; and the sales pitch began with someone who had a long history as a trusted adviser. In two North Carolina lawsuits, the trusted adviser was a banker, but in the other cases it was the accountant who had prepared the person's tax returns before recommending the tax shelter being sold by his firm.

In Asheville, N.C., three businessmen who sold a local mall at a huge profit said that William Spitz of KPMG told them that the strategy to shelter those profits was "bulletproof" and that it "used the I.R.S.'s own rules against" the agency. Mr. Spitz was also quoted in court papers as saying that Dale Earnhardt, the race car driver who died in a crash in 2001, saved $4 million using the tax shelter in 1997.

The three businessmen, Richard L. Coleman Jr., Stewart B. Coleman and Thomas W. Coleman, said in their suit that KPMG told them to pay no attention to I.R.S. rules requiring that tax shelters be registered. KPMG was adamant, the men said, that it was selling something different, called a "tax investment strategy." The Colemans said the I.R.S. later rejected the strategy as a worthless "tax shelter scam."

Responding to all the accusations that KPMG sold worthless shelters, George Ledwith, a spokesman, said, "KPMG provides tax planning advice in an appropriate manner and in accordance with applicable state and federal tax rules."

Sellers of shelters are obligated to defend their clients in tax proceedings, which typically go on for years.

The Florida case was brought last July by Joseph J. Jacobini, an entrepreneur, who said KPMG refused to let him obtain an independent legal review of the tax shelter. "KPMG executives told him he could not involve any other professionals because the investment `strategy' was `confidential,' " according to his suit.

KPMG tried to block efforts by Mr. Jacobini to examine documents related to the shelter, conduct that drew a rebuke this week from the federal magistrate overseeing the case.

"The shroud of secrecy that KPMG kept over" the two tax shelters "has been lifted," wrote David A. Baker, the federal magistrate. He noted that some of the firm's clients said KPMG was defrauding them and that the I.R.S. investigation of the tax shelters was public record.

"KPMG should recognize that its role in these transactions will be examined with no presumption of confidentiality," Magistrate Baker wrote.

KPMG said it would file an objection to the magistrate's report.

In Federal District Court in Manhattan, four Indiana men who sold their distribution business for a $70 million gain in 1999 sued Ernst & Young, saying it sold them a tax shelter that the I.R.S. had already declared improper.

To escape $14 million in capital gains taxes, the men paid $3 million in fees, with $1 million going to Ernst & Young and $2 million to Jenkens & Gilchrist, the Dallas law firm that had conceived the shelter.

The men also paid $75,000 to Sidley Austin Brown & Wood, a major law firm, for a letter attesting to the propriety of the tax shelter. The suit said the fee was unconscionable because at least 43 other clients paid the same amount for virtually identical letters, even though the only extra cost was for printing out copies from a computer.

The suit contends that the accountants and the law firm "reaped as much as $50 million in fees from as many as 47 other clients" that the firms "enticed into the scheme."

The defendants have all denied any wrongdoing. Jenkens & Gilchrist has called the lawsuit baseless.

The shelter sold to the Indiana men, called Cobra — currency options bring reward alternatives — used foreign currency trades in an attempt to reduce the size of gains.

The widespread sale of tax shelters is not limited to the wealthy clients of the big accounting firms. In Cincinnati yesterday, the Justice Department filed suit to close a tax shelter that was marketed to middle-class customers of State Farm by one of its former insurance agents. The government said it lost at least $30 million in 1999 and 2000 from the scheme. Earlier, State Farm had tried on its own to stop the shelter, according to court papers.

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