note: Dr. Boris I. Bittker is a consummate craftsman in that most
exacting of legal specialties, federal taxation. Yet he infuses
his craft with a humanist's constant concern for the larger social
values. The very titles of his books reflect that mix of comprehensive
technical scholarship and ethical preoccupationFederal Income,
Estate and Gift Taxation (1958, 1972), Professional Responsibility
in Federal Tax Practice (1970); and The Case for Black Reparations
(1973), to name just some of them.
Mr. Bittker was born in Rochester, New York, in
1916. He received his B A from Cornell and his LLB from Yale. After
clerking for Judge Jerome N. Frank of the Second Circuit, he went
to Washington to serve with the LendLease Administration at
the outbreak of World War II, and with the Alien Property Custodian
at the war's end. Between those two posts came a hitch in the Army.
Since 1946 Dr. Bittker has been a member of the
Yale Law School faculty, holding the Sterling professorship for
the last three years. He has also taught at Pavia and Siena in Italy,
and at Stanford, New York University, and Colorado.
The range of Dr. Bittker's teaching is a further
measure of the breadth of his interests. This year he is offering
constitutional law and international transactions in addition to
federal taxation. In the past his subjects have included corporations
and corporation finance.
Professor Bittker's lecture, entitled "Tax
Shelters: Their Cause and Cure," examines the burgeoning area
of tax shelters, seeking to identify what characteristics the transactions
embraced by the popular label "tax shelter" have in common.
He then discusses the minimum tax on tax preferences, the proposed
"Limitation on Artificial Accounting Losses," and other
remedies proposed by the Treasury or enacted by Congress in this
Tax shelters are very much in the news, not only in professional
journals and at professional institutes but also in the popular press.
A recent advertisement in the help wanted column of the Wall Street
Journal, for example, sought "a tax shelter specialist.
The qualifications for the post were not stated; apparently it was
thought that the people to whom the advertisement was addressed needed
What might be called the "classic" tax shelters are oil
and gas drilling funds, equipment leasing arrangements, cattle breeding
and cattle feeding activities, and highly mortgaged real estate. But
if one collects examples of what are advertised as tax shelters, as
I've been doing for a few months, the list rapidly expands. Foreign
countries, usually exotic islands with low tax rates, are often described
as tax shelters. We find tax-exempt municipal bonds referred to as
tax shelters along with franchises for professional sports teams,
citrus groves, movies, bulk whiskey, chickens, catfish, minks, and
even the so-called Mexican vegetable roll over. Only last year the
Assistant Secretary of the Treasury for Tax Policy described qualified
pension and profit sharing plans as the biggest tax shelter of them
all, costing the Treasury, according to his estimate, some $4 billion
of revenue a year.
If one looks for more generalized description or definitions, one
also finds a wide range of choice, with differences that depend upon
the author you read.
I have picked two definitions for illustrative purposes. The first
is from the West Coast:
"A tax shelter, broadly defined, is any deduction,
credit, exclusion or other allowance that permits income to come in
tax-free. In this sense, the $103 exclusion for municipal bond interest
is a shelter since the interest income comes in without tax. Some
tax shelter investments attempt to shield not only their own income
but to shelter other income as well. By producing excess loss or depreciation
or depletion or interest or state tax deductions, an investment in
an apartment house or a cattle feeding operation, equipment leasing
or an orchard, can give the investor, at least temporarily, some deductions
to use against income he or she earns from work or other investment
The second is from the East Coast:
"There are two typical elements of a tax shelter.
One, referred to as "deferral," arises in situations where
taxpayers are permitted to deduct capital expenditures over a period
of time shorter than normal tax rules would permit. In effect, the
tax-payer is granted an interest-free loan in the amount of the tax
saving, which he theoretically repays in later years when his deductions
are less than he would ordinarily be entitled to claim. The second
aspect of the tax shelter is "leverage," that is, the use
of a high percentage of borrowed money to finance the acquisition
of a capital asset which borrowing then produces the same deduction
benefits for the taxpayer as are accorded to the taxpayer's own funds
invested in the asset." (2)
These definitions diverge in important respects from each other,
as well as from a recent Treasury definition:
"The essence of a tax shelter is the deferral or postponement
of tax on current income, accomplished by accelerating future deductions
into the current taxable year." (3)
A curious aspect of this Treasury definition is that it does not
embrace the qualified pension and profit sharing plans, which the
same Treasury, through one of its spokesmen, had several months earlier
described as the biggest tax shelter of them all, because the qualified
pension plan involves deferral but through an acceleration of deductions.
From the point of view of the employee the plan's tax shelter function
results from the nonrecognition currently of credits and increases
in the value of his or her pension and profit sharing rights; they
fall in for tax purposes only when the cash is received in later years.
When I was preparing myself in this area, I though that I might get
some help in defining tax shelters from California, whose Commissioner
of Corporations has an active program of requiring registration of
tax shelters under State Security Laws. I wrote, therefore, to the
California Department of Corporations asking how they define tax shelters.
They wrote back that anything advertised as a tax shelter, "we
regard as a tax shelter." There seems to be a little circularity
In an effort to apply these general definitions to specific areas,
I have picked out the central themes in a number of transactions that
have been called tax shelters, at least by some writers. Here one
finds again, that the descriptions are very broad, starting with almost
anything that the writer feels is an excessively large tax allowance.
The only two tax allowances that I have not seen described as tax
shelters are the extra personal exemptions permitted to persons over
the age of 65 and for the blind; but, for all I know, there may be
some who regard old age as a tax shelter.
A feature of some transactions that are referred to as tax shelters
is the lack of any nontax, economic purpose for the transaction. One
example, which is no longer feasible but which illustrates the point,
is the borrowing of money in order to buy tax-exempt bonds. If you
borrow at 10 percent to buy tax-exempt bonds paying 8 percent, you
lose 2 percent every year on your investment, but nevertheless would
make money if the 10 percent paid for the borrowed funds is deductible
while the 8 percent yield on the tax-exempt bonds is tax-free. This
device has been forbidden by the Internal Revenue Code for a long
time by ¶265(2), although, as many of you know, there are problems
in determining when borrowed funds are to be linked with tax-exempt
securities for purposes of disallowing the interest paid on the former.
There are other instances of this kind of transaction, mostly much
more complicated, some of them involving life insurance, where the
taxpayer borrows money in order to pay the premiums. Often these transactions
do not achieve the hoped-for results because the courts have concluded
that transactions making no economic sense should not be treated as
what they purport to be for tax purposes.
I have already mentioned the simple postponement of the recognition
of income, as in qualified pension plans. More frequently, the term
"tax shelter" is applied to transactions where postponement
of recognition of income is accomplished by speeding up deductions
(e.g., accelerated depreciation on real estate or rapid amortization
of other capital outlays), where eventually income will be realized.
In these cases the transaction serves an economic purpose, at least
if it turns out to be profitable as intended, but there are tax advantages
in the earlier years. Sometimes it is expected, or hoped, that the
transaction, though producing income that will not have to be reported
until a later time, will permit the profit to be reported as long-term
gain and taxed at the more lenient capital gain rate.
Another feature of some tax shelters is the production of excess
losses, where the transaction not only produces no taxable income,
at least in the early years, but in addition, generates losses which
can be used to offset, and therefore to shelter, other forms of income.
This is sometimes referred to as a "broad" shelter. Many
of the most highly publicized tax shelters involve this feature. Oil
and gas drilling is an example because the cost of drilling can be
deducted in the year in which the drilling occurs. If the drilling
and development expenditures exceed the income, if any, from the well
in the year it is drilled (as is usual), the excess can be deducted
from other income by the lawyer, accountant, or orthodontist. Sometimes
a broad shelter producing these excess deductions will be used by
a person who is in the same business, to shelter other income from
the same kind of investment. But often, and these are the more dramatic
cases so far as the public is concerned, the income that is being
sheltered comes from other activities. I will return to this distinction
a little later.
It should be noted that excess losses can arise from the rapid amortization
of capital outlays in a variety of other fields other than those commonly
identified as tax shelter areas (viz., real estate, oil exploration,
and cattle feeding). Advertising, even of an institutional character
designed to have long run advantages, for example, can be written
off currently. Research and experimental expenditures can either be
deducted currently or amortized over a short period, even if they
create assets that will generate income for many years. The same is
true of trade name and trademark expenditures. The deductions produced
by these activities may be in excess of income from that particular
part of the business and can be used to shelter income from other
business activities. But this is an area that has not been much explored
so far as tax shelters are concerned. It's hard to get the lawyer,
accountant, or orthodontist into an arrangement by which he can participate
in those losses in return for income from the business in later years;
and leverage may be harder to achieve in these areas. But nothing
at a theoretical level distinguishes these cases of rapid amortization
or immediate deduction of capital expenditures from the commonly cited
tax shelter transactions.
Another feature that is often encountered in the tax shelter area,
stimulating some of the congressional interest and criticism, is syndication
-- the bringing in of people from outside the industry -- when the
investment requires a finder, investment broker, lawyer, accountant,
or other person to act as the bridge between the industry needing
the funds and the investors who would like to participate. Syndication
may be formalized to the point where there is a public offering of
securities within the meaning of the Securities Act of 1933, or it
may entail no more than informal contacts with a small group of well-to-do
investors in a single community. Syndication has often generated criticism
because the middleman expects a profit for his activities; this is
often seen by critics of the tax shelter area as a waste. Yet it might
be argued that the syndicator is performing the normal function of
bringing persons who want to invest into enterprises that need investment
funds. But syndication seems to exacerbate the complaint that I mentioned
earlier, that the entry of "outsiders" -- people who are
not commonly engaged in the business -- is unfair to those already
in the industry. Thus, it is often said that "genuine farmers"
are being crowded out by "white collar cowboys" whose investments
either increase the price of land by bringing more acreage into production
or decrease the price of the product by throwing more on the market.
Once one recognizes how diversified a range of transactions can be
called tax shelters, one finds that many of their features have been
recognized over a long period of time. This in turn has led to many
a number of statutory attempts to limit the use of these tax allowances,
when Congress, the Internal Revenue Service, or the courts felt that
they were being exploited to an unreasonable extent. This reaction
can be seen in the statutory provisions and judicial decisions limiting
the deduction of interest incurred to purchase or carry certain forms
of life insurance and annuity contracts, where the transactions makes
little or no economic sense. (5)
There are also many areas in which tax allowances are subject to
dollar limitations, where Congress has restricted the use of a tax
allowance by, so to speak, spreading the goodies around instead of
permitting any one taxpayer to avail himself of the allowance to the
hilt. Thus, the 25 percent rate on long-term capital gains is available
only for the first $50,000 of such gains. Similarly, section 179 limits
the amount qualifying for the special first year depreciation deduction.
In 1969 and again in 1971 Congress imposed limits with respect to
the write off of expenditures for citrus and almond groves, which
had previously been deducted at the time the expenditures were incurred
and now have to be capitalized. There are also several provisions
for the recapture of certain types of tax allowances; the most familiar
is the recapture of accelerated depreciation on personal and real
property under sections 1245 and 1250. There is also a recapture provision
for excess farm losses. Because the cash method of accounting is so
broadly available for farming, farm losses are often incurred in early
years of profitable operations. Congress intervened in this area by
providing that if the farm is ultimately sold at a profit, the gain
will have to be reported as ordinary income rather than capital gains
up to the amount of the accumulated excess losses in the deferred
excess loss account.
Still another type of Congressional response to what was seen as
the exploitation of tax allowances is what I call the "channelization"
of income. An example is ¶163(d), concerned with excess investment
interest. Under this provision the taxpayer who borrows to carry portfolio
securities is not always permitted to deduct all of the interest paid
on the borrowing, because it felt that he would be getting excess
deductions in the early years of an investment that might not produce
taxable income for many years. In effect Congress decided that an
allowance for interest genuinely paid on borrowed funds to carry a
profit-making investment should not be allowed currently, beyond certain
limits, because the income would not come in until a late date. The
statutory restriction matched up the deduction with the income, in
a sense, even though this kind of matching is not normally required
of cash basis taxpayers. Congress provided that the interest paid
would be allowable up to the amount of the taxpayer's net investment
income plus capital gains and certain other adjustments, but that
it could not offset income from other activities. This restriction,
therefore, produces a kind of channelization, requiring investment
operations to be held, so to speak, within a specific channel and
not allowed to spill over (beyond a certain amount) to be used against
I want now to turn from these individualized approaches, which are
applied provision by provision or allowance by allowance, to two more
general legislative approaches to tax shelters. The first is the minimum
tax, enacted in 1969, though not in the form proposed by the Treasury,
which has been proposed for amendment in certain respects by the House
Ways and Means Committee. The minimum tax, as enacted in 1969, is
a supplemental flat rate tax, to be paid on specified tax preferences
in addition to the regular income tax. Some of these preferences are
exclusions from income, like the deducted one half of long-term capital
gains and percentage depletion in excess of the property's basis.
Others are deferral items, like accelerated depreciation on real estate
to the extent that it exceeds straight line. As originally proposed,
and as revived in 1973 by the Treasury and recently by a tentative
decision of the House Ways and Means Committee, it will be an alternative
tax, with the taxpayer paying either the regular tax or the alternative
minimum tax, whichever is higher. The alternative minimum tax would
be imposed upon a concept that might be called economic income, in
the sense that it is a broader base than statutory taxable income.
Roughly speaking, the base on which the alternative minimum tax would
be imposed is adjusted gross income plus some exclusions and minus
The minimum tax has been concerned primarily with exclusions from
income rather than with provisions for the deferral of income. For
this reason, in 1973, the Treasury proposed a so-called limitation
on artificial accounting losses which would focus much more heavily
on the deferral of income and the rapid amortization of capital outlays.
This proposal, which has some earlier antecedents, pur-ports to focus
directly on tax shelters. But it is concerned with tax shelters only
in the sense that I described earlier; that is to say, the "broad"
shelter, creating deductions that can be used to shelter income that
is unrelated to the activity generating the deductions. The Treasury
said the following about its proposal (and the House Ways and Means
Committee's tentative decision follows along):
"While such losses are frequently generated in the
mineral, real estate and agricultural industries, LAL will normally
affect neither the ordinary farmer, the professional oilman, nor the
ordinary real estate developer, but rather the outsider who buys into
those industries in search of tax "losses." Artificial "losses"
from such sources as accelerated depreciation, the current deduction
of pre-opening costs, intangible drilling costs on successful wells,
and prepaid feed dells, will no longer be permitted to shelter unrelated
Roughly speaking an "artificial accounting loss" is defined
as a loss resulting from accelerated deductions -- rapid amortization,
and so on -- which is in excess of the income produced by either the
same project or other projects carried on by the taxpayer in the same
business. Only to the extent that the deductions spill over beyond
these types of income to so-called unrelated income would the Treasury
impose restrictions. These excess amounts will not be currently deductible
from income from the practice of law accountancy, and so on but will
instead be carried forward in a deferred loss account. They will then
be available for use when and if the taxpayer has related income from
the favored business, and if not fully used up against related income,
they will reduce the gain when the investment is sold or otherwise
Under this proposal the vague concept of "related income"
will obviously be very important, since it will determine how much
of these losses can be deducted currently and, conversely, how much
must be held in abeyance and deferred until a later date. Related
income as defined by the proposal is very broad for some industries
and narrow for others. For example, all oil and gas income, whether
from the field in which the taxpayer is drilling currently or from
other fields, qualifies as related income. In the case of real estate,
on the other hand, there is a distinction between residential property
and nonresidential property. All rental income from residential property
is related and, therefore, can be offset by current deductible expenditures.
But for nonresidential property, the proposal operates property-by-property,
and there are problems in defining when several related properties
make up a single project and when, on the other hand, the properties
In reviewing these proposals and seeking to evaluate them, I am struck
by the fact that most the public discussion has been concerned with
details, to the exclusion of the broader issues that deserve attention.
To make just one simple point, the tax allowances reached by the minimum
tax and the limit on artificial accounting losses were presumably
enacted by Congress for some economic or social purpose. I don't mean
to say that political muscle was not at work as well; obviously, it
was. But to some extent, accelerated depreciation was designed to
increase investment in real estate, the allowances in the oil and
gas field to increase investment in that area, and so on. One may
or may not believe the tax allowances have been successful in achieving
those objectives. Some are very enthusiastic about the results achieved;
others are very are critical. There are differences of opinion about
the cost of what has been achieved. But one finds very little discussion
of whether the tax shelters that are under attack have or have not
helped in increasing investment in the areas for which the allowance
was originally enacted by Congress. There is also little discussion,
except of a self-serving variety, of the extent to which investment
would be adversely affected in particular industries if limitations
of this kind are imposed. This is particularly surprising, it seems
to me, because some tax commentators in the last few years have been
arguing that if a tax allowance for a particular area is repealed,
Congress ought to give serious thought to whether some other legislative
measure should be adopted to take its place. For example, almost all
the recent discussion of tax exempt bond interest has been of this
type, in which criticism of existing law is tempered by recognition
that it enables cities and states to borrow money at lower rates than
they would otherwise have to pay. If Congress withdraws the exemption
for future state and municipal bond issues, it will almost certainly
have to increase revenue-sharing, provide an interest subsidy, create
a federal bank to buy the securities, or enact other affirmative measures
to take up the slack created by withdrawal of the tax allowance. It
is surprising that discussion of tax shelters has not been coordinated
with a consideration of similar alternative measures.
One of the reasons there has been little discussion of the consequences
of taxing tax shelters is that they have usually been viewed as unadulterated
bonanzas for the taxpayer. Of course, as those who read the newspaper
know very well, a lot of promising tax shelters have turned out to
be failures. Quite apart from the contrast between rosy prospectuses
and dismal track records in this area, the idea that shelters are
all gravy deserves closer analysis. I can illustrate what I mean by
taking the case of tax exempt bonds. Let's assume that industrial
bonds are being floated at a 10 percent interest rate. Assume, for
the moment, that the exempt bonds to be floated are a relatively small
amount in the aggregate, small enough so they can be bought up entirely
by taxpayers whose marginal tax rate is 70 percent. On these assumptions,
states and municipalities are not going to have to pay 10 percent
to sell their bonds in competition with 10 percent taxable industrial
bonds. Rather, if the exempt bonds are all taken up by persons at
the 70 percent bracket, they ought to be willing to buy the bonds
with a 3 percent interest rate, because 3 percent tax-free for them
will be the same as 10 percent taxable. Of course, states and municipalities
have been floating more and more bonds in recent years, and they are
selling more than taxpayers in the 70 percent marginal bracket are
willing to buy. Therefore, the bonds have got to be made attractive
for people further down the line. If you want investors subject to
a 50 percent tax rate to buy the bonds as an alternative to 10 percent
taxable bonds, you have to pay 5 percent. If you want to reach further
down and appeal to people whose tax rates are lower than 50 percent,
you've got to pay still more; and this of course, is, what has happened
in recent years. This inures to the benefit of people further up the
line, who would have been willing to buy the bonds, on my original
hypothesis, at a 3 percent yield. They can currently buy exempt bonds
with a 7 percent or even higher yield, and, of course, this gives
them a free ride. Still, wherever the interest rate ends up -- 5,
6, 7, or even 8 percent -- the rate is lower than the rate on taxable
bonds. This means that the buyer of exempt bonds is paying something
in the form of a reduced rate of return.
Tax shelters probably have a similar effect. As people are stimulated
by tax allowances to make investments that previously did not look
attractive, they probably accept a lower yield. Indeed, the complaint
that tax shelters induce "white collar" cowboys to pay more
for farm land (or sell its produce for less) than "real"
cowboys or farmers, implies that persons attracted into the industry
by tax shelters are making investments that would not have been otherwise
attractive. This in turn implies a lower pretax yield, so that some
of the tax allowance is being competed away; in short, it is not all
There are few studies of the consequences of competition on tax allowances,
The most recent study of the gas and oil field -- done by a person
who has been a critic of the tax allowances in that field -- concludes
that only about 10 percent of the tax allowance goes to increase profits
for oil and gas companies. About 40 percent of the tax allowances
go to the owners of royalty interests, that is, the ranchers and landowners
who hold areas that were not previously attractive enough to be drilled.
Finally, about half of what the Treasury loses through the tax allowances
is reflected in lower prices for oil and gas products. It seems likely
that all other tax allowances similarly attract investment into their
fields, resulting in some decline in the pretax yield on the investment.
I suggest, then, that generalized proposals for dealing with tax shelters
insufficiently examine the extent to which Congress is achieving its
objectives through the tax allowances that are the target of the complaint.
Second, there may be a substantial amount of exaggeration or misunderstanding
of the profits to be made, with prospectuses being taken at face value,
though common sense, as well as economic theory, suggests a resultant
decline in pretax yields.
Finally, I want to return to my comments about "channelization,"
the idea that tax allowance should be reserved for people in the industry,
to the exclusion of "outsiders." The LAL proposal, if enacted,
is capable of very substantial expansion over a period of time. This
would undermine the global tax system that we now have. I refer to
it as "global" because, by and large, all income is thrown
together in one pot, deductions are then taken, and the residue is
taxable income. (I simplify somewhat because, in point of fact, capital
gains are handled differently, and there are some other existing exceptions
to the "global" concept.) By contrast the British have,
or used to have, a "schedular" form of income tax, involving
separate computations of income from the taxpayer's profession or
main occupation, income from investment, income from farming, income
from other activities, etc., with a separate tax for each kind of
income. A great deal would be, lost, in my view, if we move very far
down the road toward a schedular system in which the income and deductions
of each separate activity are kept in watertight channels. The proposed
limit on artificial accounting losses is a step in that direction.
A curious thing about this approach is that it will not affect persons
who are only, so to speak, ankle deep in an unrelated activity. The
orthodontist who makes a small investment in farming will not be required
to channelize because of the minimum allowance which creates a floor
above which the limitation begins. On the other hand a person who
is up to his ears in a particular business will be allowed to use
the losses against all income from that business. Those who are waist
deep, however, are "outsiders" who will be subject to the
This approach seems to me undesirable so far as the future of our
tax system is concerned. I also have grave doubts about it from a
business or economic point of view, although I am not here to offer
an expert opinion in that area. Much can be said for permitting investment
to flow wherever it is more profitable. And if it is made more profitable
by tax allowances, much can be said for letting anybody go into the
business, rather than reserving the allowances for those who have
been in it in the past. The phrase "white collar cowboy"
is amusing, but from an economic point of view why isn't someone who
invests in the area "really" in that business just as much
as that person who happens to live in Oklahoma, California, or Kansas.
We don't say an investor in Xerox stock is an ersatz investor because
he is "really" an orthodontist or a lawyer.
A few words of conclusion. Some may say that I have analyzed this
area more than it deserves to be analyzed. Their view may be that
the minimum tax and the limit on artificial accounting losses are
really intended both by the Treasury and by their Congressional proponents
to be cosmetic, enacted only to palliate a popular demand that "something
be done." Cosmetic devices, it may be argued, should not be analyzed
closely because they were never intended to stand up to close analysis.
You may not like the music, but don't shoot the piano player; he's
giving the customers just what they want. Unfortunately, even if a
tax provision starts out as a cynical cosmetic operation, it will
soon get a life of its own. Thus, most of the discussion of the minimum
tax and LAL has focused on details and points to this or that defect.
The commentators, understandably, suggest that the proposals are leaky
sieves and should be plugged up. Before converting a cosmetic device
into an effective one, I suggest that its basic assumption be debated.
I would not want to appear to be an unqualified endorse of every tax
allowance in the Code. Far from it. I would criticise many provisions.
My point, rather, is that tax allowances ought to be examined one
by one to see what can be said in favor of and against each of them
and that remedies should grow out of the diagnosis of each particular
allowance. Attempts to prescribe a cure-all for transactions that
are as diversified as the allowances I have discussed here are likely,
in my opinion, to be unsuccessful and, in the long, run, counter productive.
(1) A Kragen &
J. McNulty, Federal Income Taxation 700 (2 d ed.1974).
(2) S.Surrey, W.Warren,
P.McDaniel & H.Ault, Federal Income Taxation 392 (1972).
on General Tax Reform Before the House Committee on Ways and Means,
93d Cong., 1st Sess. 6997(1973).
(4) See e.g., Knetsch
v. United States, 364 U.S. 361 (1960).
(5) Int. Rev Code
of 1954. ¶264(a)(2) and (3); see Ballagh v. United States,
331 F.2d 874(Ct. CI.1964), cert. denied, 379 U.S. 887 (1964), and
Robert Gerstell, r62, 181 P-H Tax Ct. Mem. Dec.
(6) House Hearings,
supra note 3, at 6996.