Attorney General William French Smith personally invested $16,500 in an oil and gas tax shelter late last year that gave him about $66,000 in tax deductions--at least twice the amount permitted by a current Internal Revenue Service ruling.
Two hundred pages of confidential documents obtained by The Washington Post show that Smith and 34 partners have invested in what some experts described as one of the most aggressive and perhaps questionable tax shelters available to wealthy Americans.
Smith and his partners relied on a tax opinion from a Los Angeles law firm that says they hope to beat an IRS challenge in court, although the opinion warns that "there are risks and uncertainties on a number of tax issues."
The partnership, called Yale-Quay Energy Partners, filed a certificate listing the investors at the recorder's office in Los Angeles County at 4 p.m. on Dec. 31 last year--just eight hours before the end of the tax year.
The partnership offered 200 investment units for sale, and a partner had to buy at least 6 units at $5,500 each--half payable in 1981 and the other half by March 31, 1982.
According to the confidential investment summary, "Investors are expected to receive a tax write-off in the ratio of $4 for each $1 paid in 1981. In 1982, investors are expected to receive an additional write-off in the ratio of $2 for each $1 paid in 1982."
To make the investment, Smith and the other investors had to sign a statement that they were aware of the risks involved and have net worths, not counting their homes and personal belongings, of more than $200,000.
Using an accounting method often questioned by the IRS, Yale-Quay builds the base for the large deductions on future liabilities. The company had no gas or oil drilling last year. Operations were under way by February on 198 acres of land in Payne County, Okla., near the small town of Yale, but the first drilling effort failed to produce any oil.
Richard J. Sideman, a San Francisco attorney hired by Yale-Quay to defend an anticipated challenge by the IRS, said yesterday that the partnership has a tax and legal concept that is "most adventurous . . . I don't think we've ever seen one with a write-off of this magnitude."
Sideman said he has since terminated his representation with Yale-Quay for reasons he declined to discuss. Before he left, he was given $5,000 in what an Oct. 20, 1981, agreement with his law firm called a "Tax Defense Fund."
Thomas P. DeCair, a spokesman for Smith, yesterday confirmed that Smith had personally made the investment. "He knows very little about it," DeCair said. "He did it himself despite his blind trust that holds his assets."
The trustee who hold Smith's considerable assets both prepares and signs Smith's tax returns, according to a special arrangement with the IRS, so Smith does not know precisely what was filed with the IRS, DeCair said.
As required under terms of the agreement, Smith paid an additional $16,500 into Yale-Quay on March 30 of this year. This entitles him to receive a tax deduction for his 1982 taxes of about $33,000. As a limited partner, he is only an investor and has no role in managing Yale-Quay.
Smith is also formally committed to pay other sums to those drilling the wells, but the partnership agreement indicates that these payments could be made from actual oil and gas drilling profits.
"The attorney general considers this a legitimate investment," DeCair said. "He relied on his former law partner Francis Wheat who went over its legality."
Wheat, a partner at Smith's former firm of Gibson, Dunn & Crutcher of Los Angeles, also invested the same amount in Yale-Quay.
Wheat, a former Securities and Exchange commissioner, yesterday confirmed his role and said he felt everything was perfectly proper, although, he added, "The investment did provide a rather larger tax deduction than I expected."
A formal IRS ruling of 1980 challenges the basic concept and theory of the deductions in Yale-Quay, according to a 41-page tax opinion issued to Yale-Quay by the Los Angeles law firm of Meserve, Mumper and Hughes. Citing a later federal Court of Appeals decision in California, the law firm says, "We have expressed the opinion based on this case and other judicial authority that this ruling is incorrect."
"If the service IRS were to successfully take the position set forth in Revenue Ruling 80-70 in this case, the partnership would not be permitted" the large deduction from 1981 federal taxes.
The tax opinion, dated Sept. 15, 1981, warns that "there are risks and uncertainties of a number of tax issues," including another problem on the method of accounting that the tax opinion says could cause the IRS to disallow other deductions.
As attorney general, Smith represents the IRS in court and is supposed to defend the federal government in challenges to IRS actions and rulings, such as the Revenue Ruling issued in 1980.
As a Los Angeles lawyer, Smith managed Reagan's financial affairs and once was the manager and trustee of Reagan's personal finances.
Smith is reliably reported to be a millionaire and to have extensive investments which would bring him income in his blind trust that could be sheltered by the Yale-Quay deductions. That means investment income from stocks and other sources would be offset by the Yale-Quay deductions of $66,000. Or, this deduction could be used to make his annual $69,630 salary as attorney general totally tax-free.
Several tax experts consulted yesterday said that as a general rule such oil and gas partnerships can now only be expected to provide deductions of twice the initial investment, and most partnerships adhere to the 1980 IRS ruling.
IRS spokesman Leon Levine yesterday said the IRS stands behind the 1980 ruling, which he said prevents a taxpayer from improperly allocating deductions.
IRS Commissioner Roscoe L. Egger Jr. has made it a high priority to crack down on abusive tax shelters and has given a series of speeches around the country criticizing them.
Yale-Quay was set up Oct. 12, 1981, with only $50 in assets by Donovan M. Essex, a former Montgomery Ward salesman and store manager in California. The partnership raised $1.1 million from wealthy individuals, including Smith, who purchased 3 per cent of the investment shares.
Alan L. Brown, a petroleum geologist who did the study showing that Yale-Quay could expect to find oil on the Oklahoma land, said yesterday that one well was drilled earlier this year but "it hasn't done well. That location we drilled wasn't any good."
According to Bonnie Lawrence, an attorney for Yale-Quay, "We hit a lot of salt water." But she said that Yale-Quay plans to go ahead with more drilling and indications are that oil will be found.
Brown's geological survey, which was included in the Yale-Quay investment prospectus, states that about 68,500 barrels of oil might be recoverable from each of four wells drilled on the partnership property.
Brown says in his report, however: "By the nature of oil and gas business, no guarantees can be made. In fact, there is no certainty that any wells drilled on the prospect will be productive, or if productive will produce oil and gas in quantities sufficient to return even the cost of drilling and completion."
In a recent report to investors, Essex, the president of Yale-Quay, wrote:
"May the Snow of Oklahoma Be Blackened With the Future Production of Y-Q." CAPTION: Picture, WILLAIM FRENCH SMITH. . . $4 in write-offs for each $1 paid.