Attorney General William French Smith, who obtained a $66,000 deduction from an oil tax shelter on his 1981 taxes, also invested in a similar gas tax shelter at the end of 1980 for another tax deduction of $50,000.
Smith personally invested in the first gas tax shelter on Dec. 17, 1980, six days after he was nominated to be attorney general in the Reagan administration.
Justice Department spokesman Thomas P. DeCair yesterday said that Smith inadvertently failed to list the gas tax venture, called Blackhawk Energy Partners Ltd., on his financial disclosure form for that year, as required by law. Both tax shelters were listed on his disclosure form this year. The form was made available Wednesday, a few days before the Saturday filing deadline.
From both shelters, Smith has or will obtain at least $175,000 in tax deductions over three years--1980, 1981 and 1982--for an investment of approximately $60,000. Both shelters provided Smith and other partners with $4 in tax write-offs in the first year for each $1 invested, the type of tax shelter that is virtually certain to be audited by the Internal Revenue Service, according to published IRS standards.
IRS Commissioner Roscoe L. Egger Jr. outlined these standards in a speech last Oct. 6. He said there are generally seven criteria, any one of which, since 1973, has automatically triggered an IRS audit of a tax shelter. Both of Smith's shelters--Blackhawk and the second partnership, called Yale-Quay Energy Partners--seem to meet three of these standards: each was formed late in the year; each generated a large deduction ($4 of losses for each $1 invested); each was not in actual operation during the year of the first deductions.
Several private tax attorneys in Washington and former IRS officials consulted this week were critical of Smith's investment, pointing out that technical details in the partnerships show that the deductions have been taken for a future debt or liability that may not have to be paid or, at minimum, can be deferred automatically for 12 years.
It is precisely this debt--the major basis for the large tax deductions--that the experts said quite likely would be questioned by the IRS. After an audit the IRS could disallow all or some of the deductions, a finding that Smith or his tax shelter partnerships could dispute with the IRS or in court.
IRS spokesman Leon Levine yesterday declined to say whether Smith's tax shelters would be audited. "To answer that would violate federal tax law which prohibits me from answering questions about specific cases," he said, adding, "But I will say that those things audit criteria mean what they say. The reason we publicized them is to deter people from joining abusive shelters. We have a vigorous audit program."
A Justice Department official involved in tax matters and who declined to be quoted by name said that publicity about the attorney general's tax shelter made an audit "inevitable and certain."
DeCair on Wednesday said that, "The attorney general understands this to be a proper oil and gas investment . . . and he plans to look into it to reassure himself."
Smith invested $16,500 in Yale-Quay last year for his $66,000 write-off. That is twice the amount permitted by current IRS rules. This year he paid an additional $16,500, which will give him an approximate tax write-off of $33,000 on his 1982 taxes.
In 1980 he invested $12,900 in Blackhawk to get a deduction of about $51,600; in 1981 he paid Blackhawk another $12,900 for a deduction of $25,800, according to DeCair and John R. Deacon, a lawyer for the Los Angeles firm of Meserve, Mumper and Hughes, which prepared the tax opinions for both shelters.
The IRS allows deductions beyond the cash investment made by a taxpayer if it can be shown that there is an actual financial obligation or risk to the taxpayer roughly equivalent to the deduction.
The 200-page confidential Yale-Quay tax shelter document shows how Smith got his $66,000 deduction for 1981 taxes. The $16,500 he personally invested was deducted for anticipated expenses by the partnership for services and labor (called the "intangible drilling costs"). In addition, Smith has signed a note saying that he owes $49,500, his share of what is called a "minimum annual royalty" due to an intermediary who subleases an exploratory 198-acre Oklahoma tract.
The Yale-Quay agreement on this sublease shows that the partnership can "defer actual payment of the minimum annual royalties" as long as profits from actual operations of oil and gas drilling are applied. Then, according to the agreement, "any unpaid liability . . . for minimum annual royalties" is not due until the day before "the twelfth anniversary date of the sublease."
This 12-year deferral means for practical purposes that Smith's royalty payment of $49,500, which he deducted in 1981, would not be due until 1993. The agreement indicates that no interest would have to be paid. Assuming about 10 percent a year in inflation, in 1993 the obligation would be $15,000 in current dollars.
Three tax attorneys said this week that this is the type of paper liability the IRS frequently disallows. They said that the tax shelter was not illegal, but was based on an interpretation of the IRS code that they doubted the federal courts would allow to stand.
IRS spokesman Levine said yesterday that, in general, the IRS would question any attempt to "stretch out" a debt into what he called a "dubious real liability." He added that tax shelters with this deferred liability are relatively new.
"There seems to be a certain trend that has come out of California and we don't have a published position" on it yet, he said.
Under the partnership agreement with the sublessor, Bowmor Petroleum Ltd., another California partnership, Yale-Quay also can absolve itself of "all future liability for the minimum annual royalty." This can be done by giving 30 days' notice and assigning 5 percent more of the actual interest in the profits from any gas or oil wells to Bowmor.
The 41-page tax opinion written by the Meserve firm for the Yale-Quay partnership warns of tax "risks and uncertainties," but says the large deductions could be justified.
A 1980 IRS ruling, which does not have the force of law but is the government's current interpretation, holds that the minimum annual royalty portion of a deduction ($49,500 for Smith's share) taken at the end of the year could only be partially deductible for the 1981 taxes.
The IRS has said only 1/12th of the payment could be deductible for the one month, December, 1981, that Yale-Quay was established. But other tax experts consulted this week said that, since Yale-Quay was formally certified in October and since Smith made his $16,500 payment in November, as much as one quarter of the large royalty might be deductible.
So Smith's full deductions might be roughly $10,000 to $15,000. Added to the $16,500 intangible drilling cost deduction, Smith could wind up with about $30,000 in deductions. This is why tax experts said his $66,000 deductions seemed to be at least twice that allowed by current IRS rulings.
Nonetheless, the IRS 1980 ruling has been successfully challenged in court, though as far as the IRS is concerned, until finally resolved, it should be followed by investors.