The new tax code being hammered into shape by 22 members of Congress contains a wrinkle that could deliver billions of dollars of tax relief to wealthy investors, or could force them to pay billions in back taxes and penalties, according to administration calculations.
The issue touches less than 1 percent of all taxpayers, and doesn't even figure in the big debates under way in a House-Senate conference committee. But it involves as many dollars and as much intensity as some issues affecting millions of people.
On one side are up to 70,000 investors who until 1981 avoided several billion dollars in taxes through complex deals in silver, soybeans and other commodities. Congress cracked down on the transactions, known as "tax straddles," in 1981 and the Internal Revenue Service has since moved aggressively to collect taxes from those involved.
A highly technical provision in the House bill would enable the IRS to collect as much as $7 billion in back taxes and interest from these investors, according to a government brief in a recent straddle case. Since the cases are so old, the interest has grown to the point that it almost equals the taxes, according to several lawyers involved.
With so much money at stake, the investors have turned to influential allies for help. Sen. Paul Laxalt (R-Nev.) recently wrote a letter opposing the House provision to senators on the conference committee. The investors also hired a Washington lobbyist -- John Rafaelli, former aide to Sen. Lloyd Bentsen (D-Tex.), a member of the conference committee.
Tax straddles became widely used in the mid-1970s when leading accounting firms and brokerage houses promoted them as a means of avoiding taxes.Investors took out contracts both to buy and sell a commodity in the future. Whether the price rose or fell, the investors made money on one contract and lost on the other.
The trick was to cash in the losing contract at the end of a tax year, use the loss to shelter income from other sources, declare the earnings from the other contract in the next year -- usually as a capital gain rather than at the full income tax rate -- and then start the process over again.
In 1981, after widespread reports of multimillionaires wiping out their taxes with such straddles, Congress eliminated this tax shelter.
For straddles set up before 1981, it was left largely to the courts to determine whether the deals were undertaken for profit or purely for tax purposes. (In 1984, Congress created a special amnesty for professional commodities dealers but restated the same law regarding individual investors.)
In its early cases, the IRS won several key rulings against investors in the pre-1981 straddles. In those cases, the courts interpreted the law to mean that investors had to prove that their primary motive in entering the straddle was profit.
But in 1984, while not changing the law for individual investors, Congress included a phrase in the conference report on the Deficit Reduction Act saying that "a reasonable prospect of any profit" would suffice in pre-1981 straddles. Treasury officials insist the phrasing was unintentional; some congressional staffers say it was part of an intentional deal with investors.
Since then, tax courts have issued two key rulings in favor of individual investors on the basis of the relaxed language. Treasury officials have warned that unless the conference committee adopts the House provision, the government could lose billions of dollars that it now expects to collect -- although not the entire $7 billion.
These officials emphasized that the IRS won some of the cases because some deals do not even meet the relaxed test of the recent decisions. Nonetheless, they said, the issue could create a surprise deficit.
But aides to several senators said they may balk at adopting a House provision that cracks down on individual investors while leaving in place the 1984 loophole for professional commodities traders -- many of whom are headquartered in the district of House Ways and Means Chairman Dan Rostenkowski (D-Ill.).