kpmg tax shelter case study

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KPMG: Running for Shelter

By: Michael Ragsdale , Erin Bucholz & James S. O’Rourke
Publisher: The Eugene D. Fanning Center for Business Communication, Mendoza College of Business, University of Notre Dame
Publication year: 2006
Online pub date: January 04, 2017
Discipline: Auditing , Business Ethics (general)
DOI: https:// doi. org/10.4135/9781526405920
Keywords: clients , Department of Justice , firms , former clients , settlement , shelters , taxes Show all Show less
Contains: Content Partners | Supplementary Resources | Teaching Notes Length: 3,989 words Region: Western Europe Country: Netherlands Industry: Other professional, scientific and technical activities Originally Published In: Ragsdale , M. , Bucholz , E. , & O’Rourke , J. S. ( 2006 ). KPMG: Running for shelter . 06-06. Notre Dame, IN : The Eugene D. Fanning Center for Business Communication, Mendoza College of Business, University of Notre Dame . Organization: KPMG Type: Indirect case info Organization Size: Large info Online ISBN: 9781526405920 Copyright: © 2006. The Eugene D. Fanning Center for Business Communication, Mendoza College of Business, University of Notre Dame More information Less information

Teaching Notes

Supplementary resources.

Beginning in the late 1990’s, public accounting firm KPMG marketed and sold tax shelters specifically designed to help clients evade taxes. When the IRS challenged these tax shelters, KPMG resisted its investigation. In the face of mounting evidence against the firm, KPMG eventually realized it had no choice but to cooperate with the Justice Department and try to save itself from criminal indictment. Late in the summer of 2005, KPMG reached a settlement with the Department of Justice, which required KPMG to make a public admission of wrongdoing. This admission paved the way for the Justice Department to file suit against former KPMG employees involved with the tax shelters. Some argue that KPMG betrayed its former employees. With the risk of criminal indictment abated, now KPMG must turn its attention to rebuilding the trust of its partners and its clients.

Introduction

It was September 30 th and Timothy Flynn was all too ready for the month to end. Only a few months earlier, Flynn had taken over as Chairman and Chief Executive Officer of KPMG, LLP when his predecessor, Eugene D. O’Kelly, stepped down after being diagnosed with a terminal form of cancer. 1 Flynn took office during a difficult time in the company’s history. Flynn’s first few months as CEO marked a time when KPMG almost met its end.

An ongoing Internal Revenue Service investigation revealed that KPMG had committed illegal acts by marketing and implementing tax shelters with the sole purpose of creating tax losses. Since the transactions in question had no legitimate business purpose other than to create tax losses, they were not tax deductible. The U.S. Justice Department could have filed criminal charges against KPMG; an indictment would have ruined the company. Instead, the Justice Department decided to spare KPMG by negotiating a settlement with the company.

On August 28, 2005, the settlement was finalized. KPMG then moved quickly to settle the flood of civil suits filed by former tax-shelter clients. These clients claimed that they were unaware of the risk that the I.R.S. might not accept these deductions. On September 29, KPMG agreed to settle a class action suit with a number of these former clients.

Flynn was relieved that KPMG had escaped federal prosecution and was beginning to address former clients’ grievances; he knew, however, that more challenges lay ahead for the company. The terms of the settlement imposed significant restrictions on KPMG’s tax department. Flynn could only hope that the company had not lost the trust of its audit clients and that the core of its clients would stay with the company.

Flynn also worried about the backlash surrounding the indictment of eight former KPMG executives. The indictments were announced on August 29, 2005, the day after KPMG reached its settlement with the Justice Department. Some of the lawyers representing those indicted argue that KPMG sacrificed some of the partners involved in its tax sheltering business in order to save the company. Flynn worried that this perception might injury partner loyalty and talent recruitment.

Additionally, Flynn realized that as the media continued to follow these indictments, they would continually remind the public of the fraudulent nature of the tax shelters and of KPMG’s admission of wrongdoing. Although it looked as if KPMG would survive, Flynn braced himself for the imposing challenge of saving the company’s tarnished reputation and leading KPMG into the future.

Industry Profile

The public accounting profession is highly concentrated and that concentration has only increased over the last few years. The Big Six of the early 1990s are now the Big Four since Price Waterhouse merged with Coopers & Lybrand and since Arthur Andersen collapsed. 2 When Andersen failed, the remaining Big Four absorbed their former competitor’s clients. The Big Four include Deloitte & Touche, PricewaterhouseCoopers, Ernst & Young and KPMG. These four firms audit more than 78% of all U.S. public companies, representing 99% of public company sales. 3 These firms provide accounting, audit and tax services that are virtually indistinguishable, even for those trained in accounting. They generate the largest portion of their revenue from audit services and the second largest portion from their tax services. The most important differentiating factor between the Big Four and other accounting firms is their size.

The advantages these firms derive from their size goes far beyond economies of scale. With relatively few exceptions, public companies turn to one of the Big Four for audit services. Other accounting firms cannot offer a large enough collateral bond to its clients. A collateral bond is the restitution an accounting firm can afford to make to its client if the firm issued an unqualified opinion on the financial statements despite a material misstatement and a lawsuit results.

Business Profile

As the fourth largest accounting firm in the United States, KPMG is one of the accounting profession’s Big Four. KPMG, LLP represents the United States operations of KPMG International. Built over time through mergers of several international accounting firms, KPMG boasts the widest international operations of all firms in the industry. 4 Although the smallest of the Big Four, KPMG’s ninety-five domestic offices evidence the company’s strong presence in the United States. 5 In 2004, KPMG, LLP generated over $4 billion in compensation for services. 6 KPMG International numbers for the same year totaled almost $13.5 billion. 7 The company’s audit and tax functions have been trusted by clients for over 100 years.

In 1997, KPMG and fellow Big Four competitor, Ernst & Young discussed merging their firms. 8 The merger negotiations eventually died, largely because of concerns about antitrust regulations. 9 Despite its failure, the proposed merger indirectly made a significant impact on KPMG’s business. During a routine pre-merger examination of Ernst & Young’s books, KPMG discovered the impressive profits its competitor was gleaning from selling tax shelters. 10 KPMG’s then chief executive, Stephen G. Butler, decided the company could not afford to miss out on this market opportunity. 11 Butler placed Jeffrey Stein, then head of KPMG’s tax department, in charge of creating a brand of tax shelters for the company. 12 Stein’s tax shelters likely made a significant contribution to the tremendous growth experienced by the tax department between 1998 and 2001. During this time, the department’s annual gross revenue increased from $829 million to $1.2 billion. 13

Introduction to Tax Shelters

The Oxford English Dictionary defines a tax shelter as “an opportunity for incurring expenses so that they can be used to reduce tax liability.” In the 1990s, it was common practice for accounting firms to market tax shelters to taxable entities, most often wealthy individuals or corporations. A tax shelter works as follows: the accounting firm finds a way to structure a transaction or series of transactions for the taxable entity which intentionally create a loss. The entity then uses this loss to offset income and reduce its tax liability. The accounting firm then takes a fee for the service of helping the entity make this transaction happen. The American Institute of Certified Public Accountants (AICPA) rules stipulate that Certified Public Accountants (CPA) may not receive contingent fees based on the services they provide, so the firm receives compensation for structuring the tax shelter even if the transaction is challenged by the Internal Revenue Service (I.R.S.).

In order for a transaction that creates a loss to be tax-deductible, it must have a legitimate business purpose other than tax avoidance, economic substance, and profit motive. The taxable entity must prove to the I.R.S. that the tax shelter meets this requirement. If the taxpayer fails to establish that the transaction had a legitimate business purpose, then the taxpayer will be guilty of filing a false return. The fulfillment of this requirement is anything but bright line. The definitions of business purpose and economic substance used by the I.R.S. and articulated through the courts are vague, confusing, and inconsistent. Since the rules involved are difficult to interpret, an accounting firm decides whether to market a tax shelter based on an assessment of the risk that the I.R.S. may challenge the transaction. Firms usually adopt a decision structure that allows a tax shelter to be marketed as long as it is “more likely than not” that the tax shelter will not be challenged.

KPMG’s BLIPS

The federal investigation into KPMG’s practices was in response to four tax shelters known as BLIPS, FLIP, OPIS, and SC2. The tax shelter known as BLIPS, which stands for “Bond Linked Issue Premium Structure,” was sold to 186 individuals and was the most profitable of the four shelters, generating over $53 million in revenue for KPMG. 14

BLIPS were marketed to individuals who had at least $20 million in ordinary or capital gains income. KPMG and Presidio, an investment bank, approached such wealthy individuals and proposed a transaction to create a loss that would offset their capital gains. Presidio arranged the necessary investments and financing for the individual, while KPMG and a separate law firm provided opinion letters indicating that is was “more likely than not” that the tax loss would survive an I.R.S. challenge.

BLIPS worked as follows: The taxpayer formed a limited liability corporation (LLC) to which they contributed cash equal to 7% ($1.4 million) of the gain to be offset. The LLC then obtained a loan from a bank, usually for about $50 million, at an above-market interest rate. Since the interest rate was greater than the market rate, the LLC received a loan premium equal to the amount of the gain to be offset. The LLC then agreed to severe restrictions on the loan in order to reduce credit risk. The restrictions included the provision that the LLC maintain 101% of the loan amount in cash or liquid securities.

Next, the LLC formed a partnership with two affiliates of Presidio known as a Strategic Investment Fund. The LLC received a 90% partnership interest, one of the affiliates received a 9% interest, and the other affiliate received a 1% interest and assumed the role of managing partner.

The LLC then contributed all of its assets, including the loan, the loan premium, and the cash contribution, to the partnership. The two affiliates also contributed cash in the amount of 10% of the LLC’s total assets or about $155,000. The Fund then had total capital of $71.6 million. The partnership assumed the obligation to repay the loan. At this point, the Fund entered into an interest rate swap with the bank, which effectively reduced the interest rate of the loan to a market-based rate.

The Fund converted most of the U.S. dollars into euros with a contract to convert them back to U.S. dollars in 30-60 days. The Fund used the euros to engage in short-selling low-risk foreign currencies, which were monitored by the bank to ensure the restrictions on the loan were not violated. (See Figure 1)

After 60-180 days, the LLC withdrew from the partnership and the partnership was liquidated. All of the euros were converted back to U.S. dollars, which were then used to pay off the loan. Any remaining assets in the partnership were divided among the three owners and the LLC sold any securities obtained at fair market value.

For tax purposes, the LLC passed its gains or losses to the individual owner. The opinion letters issued by KPMG and the law firm stated that the LLC should be able to claim both the cash contribution of $1.4 million and the $20 million of loan premium as losses for tax purposes. This is how the original gain of $20 million was claimed to be offset. KPMG profited through the receipt of up to 7 percent of imaginary loss figure. 15 (See Figure 2)

The Investigation

The I.R.S. started investigating KPMG in 1999 after receiving anonymous tips about the company’s tax shelters. 16 The I.R.S. asked KPMG to turn over details about how the tax shelters worked and who invested in them. The company refused.

While KPMG was not the only auditing firm promoting questionable tax shelters, the firm did put up the most resistance to government regulatory efforts. When the I.R.S. began raising concerns about tax shelter abuses, other firms decided to quickly and quietly settle. 17 Ernst & Young, KPMG’s inspiration in the tax shelter business, settled with the I.R.S. in 2003 for a mere $15 million dollars. 18 KPMG took the opposite approach, insisting the company did nothing wrong. Unnamed insiders suggest that KPMG either arrogantly thought that it could outsmart the I.R.S. and the Department of Justice or thought that with its industry position the I.R.S. would not or could not challenge them. 19

KPMG defended itself as late as the November 2003 Senate subcommittee hearing over the company’s tax shelters. KPMG was railed at the hearing. The Senate produced internal documents which revealed that firm’s tax department gave little concern to the legality of the tax shelters. Instead, the documents showed how KPMG engaged in a cost benefit analysis and decided that the gains to be made from selling tax shelters outweighed the costs associated with the risk of I.R.S. disapproval. 20

After seeing the disparaging subcommittee report, Flynn’s predecessor, Eugene D. O’Kelly, announced to KPMG’s board that the company would begin cooperating with the investigation. 21 In January 2004, KPMG began making personnel changes. The company forced Stein to retire. The company reassigned Richard Smith, the vice chairman of tax services and placed another high level partner, Jeffrey Eischeid, on leave. Despite some signs of remorse, KPMG was not yet ready to turn over all relevant documents. In February 2004, out of frustration with KPMG’s lack of cooperation, the Department of Justice convened a grand jury to begin a criminal inquiry. By May 2004, a federal judge hinted that KPMG might be guilty of obstruction of justice. In March 2005, KPMG finally got serious about resolving the dispute. The company hired Sven Erik Holmes, a federal judge from Tulsa, as vice chairman of legal affairs. Holmes quickly fired several partners involved in the questionable shelters.

Prior Trouble at KPMG

This is not the first time that KPMG, LLP has been in trouble with the law. In 2003, the SEC filed fraud charges against the company and some of its partners. The allegation related to former KPMG client Xerox, who fraudulently inflated its profits in the late 1990s. 22 In October 2004, KPMG settled charges that its audit of Gemstar-TV Guide International’s financial statements was improper. 23 KPMG was also implicated recently when audit client Fannie Mae had to restate its earnings. 24

Reluctance to Indict KPMG

Had the Justice Department indicted KPMG it would have meant the end of company in the same way that Arthur Andersen’s indictment led to its departure from the industry. Andersen’s case proved how quick industry clients and partners are to leave a firm following its indictment. Convicted firms are banned from practice, according to SEC regulations. 25 Neither clients nor partners are willing to stick around, chancing their luck that an indictment will not result in conviction.

The Justice Department likely considered that indicting KPMG would mean the end of the firm, leaving only three large firms in the industry. A reluctance to see the industry become even more concentrated likely factored into the Justice Department’s decision to settle with the company.

Settlement with the Justice Department

After a few months of pleading, KPMG’s outside counsel Skadden, Arps convinced the Justice Department not to indict the company. On August 28 th , a settlement was announced. The settlement is structured as a deferred prosecution agreement. As long as KPMG complies with the terms of the agreement, the Department of Justice will dismiss charges against the firm on December 31, 2006. The terms of KPMG’s settlement require the company to pay $456 million in fines to the government in a series of three installments over a period of 16 months. The conditions of the settlement stipulate that the fine cannot be paid with insurance money. The settlement figure represents $100 million in civil fines for failure to register the tax shelters with the I.R.S., $128 million in criminal fines over fees earned by KPMG, and $228 million in restitution over lost I.R.S. revenue. The fines constitute 11% of the firm’s fiscal 2004 revenue and average to $300,000 per U.S. partner.

As part of the settlement terms, KPMG also agreed to supervision by an independent monitor for a period of 3 years. Former SEC chairman Richard Breeden will monitor KPMG’s compliance with the agreement. Breeden has a great deal of experience with criminal investigations. He previously acted as Corporate Monitor of WorldCom, Inc. on behalf of the U.S. District Court. Breeden will monitor KPMG’s compliance with the specific restrictions the settlement imposes on the firm’s tax practice. The settlement bans KPMG from offering pre-packaged tax products. The settlement also restricts KPMG from charging fees not based on hourly rates.

As part of the settlement, KPMG also made a public admission of wrongdoing. KPMG’s statement included the comment that “a number of KPMG tax partners engaged in conduct that was unlawful and fraudulent.” 26 KPMG’s admission paved the way for charges against individual partners.

Indictment of Employees

On August 29 th , the day after the Department of Justice proclaimed its settlement with KPMG, a federal grand jury announced the indictments of nine individuals charged with conspiracy to commit fraud in connection with the KPMG tax shelters. Eight of the nine defendants are former KPMG employees. The ninth individual, Raymond Ruble, is a former partner at the law firm of Sidley Austin Brown & Wood, LLP. Ruble contributed to the sale of the tax shelters by composing opinions supporting the shelters’ legality. Each individual faces large fines and potential prison time.

Stanley Arkin, the defense attorney for former KPMG executive Jeffrey Eischeid, argues that KPMG’s cooperation with prosecutors represents “a profound betrayal by KPMG of its partners.” 27 Arkin is not alone in this argument. Jonathan Hamilton, editor of the newsletter Public Accounting Report , warns that KPMG’s action “sends a very solid message to any partner: Even if what you’re doing has the firm’s blessing, if the firm gets in big trouble, you’re going to be on your own.” 28

Settlement with Former Tax Shelter Clients

As part of KPMG’s cooperation with the Justice Department, the firm had to turn over the names of those who invested in its tax shelters. The I.R.S. then required these tax shelter clients to restate their tax liabilities for the relevant years. Considering interest and penalties, many of KPMG’s former clients owed the I.R.S. millions of dollars. 29 Some of these clients are trying to recover a portion of these expenses by suing KPMG. These taxpayers argue that they trusted that KPMG would not advise them to do something illegal and that they were unaware of the risks that the I.R.S. might challenge these transactions.

Thus far, former tax shelter clients have filed three class-action lawsuits against KPMG. On September 29, 2005, KPMG settled a class-action suit filed by investors who bought shelters through KPMG and the law firm of Sidley Austin Brown & Wood. Brown & Wood was one of the outside firms participating in the tax shelters by drafting supporting legal opinions. The class party to this suit, which may include as many as 280 investors, will receive a $195 million dollar payment. Brown & Wood will pay 20% of this figure and KPMG will pay the remainder. KPMG and Brown & Wood will also pay the plaintiffs’ lawyers’ fees. Inclusion in the class is voluntary. Investors can opt out of the class and pursue their own lawsuits against KPMG and Brown & Wood. If the class is as large as projected, each participating investor will realize an average settlement of $686,000, a figure significantly smaller than the average taxpayers’ real losses.

This settlement represents a significant step in KPMG’s handling of the civil suits filed by former tax shelter clients. It is important to note, however, that this settlement only encompasses the grievances of clients who bought their tax shelters based on legal opinions offered by Brown & Wood. Brown & Wood is one of several law firms who supported KPMG’s tax shelters. KPMG is not yet finished addressing suits by angered tax shelter clients. KPMG still faces two other class-action lawsuits and the possibility that more suits will be filed in the near future.

Moving Forward

Flynn grabbed his jacket and headed out of the office. With the immediate threats brought on by the investigation averted, he planned on spending the weekend relaxing and rejuvenating his energies. Flynn knew that Monday would represent another day in the company’s marathon to rebuild its tarnished reputation. Now that the firm’s efforts to settle civil suits filed by former tax-shelter clients were finally meeting with success, Flynn wondered where he should focus his attention on next.

Discussion Questions

1. What is the biggest risk facing KPMG post-settlement?
2. In the aftermath of the criminal indictments against former employees, what message should KPMG communicate to its current partners?
3. How should KPMG respond to I.R.S. or Department of Justice inquiries in the future?
4. What should KPMG do to regain its clients’ trust?
5. What type of relationship should KPMG strive to create with independent monitor Richard Breeden?

1. “KPMG L.L.P.,” Hoover’s In-Depth Company Records. Hoover’s Inc. September 7, 2005.

2. “KPMG International.” Hoover’s In-Depth Company Records. Hoover’s Inc. September 7, 2005.

3. Bloom, Robert and David C. Schirm. “Consolidation and Competition in Public Accounting.” The CPA Journal, June 2005.

4. “KPMG International.” Hoover’s In-Depth Company Records. Hoover’s Inc. September 7, 2005.

5. “KPMG L.L.P.,” Hoover’s In-Depth Company Records. Hoover’s Inc. September 7, 2005.

6. “KPMG L.L.P.,” Hoover’s In-Depth Company Records. Hoover’s Inc. September 7, 2005.

7. “KPMG International.” Hoover’s In-Depth Company Records. Hoover’s Inc. September 7, 2005.

8. “KPMG International.” Hoover’s In-Depth Company Records. Hoover’s Inc. September 7, 2005.

9. “KPMG International.” Hoover’s In-Depth Company Records. Hoover’s Inc. September 7, 2005.

10. Browning, Lynnley and Jonathan D. Glater. “How an Accounting Firm Went From Resistance to Resignation.” New York Times , August 28, 2005, pp. 1.

13. Browning, Lynnley. “Report Gives New Details on KPMG Shelters.” New York Times, February 11, 2005, pp. C3.

14. Report prepared by the Minority Staff of the Permanent Subcommittee on Investigations of the Committee on Governmental Affairs, United States Senate. “U.S. Tax Shelter Industry: The Role of Accountants, Lawyers, and Financial Professionals; Four KPMG Case Studies: FLIP, OPIS, BLIPS, and SC2.” Appendix A.

15. “Former KPMG executives indicted 8 face charges; firm to pay $456 million.” Charleston Gazette , August 30, 2005, pp. P2D.

16. Browning, Lynnley and Jonathan D. Glater. “How an Accounting Firm Went From Resistance to Resignation.” New York Times , August 28, 2005, pp. 1.

17. Norris, Floyd. “KPMG, A Proud Old Lion, Brought to Heel.” New York Times , August 30, 2005, pp. C1.

18. Browning, Lynnley and Jonathan D. Glater. “How an Accounting Firm Went From Resistance to Resignation.” New York Times , August 28, 2005, pp. 1.

22. “KPMG L.L.P.,” Hoover’s In-Depth Company Records. Hoover’s Inc. September 7, 2005.

23. Glater, Jonathan D. and Lynnley Browning. “Settlement Seen on Tax Shelters By Audit Firm.” New York Times , August 27, 2005, pp. A1.

25. Sloan, Allan. “KPMG Partners Lucked Out – Thanks to Enron and Arthur Andersen.” The Washington Post , pp. B2.

26. Bayot, Jennifer. “8 shelter experts indicted.” New York Times New Service. Chattagnooga Times Free Press , August 30, 2005, pp. C1.

27. Weil, Jonathan. “Nine are Charged in KPMG Case on Tax Shelters.” The Wall Street Journal , August 30, 2005, pp. C1.

28. Gleckman, Howard and Amy Borrus. “Inside the KPMG Mess: Why eight partners may be facing jail time – and what the suit could mean for the tax-shelter business.” Business Week , September 12, 2005, pp. 46, vol. 3950.

29. Browning, Lynnley. “Law Firm and KPMG Settle Suit by Tax Clients.” The New York Times , September 30, 2005.

This case was prepared for inclusion in Sage Business Cases primarily as a basis for classroom discussion or self-study, and is not meant to illustrate either effective or ineffective management styles. Nothing herein shall be deemed to be an endorsement of any kind. This case is for scholarly, educational, or personal use only within your university, and cannot be forwarded outside the university or used for other commercial purposes.

The case studies on Sage Business Cases are designed and optimized for online learning. Please refer to the online version of this case to fully experience any video, data embeds, spreadsheets, slides, or other resources that may be included.

Figure 1. Investment Scheme.

Source: Report of the Minority Staff of the Permanent Subcommittee on Investigations of the Committee on Governmental Affairs, United States Senate. “U.S. Tax Shelter Industry: The Role of Accountants, Lawyers, and Financial Professionals; Four KPMG Case Studies: FLIP, OPIS, BLIPS, and SC2.” Appendix A.

Figure 2. Unwind/Termination.

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