Lingering Pain From Exotic Tax Shelters

As the April 15 tax-filing deadline nears, millions of Americans wish they could find some shelter from the Internal Revenue Service’s biting winds.

But scores of taxpayers, including many wealthy Southern Californians and some big-league baseball players who invested millions of dollars in exotic tax shelter programs sold by an imaginative New York promoter, wish they had not tried.

During the past six years, the investors bought shelters based on Picasso prints and postage stamps from the uninhabited Scottish islands of Eynhallow and Grunay. They bought pieces of a run-down Arizona tree farm and the rights to the Terra Drill, an unorthodox oil drilling tool that has yet to prove its commercial worth.

One investor, looking for an equipment depreciation writeoff, ended up the unhappy owner of an $80,000 Peterbilt truck.

Participants in these programs stand to lose their investments, which by one estimate total more than $100 million, plus back taxes, interest and IRS penalties. All these investment programs are the subject of past or current court action and close IRS scrutiny.

The 1986 tax reform law and an IRS crackdown on “abusive” shelters have taken most of the fun out of the tax shelter game as it was played in the early and mid-1980s.

Rich taxpayers sank tens of thousands of dollars--and sometimes much more--into programs that promised them writeoffs of as much as four times their cash outlay.

Belatedly, the IRS is catching up with dozens of these schemes, retroactively wiping out the huge deductions and hitting the taxpayers with stiff penalties and fines.

The IRS and federal prosecutors are now also vigorously pursuing the promoters of such tax-avoidance schemes.

Last month, a federal grand jury in New York indicted three promoters of an allegedly fraudulent tax shelter that generated more than $350 million in writeoffs for more than 400 wealthy investors, including many prominent business and Hollywood figures.

The IRS is also seeking back taxes, interest and penalties from the investors, who include CBS Chairman Laurence A. Tisch, television producer Norman Lear, actors Sidney Poitier and Lorne Green, the late artist Andy Warhol and three top executives of the Wall Street investment bank of Lazard Freres.

The painful experience of investors in all these schemes offers a cautionary tale with two simple but oft-forgotten lessons: If it sounds too good to be true, it probably is. And, don’t get greedy.

The tax programs involving the artwork, the stamps, the nursery, the drill and the trucks were all the handiwork of Herman Finesod, a New York financial innovator described by one courtroom opponent as “the King of Tax Shelters.”

The tax men have disallowed deductions from several of his deals, including the Terra Drill, the trucks and the artwork.

A federal appeals court halted the stamp program, describing it as “a simple conspiracy . . . to perpetrate a tax fraud.” An Arizona state court found that Finesod’s syndication of the rights to reproduce artwork was a violation of that state’s anti-racketeering law.

Nevertheless, associates said, Finesod is not giving up his quest for new investment opportunities in the U.S. Tax Code.

“Prohibition is to the barkeep as the tax laws are to the tax shelter promoter,” one of Finesod’s lawyers said when asked about Finesod’s current ventures. He added, however, that most of Finesod’s energies today are devoted to designing investments for profit rather than for tax savings.

Despite the size and scope of his investment empire, Finesod is little known outside the tax shelter and equipment-leasing businesses. He maintains a low profile and markets his products through numerous subsidiary companies and hired general partners.

Two programs, a computer-leasing syndicate and a Connecticut plant nursery, list former Rep. Barry Goldwater Jr. (R-Calif.) as general partner.

Described as Charming

Goldwater could not be reached for comment. A Finesod lawyer said he did not know how much of Goldwater’s time is spent overseeing the investment programs or if he is still actively involved in Finesod businesses.

Neither program for which Goldwater serves as general partner has been subject to legal action or an IRS challenge.

A former employee described Finesod as “smooth, charming, an art collector, very worldly. He has some notoriety in the art world because of the Picasso deals. . . . He’s sincere and enthusiastic. He could sell you the Brooklyn Bridge.”

Although most of Finesod’s business entities operate under his New York umbrella company, Worldco, he also maintains an office in Century City and keeps an apartment in Los Angeles, according to Worldco documents and Finesod associates.

Finesod declined repeated requests to be interviewed for this article. One of his attorneys, William B. Wachtel of the New York law firm of Gold & Wachtel, did consent to discuss some aspects of Finesod’s wide-ranging enterprise.

“In the tax shelter business, there are two kinds (of operators),” Wachtel said. “There are the fraudsters, who put a product on the street and head for the hills. There are others, and I for one believe Finesod falls into this category, who are creative, novel, who put out a tax product in a Rolls-Royce fashion.”

In response to questions about the numerous investor lawsuits that have been filed against Finesod over tax shelters that were disallowed by the IRS or that did not deliver other expected benefits, Wachtel said:

“Enough with the crying investors. They’re disappointed. But there’s no fraud. There’s no impropriety. If people feel they have a righteous claim and want to litigate, fine. We’ll litigate with them.”

Accusation of Fraud

Among those suing Finesod over deals that allegedly went sour are three former professional baseball players who live in California: relief pitcher Ed Farmer, catcher Bill Fahey and utility player Mike Ivie.

Each sank $90,000 into a tax shelter deal involving the Terra Drill and lost it all, according to the complaint in a lawsuit filed last year in federal court. They still face adverse action by the IRS, which disallowed deductions taken for losses from the drill deals.

In their suit, the ballplayers and 55 other Terra Drill investors accused Finesod and various other entities of fraud, concealment of critical information and racketeering.

Said Wachtel: “The Terra Drill is a fascinating product. If one of these deals turns around, you’ll have a lot of instant millionaires.”

Finesod’s chief antagonist in the courts over the coming months and years will be Herbert Beigel, a Chicago attorney specializing in tax shelter litigation. He represents 175 investors, including the ballplayers, in suits against three Finesod programs--the Terra Drill deal, the Arizona nursery and the truck-leasing program.

“There never was a chance of any profit from these deals,” Beigel said, echoing a charge central to his legal challenges to Finesod’s programs. His lawsuits, filed last year in U.S. District Court in New York, allege that Finesod and his associates cheated investors through fraud, securities violations, misrepresentation and racketeering.

In a 1984 offering memorandum issued for the Arizona nursery deal, Finesod is described as 48 years old, “a New York entrepreneur and investor with over 22 years experience in the investment management field.” He is the sole stockholder and president of M&J; Holding Corp., the parent of various business entities and tax-advantaged investment programs.

M&J; Holding, organized in June, 1979, was said to have an unaudited net worth in excess of $25 million in mid-1984.

“Mr. Finesod,” the document says, “has or has had active interest in real estate, the sale of art-related products, the sale of stamp-related products, oil and gas drilling, oil and gas technology, outdoor advertising, trucks and equipment leasing.”

Typical Structuring

Finesod’s marketing program is like that of many other investment and tax shelter promoters. He employs a network of salesmen around the country who call on accountants, tax lawyers and business managers for wealthy individuals.

These tax advisers look over the slick color brochures and fat prospectuses and then decide whether to recommend them to their clients.

In the Arizona nurseries program, which a former salesman said was structured as a typical Finesod deal, the sales agents and the accountants who passed it on to their clients split a commission of 10% of the sales price.

“I got into this through a tax attorney, who was giving me investment planning advice on several shelters that same year,” said Michael Solomon, owner of a Los Angeles furniture company, who invested $50,000 in the Arizona nursery deal in late 1984. “He would find the deals and advise me on them. I was paying the guy $200 an hour; I relied on him totally. I was paying him to do the due diligence. Yes, he failed me. Absolutely.”

Several tax advisers who put their clients into these deals said they studied the offerings, and they looked as if they had a reasonable chance of making a profit and surviving IRS scrutiny.

They all noted that they are under tremendous pressure from rich clients to shield their income from the government’s clutches.

“We get three to 15 prospectuses every week, maybe more,” said a partner in a Los Angeles accounting firm that advised a client to invest $25,000 in the Arizona tree farm. “We are pressured by a lot of clients in high-income brackets who want to shelter their income. I won’t say we’re hounded, but we were pushed by them to find these things. We knew they were high risk. We were reluctant, but we did it.”

The Arizona nursery program is now tied up in the courts, because the Finesod-run entity that bought the property to syndicate to 200 limited partners like Solomon refused to make a $250,000 payment to the former owners in a dispute over the use of proceeds from the sale of trees.

Default Ruling

An Arizona court ruled last summer that the partnership was in default and allowed the property to revert to its original owners. The former owners are suing the 200 partners to try to recover $22 million they were promised as the full sale price of the nursery property.

Solomon and 60 of his fellow investors are suing Finesod and numerous other parties to try to recover their investments. Meanwhile, the IRS is scrutinizing the deal to see whether the tax deductions taken by the partners were legitimate.

The investors stand to lose more than their simple investments, which in most cases were between $25,000 and $100,000. Under the Finesod partnership arrangement, the investors were told they could deduct $90,000 for each $25,000 invested.

To qualify for this 3.6-to-1 deduction, however, under IRS rules the investors must have the additional amount above their direct investment actually “at risk.”

The at-risk portion of the investment was represented by the investors’ pledge on a promissory note to the former owners of the property.

Solomon and the other investors never suspected that they would actually have to make good on the note, which was to have been paid off over 13 years from the cash flow of the nursery.

But today that looms as a distinct possibility if the IRS disallows their entire writeoffs or if the Arizona courts rule that the former owners are entitled to immediate payment of the $22-million note.

“As disappointed as Herman Finesod is in the performance of Arizona World, and anxious as he is to see that investors are accommodated, he also feels quite strongly there has been no impropriety with regard to the transaction,” Wachtel, Finesod’s attorney said.

“Investors in these programs are not naive,” Wachtel added. “They all know what they’re getting into.”

Perhaps. If they had read the private placement memorandum on the nursery deal, which runs 228 single-spaced pages, they would have learned that Finesod and several of his associates had been identified by the IRS as promoters of tax shelters that will be subject to special IRS review.

They would have learned of several potential conflicts of interest between various Finesod entities involved in the nursery syndication.

They would have learned that just by investing in the Arizona program they would be flagging themselves as taxpayers who deserve close attention from IRS auditors.

They would have learned that there was a good chance that their writeoffs would be disallowed if the IRS took a strict view of the deductibility of nursery stock.

Little Sympathy

The offering memorandum, in addition to all the usual disclaimers contained in such documents, also revealed that another Finesod investment program was in trouble with the IRS for overvaluing its products by more than 200%.

It noted that neither Finesod nor any of his affiliates had any experience in the tree farming business. It also disclosed the fact that nearly 25% of the investors’ money would be used for salesmen’s commissions, attorneys’ and accountants’ fees, and overhead for Finesod companies.

Given this information, investors who sink $50,000 or $100,000 into such programs seldom get much sympathy. But their experience might serve as a warning to any investor, whether he is looking for a tax savings or a straight economic return.

Robert A. Stanger, publisher of the Stanger Report, a tax shelter newsletter, offers the following observations and advice after years of studying hundreds of tax shelter gimmicks:

“The real fault is that investors and advisers alike seem to adopt different standards when the smell of alleged tax loss permeates the fall air. And it’s amazing how many ‘sophisticated’ intermediaries, like financial planners, accountants, lawyers and brokers, jump into the leaf pile,” Stanger wrote a few years ago.

“Beware of the esoteric or offbeat deal. The odds are strong that by the time it gets to you, it’s well known to the IRS or the SEC (Securities and Exchange Commission). And an adverse revenue ruling is probably seconds away. We’ve never seen any ‘wild one’ that had a particle of substance to it. You can easily end up being denied the tax losses and losing your capital, too.

“Ask yourself why, if the deal is so good, they are offering it to you .

“Beware of deals that seem to have no economic function besides avoiding taxes. If that’s how it looks to you, that’s probably how it will look to the IRS, too,” Stanger wrote in 1981. Maybe he was ahead of his time?