ABUSE OF STRUCTURED FINANCIAL PRODUCTS- Misusing Basket Options to Avoid Taxes and Leverage Limits MAJORITY AND MINORITY STAFF REPORT

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system, the many ways in which financial firms are bypassing federal margin rules and leverage
limits, and the extent to which highly leveraged financial instruments and arrangements may be
contributing to overextensions of credit by lenders, asset bubbles, and systemic risks. Federal
margin rules, which are a direct response to the stock market crash of 1929, represent a vital
financial safeguard whose circumvention is too important to be disregarded by federal regulators
charged with detecting and evaluating systemic risk.
More generally, the financial sector and the corporate community are using derivatives to
try to achieve a variety of favorable outcomes in accounting, tax, financial, and other regulatory
contexts, even when the derivative instruments mimic economic activities that by themselves
yield different results. Two examples have been highlighted in this report. Congress and the
appropriate agencies should closely examine the growing use of derivatives to circumvent
accounting, tax, or regulatory rules, and what steps should be taken to prevent disparate
outcomes, particularly when they may pose a threat to the transparency, safety, soundness of our
financial system or the economy as a whole.
Auditing Large Partnerships. Third, despite ongoing IRS audits of RenTec’s basket
options activities, the IRS’ overall audit coverage of large partnerships similar to RenTec is poor.
Large partnerships – which include hedge funds, private equity funds, and publicly traded
partnerships – are some of the most profitable entities in the United States. According to a 2013
preliminary report issued by the U.S. Government Accountability Office (GAO), “[i]n tax year
2011, nearly 3.3 million partnerships accounted for $20.6 trillion in assets and $580.9 billion in
total net income.” 497
That GAO report also found that the IRS was failing to audit 99% of the tax returns filed
by large partnerships with assets exceeding $100 million. 498 The GAO report showed that while
the number of those large partnerships had increased significantly in recent years, IRS audits had
not kept pace. According to the GAO after examining a ten-year time frame, between tax years
2002 and 2011, the number of businesses organized as “large partnerships (with 100 or more
direct partners and $100 million or more in assets) increased more than 200 percent, accounting
for $2.3 trillion in total assets and $69.1 billion in total net income by tax year 2011.” 499 The
IRS’ audit efforts worsened yet again in 2012. According to the preliminary report, IRS field
audits reviewed the books and records of only 0.8% of large partnership returns. 500
In response to a Subcommittee inquiry about low audit coverage of large partnerships, the
IRS Large Business and International Division and Office of Chief Counsel explained that one of
the reasons for the low audit performance was because of the procedural hurdles erected by the
Tax Equity and Fiscal Responsibility Act (TEFRA). 501 The IRS pointed out that a TEFRA
notification provision requires the IRS to notify all partners holding more than a 1% interest in a
partnership prior to initiating an audit. 502 The IRS explained that some large partnerships, such
497 3/19/2014 “Large Partnerships: Characteristics of Population and IRS Audits,” prepared by the Government
Accountability Office, GAO-14-379R, at 1, http://www.gao.gov/assets/670/661772.pdf.
498 Id. at 4, 6.
499 Id. at 1.
500 Id. at 20.
501 Tax Equity and Fiscal Responsibility Act of 1982, Pub. L. No. 97-248.
502 26 U.S.C. § 6223.