Hundreds of Western New Yorkers thought they found a tax shelter and a source of retirement income when they invested in a coal mining business called the Swanton Coal Partnership in the late 1970s.
But instead of a tax shelter, the investment turned into a nightmare, leaving some investors with tax liabilities as high as $600,000 today.
After more than a decade of litigation, an estimated 200 people from the Buffalo and Rochester areas are now facing tax bills of $100,000 or more.
The Internal Revenue Service conducted a series of audits and determined that the business was not a legitimate tax shelter. Those who invested are being forced to pay the IRS back taxes, interest and fraud penalties.
One Buffalo tax lawyer said he knows some local investors who sank their lifetime savings into the venture. Some owe the IRS as much as $500,000 to $600,000.
"It was a disaster," said an Amherst businessman who is among those who got stung. "I invested $17,500 back in 1979. I got very little tax advantage and wound up paying $160,000 to the IRS this spring. The IRS says I defrauded the federal government. And (earlier this month) I got a letter from the IRS saying they had recalculated and I now owe them even more."
"It's a horrendous situation. A lot of these people had a very small tax bill that multiplied geometrically over 10 years of litigation," said attorney Victor T. Fuzak, who represented some of the investors. "When you take on the IRS, you're taking on a very formidable adversary, and you put a lot on the line. I think the treatment (of investors) was not fair in this case."
Tax experts call the case a classic illustration of the risky nature of tax shelter investments and of the cold, unyielding approach sometimes taken by the IRS.
It's also a graphic illustration of how a relatively small debt to the IRS can multiply with interest and penalties. Many investors are being hit with tax bills that are six to 10 times the amount they actually invested.
The Amherst businessman said he put money into the Swanton partnership for two main reasons: Salesmen convinced him it was a legitimate tax shelter, and the fear set off by the Arab oil embargo earlier in the decade prompted the federal government to promote coal as a good alternative fuel source.
Invest $17,500 in the partnership, sales promoters said, and if it shows a loss, you can deduct tens of thousands of dollars in losses on your tax return. And someday, the business will begin turning a profit and you'll make a healthy retirement income.
"The investors were the victims here," said one tax lawyer, who asked to speak on the condition of anonymity. "They were victimized by the company that sold the partnerships, and then they were victimized by the IRS."
Another local businessman invested $70,000 and tried to deduct more than $100,000 in losses on his tax returns. In the summer of 1996, the IRS hit him with a tax bill of $600,000 that he's still trying to pay.
"It's devastating," the man said, also asking that his name not be used. "This battle has gone on longer than World War I and II combined. The pressure has been unbelievable. I had two strokes, four heart attacks and six bypasses while all this was going on. After we lost in court, it took three years for the IRS to send me a tax bill."
IRS officials this week refused to discuss any aspect of the Swanton case, but they said investors should be extremely cautious about any venture that calls itself a tax shelter.
"It's a risky business any time you get into an investment looking for tax write-offs," said Richard Denesha, a research accountant for the IRS Buffalo District. "People have to know upfront that you have no guarantee that something which is advertised as a tax shelter will stand up under an audit."
The Swanton case began in the late 1970s, according to court papers, when a company run by developer Norman F. Swanton began selling coal mining partnerships in Buffalo and Rochester. The shares cost $17,500 each, and salesmen were promoting them as "money machines" that would allow investors to cut their tax bills by taking write-offs. Swanton's company planned to mine coal in Pennsylvania and Kentucky.
After a series of audits in the early 1980s, the IRS began telling investors the coal partnership did not qualify as a tax shelter because it was a sham business not really intended to develop coal resources. The IRS said the partnership's purpose was to help people avoid paying taxes.
"Mineral-based tax shelters were common in the '70s and '80s," said Denesha. "In a lot of cases, the IRS conducted audits and determined that these businesses were strictly tax-driven. They lacked real economic substance."
According to Denesha, a typical tax shelter works like this:
The business tells investors they can become partners if they put $20,000 upfront and sign an agreement to invest $80,000 more. The business shows steady losses, and over the next few years the investor deducts $100,000 in losses on his tax returns. Later, the business folds, and the investor has received $100,000 in tax deductions while only investing $20,000.
"(But) in order to be accepted as a tax shelter, a business has to be a legitimate business," he said. "It can't be something that is started for the pure reason of showing losses and being used as a tax shelter."
A group of 300 Swanton investors, many of them Western New Yorkers, took the IRS to U.S. Tax Court over the issue. The Tax Court case continued until 1993, when a judge concluded that the IRS was right -- the Swanton partnership was a bogus tax shelter.
Meanwhile, having mined very little coal, the business filed for bankruptcy protection in 1985 and shut in 1986. Tax Court Judge Carleton D. Powell said investors should have done a lot more research before investing.
"There is nothing in the record to indicate that the (Swanton) advisers had any expertise in coal-mining," wrote the judge. "A prudent person would have surely investigated further."
Although some investors now feel they were defrauded, none of the salesmen who pushed the venture were criminally charged in the case.
"At one time in 1984, the IRS told us they were conducting a criminal fraud investigation and that they would make settlements with all the investors," said one Buffalo businessman who now owes the IRS more than $500,000. "The settlement offer was then pulled off the table, and nothing ever came of the criminal investigation."
The Amherst businessman said public statements made by former President Jimmy Carter also helped persuade him to invest.
"You have to remember, this was the time of the Arab oil embargo and the nationwide oil shortage. Carter was telling people to invest in alternate fuel sources, like coal," the businessman said. "All of a sudden, we were friends with the Arabs again, and people like me were out of luck.
"The IRS could have taken a more reasonable position. They've been very hard on people -- actually cruel to people -- in this case. I can't believe my government is doing this to me."
Richard Schroeder, a certified financial planner from Amherst, said the IRS can be extremely tough on taxpayers in such cases.
But he also said the burden is on taxpayers to be careful where they invest their money. When a tax shelter fails, the interest and penalties demanded by the IRS can rise at an astonishing rate.