Compiled annually, the IRS’ “Dirty Dozen” lists a variety of common scams that taxpayers may encounter anytime but many of these schemes peak during filing season as people prepare their returns or hire people to help with their taxes.
Abusive Tax Structures
Using abusive tax shelters and structures to avoid paying taxes continues to be a problem. Abusive tax schemes have evolved from simple structuring of abusive domestic and foreign trust arrangements into sophisticated strategies that take advantage of the financial secrecy laws of some foreign jurisdictions and the availability of credit/debit cards issued from offshore financial institutions.
Multiple flow-through entities are commonly used as part of a taxpayer’s scheme to evade taxes. These schemes may use Limited Liability Companies (LLCs), Limited Liability Partnerships (LLPs), International Business Companies (IBCs), foreign financial accounts, offshore credit/debit cards and other similar instruments. They are designed to conceal the true nature and ownership of the taxable income and/or assets.
Whether something is “too good to be true” is important to consider before buying into any arrangements that promise to “eliminate” or “substantially reduce” your tax liability. If an arrangement uses unnecessary steps or a form that does not match its substance, then that arrangement is an abusive scheme. Another thing to remember is that the promoters of abusive tax schemes often employ financial instruments in their schemes; however, the instruments are used for improper purposes including the facilitation of tax evasion.
Trusts also commonly show up in abusive tax structures. They are highlighted here because unscrupulous promoters continue to urge taxpayers to transfer large amounts of assets into trusts. These assets include not only cash and investments, but also successful on-going businesses. There are legitimate uses of trusts in tax and estate planning, but the IRS commonly sees highly questionable transactions. These transactions promise reduced taxable income, inflated deductions for personal expenses, reduced (even to zero) self-employment taxes and reduced estate or gift transfer taxes.
These transactions commonly arise when taxpayers are transferring wealth from one generation to another. Questionable trusts rarely deliver the tax benefits promised and are used primarily as a means of avoiding income tax liability and hiding assets from creditors, including the IRS.
Another abuse involving a legitimate tax structure involves certain small or “micro” captive insurance companies. Tax law allows businesses to create “captive” insurance companies to enable those businesses to protect against certain risks. The insured claims deductions under the tax code for premiums paid for the insurance policies while the premiums end up with a captive insurance company owned by the owners of the insured or family members.
The captive insurance company, in turn, can elect under a separate section of the tax code to exclude up to $1.2 million of its net premium income per year, so that the captive is taxed only on its investment income.
In the abusive structure, unscrupulous promoters, accountants or wealth planners persuade the owners of closely held entities to participate in these schemes. The promoters assist the owners to create captive insurance companies onshore or offshore and cause the creation and sale of the captive “insurance” policies to the closely held entities. The policies may cover ordinary business risks or esoteric, implausible risks for exorbitant “premiums,” while the insureds continue to maintain their far less costly commercial coverages with traditional insurers. Captive “insurance” policies may attempt to cover the same risks as are covered by the entities’ existing commercial coverage, but the captive policies’ “premiums” may be double or triple the premiums of the policy owners’ commercial policies.
Annual premium amounts are frequently targeted to the amounts of deductions business entities seek in order to reduce their taxable income. In these abusive schemes, total premiums can equal up to $1.2 million annually to take full advantage of the premium income exclusion provision. Underwriting and actuarial substantiation for the insurance premiums paid are either absent or illusory. The promoters manage the entities’ captive insurance companies for substantial fees, assisting taxpayers unsophisticated in insurance, to continue the charade from year to year.
As with other arrangements, taxpayers should seek the advice of a trusted professional before entering a trust structure.
Frivolous Tax Arguments
Promoters of frivolous schemes encourage taxpayers to make unreasonable and outlandish claims to avoid paying the taxes they owe. These arguments are wrong and have been thrown out of court. While taxpayers have the right to contest their tax liabilities in court, no one has the right to disobey the law or disregard their responsibility to pay taxes.
The penalty for filing a frivolous tax return is $5,000. The penalty applies to anyone who submits a purported tax return or other specified submission, if any portion of the submission is based on a position the IRS has identified as frivolous or reflects a desire to delay or impede administration of the tax laws.
Those who promote or adopt frivolous positions also risk a variety of other penalties. For example, taxpayers could be responsible for an accuracy-related penalty, a civil fraud penalty, an erroneous refund claim penalty, or a failure to file penalty.
For more information on the IRS Dirty Dozen tax schemes, visit www.IRS.gov.