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Run for Your Life

Tax and Financial News

January 2002

Run for Your Life

Well, here we are again – another year has come and gone and now the daunting task of filing your income tax looms before you.

Even though a lot of us took a drubbing on our personal stock portfolios this past year, we hope you had some taxable income to show for your efforts. While having an income is a good thing, when you sign that Form 1040 this year, the reality is that you will pay tax if you made money.

We haven’t told you anything new yet, have we? No, because we're honest in our dealings with you. It’s who we are. Unfortunately, there are a few people out there who aren’t bound by the niceties of ethics and morality and will be more than glad to tell you how you can "legally" pay no taxes. When your meet them, it is quite literally true you need to "run for your life," because if you accept their offers, you're likely to end up paying most, if not all, of your estate to Uncle Sam for back taxes, penalties and interest.

To help you know when to run is the object of our discussion this month. What red flags should you look out for when approached by promoters of what the IRS calls "abusive tax shelters?"

What exactly is an abusive tax shelter? If you look at the law, you won’t find a definition under "abusive tax shelters." That’s because the term is hard to define and just when you think you’ve seen everything, something else happens to test the limits of an already broad definition. Let’s just say that "abusive tax shelters" are any arrangement that promises to give you excessive tax benefits for a relatively small investment or no meaningful change in income or control over your assets.

Red Flag #1: Never Pay Taxes Again – How many times have you heard this on the late night commercials? If you do, don’t call that 800 number, because the reality is, there’s no legal way out of paying taxes if you make enough money. As you'll see later, many people try to tell you if you put your assets into some sort of entity, you can avoid paying tax. However, there is no entity that will keep you tax-free without requiring you to give away all of your assets, and the income derived from them.

Red Flag #2: Deduct Your Personal Residence – Personal residence partnerships or trusts have become hot items in some quarters. In trusts of this type, your house and furnishings are put into the trust. Then, you rent the home back from the trust and deduct all the expenses, including depreciation. There’s only one hitch –– there’s no legal way to convert nondeductible personal expenses into business expenses just by putting your residence into another entity.

Red Flag #3: The IRS Doesn’t Want You to Know About This – Here’s another line that's a sure tip to potential problems. The reality is that the IRS is mandated by federal law to inform taxpayers of their rights, and applicable laws, in any given circumstance. The IRS Agents we know don’t want to collect tax unless the tax is rightfully due under applicable law. And if, under applicable law, there is a way to minimize your taxes and you use it, no problem. What the IRS doesn’t want you to know about is fraudulent schemes that can get you in trouble.

Red Flag #4: This Is So New, Even Your CPA Doesn’t Know About It – Aw, come on now, you know that we CPAs know everything there is to know about taxes. OK, maybe not everything, but we have a pretty good handle on the major stuff. That means we know enough to spot potential fraud and that’s why people who tout illegal schemes don’t really want you talking to your CPA. Nevertheless, we admit there are sometimes minor laws that don’t make the headlines that prove to be beneficial for some people. So when you get an offer like this, give us a call. We’ll look at it and give you an honest, unbiased opinion.

Red Flag #5: Multiple Entities or The Old Shell Game – Anytime someone tells you that you can save on income taxes by setting up numerous entities, think long and hard about who you're dealing with. Then take the information to your CPA. We are not implying that all such schemes are abusive tax shelters. Sometimes there are very good business reasons for setting up different entities, and these entities will pass muster. However, the key is that there is a business purpose which generally entails a profit motive. Hence, you or one of the entities will eventually pay tax on the income generated –– if you make a profit

Red Flag #6: Involvement of Foreign Entities – Foreign trusts and other entities are not necessarily bad in and of themselves. There are many good business reasons for their existence, but tax savings is not one of those reasons. If you go into a venture involving foreign entities and the sole purpose of the transaction is tax savings, you will eventually pay a great deal in interest and penalties. The fact is that setting up a foreign entity will usually expose you to more taxes (U.S. tax and Foreign country tax), not less.

As previously mentioned, many of the current schemes being used involve a variety of trusts and other entities. A brief discussion of trust taxation might be helpful here.

Trusts are entities set up to hold assets on behalf of another person or entity (Beneficiary). Typically there are one or more trustees and their job is to collect income and pay expenses for the benefit of the beneficiary. The trust, as a legal taxpayer, must pay taxes on its undistributed net income. The trust’s taxable income is generally determined in much the same manner as that of an individual, with one exception. Distributions to the beneficiaries are considered deductions in arriving at taxable income.

Sounds good, doesn’t it? Give the money to the beneficiary and pay no taxes. The beneficiary doesn’t pay any taxes on the income because it is, after all, a gift, right? Wrong. Tax law says if the trust doesn’t pay tax on the money, the beneficiary does and this is where promoters nab their prey. Though the creation of multiple layers of entities, which create false administrative expenses, sounds logical to the promoter's mark, the argument –– to the IRS –– is absolutely false.

How they do it – According to the IRS Criminal Investigation Division, the typical abusive trust scheme can include the following types of trusts:

  • Asset Management Company – An Asset Management Company (AMC) is a trust formed by the promoter that lists the taxpayer as a director and, eventually, the taxpayer becomes the trustee. The purpose of this trust is to make it look like the taxpayer is not involved in managing his or her own business –– even though they are.

  • Business Trust – A trust is then set up to convert the taxpayer’s business into the form of a trust with the AMC as the trustee. This takes the taxable income and puts it into the AMC's name. At this point, various false administrative expenses and management fees may be shown as deductions on the Business Trust’s tax return. This gives the appearance that the taxpayer has relinquished all control of their business when, in fact, they are really still running the day-to-day operations.

  • Equipment or Service Trust – An equipment or service trust is formed to hold equipment which is rented or leased to the business trust at inflated rates. This reduces income by claiming deductions for payments made to the trust.

  • Family Residence Trust – As mentioned earlier, some taxpayers have been advised to place the family residence, including furnishings, in a trust. The trust then rents the property back to the family and then false deductions are made for such personal expenses as gardening, maintenance, utilities and other household expenses. It may even attempt to depreciate the assets as legitimate deductions.

  • Charitable Trusts – The final layer in some schemes is the creation of a "charitable trust" to pay the personal expenses of the taxpayer. It reflects these as charitable contributions on its tax return and pays no income taxes.

Does all of this sound a little far-fetched to you? It does to the IRS. So, for that reason, the IRS Criminal Investigation Division is directing more of it’s audit activity to "pass-through" entities like trusts and partnerships in order to catch these fraudulent schemes.

Your best bet –– If you're presented with an investment or business opportunity that has any of the characteristics we've discussed, contact us immediately so we can review the structure and terms of the deal before you get all tangled up in something you'll wish you hadn't. We're always available to consult with you and help you make the best possible decision. After all, that’s what we're here for.

Happy New Year!!!! May this be the best year yet for you and your family!!!!

These articles are intended to provide general resources for the tax and accounting needs of small businesses and individuals. Service2Client LLC is the author, but is not engaged in rendering specific legal, accounting, financial or professional advice. Service2Client LLC makes no representation that the recommendations of Service2Client LLC will achieve any result. The NSAD has not reviewed any of the Service2Client LLC content. Readers are encouraged to contact their CPA regarding the topics in these articles.

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