What Is An Abusive Tax Scheme?
You may have heard of a program or tax scheme that promises to eliminate or substantially lessen your tax burden and taxes due to the Internal Revenue Service. A promoter of such a scheme will likely use financial instruments such as a trust or pass-through entities such as a limited liability company or limited partnership. When these programs and schemes are misused to facilitate tax evasion, IRS may criminally investigate the scheme and prosecute the promoters and investors. You should discuss any potential tax scheme or program with a tax attorney. You should remember that if something sounds too good to be true, it could lead to an investigation by the Internal Revenue Service and potential criminal tax charges. A Denver Tax Attorney drafted the article below to provide more information regarding abusive tax schemes. However, this article is for informational purposes only; please discuss your specific issues with a tax attorney.
Basic Trust Law
A trust is created when someone transfers property to another party with the understanding that the transferee will hold the property as trustee for the benefit of a third party. In return, the transferee receives legal authority over the property. This arrangement is called a trust because the transferee becomes a “trustee,” or caretaker, for the property.
The term “trust” is often used interchangeably with “fiduciary.” However, there are essential differences between a trust and a fiduciary relationship. For example, a fiduciary must act solely in their client’s interests, while a trust does not require such loyalty. Instead, a trust allows a person to delegate property management to another person.
Abusive Tax Avoidance Transaction (ATAT)
An abusive tax avoidance transaction (ATAT) occurs when taxpayers use legal and illegal methods to reduce or avoid paying taxes. ATATs are often referred to as “tax planning schemes.” In addition to being unlawful, ATATs are also unethical because they deprive the government of revenue it otherwise could collect.
The Internal Revenue Service defines a listed transaction as one where the taxpayer uses a method of avoiding or reducing tax liability that involves either the evasion or concealment of taxable items or the creation of false or fraudulent deductions. Examples include:
• Using foreign trusts or corporations;
• Offering gifts to family members that qualify as charitable contributions;
• Hiding assets in offshore accounts;
• Filing false information on returns;
• Making false statements about ownership interests in a partnership;
Over time tax schemes have developed from relatively simple single structure arrangements into more complex and sophisticated overall schemes and strategies that take advantage of foreign jurisdictions and financial secrecy laws. Our government has and will continue to criminally prosecute the promoters of illegal tax schemes and those who play substantial roles in aiding or assisting the tax scheme, which could include investors in the tax scheme. The Internal Revenue Service Criminal Investigation has a national program to fight these illegal tax schemes and programs and prosecute violators with criminal tax charges.
When initially looking at these issues, the biggest question is, what constitutes an abusive or illegal tax scheme and could lead to criminal tax evasion and criminal tax charges? In short, an abusive tax scheme that could lead to criminal matters would violate the Internal Revenue Code and related federal statutes. Furthermore, the violations of the federal tax law and related statutes would use domestic or foreign trusts and pass-through entities such as partnerships as vehicles in violating the federal tax laws. In recent years, foreign bank accounts and other financial accounts have been used more frequently for tax evasion because of reporting issues (one may refer to FATCA for further information). Many foreign banks and financial institutions do not report income such as interest and dividends, and thus there is no record of the income to the trust, entity, or individuals. The income goes unreported to the federal government without reporting on applicable tax returns.
Common Tax Scheme Variations
As stated above, foreign accounts or trusts may be used frequently in illegal tax schemes. A common scheme that may have many variations may flow as follows. A United States citizen has a business in the United States and also forms a foreign corporation and foreign bank account in the exact name of their US business. When checks are received, the checks are processed through the foreign business and foreign bank account. The foreign account will likely be in a foreign jurisdiction that does not report income and related items to the US government. Thus, the income goes unreported on the taxpayer’s tax return, and there are no 1099s issued to the US government to have any knowledge of the account and thus income going into the account. Some schemes will involve a foreign business that issues invoices to a United States business. The invoices are paid to the foreign business, and the US business takes a deduction, but the income of the foreign business is not claimed. The business is commonly owned, and US citizens are not claiming the income of the foreign business. Again, we have unreported income into a foreign account and likely interest or dividends in a foreign account that would not be reported. The above examples could go many more layers but provide good examples of how an illegal tax shelter or abusive tax scheme could be established.
Abusive Tax Shelter
An abusive tax shelter is a transaction structured to avoid taxes without violating the law. These transactions include offshore trusts, foreign corporations, partnerships, limited liability companies, etc. They often involve complex structures such as shell entities, nominee owners, or multiple layers of ownership.
The IRS defines tax shelters as “transactions designed to reduce income subject to taxation or increase deductions or credits against income subject to taxation.” This includes real estate investment trusts, like REITs, and certain types of charitable contributions. However, it does NOT include ordinary businesses.
A tax shelter differs from an ATAT because the latter involves illegal activity or fraud. For example, an individual could claim a deduction for personal expenses paid out of his trust account, even though he did not pay those expenses. In addition, the taxpayer is not required to report the interest earned on the money deposited into the trust. All of these actions constitute fraud.
The above article has been prepared by John McGuire of the McGuire Law Firm for informational purposes and should not be relied on as legal advice. Mr. McGuire is a Denver tax attorney representing individuals and businesses before the Internal Revenue Service and can be contacted directly through the McGuire Law Firm.