Link to special CCH Tax Briefings on key topics from 2003:
 

• Year-End Tax Legislation Update (Dec. 10)
• Corporate Income Tax and 'Bonus' Depreciation
  (Dec. 4)
• Military Family Tax Relief Act (Nov. 11)
• Jobs and Growth Tax Relief Reconciliation Act of 2003 (May 28)

CCH can assist you with stories, including interviews with CCH subject experts. Also, the CCH Whole Ball of Tax 2004 is available in print. Please contact:
 
Leslie Bonacum
(847) 267-7153
mediahelp@cch.com
 
Neil Allen
(847) 267-2179
allenn@cch.com

IRS, Congress, Courts Target Shelters and Scams

(RIVERWOODS, ILL., JANUARY 2004) – Helping taxpayers seems to be all the rage in Washington. Congress and the President are eager to cut tax rates, plump up deductions and shower credits far and wide, while the IRS is striving to become a more friendly, responsive, customer service organization. For some people, however, this just isn’t enough. So, as they endeavor to create their own personal tax relief, these people pay for elaborate tax shelters, adopt bizarre legal theories and sometimes just plain lie, according to CCH INCORPORATED (CCH), a leading provider of tax law information and software.

But beware if you’re tempted to try some of these sorts of do-it-yourself tax savings tactics: anti-tax-shelter sentiment has reached fever pitch. Congress, the IRS, Treasury, the courts and state tax officials have had just about enough and are trying to give some would-be tax cheats reason to think twice. Whether their efforts will be enough to stem a rising tide of tax chicanery is another question.

Everything Old is New Again

This is not the first time that the government has struggled to curb tax shelter abuses. Throughout the 1970s and 1980s, a range of tax shelters were marketed to high-income individuals.

While the Tax Reform Act of 1986 was designed to address these abuses, new types of corporate shelters sprang up shortly thereafter and, in the years since, practitioners have been busy developing and marketing new types of shelters.

Shelters or Shell Game?

One recent focus of the IRS and Congressional investigators has been the tax shelters marketed to wealthy individuals to help them greatly reduce or eliminate taxes.

In tax talk, a "shelter" can mean a legitimate tax-saving feature of the law, such as the various benefits associated with home ownership, or it can be a scheme for making taxable income appear to be untaxable, with nothing of any real economic substance taking place. Certain kinds of schemes require registration with the IRS, which may decide to label them as "potentially abusive," warning taxpayers that they may be subject to audit and assessment of back taxes, interest and penalties for using them.

Within the last year, the government has turned its attention toward tax shelter promoters and has begun issuing summonses against accounting firms, investment bankers and law firms.

Underpinning the government’s pursuit of professionals promoting tax shelters is the belief that practitioners must be held accountable and set a positive example, instead of exploiting the complexity of the tax code to generate unintended tax consequences. This has lead to issues with respect to the scope of the attorney/client privilege and tax practitioner privilege.

The IRS also has announced that it will take a closer look at "opinion letters" by lawyers that are used to avoid penalties in tax shelter cases. The letters would no longer provide a near-automatic defense in cases where the shelter is found to be abusive, especially in cases where the attorney is involved in promoting the shelter.

"A bigger question is whether the complexity of the tax laws doesn’t invite ingenious people to come up with ingenious ways to pay less tax," CCH Principal Tax Analyst Mark Luscombe, JD, CPA, noted. "It can be difficult to draw a sharp line between legitimate and illegitimate practices, and if the legality of a shelter isn’t immediately obvious to IRS lawyers, how can anyone else tell a valid tax-saving mechanism from outright tax cheating?"

Sleight of Hand with Deductions

At the other end of the income spectrum from the investors in elaborate tax shelters were the clients of New Mexico tax preparer. Typically, they were wage earners or owners of small business who were referred to the preparer by friends who reported getting nice refunds when they had feared they would owe additional taxes on their returns. This was all due to this preparer’s ability to materialize deductions seemingly out of thin air.

If nothing else, he was easy to work with. He didn’t require his clients to bring in detailed records to substantiate their itemized deductions, and seems to have told several of them that such things weren’t necessary: One couple reported that they handed him "everything we had and he handed it back to us," stating that he didn’t need to see it.

The preparer claimed instead that permissible deductions could be determined through use of a formula based on the client’s income. Using this mysterious formula, he prepared returns that made tax liabilities vanish as if by magic.

Things became much less enchanting for the preparer’s clients after the IRS started examining their returns. He advised clients to ignore the IRS’s demands for documentation and the Tax Court’s insistence that they lay out the facts of their cases prior to trial.

They had no basis to contest the IRS’s denial of their deductions, finally admitting that various deductions had little or no basis in fact, but did ask to be spared penalties for negligence. The court can waive the penalty if taxpayers can show that they properly relied on the advice of a professional in preparing their return, even if the advice turned out to be incorrect.

The court wasn’t buying that argument in any of the 10 small-claims cases reported thus far. The taxpayers had not checked the preparer’s credentials and had no reason to rely on him, especially since they knew that the deductions that Beltran had entered on their returns had no basis in fact.

What’s more, in most of the cases, the judge imposed an additional $500 penalty for even bringing the matter to court. The taxpayers’ cases were so hopeless that the only possible purpose they could serve would be to delay the eventual day of reckoning with the IRS, he reasoned.

Penalties and Injunctions for Protestors

Many people combine a dislike for paying taxes with a devotion to one or more oddball political and legal theories. They may refuse to file, file returns with zeros on almost every line or demand a refund equal to the amounts withheld from their earnings.

The beliefs behind their attempts at nonpayment are a crazy quilt of contentions – that Ohio was not a state when it ratified the constitutional amendment that makes the income tax possible, that paying taxes is strictly voluntary, that "sovereign citizens" of states are not subject to federal taxation, that wages represent an equal return for services rendered and hence are not "income," and a variety of other others. The IRS lists a total of 21 "frivolous tax arguments" on its web site (irs.gov), citing cases in which various courts have held them to be invalid.

But that does not keep some tax preparers and promoters from selling various services, books and kits to customers yearning to be free of taxes. And true believers find it difficult to take a firm "no" from the IRS or the courts as final.

The IRS or the Tax Court may warn them not to advance a "frivolous" position, but they persist. They appeal from IRS hearings to the Tax Court or from the Tax Court to District Court, refusing to concede defeat.

When tax protestors or others try to use the courts as a soapbox or simply hope to use legal proceedings to delay the day of reckoning – and paying – their taxes, the law provides that they can be socked with a penalty of up to $25,000. The courts haven’t been shy about applying this "frivolous proceedings" penalty in recent years, according to Luscombe.

"In cases where the court might have warned a taxpayer in the past, they now may impose at least a token penalty. Where the courts think the taxpayer is willfully clinging to a discredited argument after they’ve been warned, it’s getting more common today to see multi-thousand dollar penalties handed down," Luscombe observed.

The IRS also has been asking the courts for injunctions to stop preparers from practicing and from selling kits that facilitate system abuse. In many cases in which they have prevailed, the courts have ordered promoters to take down sales material from their Internet sites and post a copy of the injunction there instead.

"In some cases, promoters have raised First Amendment issues, but the IRS has maintained that there is no right to commercial speech that amounts to a blueprint for breaking the law," Luscombe said.

A ‘Compliance Gap’

Most worrisome for many observers are not the protestors who flaunt their noncompliance or the well-heeled investors in sophisticated shelters, but average taxpayers who increasingly may ask: "If other people get away with it, why not me?"

The IRS Oversight Board – a group set up to provide long-term guidance and direction to the IRS – has commissioned a series of surveys showing an increasing willingness of the general public to consider cheating – at least somewhat – on their taxes. In the most recent survey, about 17 percent of respondents said that it was all right to cheat on their returns.

In its annual report issued in April of 2003, the board also warned that the IRS faces a growing compliance gap, fueled by a workload that has grown while its workforce shrank between 1995 and 1998. Since then, while the total level of staffing has remained more or less constant, employees assigned to field compliance has continued to decline as more people are assigned to customer service tasks.

Quoting figures provided by former Commissioner Charles Rossotti in 2002, the Board noted that many who flouted the law were likely to escape unscathed:

• 60 percent of identified tax debts were not pursued
• 75 percent of taxpayers who do not file a tax return were not pursued
• 79 percent of identified taxpayers who used abusive devices (such as offshore accounts and abusive tax shelters) to evade tax were not pursued
• 56 percent of identified taxpayers with incomes of $100,000 or more and underreported tax were not pursued

The Board noted that educating the public through activities such as telephone support helps people understand and obey the law, but said that more enforcement personnel were needed and endorsed a proposal by Rossotti to increase IRS staff by 2 percent per year until 2010.

A later report by the General Accounting Office (GAO) noted that the IRS has planned to greatly increase the number of employees specializing in certain kinds of abuses for fiscal years 2003 and 2004, but it pointed out that planning was far from an exact science at this stage.

For example, the IRS assumed that in 2003, the equivalent of 561 full-time employees would be devoted to schemes in which credit cards issued in Caribbean countries were used to hide U.S. income.

In fact, based on the work completed by mid-year, it looked as though only 10 percent of that number would actually be deployed. The GAO noted that the IRS underestimated both how long it took to prepare cases for examination and how long it takes to close a case. By contrast, it found that revenue agents assigned to other abusive schemes were closing them almost twice as quickly as anticipated.

"The IRS is just beginning to apply budgeting and management techniques to many categories of abuse, and it may well improve with practice," Luscombe said. "But if it doesn’t have the wherewithal to go after people who already owe it money, how effective will its overall compliance effort be, and what conclusions will the general public draw?"

About CCH INCORPORATED

CCH INCORPORATED, headquartered in Riverwoods, Ill., was founded in 1913 and has served more than four generations of business professionals and their clients. The company produces more than 700 electronic and print products for the tax, accounting, legal, securities and small business markets. CCH is a Wolters Kluwer company. The CCH Federal and State Tax group, CCH Tax Compliance and Aspen Publishers Tax and Accounting group comprise the new Wolters Kluwer Tax and Accounting unit. The unit’s web site can be accessed at tax.cchgroup.com.

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Editor’s Note: For members of the press, a complimentary subscription to the CCH Tax Shelter Alert newsletter is available by contacting Leslie Bonacum, mediahelp@cch.com, 847-267-7153.