With the end of the year approaching and tax changes on the horizon for 2018, many business owners and investors are seeking creative ways to minimize their current and future tax burdens. While some plans are legally sound and others may appear aboveboard, at least on their face, taxpayers should remember the age-old adage: “If it sounds too good to be true, it probably is.” As has been demonstrated time and time again, those participating in tax savings schemes may appear initially receive a benefit on their tax return, but many are eventually caught by the Internal Revenue Service (“the Service”) and face penalties far exceeding any potential tax savings.
For instance, I recently spoke with a friend about a “tax product” that was promoted to him and his colleagues. In the proposed transaction, an investor with substantial taxable income contributes money to the promoter in exchange for significant deductions. After getting into a bit of detail with him, I learned that the promoter would essentially facilitate his cash contribution to a partnership in exchange for a partnership interest. The partnership would allegedly use these funds to purchase real estate. (It is not clear if, how, or what real estate would be purchased.) Likely through some creative accounting and appraisals, the partnership would then donate a conservation easement to a charitable organization. According to the promoter, each of the investors would receive their share of a large charitable deduction stemming from the donation on a Schedule K-1. The deduction would have a more significant tax benefit than the financial cost of the contribution to the partnership. The promoter stated that the transaction is legal and that similar partnerships formed by the promoter have a historically low audit rate. While it is not clear from the promoter, it is likely that it pockets the cash contribution as a fee in exchange for the advice.
To most tax professionals, it should be clear that this type of promotion is likely a scam and is almost certainly not permitted under current tax laws. While some of the basic concepts described in the promotion are rooted in tax law and the transaction as a whole could pass muster under a different set of facts, the product, as described to my friend, will only cause trouble to everyone involved and expose them to potentially severe penalties – even if the transactions arguably comply with the letter of the law. In fact, IRS Notice 2017-10 (Listing Notice – Syndicated Conservation Easement Transactions) specifically includes this type of transaction as a “listed transaction.” The Service concludes that these syndications, and other “listed transactions,” do not generally comply with the internal revenue laws. Both promoters and investors will be subject to a number of significant penalties if they engage in a “listed transaction.”
Syndicated conservation easement transactions, one of which was peddled to my friend, are but one of a countless number of tax schemes that have been promoted to those desiring to avoid or evade tax. Others that have cropped up in recent years include the following:
Captive Insurance Tax Shelters. As described by the Service, this scheme generally involves the creation of a “micro” captive insurance company which insures against certain discrete risks that may (or may not) be faced by a business and/or its owners. The insured business will claim deductions for premiums paid by the business pursuant to the policy entered into with the insurance company; however, the premiums are ultimately received by an entity composed of the owner of the same business or related family members. Since there is a separate tax code section permitted certain insurance companies to exclude up to $1.2 million of certain types of income, the captive insurance company does not pay tax on the premiums received. The Service has found fault with these structures because the premiums generally lack sufficient substantiation or actuarial backing. A recent opinion of the United States Tax Court in Avrahami v Commissioner, 149 T.C. No. 7 (Aug. 21, 2017) illustrates some of the consequences facing those involved in this type of tax shelter. These shelters are currently listed on the Service’s hit list (The Dirty Dozen) and significant enforcement efforts are being taken against all parties involved.
Son of BOSS. In another popular set of promoted schemes, referred to as “Son of BOSS,” transactions would be created to generate losses by artificially inflating the basis of various partnership interests. After discovering the scheme, which had been marketed to many companies and individuals by tax professionals, the Service aggressively pursued all known promoters and investors. As a result of its enforcement efforts, the Service netted a total of over $3.2 billion in tax payments. This initiative was successful as it provided a defined and reduced penalty settlement structure for taxpayers exposed to substantial civil and criminal penalties.
A more comprehensive listing of transactions that Service currently views as potentially abusive includes, but is not limited to, the following:
Corporate Distributions of Encumbered Property (BOSS) (Notice 99-59)
Inflated Basis “CARDS” Transactions (Notice 2002-21)
Lease In/Lease Out or LILO Transactions (Rev. Rul. 2002-69)
Offshore Deferred Compensation Arrangements (Notice 2003-22)
Transfers of Compensator Stock Options to Related Persons (Notice 2003-47)
Sale-In Lease Out Transactions (Notice 2005-13)
Distressed Asset Trust (DAT) Transaction (Notice 2008-34)
Contribution of Successor Member Interest (Notice 2007-72)
Certain Uses of Grantor Trusts (Notice 2007-73)
Sales of Charitable Remainder Trust Interests (Notice 2008-99)
Certain Transactions Involving Subpart F Income (Notice 2009-7)
Basket Contracts (Notice 2015-74)
Micro-Captive Insurance (Notice 2016-66)
While not everyone participating in these schemes will be caught by the Service, investors in these schemes face a number of substantial penalties. Even if the investor can establish that they did not know or have reason to know that the transactions were not legally permitted, all of the tax savings will likely be reversed in an audit. Coupled with the time, legal expenses, and additional interest resulting from the need to prove a lack of ill-will, the ultimate financial burden can be significant. Moreover, in these situations, the Service typically has extended or unlimited periods to make additional assessments. Therefore, the audit could be expanded to include many more tax returns than just the last three. Aside from the burden of an audit, many of these tax shelters will expose investors to additional civil penalties and, in some cases, criminal penalties.
In typical cases, the Service will seek at least a 20% or 40% accuracy-related penalty (based on the amount of underreported tax). If fraud can be proven, the accuracy-related penalty can be increased to 75%. Depending upon the type of scheme, there may be information-reporting deficiencies where a penalties can be assessed upon the amount of the transaction itself (i.e., not the relevant tax savings). And, an expansion of the audit to other periods may bring heightened scrutiny to other areas of tax returns that may contain inaccuracies. In some situations, the net result of an audit may be a liability that is many times greater than its purported tax savings. See, e.g., Larson v. United States, No. 16-CV-00245 (S.D.N.Y., Dec. 28, 2016); Esrey v. United States, No. 16-03019 (S.D.N.Y., March 23, 2017). Finally, in the most egregious situations, taxpayers have been criminally prosecuted for engaging in and/or promoting abusive tax shelter transactions.
Bottom line: There are legitimate ways to minimize exposure to income taxes; however, if an offer sounds too good to be true, it probably is. If the sole purpose of a transaction is to reduce taxes, there is a significant probability that it is not legal or will not work as advertised. Deductions, credits, and other tax savings can almost never be created out of whole cloth or merely by pushing paper. The Service has frequently been successfully in litigating the substance-over-form and step transaction doctrines, which can invalidate many of these schemes. For those considering an investment or set of transactions promising a tax reduction, it is paramount that they at least seek counsel from an independent tax professional. At the least, consultation with an independent tax professional may help to establish a basis for reasonable cause as a defense to assessment of accuracy-related penalties.
These descriptions are intended for informational purposes only and should not be taken as legal advice on any particular set of facts or circumstances. Rosenberg Martin Greenberg, LLP is experienced in all aspects of federal and state tax laws, including tax shelters, criminal tax matters, addressing prior compliance issues, white collar criminal litigation, litigation of tax penalties, and more. Please contact Brandon Mourges at 410.951.1149 or firstname.lastname@example.org for a free consultation.