Make sure year end planning is tax-compliant

By F Hale Stewart, JD, LLM, CAM, CWM, CTEP

The Law Office of Hale Stewart


As the end of the year approaches, tax promoters are out in full force, reminding potential clients that they must act before December 31st in order for a transaction to have an effect on this calendar year. And as the New Year approaches, the sales pitches become harder, admonishing clients to act quickly. But often lost in the year-end tax crush is the fact that a lot of these plans just don’t add up from a compliance perspective — that is, if the IRS challenges these transactions, the taxpayer will lose.

So, what should you be looking for to determine if these proposed plans make sense? Let’s start with a few positives. Most viable transactions are entered into for three reasons: making a profit, lowering expenses or raising capital. Making a profit is easy to establish and is rarely questioned. Examples include opening up a branch in a new location where your product would be popular, forming a joint-venture, developing a new product, etc. Lowering expenses would include such things as combining a group of subsidiaries to obtain economies of scale, purchasing a supplier to vertically integrate operations, or outsourcing parts of your business to an organization that is more efficient. And raising capital involves debt and/or equity financing. All of the preceding transaction are standard, run-of-the mill, everyday business activities that would never be questioned by the service.

Let’s turn the equation around and look at some things that are often included in a fraudulent tax promotion, thereby providing us with potential warning signs that something is amiss:

Offshore entities

First, there is nothing inherently wrong with moving some of your assets offshore. In fact, it may make sense from an asset protection perspective. But some of the more infamous tax scams involved offshore financial centers, largely because these jurisdictions also have fairly aggressive secrecy provisions. Adding to the potential problem is the fact that the IRS’s offshore enforcement has been far more aggressive over the last 3 to 5 years. A good rule of thumb is this: If you don’t already sell your product offshore, then don’t make your first international transaction one that involves an offshore financial center with strong secrecy laws. It just doesn’t look that good from a compliance perspective.

Tax-heavy literature

Some of the most famous tax scams involved sales literature which heavily discusses the tax benefits of a certain transaction. In fact, this may be the subject of a vast majority of the literature. If you receive promotional materials that talk heavily of tax benefits, you should probably have the plan checked out by a neutral third party.
A legal opinion

While this might sound counterintuitive, a bit of history will explain why this could be a warning sign. In the 1990s, the tax shelter industry was in full force. Large accounting firms designed densely structured plans that were exceedingly complex. In fact, their sheer complexity was determined to be a negative selling point, as potential buyers simply wouldn’t understand the structure. Enter large law firms who wrote impressive opinions which essentially said, “This is legal.” Unfortunately, both the accounting firms and the law firms had determined that the fees they could make were far larger than the potential pay-outs in the event the IRS ruled against them. In addition, most of the opinions were, well, not well done (all of the preceding is contained in a report published by the U.S. Senate Finance Committee).

If someone says the plan has been pre-approved by a law firm, have an independent attorney evaluate the plan. And, as a last resort, ask if they will help you get a private letter ruling from the IRS. If they balk at this, chances are there’s a problem.

An overly complex structure

Most business transactions are actually remarkably simple: Company X buys company Y; company X combines two sub-divisions into one company, etc. If someone has a multiple-step plan, it's best to question the validity of each step. Chances are, some steps are there for no other reason than to obfuscate the transaction’s true purpose.

The transaction falls outside your business comfort zone

Suppose you own a company that manufactures steel pipes. One day, someone (a stranger or trusted advisor) asks you, “Have you ever thought about investing in the publishing rights of a new book? It’s a very lucrative business.” While you have years of experience in the pipe manufacturing business, you don’t know anything about the publishing business. So, why is someone asking you to invest in this business? Yet, this exact thing happens fairly regularly in the tax shelter business, as promoters sign people up to start-up businesses in areas of the market in which they have absolutely no knowledge.

No tax substance

There is an entire branch of law called “anti-avoidance law,” a doctrine that spans over 1,000 individual citations and 80 years of legal history. While there are technically five different doctrines, an argument could be made that there is only one, two, four or five due to regrettably consistent judicial confusion on some of the more subtle nuances. However, all of these come down to a few basic principles: The transaction was only entered into for tax reasons, thereby establishing that there is no meaningful tax substance to the transaction. Regrettably, most promoters have absolutely no knowledge of this area of law, meaning the plans they propose won’t withstand judicial scrutiny.

Ultimately, a few basic, common-sense principles will help you determine if a plan won’t pass muster. First, if it sounds too good to be true, it probably is. Second, there is no such thing as a free lunch. While we do have a legal right to minimize our respective tax burden, we have to do so in a manner that is consistent with the law.

See also:

Year-end tax planning items

12 year-end financial ideas to make the yuletide merrier

Year-end income tax reduction strategies: the good, bad and ugly