Problems with tax shelters: What does a tax scam look like?
By F Hale Stewart, JD, LLM, CAM, CWM, CTEP
The Law Office of Hale Stewart
Planners have offered questionable ways to "minimize" taxes since the implementation of the tax code. Attesting to this are the first assignments of income cases which tested the validity and strength of the grantor trust rules when first established (see code sections 671-679). In fact, a thorough reading of anti-avoidance case law shows there were several important periods in tax scams. The 1950s brought attempts to create phantom "interest" deductions; the 1970s and early 1980s brought limited partnership plans; and the 1990s saw the creation of an entire industry encompassing the accounting, legal and financial professional industry.
But while the long history of this industry could lead to the impression that there is a vast difference regarding these plans, there is in fact a remarkable amount of similarity to the way they were structured. What follows are some of the more common elements.
A hyper-technical reading of the tax code
This is probably one of the most common traits of tax shelters across the time periods listed above. While the ability to comprehend particular sections of the tax code is obviously a prime requirement for a tax attorney, that knowledge has to be placed in the context of the legislative intent of the code in general.
For example, a common tax shelter in the 1990s involved the contingent liability section of the tax code, which would shift the gains of a transaction to a tax neutral participant (a party for whom income was immaterial) while it shifted the losses to a party that was trying to offset capital gains (usually a U.S. taxpayer). While these transactions complied with the technical aspects of the contingent liability section of the code, they had no substance, meaning there was no meaningful business purpose for the transaction, save sheltering taxable income.
Ground-up tax planning
Most legitimate tax planning starts with a company approaching their attorney with one of four basic needs: the need to increase income (such as expanding into a new market), the need to lower expenses (combining subsidiaries; lowering taxes alone is not a legitimate reason), the need to raise capital or the need to lower risk. But all four of these transactions start at a high level and are motivated by a legitimate business need.
In contrast, most tax shelters are transactions in search of a client — that is, a tax promoter will develop a transaction (usually involving a hyper-technical reading of the tax code) and then sell it to a client, one who is usually looking to offset income or capital gain. When a transaction starts at a low level, it has a difficult time establishing business purpose. Multiple, pre-planned steps
Most transactions are actually very simple: company X buys company Y; company X forms an accounts receivable sub-division; company X divests itself of a subsidiary; company X issues stock, etc. In contrast, most tax shelters use multiple, pre-planned steps to arrive at a particular destination.
For example, company X and company Y form an offshore partnership. After 30 days, they purchase short-term notes. After 35 days, they sell notes to received a contingent liability note. After 12 months, company Y leaves the partnership ... you get the idea. Pre-planned steps are a big warning sign that something is probably amiss.
First of all, about 30 percent of my practice involves international tax planning, so I'm obviously not against the practice. However, tax shelter promoters typically use an offshore jurisdiction for one reason: secrecy, a trait shared by many offshore jurisdictions (although this practice is changing). This has obvious benefits if the participants are attempting to lower their tax burden in a questionable manner.
Business entities with a short life span
How long should a business enterprise exist? Ideally in perpetuity, which is one of the primary advantages of the corporate form. And while businesses do go bankrupt or are sold, thereby ending their corporate life, most business owners want their businesses to exist for as long as possible, as this indicates the company is a viable, ongoing concern. In contrast, short duration corporations or partnerships are common in tax shelters, some of which contain entities with a life span of no more than 18 months. While some could argue that joint ventures are an exception to the rule, most of these short-term combinations still have an expected corporate life expectancy of multiple years.
The above points cover most of the basic problems seen in tax shelters. If you can think of others, please post them in the comments section.