The IRS’s Dirty Dozen for 2006
Common Abusive Domestic Trust Schemes
Each year, the IRS identifies common tax scams it refers to as the Dirty Dozen. The following schemes were highlighted by the IRS in 2006:
1. Zero Wages. In this scam, new to the Dirty Dozen, a taxpayer attaches to his or her return either a Form 4852 (Substitute Form W-2) or a “corrected” Form 1099 that shows zero or little wages or other income. The taxpayer may include a statement indicating the taxpayer is rebutting information submitted to the IRS by the payer. An explanation on the Form 4852 may cite "statutory language behind IRC 3401 and 3121" or may include some reference to the paying company refusing to issue a corrected Form W-2 for fear of IRS retaliation. The Form 4852 or 1099 is usually attached to a “Zero Return.” (See number four below.)
2. Form 843 Tax Abatement. This scam, also new to the Dirty Dozen, rests on faulty interpretation of the Internal Revenue Code. It involves the filer requesting abatement of previously assessed tax using Form 843. Many using this scam have not previously filed tax returns and the tax they are trying to have abated has been assessed by the IRS through the Substitute for Return Program. The filer uses the Form 843 to list reasons for the request. Often, one of the reasons is: "Failed to properly compute and/or calculate IRC Sec 83––Property Transferred in Connection with Performance of Service."
3. Phishing. Phishing is a technique used by identity thieves to acquire personal financial data in order to gain access to the financial accounts of unsuspecting consumers, run up charges on their credit cards or apply for new loans in their names. These Internet-based criminals pose as representatives of a financial institution and send out fictitious e-mail correspondence in an attempt to trick consumers into disclosing private information. Sometimes scammers pose as the IRS itself. In recent months, some taxpayers have received e-mails that appear to come from the IRS. A typical e-mail notifies a taxpayer of an outstanding refund and urges the taxpayer to click on a hyperlink and visit an official-looking Web site. The Web site then solicits a social security and credit card number. In a variation of this scheme, criminals have used e-mail to announce to unsuspecting taxpayers they are “under audit” and could make things right by divulging selected private financial information. Taxpayers should take note: The IRS does not use e-mail to initiate contact with taxpayers about issues related to their accounts. If a taxpayer has any doubt whether a contact from the IRS is authentic, the taxpayer should call 1-800-829-1040 to confirm it.
4. Zero Return. Promoters instruct taxpayers to enter all zeros on their federal income tax filings. In a twist on this scheme, filers enter zero income, report their withholding and then write “nunc pro tunc”–– Latin for “now for then”––on the return. They often also do this with amended returns in the hope the IRS will disregard the original return in which they reported wages and other income.
5. Trust Misuse. For years unscrupulous promoters have urged taxpayers to transfer assets into trusts. They promise reduction of income subject to tax, deductions for personal expenses and reduced estate or gift taxes. However, some trusts do not deliver the promised tax benefits, and the IRS is actively examining these arrangements. There are currently more than 200 active investigations underway and three dozen injunctions have been obtained against promoters since 2001. As with other arrangements, taxpayers should seek the advice of a trusted professional before entering into a trust.
6. Frivolous Arguments. Promoters have been known to make the following outlandish claims: the Sixteenth Amendment concerning congressional power to lay and collect income taxes was never ratified; wages are not income; filing a return and paying taxes are merely voluntary; and being required to file Form 1040 violates the Fifth Amendment right against self-incrimination or the Fourth Amendment right to privacy. Don’t believe these or other similar claims. These arguments are false and have been thrown out of court. While taxpayers have the right to contest their tax liabilities in court, no one has the right to disobey the law.
7. Return Preparer Fraud. Dishonest return preparers can cause many headaches for taxpayers who fall victim to their schemes. Such preparers derive financial gain by skimming a portion of their clients’ refunds and charging inflated fees for return preparation services. They attract new clients by promising large refunds. Taxpayers should choose carefully when hiring a tax preparer. As the old saying goes, “If it sounds too good to be true, it probably is.” And remember, no matter who prepares the return, the taxpayer is ultimately responsible for its accuracy. Since 2002, the courts have issued injunctions ordering dozens of individuals to cease preparing returns, and the Department of Justice has filed complaints against dozens of others. During fiscal year 2005, more than 110 tax return preparers were convicted of tax crimes.
8. Credit Counseling Agencies. Taxpayers should be careful with credit counseling organizations that claim they can fix credit ratings, push debt payment plans or impose high set-up fees or monthly service charges that may add to existing debt. The IRS Tax Exempt and Government Entities Division is in the process of revoking the tax-exempt status of numerous credit counseling organizations that operated under the guise of educating financially distressed consumers with debt problems while charging debtors large fees and providing little or no counseling.
9. Abuse of Charitable Organizations and Deductions. The IRS has observed increased use of tax-exempt organizations to improperly shield income or assets from taxation. This can occur, for example, when a taxpayer moves assets or income to a tax-exempt supporting organization or donor-advised fund but maintains control over the assets or income, thereby obtaining a tax deduction without transferring a commensurate benefit to charity. A “contribution” of a historic facade easement to a tax-exempt conservation organization is another example. In many cases, local historic preservation laws already prohibit alteration of the home’s facade, making the contributed easement superfluous. Even if the facade could be altered, the deduction claimed for the easement contribution may far exceed the easement’s impact on the value of the property.
10. Offshore Transactions. Despite a crackdown by the IRS and state tax agencies, individuals continue to try to avoid
11. Employment Tax Evasion. The IRS has seen a number of illegal schemes that instruct employers not to withhold federal income tax or other employment taxes from wages paid to their employees. Such advice is based on an incorrect interpretation of Section 861 and other parts of the tax law and has been refuted in court. Lately, the IRS has seen an increase in activity in the area of “double-dip” parking and medical reimbursement issues. In recent years, the courts have issued injunctions against more than a dozen persons ordering them to stop promoting the scheme. During fiscal 2005, more than 50 individuals were sentenced to an average of 30 months in prison for employment tax evasion. Employer participants can also be held responsible for back payments of employment taxes, plus penalties and interest. It is worth noting that employees who have nothing withheld from their wages are still responsible for payment of their personal taxes.
12. “No Gain” Deduction. Filers attempt to eliminate their entire adjusted gross income (AGI) by deducting it on Schedule A. The filer lists his or her AGI under the Schedule A section labeled “Other Miscellaneous Deductions” and attaches a statement to the return that refers to court documents and includes the words “No Gain Realized.”
1. Business Trust. This involves the transfer of an ongoing business to a trust. Also called an unincorporated business organization, a pure trust or a constitutional trust, it gives the appearance that the taxpayer has given up control of his or her business. In reality, through trustees or other entities controlled by the taxpayer, he or she still runs the day-to-day activities and controls the business's income stream. Such arrangements provide no tax relief. The courts have held that the business income is taxable to the taxpayer under a variety of legal concepts, including lack of economic substance (sham theory), assignment of income, or that the arrangement is a grantor trust. In some circumstances, the trust could be taxed as a corporation.
2. Equipment or service trust. This trust is formed to hold equipment that is rented or leased to the business trust, often at inflated rates. The business trust reduces its income by claiming deductions for payments to the equipment trust. This type of arrangement has the same pitfalls as the business trust, and it will result in no tax reduction.
3. Family residence trust. Taxpayers transfer family residences and furnishings to a trust, which sometimes rents the residence back to the taxpayer. The trust deducts depreciation and the expenses of maintaining and operating the residence including gardening, pool service and utilities. The courts have consistently collapsed these types of trusts, taxing income to the taxpayer and disallowing personal expenses.
4. Charitable trust. Taxpayers transfer assets or income to a trust claiming to be a charitable organization. The trust or organization pays for personal, education or recreation expenses on behalf of the taxpayer or family members. The trust then claims the payments as charitable deductions on its tax returns. These alleged charitable organizations often are not qualified and have no IRS exemption letter; hence, contributions are not deductible. Charitable deductions are not allowed when the donor receives personal benefit from the alleged gift.
5. Asset protection trust These trusts are promoted as a means of avoiding liability for judgments against an individual or business. However, beware of any asset protection trust marketed as part of a package to reduce federal income or employment taxes. The courts can ignore such trusts and order the taxpayer's property sold to satisfy the outstanding liabilities.
1. Abusive Foreign Trust Schemes: The foreign trust schemes usually start off as a series of domestic trusts layered upon one another. This set up is used to give the appearance that the taxpayer has turned his/her business and assets over to a trust and is no longer in control of the business or its assets. Once transferred to the domestic trust, the income and expenses are passed to one or more foreign trusts, typically in tax haven countries.
As an example, a taxpayer's business is split into two trusts. One trust would be the business trust that is in charge of the daily operations. The other trust is an equipment trust formed to hold the business's equipment that is leased back to the business trust at inflated rates to nullify any income reported on the business trust tax return (Form 1041). Next the income from the equipment trust is distributed to foreign trust-one, again, which nullifies any tax due on the equipment trust tax return. Foreign trust-one then distributes all or most of its income to foreign trust-two. Since all of foreign trust-two's income is foreign based there is no filing requirement.
Once the assets are in foreign trust-two, a bank account is opened either under the trust name or an International Business Corporation (IBC). The trust documentation and business records of this scheme all make it appear that the taxpayer is no longer in control of his/her business or its assets. The reality is that nothing ever changed. The taxpayer still exercises full control over his/her business and assets. There can be many different variations to the scheme.
2. International Business Corporations (IBC): The taxpayer establishes an IBC with the exact name as that of his/her business. The IBC also has a bank account in the foreign country. As the taxpayer receives checks from customers, he sends them to the bank in the foreign country. The foreign bank then uses its correspondent account in the to process the checks so that it never would appear to the customer, upon reviewing the canceled check that the payment was sent offshore. Once the checks clear, the taxpayer's IBC account is credited for the check payments. Here the taxpayer has, again, transferred the unreported income offshore to a tax haven jurisdiction.
3. False Billing Schemes: A taxpayer sets up an International Business Corporation (IBC) in a tax haven country with a nominee as the owner (usually the promoter). A bank account is then opened under the IBC. On the bank's records the taxpayer would be listed as a signatory on the account. The promoter then issues invoices to the taxpayer's business for goods allegedly purchased by the taxpayer. The taxpayer then sends payment to the IBC that gets deposited into the joint account held by the IBC and taxpayer. The taxpayer takes a business deduction for the payment to the IBC thereby reducing his/her taxable income and has safely placed the unreported income into the foreign bank account.
1. Fictitious or Overstated Invoicing. Some
2. Offshore Deferred Compensation Arrangements. Many highly compensated professional persons and business owners in the
3. Factoring of Accounts Receivable. A
4. Abusive Insurance Arrangements. Some promoters have devised arrangements that are characterized as insurance arrangements, giving rise to a deduction for the
5. Shifting of Income Using Offshore Private Annuities. Some promoters suggest that
6. Offshore Internet Business. For businesses conducted primarily through the internet, promoters offer "kits" which give the appearance that the business is foreign owned and operated. Transactions may be routed through offshore servers, and business receipts may be collected through offshore bank accounts or credit card merchant accounts. These schemes particularly target businesses that offer delivery of computer software and other digital products such as music, pictures, or video. They may also provide a means of operating offshore gaming activities.
7. Offshore Wagering. Over the last few years, gambling websites have proliferated on the Internet. Many of these virtual casinos are organized and operated from offshore locations, where the operators feel free from State and Federal interference. The operators of these activities may suggest that players in the U.S. are not subject to tax on their winnings, and may handle collections and disbursements in ways designed to facilitate avoidance of U.S. taxes.
8. Repatriation of Offshore Funds Using Credit Cards. Credit cards (such as MasterCard and VISA) issued by tax haven domiciled banks are a preferred method used by U.S. taxpayers to anonymously and covertly repatriate offshore funds that may or may not have been previously taxed. American Express cards are used in the same way but differ in that these cards are issued directly by American Express rather than by member banks.
Source: Internal Revenue Service Publications. For information about specific tax schemes that have been listed by the IRS as abusive tax shelters, visit http://www.irs.gov/businesses/corporations/article/0,,id=120633,00.html
*In order to qualify for a reward, a whistleblower does not necessarily have to possess information regarding a criminal tax fraud scheme. If a whistleblower otherwise qualifies, the taxes simply have to be due.