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Archive for February, 2012

Covering President Obama’s recent tax proposals has given me a firm appreciation for what it must have been like to be a sports reporter during the latter stages of Brett Favre’s career, when journalists breathlessly covered whether he would retire or continue playing, despite the fact that everyone knew damn well Favre would show up to camp a week late and start another 16 games. And what I’ve learned is this: it’s a rather empty feeling to spend day after day analyzing a story the ending to which was preordained before it even began.

But that’s where we are with tax reform in this country. Everything is happening, but nothing’s happening. Last week the president unveiled his plans for individual tax reform, and today it’s corporate tax reform, but regardless of what’s said or written, we all know nothing will be passed unless the president wins re-election, and even then these proposals — as currently constructed — are a long-shot to ever become law.

Anyhoo, what follows is a summary of President Obama’s appeal for corporate tax reform, released today. And while the headlining proposal — the promise to reduce the maximum corporate tax rate to 28% —  is likely to win some appreciation from the Republican party, there are enough high-profile revenue raisers in the plan, such as the elimination of tax preferences for the oil and gas industry and the imposition of a “minimum tax” on a U.S. corporation’s worldwide profits, to guarantee that the president’s corporate proposals will be shelved right along with his plan for individual tax reform until after the election.

The president’s plan can be separated into three distinct categories: general corporate reform, manufacturing industry reform, and international reform.  

General Corporate Reform

While the president’s pitch to lower the maximum corporate tax rate from 35% to 28% is sure to get the most publicity, understand that the intention is for this lost revenue to be paid for by broadening the tax base, i.e.., eliminating deductions. The president (correctly) points out that our current tax system — replete with innumerable deductions, exclusions and preferences — benefits certain industries over others. Take a gander at the following table, which illustrates the effective tax rate paid by different industries in 2007 and 2008, even though they were all subject to the same 35% marginal rate:

 

The president believes that while eliminating deductions and preferences, care should be taken to equalize the benefits of the code across all industries.  To that end, he has placed a number of provisions on the chopping block, calling for the following changes:

  •  Elimination of “Last in first out” accounting. Under the “last-in, first-out” (LIFO) method of accounting for inventories, it is assumed that the cost of the items of inventory that are sold is equal to the cost of the items of inventory that were most recently purchased or produced. This allows some businesses to artificially lower their tax liability.
  • Elimination of oil and gas tax preferences. The president’s framework would repeal the expensing of intangible drilling costs, and percentage depletion for oil and natural gas wells. .
  • Reform treatment of insurance industry and products The president’s framework would close this loophole and not allow interest deductions allocable to life insurance policies unless the contract is on an officer, director, or employee who is at least a 20 percent owner of the business.  
  • Taxing carried (profits) interests as ordinary income. The framework would eliminate the loophole for managers in investment services partnerships and tax carried interest at ordinary income rates.
  • Eliminate special depreciation rules for corporate purchases of aircraft. This would eliminate the special depreciation rules that allow owners of non-commercial aircraft to depreciate their aircraft more quickly (over five years) than commercial aircraft (seven years).
  • Addressing depreciation schedules. Current depreciation schedules generally overstate the true economic depreciation of assets.
  • Reducing the bias toward debt financing. Reducing the deductibility of interest for corporations should be considered as part of a reform plan. This is because a tax system that is more neutral towards debt and equity will reduce incentives to overleverage and produce more stable business finances, especially in times of economic stress.

 Manufacturing Industry Reform

 While the president asserts that all industries should be treated equally, the plan then goes on to bestow certain preferences specifically on the manufacturers by proposing the following:

  •  Effectively cutting the top corporate tax rate on manufacturing income to 25 percent and to an even lower rate for income from advanced manufacturing activities by reforming the domestic production activities deduction. The president’s framework would focus the current I.R.C. § 199  deduction more on manufacturing activity, expand the deduction to 10.7 percent, and increase it even more for advanced manufacturing. This would effectively cut the top corporate tax rate for manufacturing income to 25 percent and even lower for advanced manufacturing.
  •   Expand, simplify and make permanent the R&D Tax Credit. The president’s framework would increase the rate of the alternative simplified  credit to 17 percent.  
  •  Extend, consolidate, and enhance key tax incentives to encourage investment in clean energy.

International Reform

It is in the international arena that the president’s proposals most deviate from those of his Republican counterparts. While Mitt Romney and Newt Gingrich have loudly called for a move to a “territorial” tax system, whereby U.S. corporations would only pay tax on U.S. income, leaving other nations to trust foreign profits, President Obama wants to expand the current corporate tax regime to tax profits earned by foreign affiliates of U.S. corporations before they are repatriated to the U.S. This is sure to be a sticking point in any future negotiations, as some powerful lobbies will not take kindly to the idea of a minimum international tax rate.

 The president’s proposals include the following:

  •  Require companies to pay a minimum tax on overseas profits. Specifically, under the President’s proposal, income earned by subsidiaries of U.S. corporations operating abroad must be subject to a minimum rate of tax. This would stop our tax system from generously rewarding companies for moving profits offshore. Thus, foreign income deferred in a low-tax jurisdiction would be subject to immediate U.S. taxation up to the minimum tax rate with a foreign tax credit allowed for income taxes on that income paid to the host country. This minimum tax would be designed to balance the need to stop rewarding tax havens and to prevent a race to the bottom with the goal of keeping U.S. companies on a level playing field with competitors when engaged in activities which, by necessity, must occur in a foreign country.
  • Remove tax deductions for moving productions overseas and provide new incentives for bringing production back to the United States. The President is proposing that companies will no longer be allowed to claim tax deductions for moving their operations abroad. At the same time, to help bring jobs home, the President is proposing to give a 20 percent income tax credit for the expenses of moving operations back into the United States.
  •  Other reforms to reduce incentives to shift income and assets overseas. The Framework would strengthen the international tax rules by taxing currently the excess profits associated with shifting intangibles to low tax jurisdictions. In addition, under current law, U.S. businesses that borrow money and invest overseas can claim the interest they pay as a business expense and take an immediate deduction to reduce their U.S. taxes, even if they pay little or no U.S. taxes on their overseas investment. The Framework would eliminate this tax advantage by requiring that the deduction for the interest expense attributable to overseas investment be delayed until the related income is taxed in the United States.

Of course, the chess match continues. In response to the president’s plan for corporate reform, the rise of Rick Santorum, and his recent slip in the polls, Mitt Romney changed his stance on the maximum individual tax rate today, proposing to reduce it to 28% (as part of a 20% cut of all rates across the board) as opposed to simply extending the Bush tax cuts (which contain a 35% maximum tax rate), as he’d proposed earlier in his campaign. Romney also went on to promise a free Chalupa to anyone who votes for him.* Desperation, as they say, is a stinky cologne.

*this may not have happened

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It’s going to be a busy day in the tax world, as President Obama will be unveiling  his long-awaited  proposal for corporate tax reform in a few hours. Expected to be included among the proposals are the following:

  • A reduction in the corporate tax rate from 35% to 28%;
  • A modification to Section 199 to ensure that U.S. manufacturers pay no more than a 25% effective tax rate;
  • Elimination of up to a dozen tax deductions currently available;
  • Renewal of the R&D credit under Section 41; and
  • The addition of a “worldwide minimum tax” to ensure that U.S. corporations that move operations offshore pay tax on its overseas profits.

It’s important to note, while the 7% reduction in the corporate tax rate may look universally appetizing, for those corporations that currently take advantage of many of the tax preferences on the chopping block, they may actually see their effective tax rate increase as a result of the lost deductions. Those corporations — typically in the technology and pharmaceutical fields — likely will not be on board with the proposed changes.

In general, however, corporate tax reform is one of the few areas where Republicans and Democrats may be able to find some common ground, as it is widely recognized that the current corporate tax regime is putting the U.S. at a competitive disadvantage with other nations.

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In December 2010, an Iowa district court decided Watson, a reasonable compensation case involving an S corporation shareholder-employee. For a primer on why reasonable compensation is a frequently litigated issue with regards to closely held S corporations, click here.

Watson, in many respects, was a precedent-setting case in the S corporation reasonable compensation arena, as it shed much-needed light on the methodology the IRS and the courts will employ to determine reasonable compensation, providing an analytical approach tax advisers could follow when guiding their clients.

Today, the Eighth Circuit affirmed the district court’s decision in Watson, holding that an S corporation shareholder-employee (Watson) who paid himself only $24,000 in salary during 2002 and 2003 while withdrawing over $375,000 in distributions was not reasonably compensated for his services. The court further upheld the district court’s determination of an annual reasonable compensation amount of $93,000, requiring Watson to recharacterize $69,000 of distributions in each year as salary. As a result, the corporation and Watson were held liable for over $23,000 in payroll taxes, penalties, and interest.

Facts in Watson:  

David Watson — like many of the subjects of reasonable compensation scrutiny — was a CPA.[1] He was also the sole shareholder and employee of an S corporation, which in turn was a 25% shareholder in a very successful accounting firm. Watson’s share of the revenue generated by the accounting firm was allocated to his S corporation, which would then pay Watson a salary and distributions. Any amounts not paid out in salary by the corporation were reported by Watson as his share of the S corporation’s income on his personal tax return, where it was not subject to payroll tax.[i]

In 2002 and 2003, Watson set his compensation from his wholly owned corporation at a mere $24,000 per year, an amount that was less than what first-year employees at his firm were earning.  In comparison, Watson received distributions of $203,651 and $175,470, respectively, in those years.

The IRS challenged Watson’s compensation as being unreasonably low; arguing that by foregoing salary in favor of distributions, Watson and the S corporation were avoiding payroll tax responsibilities.

Significance of Watson

In nearly all of the S corporation reasonable compensation cases that preceded Watson, the shareholder-employee failed to take any salary but withdrew distributions, leaving the IRS and the courts the simple task of reclassifying  the distributions as compensation for services.  

Because Watson actually reported compensation of $24,000 in each of the years in question, however, the Iowa District Court and the Eighth Circuit was faced with an issue of first impression: quantifying just what constituted “reasonable compensation” for Watson’s services. The resulting analysis provided the first court-approved roadmap for tax advisers to use in setting appropriate salary amounts for their S corporation shareholder-employee clients.

IRS Approach, District Court Decision

In setting Watson’s salary, the IRS engaged the services of a general engineer, who testified that based on the health of the accounting firm and the compensation of Watson’s peers in the industry, his compensation was unreasonably low.

To quantify the appropriate salary, the engineer utilized MAP surveys conducted by the AICPA, which indicated that the average non-owner director of a CPA firm the size of Watson’s would be paid $70,000. The engineer then grossed up this salary by 33% to account for Watson’s stake as a shareholder,[ii] resulting in “reasonable” compensation of $93,000 for each of 2002 and 2003.

The District Court agreed, citing Watson’s experience, expertise, and time devoted to his role as one of the primary earners at a well-established firm.

Eighth Circuit Decision

Today, the Eighth Circuit affirmed the holding of the district court. In reaching its decision, the court concluded that the characterization of funds distributed by an S corporation to its shareholder-employees turns on the analysis of whether the payments were made as compensation for services, not on the intent of the S corporation in making the payments. [iii]

The Eighth Circuit did briefly address Watson’s argument that his reasonable compensation should be capped at the revenue he personally generated for the CPA firm, less his allocable expenses. While the court admitted that evidence of shareholder billings may be probative on the issue of compensation, the Eight Circuit ultimately refrained from adjusting the previous calculation of Watson’s reasonable compensation performed by the IRS.  

What Can We Learn?

For tax advisers, the Eighth Circuit’s decision should reinforce the lessons taken home from the original Watson decision. The IRS is taking a formal, quantitative approach towards determining reasonable compensation, so to adequately advise our clients, we must be prepared to do the same thing.

At a minimum, in setting the compensation of our S corporation shareholder-employee clients, we must consider the following (note, all of these considerations are discussed in much greater detail in this PDF: Tax Adviser – S Corporation Shareholder-Employee Reasonable Compensation):

1. Nature of the S Corporation’s Business. It is no coincidence that the majority of reasonable compensation cases involve a professional services corporation, such as law, accounting, and consulting firms. It is the view of the IRS that in these businesses, profits are generated primarily by the personal efforts of the employees, and as a result, a significant portion of the profits should be paid out in compensation rather than distributions.

2. Employee Qualifications, Training and Experience, Duties and Responsibilities, and Time and Effort Devoted to Business. A full understanding of the nature, extent, and scope of the shareholder-employee’s services is essential in determining reasonable compensation. The greater the experience, responsibilities and effort of the shareholder-employee, the larger the salary that will be required.

3. Compensation Compared to That of Non-shareholder Employees or Amounts Paid in Prior Years.  Here, common sense rules the day. In Watson, a CPA with significant experience and expertise was  paid a smaller salary than recent college graduates. Clearly, this is not advisable.

4. What Comparable Businesses Pay for Similar Services. Tax advisors should review basic benchmarking tools such as monster.com, salary.com, Robert Half, and Bureau of Labor Statistics wage data to determine the relative reasonableness of the shareholder-employee’s compensation when compared to industry norms.

5. Compensation as a Percentage of Corporate Sales or Profits. Tax advisors should utilize industry specific publications such as the MAP to determine the overall profitability of the corporation and the shareholder-employee’s compensation as a percentage of sales or profits. Whenever possible, comparisons should be made to similarly sized companies within the same geographic region. If the resulting ratios indicate that the S corporation is more profitable than its peers but paying less salary to the shareholder-employee, tax advisors should determine if there are any differentiating factors that would justify this lower salary, such as the shareholder’s reduced role or the corporation’s need to retain capital for expansion. If these factors are not present, an increase in compensation to the industry and geographic norm provided for in the publications is likely necessary.

6. Compensation Compared With Distributions. While large distributions coupled with a small salary may increase the likelihood of IRS scrutiny, there is no requirement that all profits be paid out as compensation. Though the District court in Watson recharacterized significant distributions as salary, it permitted Watson to withdraw significant distributions in both 2002 and 2003. Perhaps the court was content to recharacterize just enough distributions to ensure that Watson’s compensation exceeded the Social Security wage base in place for the years at issue.[iv] In doing so, the payroll tax savings on Watson’s remaining distributions amounted only to the 2.9% Medicare tax.

[1] See Joseph M. Grey.
[i] See Rev. Rul. 59-221.

[ii] The MAP revealed that in general, shareholders billed at a rate 33% higher than non-owner directors.

[iii] Watson tried to argue that it was the intent of the S corporation to pay him only $24,000 for his services, with the remaining cash to be distributed based on the CPA firm’s success, a fact both courts found highly implausible given Watson’s experience and expertise.

[iv] $84,900 in 2002 and $87,000 in 2003.

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In a case decided earlier today, the Supreme Court held that a husband and wife who were Japanese citizens but lawful residents of the U.S. could be deported after pleading guilty to filing a false tax return.

Mr. and Mrs. Kawashima, seeking refuge from the repeated Godzilla attacks that plague their homeland, fled Japan and became legal permanent residents of the U.S. in 1984. Ten years later, Mr. Kawashima completed the process of assimilating into our society and becoming a “true” American by egregiously cheating on his taxes. He pled guilty to filing a false return under I.R.C. § 7206(1), while his wife pled guilty to aiding and assisting in the filing of a false return under I.R.C. § 7206(2).

I.R.C. §§ 7206  provides that willfully filing a false tax return is a felony. The issue at hand for the Supreme Court, however, was whether a conviction under these sections constituted an “aggravated felony” under the immigration laws, punishable by deportation.

An aggravated felony is one that either:

Clause #1: Involves fraud or deceit in which the loss to the victim or victims exceeds $10,000; or

Clause #2:  Is described in I.R.C. § 7201 (relating to tax evasion) in which the revenue loss to the government exceeds $10,000.

The Kawashimas argued that their conviction for filing a false return failed to meet the standard of an aggravated felony for three reasons:

1. Clause #1 did not apply to their crime, as I.R.C. § 7206 does not contain the words “fraud” or “deceit,”

2. Clause #1 was not intended to cover tax crimes, as that was solely the responsibility of Clause #2, and

3. Since Clause #2 was specific to tax evasion under I.R.C. § 7201, it did not cover their conviction under I.R.C. § 7206.

In its 6-3 decision, the Supreme Court shot down all three arguments, holding that the Kawashimas’ previous conviction qualified as an aggravated felony under Clause #1, as it involved fraud — even if fraud was not an express requirement of the statute — and the loss to the government exceeded $10,000. So sadly, it’s back to Japan for the Kawashimas.

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David Marotta over at Forbes asks a question that was beaten into the ground in 2010 and 2011, but in light of President Obama’s recent tax proposals, bears repeating in 2012. Have you considered converting your traditional IRA into a Roth IRA? Because contributions to a traditional IRA are generally tax-deductible, they are subject to income tax on the other end of their life cycle, i.e., upon distribution. If you’re years from retirement, it’s impossible to predict what tax rate you’ll be paying when distributions are received from the IRA, but you wouldn’t be foolish to suspect that our current tax rates may be the lowest we’ll see for a long, long time. If that’s the case, you may well benefit from converting your traditional IRA into a Roth IRA during 2012.[i] The tax implications of a Roth IRA are the polar opposite of its traditional cousin; contributions are not deductible from taxable income, but the subsequent growth and distribution of the contributed funds are free from income tax. In addition, unlike traditional IRAs , which require owners to start taking distributions at age 70 ½ , no such requirement for distributions exist for Roth IRAs. If one could convert a traditional IRA to a Roth IRA without generating taxable income, one could enjoy the best of both retirement plans. The contribution to the traditional IRA would have been deducted from taxable income, and the subsequent distribution would be tax-free. For this very reason, upon the conversion of a traditional IRA into a Roth IRA, a taxpayer must recognize taxable income to the extent of the converted balance (assuming all of the contributions to the traditional IRA were tax deductible). If President Obama is re-elected, he is promising to increase the top tax rates from 33/35% to 36/39.6% starting January 1, 2013. So for wealthy taxpayers, 2012 may represent the last chance to take advantage of a Roth IRA conversion while saving 3-4.6% in federal income tax. Of course, there is an element of risk involved, as by converting your traditional IRA to a Roth IRA you’re voluntarily accelerating taxable income because you’re gambling that tax rates will increase in the near future (thus making this the right time to do the conversion). These conversions are not without potential with misstep, making proper guidance a must. You’re best served talking to someone who knows what he’s doing, like WS+B Partner Hal Terr, who’s consulted on several dozen conversions in the past three years. He’s even gone ahead and created this extremely helpful decision tree (PDF version), which can be used to determine if you are in fact a candidate for conversion. Below is a JPEG of the decision tree. Click to enlarge


[i] Since 2010 the $100,000 AGI limitation on conversions was eliminated, allowing all taxpayers to convert traditional IRAs to Roth IRAs

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Faced with hefty student loans and the harsh realization that unemployment isn’t just for philosophy majors anymore, 85% of recent college graduates are returning home to shack up with mom and dad.

As a parent, you’re left with the unenviable task of trying to balance society’s expectation that you won’t change your locks with your desire to teach your children to fend for themselves and become responsible adults.

To that end, might I recommend you start helping your kid spread his wings by making him or her file their own tax return. The Wall Street Journal has published a helpful article detailing the finer points of filing your first return that is essentially idiot proof, which is a good thing since Junior matriculated at Bellevue University.

From the article:

You’ll need documentation of your income and anything that qualifies for a deduction, which reduces your taxable income, or a credit, which reduces your tax burden. These documents, typically sent via mail, are often missed by young filers used to doing everything electronically, says Elaine Smith, a master tax adviser at H&R Block

As an aside, I am absolutely changing the title on my business cards to read “Master Tax Adviser.” This has got to be the most self-aggrandizing designation since the one made popular by Wile E. Coyote:

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A few things you may have missed this weekend while soaking in the first sign of spring: pitchers and catchers have reported to Phillies’ camp.  

The IRS is willing to pay $15 million for a PR firm to help improve its ruthless public image. It appears in retrospect, building the Service’s previous marketing campaign around the slogan, “We’re the IRS. Don’t F–k With Us,” wasn’t such a great idea.

There has been no shortage of wild suggestions on how the U.S. can raise additional tax revenue to chip away at its monumental deficit, but here’s an unconventional plan I can get behind: a federal sex tax.  While some may find a $2 fee on each no-pants dance to be a costly  – and grossly invasive — proposition, I’m all for it, because as a married man with a toddler, the proposal would only increase my annual tax bill by the cost of a gallon of gas.  HI-YO!!

Noticeably absent from the payroll tax legislation was the extension of a number of expired provisions, including the R&D credit. The hesitancy seems to stem from the package’s $25 billion price tag, which makes little to no sense, as Congress declining to tack a mere $25 billion onto the current $15 trillion national debt is the governmental equivalent of Farva refusing to pay a quarter to Dimpusize his meal

New Jersey finds itself in need of additional revenue to cover a planned 10% reduction in its individual income tax rate. Funny; I would have thought the State’s decision to tax fake tans would have generated enough cash to eliminate any budget concerns for the next 2,000 years.  

Lastly, this video is proof that the U.S. is the greatest nation in the world. No other country offers the same combination of infinite resources and abundant free time necessary to take an idea like this  from concept to reality:

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[Ed note: WS+B Trust and Estate Expert Hal Terr stops by to discuss a recent IRS ruling that helps clarify the proper way to structure a grantor trust. Now, on to Hal:]

Estate planners have often discussed the benefits of grantor trusts with their high net worth clients.  With a grantor trust, an individual can make a completed gift to an irrevocable trust for gift tax purposes but be treated as the owner of the trust for income tax purposes. The benefit of this technique is when the grantor pays this income tax, it is a tax-free gift to the trust. Consider the following example:

Parent has IBM stock with a fair market value of $100,000 and cost basis of $0.   If the parent gifts the stock to their child, the child has a carryover basis in the stock of $0. If the child sells the stock — and assuming a 15% long-term capital gain tax rate — the child is left with $85,000 in cash.   If instead, the parent gifts the stock to an irrevocable grantor trust and the trust sells the stock, the trust retains the $100,000 and the parent pays the $15,000 of income tax.   This transfers more wealth to the next generation and the payment of the income tax reduces the parent’s eventual taxable estate.

A common drafting technique by attorneys to create a grantor trust has always been to include a provision to allow the grantor, in a non-fiduciary capacity, to reacquire trust assets by substituting other property of equivalent value under IRC Section 675(4)(C).  Under Revenue Ruling 2011-28, the IRS has provided a safe harbor for the provisions that should be included in the trust document so that the granting of this ability to the grantor would not include the property in the grantor’s estate.   In its ruling the IRS stated:

A grantor’s retention of the power, exercisable in a non-fiduciary capacity, to acquire property held in trust by substituting other assets of equivalent value will not, by itself, cause the value of the property to be includible in the grantor’s gross estate provided the trustee has a fiduciary obligation (under local law or the trust instrument) to ensure the grantor’s compliance with the terms of this power by satisfying itself that the properties acquired and substituted by the grantor are in fact of equivalent value.  The ruling provided that the substitution power cannot be exercised in a manner that can shift benefits among the trust beneficiaries.  A substitution power cannot be exercised in a manner that can shift benefits if:

(a) the trustee has both the power (under local law or the trust instrument) to reinvest the trust corpus and a duty of impartiality with respect to the trust beneficiaries; or

(b) the nature of the trust’s investments or the level of income produced by any or all of the trust’s investments does not impact the respective interests of the beneficiaries, such as when the trust is administered as a unitrust (under local law or the trust instrument) or when distributions from the trust are limited to discretionary distributions of principal and income.

High net worth individuals, when meeting with their advisors to consider taking advantage of the $5.12M gift exemption available in 2012 should consider the benefits of grantor trusts as part of their estate plan.

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Yesterday, the IRS released its annual  “Dirty Dozen” ranking of tax scams, reminding taxpayers to use caution during tax season to protect themselves against a wide range of nefarious schemes. Narrowly missing the Top 12 this year: refusing to pay taxes for fear of supporting the “government killing machine” and the highly sophisticated “wallet inspector” scam.

All joking aside, tax scams are serious business. So if you’re gullible like my wife — who very nearly hired the Russian mob to move us from New Jersey to Aspen before I intervened — take heed of the following Dirty Dozen tax scams:

Identity Theft

 An IRS notice informing a taxpayer that more than one return was filed in the taxpayer’s name or that the taxpayer received wages from an unknown employer may be the first tip off the individual receives that he or she has been victimized. 

Anyone who believes his or her personal information has been stolen and used for tax purposes should immediately contact the IRS Identity Protection Specialized Unit.  For more information, visit the special identity theft page at www.IRS.gov/identitytheft

Phishing

Phishing is a scam typically carried out with the help of unsolicited email or a fake website that poses as a legitimate site to lure in potential victims and prompt them to provide valuable personal and financial information. Armed with this information, a criminal can commit identity theft or financial theft.

It is important to keep in mind the IRS does not initiate contact with taxpayers by email to request personal or financial information.  This includes any type of electronic communication, such as text messages and social media channels.  The IRS has information that can help you protect yourself from email scams.

Return Preparer Fraud

Questionable return preparers have been known to skim off their clients’ refunds, charge inflated fees for return preparation services and attract new clients by promising guaranteed or inflated refunds. Taxpayers should choose carefully when hiring a tax preparer. Federal courts have issued hundreds of injunctions ordering individuals to cease preparing returns, and the Department of Justice has pending complaints against many others.

Hiding Income Offshore

While there are legitimate reasons for maintaining financial accounts abroad, there are reporting requirements that need to be fulfilled. U.S. taxpayers who maintain such accounts and who do not comply with reporting and disclosure requirements are breaking the law and risk significant penalties and fines, as well as the possibility of criminal prosecution.
 

“Free Money” from the IRS & Tax Scams Involving Social Security

Flyers and advertisements for free money from the IRS, suggesting that the taxpayer can file a tax return with little or no documentation, have been appearing in community churches around the country.

Scammers prey on low income individuals and the elderly. They build false hopes and charge people good money for bad advice. In the end, the victims discover their claims are rejected. Meanwhile, the promoters are long gone. The IRS warns all taxpayers to remain vigilant.

False/Inflated Income and Expenses

Including income that was never earned, either as wages or as self-employment income in order to maximize refundable credits, is another popular scam. Claiming income you did not earn or expenses you did not pay in order to secure larger refundable credits such as the Earned Income Tax Credit could have serious repercussions.  This could result in repaying the erroneous refunds, including interest and penalties, and in some cases, even prosecution. 

False Form 1099 Refund Claims

In this ongoing scam, the perpetrator files a fake information return, such as a Form 1099 Original Issue Discount (OID), to justify a false refund claim on a corresponding tax return. In some cases, individuals have made refund claims based on the bogus theory that the federal government maintains secret accounts for U.S. citizens and that taxpayers can gain access to the accounts by issuing 1099-OID forms to the IRS.

Frivolous Arguments

Promoters of frivolous schemes encourage taxpayers to make unreasonable and outlandish claims to avoid paying the taxes they owe. The IRS has a list of frivolous tax arguments that taxpayers should avoid. 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.

Falsely Claiming Zero Wages

Filing a phony information return is an illegal way to lower the amount of taxes an individual owes. Typically, a Form 4852 (Substitute Form W-2) or a “corrected” Form 1099 is used as a way to improperly reduce taxable income to zero. The taxpayer may also submit a statement rebutting wages and taxes reported by a payer to the IRS.

Abuse of Charitable Organizations and Deductions

IRS examiners continue to uncover the intentional abuse of 501(c)(3) organizations, including arrangements that improperly shield income or assets from taxation and attempts by donors to maintain control over donated assets or the income from donated property.

Disguised Corporate Ownership

Third parties are improperly used to request employer identification numbers and form corporations that obscure the true ownership of the business.

These entities can be used to underreport income, claim fictitious deductions, avoid filing tax returns, participate in listed transactions and facilitate money laundering, and financial crimes. The IRS is working with state authorities to identify these entities and bring the owners into compliance with the law.

Misuse of Trusts

For years, unscrupulous promoters have urged taxpayers to transfer assets into trusts. While there are legitimate uses of trusts in tax and estate planning, some highly questionable transactions promise reduction of income subject to tax, deductions for personal expenses and reduced estate or gift taxes. Such trusts rarely deliver the tax benefits promised and are used primarily as a means of avoiding income tax liability and hiding assets from creditors, including the IRS.

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[Ed Note: This is the second of what will be a recurring series of posts by WS+B Tax Partner Steve Talkowsky addressing the seminal tax cases in our country's tax history. Why do something like this?

Because unless you happen to be this chick, the tax law is considerably older than you are. As a result, no matter how diligent and dutiful you may be in absorbing current events, the reality is that much of the current law was established long before you were a twinkle in your daddy's eyes.

To speed up your learning curve, Mr. Talkowsky will stop by from time to time to reintroduce and dissect those landmark decisions that have had a far-reaching impact on the tax law as we know it.

Next up: The Supreme Court's decision in Duberstein v. Commissioner. Now on to Steve…]

How do you know when you have received — or given — a gift?  If it’s not a gift then what is it?  Good questions – both of which were answered by the Supreme Court fifty years ago in  Commissioner v. Duberstein.

Facts:

Mr. Berman was president of Mohawk Metal Corporation (Mohawk). Mr. Duberstein was president of the Duberstein Iron & Metal Company. They would often talk on the phone and give each other names of potential customers. After receiving some particularly helpful information, Berman decided to give Duberstein a car, and not just any car – a Caddy!  

Although Duberstein initially said he did not need the car as he already had one, he eventually accepted it (duh!). Mohawk later deducted the value of the car as a business expense, but Duberstein did not include the value of the Cadillac in his gross income, leaving the IRS in the position of being whipsawed.  

As a result, the IRS challenged Duberstein’s position, arguing that the car was compensation for services. The Tax Court agreed, looking to Berman’s intent in giving the car to Duberstein:

The record is significantly barren of evidence revealing any intention on the part of the payor to make a gift. The payment was made by a corporation, and it entered the payment on its books as a “finder’s fee.” The corporation not only claimed the amount as a business expense on its Federal income tax return, but filed an information return (form 1099) as required…Such facts tend to negate any donative intent of the payor.

Upon appeal, however, the Sixth Circuit disagreed with the Tax Court, holding the car to represent a nontaxable gift. In support of its decision, the Sixth Circuit disregarded the subsequent treatment of the car as a business gift by Berman, and focused instead on what they believed was Berman’s initial intent: to give a gift to a non-employee:

The Tax Court inferred lack of donative intent on the part of Berman because his corporation took the value of the car as a business expense, classifying it as a “finder’s fee”. If, in fact, there was donative intent at the time of the event involved, a subsequent change of mind by the donor at income tax time cannot change the character of what was, in fact, a gift at the time it was made.

Based on the lower court’s inability to reach a consensus, the Supreme Court was left with the unenviable task of defining precisely what constitutes a “gift.”

In performing its analysis, the Supreme Court — while acknowledging that there is no “bright line” test as to what constitutes a gift for taxation purposes — agreed with the Tax Court that the critical consideration is the transferor’s intent.

In holding that the car represented taxble compensation for services, the court famously defined a gift as proceeding from a “detached and disinterested generosity,”  and as being given out of affection, respect, admiration, charity or like impulses. Compensatory payments, on the other hand, are payments given as an “involved and intensely interested” act.

Because of the pre-existing relationship between Mohawk and Duberstein, the Supreme Court believed that the transfer by Berman of  the car to Duberstein was not made out of a “detached and disinterested generosity,” but rather to compensate him for past services or induce him to provide future services.

[Ed note: Duberstein established the requirement that a gift be made with "donative intent,"  and this test has been used for the past half-century to differentiate nontaxable gifts from compenstatory transfers. The principles established in Dubserstein have been applied to everything from determining whether a parent's payment to his child's school can qualify as a charitable contribution to whether a cancellation of debt creates taxable income to the debtor or is instead treated as a gift.]

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