Benjamin Franklin supposedly said, “The only things certain in life are death and taxes.” Yet every year, thousands of Americans seek to prove the old sage wrong by using the most tenuous, illogical and even illegal tactics to eliminate or reduce their taxes.
Unfortunately, there are always financial advisors — sometimes under the guise of knowledgeable accountants, lawyers, and planners — who willingly indulge and encourage these fantasies. Read on to find out the worst of the worst.
Since earned income is the basis for most income tax and is documented by external W-2s and 1099s, the most common technique to reduce taxable income is increased deductions claimed by a taxpayer. Bad advice from your planner includes the following:
1. Claiming extra dependents Each dependent child and qualifying relative provides a personal exemption and possible use of different tax credits. However, the tax laws are very clear about who is a “dependent” and the criteria that must be met in order to have a legal claim for deductions. Divorced parents need to be particularly careful that they are not “doubling up” their legitimate exemption and deductions.
2. Exaggerating your deductible expenses Since the IRS audits a very small percentage of filed returns (1.02% of returns for filers making $200,000 or less), the urge to fudge the numbers can be irresistible. Claiming larger charitable deductions than you actually made, a home office that doesn’t exist, and mileage or entertainment expenses as business that were actually personal are the most likely areas where fiction can affect the numbers.
If you’re tempted to exaggerate, remember that all returns are electronically audited to identify unusually high deductions for certain expenses.
3. Investing in dubious or abusive “tax shelters” Legitimate shelters are designed to either transfer income from one accounting period to a later, presumably lower-taxed, period, or to convert income that would otherwise be taxed at ordinary income rates to the lower long-term capital gains rate. Cattle feeding partnerships are an example of the first, while real estate ownership does the latter.
A legitimate shelter requires risk and liability, even though it may be small. Simply stated, you cannot deduct amounts for which you have neither invested cash nor assumed debt for which you are personally liable.
Pseudo transfers of ownership
Some phony tax advisors specialize in fake transfers of ownership, so that income you might receive appears to be transferred to other parties who pay no taxes or taxes at a lower rate. Their advice might include any of the following tactics:
4. Setting up secret offshore accounts What some have called the “pirate banking” system has existed for years to the benefit of multinational corporations, wealthy individuals, and criminals. Transferring ownership of income-earning assets to an anonymous account in the Cayman Islands, the Isle of Man, or dozens of other countries where taxes and reporting requirements are nonexistent is a scheme often promoted by unscrupulous advisors.
If you’re tempted to create an offshore account, recognize that you are required by law to report any income from foreign bank accounts and file an annual form TD F 90-22.1 by June 30th each year disclosing the location and other details about any foreign financial account with an aggregate value of more than $10,000. Failure to do so can lead to criminal charges being filed against you.
5. Transferring your business to a business trust A business owner transfers his business to a trust in return for receiving shares of beneficial interests. The income of the trust (the former business) is then sent to the beneficial interest owners as deductible distributions, thereby eliminating any business or self-employment taxes that would normally be due.
Effectively, there is no meaningful change in control over the business assets, nor any business purpose other than the elimination of income taxes. The IRS is constantly on the alert for such strategies and aggressively challenges such arrangements in court if necessary.
6. Creating a family residence trust Say a homeowner transfers the title of a property to a trust at a stepped-up basis in return for trust certificates of indeterminate value. The former owner asserts that, since the value of the trust certificates cannot be determined, there is no taxable transaction. The trust claims to be in the “rental” business and rents the house back to the former owner in return for services to the trust so that no rent is actually paid. If rent is paid, the trust offsets the income by depreciation of the property and the expenses of maintenance (utilities, repairs) that would be nondeductible by the property-owning resident.
This is clearly a sham transaction that has no economic purpose other than the reduction of taxes for the homeowner. Entering into this kind of transaction may lead to severe penalties under the 2010 Revenue Reconciliation Act, with an added 40% penalty to any underpayments of tax that result.
7. Organizing a faux charitable trust Simply put, in this scenario the creator sets up a charitable trust for charitable benefit, thereby claiming any payments to the trust as charitable deductions. In reality, the charity is primarily the educational, living, recreational expenses of the creator and his family. The law is clear that supposed charitable payments are not deductible where payments are for the benefit of the creator or his or her family. The same law and penalties apply as for the Family Residence Trust.
Claims regarding the obligation to pay income tax
Over the past centuries, tax protestors have proposed a variety of theories why the requirement to pay income tax is either voluntary, inapplicable, or limited to certain specific individuals due to their status or residence. These theories have been tested in federal court and found invalid. No legitimate financial planner should make any of the following claims:
8. The filing of tax returns, the payment of federal income tax, or compliance with an IRS summons is voluntary. Based upon an incorrect interpretation of the IRS statement that “the tax system is voluntary,” some misguided advisors recommend that, in lieu of filing a complete tax form, they send the following communication from the Family Guardian Fellowship publication “The Great IRS Hoax: Why We don’t Owe Income Tax, version 4.53″:
“I am a law-abiding American Citizen who wants to pay what the law says I owe. Prove to me that the Internal Revenue Code is enacted positive ‘law’ that applies to me and then provide the positive law state within it that makes me liable for subtitles A and C income taxes and I will gladly pay what you say I owe. I have studied this issue for years now and read extensively and searched electronically the entire Internal Revenue Code and Treasury Regulations and couldn’t find a statute that makes me liable.”
Variations of this same idea would be filing a “zero tax due” return or asking the IRS to prepare a return. All of these theories are misguided and may result in civil and criminal penalties.
9. Some sources of income are not taxable. At various times, tax protestors have argued that the exchange of “labor” for money does not produce taxable income, since the value of the labor is equal to the value of the money received; in other words, there is no taxable event (income). Others argue that only foreign income is subject to tax or that payments received in Federal Reserve Notes is not valid currency and cannot be taxed.
Numerous federal court cases have determined that such arguments are “frivolous.” According to IRS Revenue Ruling 2004-28, “The Service will take vigorous enforcement action against such taxpayers (attempting to use such arguments to avoid taxes) and against promoters and return preparers who assist taxpayers in taking these frivolous positions.”
10. Income taxes are not constitutional. The Sixteenth Amendment to the United States Constitution provided the legal basis for the federal government to tax its citizens on their income when it became ratified in 1913. Since then, protestors have claimed that the amendment was never properly ratified by the requisite 38 states necessary to be passed.
Federal court cases have repeatedly and consistently repudiated that argument to the chagrin and punishment of those seeking refuge from taxes under that theory. Actor Wesley Snipes is only one of many who have tried and failed to make the argument, resulting in a three-year sentence for failure to file tax returns. Protestors have made similar arguments on the basis of the Fifth Amendment (taking of property without due process of law; self-incrimination) and the Thirteenth Amendment (involuntary servitude) with similar court success — or lack thereof.
11. Taxes are required only from a defined group of people. Some tax protestors have claimed that the United States does not include residents of the 50 states, as they are “sovereign” territories. In other words, those residents are free born citizens of the individual states and not subject to federal income tax laws. Only federal employees or residents of Washington D.C., federal territories such as Guam and Puerto Rico, or federal lands such as American Indian reservations or military bases are required to pay federal income taxes, so the theory goes.
Some advisors even argue that the term “person” defined by the Internal Revenue Code doesn’t apply to humans, but corporations and trusts. Most tax experts consider such arguments delusional.
12. Taxes can be reduced or eliminated on religious grounds. Tax filers have repeatedly failed to eliminate taxes on the basis that the acts of the federal government (and the use of the individual’s tax payments) are used for purposes which the taxpayer considers immoral or sinful. In 1982, Supreme Court case United States v. Lee 455 U.S. 252, the justices ruled, “The tax system could not function if denominations were allowed to challenge the tax system because tax payments were spent in a manner that violates their religious beliefs because the broad public interest in maintaining a sound tax system is of such a high order, religious belief in conflict with the payment of taxes affords no basis for resisting the tax.”
If you disagree with the acts of the government, protest in the voting booth or peacefully in the streets. Failing to pay your taxes is akin to an old adage: Don’t cut off your nose to spite your face.