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.