Abusive tax transactions are prolific today. Generally, these arrangements are pushed by third parties—referred to as “promoters”—who promise significant tax savings if the taxpayer enters into a specified transaction or tax structure. In most abusive tax schemes, the proposed structure guarantees “too good to be true” tax savings, such as the elimination of taxable income or the deferral of capital gains.
Taxpayers who choose to participate in abusive tax transactions should understand that they do so at their own risk. The IRS uses many different methods to uncover and fight these types of transactions. Moreover, after a particular promoter has been identified, the agency often seeks the promoter’s client list, which provides the names of those who used the promoter’s services. Armed with this incredibly useful information, the IRS can begin the process of initiating examinations against taxpayers it knows will likely owe additional taxes, penalties, and interest.
Although taxpayers may reasonably believe that they can shift the economic fallout of an adverse IRS examination to the promoter through a malpractice or legal claim, this is often not the case. By the conclusion of the examination, the promoter is usually under criminal or civil investigation or the subject to mounting civil lawsuits from similar taxpayers who also engaged in the tax structure. The result: the promoter does not have the financial means to make the taxpayer whole through a claim for legal damages, even if the taxpayer were to ultimately succeed in a lawsuit.
Given these risks, taxpayers should remain vigilant when selecting advisors to assist them with their tax situations. Abusive tax transactions vary, but there are some hallmarks that taxpayers should watch for prior to engaging the services of a third party for tax help. Some of these are discussed more fully below.
High Upfront Fees
High upfront fees can be a sure sign of an abusive tax scheme. In many instances, the promoter’s compensation may also be tied to the amount of tax savings. These latter types of arrangements are the same as or akin to contingency-fee arrangements.
Unlike unlicensed promoters, licensed tax professionals—e.g., CPAs, EAs, and tax attorneys—are regulated on the amount of fees that they may charge their clients for tax services. For example, an IRS regulation that governs these tax professionals—known as Circular 230—limits professionals from charging unconscionable fees. In addition, Circular 230 proscribes tax professionals from charging contingency fees in most instances. This proscription better ensures that the tax professional remains independent when giving tax advice to the client.
Third parties who do not fall under Circular 230 have no similar restrictions. Therefore, high upfront fees and contingency-fee arrangements can be a red flag.
Complex Transactions
Naturally, taxpayers want to better understand how a proposed transaction works and, at a minimum, how it saves them money. But most taxpayers lack a fundamental understanding of federal income tax laws, making it easy for promoters to deceive them into thinking the structure works but is too complex to understand without a tax background.
For example, several decades ago, promoters began to push a tax scheme known as Son-of-Boss. In a typical Son-of-Boss transaction, a taxpayer would use offsetting stock or currency options that were transferred to partnerships. Through some additional transactional and legal jujitsu, the taxpayers would later claim significant capital losses that were used to offset their capital gains. Both the transaction and the legal basis behind the tax savings were difficult to follow. Much easier to understand were the economics of the transaction. In the end, taxpayers were in almost the same financial position as they were prior to the transaction—i.e., the losses were only on paper.
Taxpayers should be mindful of transactions that are difficult to understand. And they should be extra mindful of claims that they can enjoy significant tax savings even though the proposed tax structure does not change their economic position considerably. The IRS has potent tools to fight these types of arrangements, including the economic-substance doctrine now codified in section 7701(o) of the Code. And the IRS uses them where necessary.
Lack Of An Independent Tax Professional
Taxpayers often rely upon their own or other independent tax professionals for advice on complex tax transactions. In many ways, these professionals serve to provide second opinions on proposed tax structures. Promoters are well aware of this inclination for trusted and independent review. As a means to try to get around it, many promoters have their own hand-selected group of tax professionals that they recommend. More times than not, these tax professionals are also in on the abusive tax scheme and have financial incentives to ensure that it continues. They are not truly independent.
Taxpayers who are uncomfortable with a proposed tax structure should consult with a trusted tax professional of their own choosing. Truly independent tax professionals have no interest in the proposed structure and can therefore provide unbiased opinions regarding the structure’s benefits and risks. If the structure does not work, it is likely that an independent tax professional will advise accordingly.
The Tax Structure Is Too Good To Be True
An age-old idiom provides that “if something seems too good to be true, it probably is not true.” This applies in tax as well. Indeed, the federal tax laws permit the IRS to impose accuracy-related penalties in these circumstances—that is, if a reasonable person would believe that an item on a tax return seems “too good to be true” and lacks a good-faith basis in law.
Whether a transaction is too good to be true often remains the ultimate benchmark of an abusive tax transaction. If a particular structure completely eliminates federal income tax or something similar, taxpayers should be wary of why Congress would permit such a structure in the first instance. There is a very high likelihood that it has not and that federal courts will also agree.
In sum, taxpayers should be cautious in entrusting their tax matters to third parties. They remain responsible for the items claimed on a return, regardless of whether they relied on a third party. Taxpayers can guard against unwelcome surprises later by being proactive prior to entering into a proposed tax structure.