You don’t want to go to jail. You don’t want to pay penalties. But you also don’t want to pay more tax than you have to-it’s not the American way. And your sister-in-law, your golf buddy or your business partner is touting a “your CPA probably doesn’t know this, but” way to pay less. How can you tell a legal tax dodge from an iffy or bad one?
The pat answer-if it sounds too good to be true, it probably is-isn’t bad advice, but isn’t always enough. Some things that sound too good to be true are allowed because Congress uses the tax code as an ersatz spending program; for example, if you invest in certain rental housing for low income folks, you can claim a special credit that isn’t subject to the limitations imposed on losses from other passive activities. Other improbable-sounding ploys work because the courts have blessed some taxpayer-friendly interpretation of a complicated code. Provided you do it right, you can chop your family’s gift and estate taxes using family limited partnerships and grantor-retained annuity trusts.
For most taxpayers the best shelters are still the mundane ones: homes, retirement accounts and stocks. Interest on up to $1 million in mortgage debt is deductible, and the first $500,000 in capital gains per couple from the sale of a primary home is tax free. For 2005 a worker can divert up to $14,000 ($18,000 for those 50 or older) into a tax-deferred 401(k). The gift-tax exclusion-$11,000 a year to each of as many different relatives and friends as you want-still works.
Want to get fancier? Here are some pointers to keep you safe.
1 Never agree to keep a tax dodge confidential. This is often a marker of a questionable shelter and limits your ability to run it by a disinterested lawyer or accountant. The tax code may seem incomprehensible to a normal person, but it’s a public document; most legitimate strategies are well-known to tax pros.
2 Get that independent opinion. If you rely on a legal opinion provided by a firm affiliated with the adviser who recommends a shelter, you could get stuck paying penalties as well as back taxes and interest if it doesn’t work. Getting a pro’s blessing can save you from penalties-if the pro is independent.
3 Don’t pay outsize fees or fees that represent a percentage of taxes saved. Tax lawyers and CPAs can be expensive, but they charge by the hour. Watch out, too, for promoters who guarantee a fee refund if you don’t get the desired tax result-the IRS considers this a marker of a suspect shelter.
4 Don’t sign misleading or backdated documents. Abusive shelters often involve a series of transactions that were supposedly undertaken for nontax reasons. The taxpayer is asked to sign a letter claiming he made moves for business reasons, when those moves were really orchestrated by a promoter.
5 Be wary of charity-related shelters. There are some great tax-savvy ways to give to charity, such as contributing appreciated stock. But steer clear of any scheme that suggests charitable contributions can be used for your own benefit (say, reimbursing you for volunteer work you perform during retirement) or that involves claiming inflated deductions for noncash contributions. Promoters have moved into this area, and the IRS and Congress are now responding with crackdowns.
6 Stay onshore. Avoid schemes that promise secrecy through offshore entities. You must report foreign accounts worth $10,000 or more to the IRS; failing to do so is a criminal offense and one the IRS, thanks to new information-sharing agreements with other countries, may uncover.
7 Ignore claims that “none of my clients has been audited for this.” It’s irrelevant, even when true. The IRS has traditionally been slow to catch up with schemes, although it’s speeding up. If the IRS really approves of some new strategy, in most cases you can get a “private letter ruling” from it saying so-for a fee.
8 Give extra scrutiny to ploys that combine different legitimate tax-favored entities to produce outsized results Congress didn’t intend. Recent combo schemes the IRS has branded abusive couple S corporations with ESOPs and S corps with tax-exempt entities, such as public pension plans.
9 Don’t make deals with your own IRAs or retirement accounts. There are stiff penalties for such “prohibited transactions.” In one abusive scheme business owners sold their receivables for less than fair value to a shell company owned by their Roth IRAs-thus pumping excess money into the tax-free Roths.
10 Use the Web. Fraud-busting sites, such as quatloos.com, enable you to read up on the latest questionable schemes. At irs.gov you’ll find a rundown on “listed” shelters-high-end strategies such as Son of Boss that the government says don’t work-plus information on the latest lower-end scams, from “corporation soles” to flaky constitutional arguments on why the income tax isn’t legal. Remember, however, that scam promoters have some pretty smart-looking Web pages, too.
by Janet Novack
Source: Forbes Magazine
Leave a Reply