Executive Loans: In the wake of criminal allegations against Tyco and WorldCom executives, whose companies forgave millions in loans, executives should be prepared to prove that corporate loans are actually loans, whether they bestow them or accept them. “I am seeing an absolute flood of audits of the executive compensation plans of major companies,” Gerachis says. The IRS wants to verify that a loan to leadership is not a cleverly disguised bonus, which would be taxed at a higher rate. To reassure the IRS, make sure the company acts like a bank, documenting everything and charging interest, and be sure to pay off both interest and principal regularly. If the company forgives the loan, “the IRS will sometimes try to argue that it wasn’t a real loan in the first place, and it will try to include the entire loan proceeds in income in the year of the loan,” Gerachis adds. This could result in penalties for both the company and the executive.

Earnings From Abroad: In this age of globalization, many investors have diversified their holdings worldwide. However, money earned overseas by American citizens remains subject to U.S. taxes, although they should receive a U.S. tax credit if they are taxed on it abroad, says Dirk Edwards, a CPA and financial planner with Edwards Consulting in Portland, Ore. The IRS will also look for foreign currency exchange implications, such as the accurate conversion of money after selling the summer home in Mallorca. Investors should also be careful when sinking cash into complicated deals located in known tax havens, such as the Cayman Islands. “There are some very sophisticated and complex insurance products using offshore hedge funds,” Gerachis says. “Basically, these things all try to earn profits on trading and securities, but they don’t pay current U.S. tax on the gain.” Disclosing everything remains a good rule of thumb when investing abroad.

Multiple Partnerships: The presence of numerous limited partnerships sends up a red flag to the IRS signaling potential improprieties. Investors often enter into these complicated deals by pouring large sums into money-hungry companies, frequently operating in real estate or oil exploration, while leaving the day-to-day management to others. Any income lost through such an entity may not be used to offset most gains. “If you don’t spend enough time actually working in the business to generate a loss, the service won’t let you deduct the loss,” says Barbara Raasch, a partner with Ernst & Young in New York.

Foundation Filching: Family foundations are also coming under fire, as the IRS tries to filter out taxpayers using foundation assets for personal gain. To avoid unwanted scrutiny, family members should set up a business plan and lay down guidelines. Staff salaries should be calculated carefully, especially if the employees are relatives. It appears suspicious if a foundation with $10 million in assets pays someone a $1 million salary. Place only a small percentage of the assets in high-risk investments, such as real estate, lest the IRS slap on an excise tax because the trustee placed the foundation in a precarious position. Keep in mind that controlling members cannot legally borrow money from the foundation.

Family Partnerships: If a family-limited partnership does not truly function as a business, it certainly will not seem like one to the IRS. If, for example, an elderly father places his home in such a partnership in order to transfer it to his heirs and avoid part of the estate tax, he cannot retain any interest in the property, meaning he cannot live there. Families should also calculate how much money they need for monthly bills, and exclude that sum from the partnership.

But audits can, and increasingly do, happen. In that case, hiring truly autonomous counsel is a taxpayer’s best defense. If individuals can clearly prove to the IRS that they were mislead by advisors they believed independent, they may be spared the fine doled out for investing in an abusive shelter (although they will have to pay back taxes with interest). However, do not rely too heavily on this defense: The IRS assumes that clients in the position to buy into a tax shelter are financially savvy. “You can’t go and bury your head in the sand,” Doyle says. “If you took a chance and lost, the IRS won’t let you off the hook. If you have a reasonable cause for doing what you did, the IRS will abate the penalties. But most sophisticated investors should have known.”
 
Illustrations by Ken Orvidas.

Amy Braunschweiger, a freelance journalist, has been published in the Wall Street Journal and the Village Voice. braunscal@earthlink.net

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Auditory Nerve