The number of face-to-face audits for high-income individuals (as opposed to computer-generated correspondence audits that are by nature fairly superficial) rose just slightly for the 2003 tax year, to four audits per 1,000 returns up from 3.8 audits per 1,000 in 2002, according to figures from the Transactional Records Access Clearinghouse at Syracuse University. Corporate audit rates fell over the same period. Currently the chance of an affluent individual being audited is about 1 in 68, according to the IRS, but the agency also reports having collected a record $43 billion in unpaid taxes through audits of wealthy taxpayers over the past year. While the Bush administration remains adamant about the idea of stimulating economic growth by cutting taxes, the government also appears to be serious about collecting money due from taxpayers who have been overly assertive when it comes to claiming deductions.

“I cannot imagine the IRS being more aggressive or hostile to tax avoidance than under the Bush administration,” says George Gerachis, a partner at the Houston law firm of Vinson & Elkins, which specializes in international tax planning. “A lot of people think that the Bush administration is soft on taxes because it wants a lower rate, but it’s been incredibly aggressive in pursuing audits and not settling in abusive cases.” In order to put fraudulent investors and advisors on notice, the Senate last fall passed legislation that enacts stiffer consequences for not disclosing tax-avoiding transactions, increases the number of penalties imposed, and tacks on additional interest charges, making it more expensive than ever to “save money” by dodging taxes.

TOP VIEW With the IRS calling for a crackdown on high-income scofflaws, and individual audits on the rise, taxpayers have been put on notice. Even traditional tax shelters, such as executive loans and offshore investments, can now raise red flags. But some wonder if the IRS has the resources to enforce its take-no-prisoners rhetoric.

Still, in spite of all the clamor, some question whether the IRS will have the funding necessary to pursue the chase. “The politicians will say they’re getting the money they need, but from what I’ve seen, they don’t really have the resources,” says Jere Doyle, senior director of Mellon’s Private Wealth Management group. “To do a good job, they need more money.” Although the IRS received a budget increase this year, much of the funding is going toward higher overhead costs, such as pay raises, which are not related to increasing the number of audits or collecting back taxes.

What seems likely is that the IRS will concentrate on certain practices that give it well-grounded cases. The Government Accountability Office figures that it missed out on tax revenues of $13.4 billion per year over the last 10 years because of known abusive shelters. The IRS Restructuring and Reform Act of 1998 effectively shifted the burden of proof in court proceedings to the IRS and away from the taxpayer, forcing the U.S. Treasury to back off, to a certain extent; consequently taxpayers became more aggressive. During this period, the popularity of a number of shelters that were initially created for Internet barons exploded. Fostering this growth, lawyers and accountants endorsed many shelters. Doyle argues that they accepted commissions like salespeople, rather than acting as independent councils.

For every listed (IRS lingo for illegal) tax shelter, there are any possible number of transactions that land in a murky area, seeming to bend, rather than break, the law. Some of these are referred to as “reportable transactions,” or deals that share characteristics with listed transactions, but which the government has not identified as such. Taxpayers are required to disclose such transactions on annual returns, and let the IRS determine their legality. “You have to file with the Office of Tax Shelter Analysis,” says Mel Warshaw, a wealth advisor with JP Morgan Private Bank in New England. “When you have to file, that’s a red flag for the IRS.” Sometimes, of course, a reportable transaction is only as solid as the tax attorney hired to defend against an IRS volley.

To date, the IRS has identified 30 illegal tax shelters; one of the most notorious is Son of Boss, which creates a counterfeit loss to offset gains. In one variation of this complex transaction, a taxpayer contributes stock options to a partnership, and although the individual actually has zero equity in the partnership, some argue that his stake equals the worth of the options. The investor then “sells” his partnership interest for zero dollars, writing off the cost of the options as a loss.

But the average taxpayer is usually more concerned with the nebulous areas of tax shelter tactics. Here are five particular situations in which the IRS might take notice:

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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