Income Tax Scams You Should Avoid

FORECASTS & TRENDS E-LETTER
By Gary D. Halbert
March 21, 2006

IN THIS ISSUE:

1. Comprehending The Incomprehensible

2. The Anatomy Of A Tax Scam

3. The IRS Takes Action

4. The “Dirty Dozen” Tax Scams

Introduction

I’ll be the first to admit that paying income taxes is not my favorite thing to do. While I feel that paying taxes is an appropriate exercise for a citizen of the greatest nation on earth, it is still a hassle (and an expensive one at that) to assemble an assortment of tax advisors to sort through my business and personal income and expenses and arrive at the appropriate tax. Of course, Congress and the IRS don’t help much as they continue to add to the complexity of the tax code.

Each year, the IRS must deal with a whole host of arguments from stubborn citizens who think they should not have to pay income tax. The reasoning behind some of these schemes ranges from the sublime to the ridiculous, but all have one common goal – to escape paying US income tax.

Perhaps these individuals are, in their own way, rebelling against the mind-numbing complexity of the tax code. Or, perhaps they are just greedy and don’t want to share any of their income. Still others might claim moral opposition to certain government-sponsored programs and don’t want to participate in their funding. There are even those who are duped into not paying taxes by entities that make their money from sharing their “secret.”

As we near the April 17th tax-filing deadline, I’m going to share my thoughts on why the tax code is so complex, and why it will probably stay that way. I’ll also discuss a list of the most common income tax dodges as presented in recent guidance from the IRS, and why you should avoid them.

Comprehending The Incomprehensible

Virtually everyone will agree that the US tax code is hopelessly complex. There are volumes of legislation, regulations, revenue rulings, letter rulings, notices, etc., etc. that make up the “law of the land” in regard to income taxation. It might not be so bad if this huge volume of rules remained constant, but they don’t. They are constantly changing which, in turn, creates job security for a whole host of CPAs, tax attorneys and other tax professionals.

If you’ve ever tried to research something in the tax code, you know what a special exercise in frustration that can be. It rarely spells out the rules clearly. Instead, it contains references to other sections that then reference still other sections, and so on. You find yourself jumping from one section to another until you sometimes forget what you were researching in the first place.

If a securities firm wrote an investment offering document in this way, it would likely be deemed at least misleading, and at most incomprehensible. Yet you and I are held responsible each year for complying with this complex set of rules.

Looking at the big picture, I guess you could call the tax code the epitome of special interest politics. It contains favors for certain types of entities, allowances for those with lower incomes, incentives for preferred behavior (such as saving for retirement), and penalties for non-compliance. Accounting for all of these special interests, plus providing for sufficient tax revenues for the government, has led to the complexity currently found in the tax code.

Sure, there are calls every year for simplifying the tax code, but in light of having so many special interest fingers in that pie, I don’t think it will ever happen. The reason I think simplification will always fail goes back to the original proposals that became the major tax restructuring of 1986.

In the beginning, President Reagan had proposed a very simple tax structure – 15% and 28% tax rates based on compensation, and virtually no deductions. I recall publications from tax attorneys and accountants at the time lamenting that it could mean the end of their professions. However, the final bill that passed Congress was far from his original idea of simplification.

Upon hearing that deductions would be curtailed, special interest groups ranging from big business to charitable organizations started lobbying Congress, telling them that their special tax provisions were absolutely necessary for their survival. When the dust cleared, the accountants and attorneys were not out of a job, but in fact were actually needed more than ever.

Perhaps Congress could simplify the tax code if special interest influence (read: money) was taken out of the mix. However, I don’t look for this to happen anytime soon. So, I wouldn’t put much stock in calls to simplify the tax code. It sounds good to the folks back home, but it just won’t sell inside the Beltway.

The Anatomy Of A Tax Scam

I guess there have been tax cheats as long as there have been taxes. Sadly, not all of those who seek to minimize taxes have the intent to defraud the government. Some are duped by slick promoters who pick up on the fact that most people don’t exactly enjoy paying taxes, and are always on the lookout for ways to reduce their tax liability.

However, not all methods of minimizing taxes are scams. One legitimate way to reduce taxes that you frequently hear about is to donate a car or boat you no longer use to charity and take the appropriate tax deduction. There are also a number of tax professionals who offer seminars on how to reduce your tax bill through legitimate deductions and credits.

Unfortunately, not all who promise to lower or eliminate taxes are as genuine. There are some organizations that actually promote bogus ways to reduce or eliminate taxes, usually through some secret process or procedure that they will be more than happy to share with you after you pay them a big fee. On the other hand, there are some organizations that are morally opposed to federal taxation and gladly share their tax schemes free of charge to anyone who will listen. I’m sure you’ve seen evidence of both in your e-mail as the Internet has been a boon to these hucksters.

The result is that many ordinary citizens get caught up in these schemes merely because of a desire to minimize their taxes, not because they deliberately want to defraud the federal government. In doing so, however, they can face some serious consequences such as repayment of all taxes plus penalties and interest. In more severe cases, they might even face jail time.

The IRS Takes Action

The number and complexity of tax avoidance schemes has expanded in recent years, no doubt fueled by the Internet. As a result, the IRS has engaged in a comprehensive strategy to combat tax scams and increase collections. According to a 2003 IRS announcement, it has built an “enforcement web” to identify and eliminate abusive tax shelters. This web seeks to identify questionable transactions early on and take appropriate action.

The reason for this attention is quite clear – government sources estimate that tax evasion costs the Treasury as much as $200 billion per year in lost tax revenues.

The question naturally arises about which promotions are legitimate and which are not. After all, we have already established that the tax code is far too complex for most people to understand, so it may be difficult to determine which are legitimate and which are not. The remainder of this E-Letter will address identifying the good ones from the bad.

One of the first rules I use to evaluate these promotions is the extent to which they promise to reduce income taxes. If you are offered a method whereby you can completely eliminate all of your tax liability, it’s probably bogus.

You should also look at the credentials of the individuals or organization promoting the service. If the person is a CPA, attorney or other tax professional with a practice in your local area, chances are better that they are legit. A qualified professional could lose their ability to practice if they are found to promote fraudulent schemes, so anyone valuing their professional status would likely think twice before hawking a bogus tax dodge.

Unfortunately, however, membership in the accounting or legal profession does not guarantee the legitimacy of their claims. Some of the organizations promoting tax avoidance have accountants and lawyers on staff who really believe that their program is legally sound. I have noticed this most often in affinity groups having an organized resistance to paying income taxes.

In addition, I’m sure there are some promoters of these tax schemes that claim to be CPAs and attorneys, but are not. After all, how many of us ask to see a professional’s certification documents? Usually the designation on a business card is good enough for us. While impersonating an accounting or legal professional can carry negative consequences, they are probably no worse than promoting a tax fraud.

The IRS “Dirty Dozen” Tax Scams

Another way to avoid bogus tax schemes is to become familiar with as many of them as possible, so you will know them if you see them again in a letter or e-mail, or hear them in a seminar or personal conversation. In addition to the initiatives being taken by the IRS that I discussed above, it has produced a flurry of notices and revenue rulings addressing abusive tax shelters in an effort to inform the public about these schemes and their promoters. On February 7, 2006, the IRS published its “Dirty Dozen” list containing the 12 most commonly encountered tax scams. Most of the text of the “Dirty Dozen” below comes directly from the IRS Announcement, but I have added a few comments where I thought it might help to clarify the item being discussed:

1. Trying To Report Zero Wages. Some promoters insist that only certain persons are subject to federal income taxation, such as federal employees and persons residing in Washington, D.C. In this scheme, a taxpayer attaches to his or her return either a Form 4852 (Substitute Form W-2) or a “corrected” Form 1099 that shows zero or little wages or other income. The taxpayer may include a statement indicating the taxpayer is rebutting information submitted to the IRS by the issuer of the Form 1099 or W-2.

An explanation on the Form 4852 may cite “statutory language behind IRC 3401 and 3121” or may include some reference to the paying company refusing to issue a corrected Form W-2 for fear of IRS retaliation. The Form 4852 or 1099 is usually attached to a “Zero Return.” (See number four below.)

2. Tax Abatement Through The Use of IRS Form 843. This scam, also new to the Dirty Dozen, rests on faulty interpretation of the Internal Revenue Code. It involves the filer requesting abatement of previously assessed tax using Form 843, which is usually used to request a refund or abatement of taxes for legitimate reasons.

In fact, many using this scam have not previously filed tax returns, but are trying to have taxes abated that have been assessed by the IRS through the Substitute for Return Program. Under this program, the IRS is allowed to file a substitute return for people who do not file voluntarily. The filer uses the Form 843 to list reasons for the request. Often, one of the reasons is: “Failed to properly compute and/or calculate IRC Sec 83––Property Transferred in Connection with Performance of Service.”

3. Phishing. This scam is not really a way to avoid paying tax, but is important nonetheless. Phishing is a technique used by identity thieves to acquire personal financial data in order to gain access to the financial accounts of unsuspecting consumers, and run up charges on their credit cards or apply for new loans in their names. These Internet-based criminals pose as representatives of a financial institution and send out fictitious e-mail correspondence in an attempt to trick consumers into disclosing private information.

Sometimes scammers pose as the IRS itself. In recent months, some taxpayers have received e-mails that appear to come from the IRS. A typical e-mail notifies a taxpayer of an outstanding refund and urges the taxpayer to click on a hyperlink and visit an official-looking website. The website then solicits a social security and credit card number. In a variation of this scheme, criminals have used e-mail to announce to unsuspecting taxpayers they are “under audit” and could make things right by divulging selected private financial information.

Taxpayers should take note: The IRS does not use e-mail to initiate contact with taxpayers about issues related to their accounts. If a taxpayer has any doubt whether a contact from the IRS is authentic, the taxpayer should call 1-800-829-1040 to confirm it.

4. Filing A Zero Return. Promoters instruct taxpayers to enter all zeros on their federal income tax filings. In a twist on this scheme, filers enter zero income, report their withholding and then write “nunc pro tunc”–– Latin for “now for then”––on the return. They often also do this with amended returns in the hope the IRS will disregard the original return in which they reported wages and other income. All taxpayers who meet minimum income thresholds must file returns and pay income tax.

5. Misuse Of Trusts. For years, unscrupulous promoters have urged taxpayers to transfer assets into bogus trusts for income tax purposes. They promise reduction of income subject to tax, deductions for personal expenses and reduced estate or gift taxes. While legitimate trusts can have valuable tax benefits, these trusts do not deliver the promised tax benefits, and the IRS is actively examining these arrangements. There are currently more than 200 active investigations underway and three dozen injunctions have been obtained against promoters since 2001.

The problem with this scam is that even legitimate trusts are very complicated and require an attorney to establish. It is sometimes hard for taxpayers to know legitimate trusts from those promoted by tax scammers. As with any other legal arrangements, you should seek the advice of a trusted professional before entering into a trust.

6. Frivolous Arguments To Avoid Paying Income Taxes. Promoters have been known to make some pretty outlandish claims as to why they should not have to pay taxes. The following are just a few of the many such attempts to escape tax liability:

- The Sixteenth Amendment concerning congressional power to lay and collect income taxes was never ratified, contradicts the original Constitution or lacks an enabling clause;

- A taxpayer can avoid income tax by referring to a separate “straw man” entity;

- Wages are not taxable income, pursuant to section 1001, because taxpayers have basis in their labor equal to the fair market value of the wages they receive;

- A taxpayer can make a “claim of right” to exclude the cost of his or her labor from income;

- Only income from a foreign source is taxable under section 861;

- Claiming not to be a “citizen” or a “person” within the meaning of the Internal Revenue Code;

- A taxpayer can escape income tax by putting assets in an offshore bank account, or by establishing a “corporate sole.”

- Nothing in the Internal Revenue Code imposes a requirement to file a return;

- Certain taxpayers (such as African Americans whose ancestors were slaves) can claim a “reparations tax credit” to right wrongs done in the past;

- Any Native American taxpayer can avoid paying federal income taxes by claiming tax-exempt status based on an unspecified “Native American Treaty.”

- Social Security taxes paid can be deducted from income or refunded;

- Filing a return and paying taxes are merely voluntary; and

- Being required to file Form 1040 violates the Fifth Amendment right against self-incrimination and/or the Fourth Amendment right to privacy.

This is just a partial list of the many dubious claims used by taxpayers to avoid paying income taxes. Don’t believe these or other similar claims. These arguments are false and have been thrown out of court. While taxpayers have the right to contest their tax liabilities in court, no one has the right to disobey the law.

As noted above, this is just a partial list of the many frivolous arguments encountered by the IRS. You can find a complete list of these arguments in Notice 2006-31, at the following web address: http://www.irs.gov/pub/irs-drop/n-06-31.pdf

7. Return Preparer Fraud. Dishonest return preparers can cause many headaches for taxpayers who fall victim to their schemes. Such preparers derive financial gain by skimming a portion of their clients’ refunds and charging inflated fees for return preparation services. They attract new clients by promising large refunds. Taxpayers should choose carefully when hiring a tax preparer. As the old saying goes, “If it sounds too good to be true, it probably is.”

And remember, no matter who prepares the return, the taxpayer is ultimately responsible for its accuracy. Since 2002, the courts have issued injunctions ordering dozens of individuals to cease preparing returns, and the Department of Justice has filed complaints against dozens of others. During fiscal year 2005, more than 110 tax return preparers were convicted of tax crimes.

8. Credit Counseling Agencies. Taxpayers should be careful with credit counseling organizations that claim they can fix credit ratings, push debt payment plans or impose high set-up fees or monthly service charges that may add to existing debt. The IRS Tax Exempt and Government Entities Division is in the process of revoking the tax-exempt status of numerous credit counseling organizations that operated under the guise of educating financially distressed consumers with debt problems while charging debtors large fees and providing little or no counseling.

9. Abuse of Charitable Organizations and Deductions. The IRS has observed increased use of tax-exempt organizations to improperly shield income or assets from taxation. This can occur, for example, when a taxpayer moves assets or income to a tax-exempt supporting organization or donor-advised fund but maintains control over the assets or income, thereby obtaining a tax deduction without transferring a commensurate benefit to charity.

10. Offshore Transactions. Despite a crackdown by the IRS and state tax agencies, a perennial favorite of individuals trying to avoid U.S. taxes continues to be illegally hiding income in offshore arrangements. These typically include offshore bank and brokerage accounts or using offshore credit cards, wire transfers, foreign trusts, employee leasing schemes, private annuities or life insurance. The IRS and the tax agencies of U.S. states and possessions continue to aggressively pursue taxpayers and promoters involved in such abusive transactions.

11. Employment Tax Evasion. The IRS has seen a number of illegal schemes that instruct employers not to withhold federal income tax or other employment taxes from wages paid to their employees. Such advice is based on an incorrect interpretation of Section 861 and other parts of the tax law and has been refuted in court. In some cases, aggressive promoters will actually file liens and other legal actions against employers who may be reluctant to comply with these instructions from their employees.

During fiscal 2005, more than 50 individuals were sentenced to an average of 30 months in prison for employment tax evasion. Employers who participate in these schemes can also be held responsible for back payments of employment taxes, plus penalties and interest. It is worth noting that employees who have nothing withheld from their wages are still responsible for payment of their personal taxes.

12. “No Gain” Deduction. Promoters of this scam attempt to eliminate their entire adjusted gross income (AGI) by listing it on the Form 1040, and then deducting the entire amount on Schedule A. The filer lists his or her AGI under the Schedule A section labeled “Other Miscellaneous Deductions” and attaches a statement to the return that refers to court documents and includes the words “No Gain Realized.”

In addition to this “Dirty Dozen” list, the IRS is in the process of updating a 65-page document entitled “The Truth About Frivolous Tax Arguments” to reflect the latest court decisions rejecting numerous false arguments about the legality of not paying taxes or filing returns. You should be able to find this and other important information about tax scams on the IRS website at www.irs.gov .

Sources of the above information include: IRS Announcement IR-2006-25; IRS Notice 2006-31, 2006-15 IRB; Rev Rul 2006-17, 2006-15 IRB; Rev Rul 2006-18, 2006-15 IRB; Rev Rul 2006-19, 2006-15 IRB; Rev Rul 2006-20, 2006-15 IRB; Rev Rul 2006-21, 2006-15 IRB; IR 2006-45

Conclusions

I have dedicated this issue of the Forecasts & Trends E-Letter to the discussion of tax scams in order to make you aware of the many ways promoters may try to entice you with promises of tax savings. While each scam could probably take up an entire E-Letter to fully explain, the above brief explanations provide basic information and key words you can look for if you happen to be approached by someone offering you a “secret” way to escape income taxes.

I would suspect that many of you already seek the assistance of a qualified tax professional when it comes to doing your taxes. The complexity of the tax code, coupled with the severity of penalties and interest if an error is made, usually work together to make the cost of paying a tax professional to do your return well worth it.

More recently, however, tax software programs and even online tax filing services offer a more cost-efficient way to file your income tax return without having to go to a professional. These programs have prompts for items sent to you from payers, as well as links to instructions and help screens. While I think these products are probably a good deal for someone with a relatively straightforward tax return, I would still suggest consulting a professional if you have a more complex return.

Tax software and online services do ask a lot of questions and provide a lot of helpful information, but they also have ways to skip over explanations that might be very important for you to see. A tax professional will usually sit down with you and ask you these questions in a private discussion, possibly jogging your memory in regard to a potential additional deduction. If you have your own business, invest in income producing real estate or have a wide variety of investment programs that produce K-1 or extensive gain/loss reports, I would suggest seeking out a qualified professional. The headache you save could be your own.

Very best regards,

Gary D. Halbert

SPECIAL ARTICLES:

2006 Tax Software Review
http://tax-software-review.toptenreviews.com/

Is This Any Way To Spend Our Tax Dollars?
http://www.washingtonpost.com/wp-dyn/content/article/2006/03/19/AR2006031901078.html?nav%3Dmost_emailed&sub=AR

The Best Defense
http://www.investors.com/editorial/IBDArticles.asp?artsec=20&artnum=1&issue=20060320

The GOP's Shrinking Middle
http://www.realclearpolitics.com/articles/2006/03/the_gops_shrinking_middle.html

Be Sure Before You Censure
http://www.nytimes.com/2006/03/21/opinion/21brands.html?_r=1&oref=slogin