Abusive Tax Shelters

Other Areas of Concern


On occasion, the IRS will announce that it is undertaking a crackdown on an abusive tax scheme, without necessarily identifying the same as a listed transaction or other reportable transaction. Again, in many of these situations, a prudent approach to take is to ask whether or not the transaction (and its attendant tax consequences or objectives) is too good to be true. Listed below are just some of the announcements made by the IRS aimed at identifying additional, abusive tax schemes, or as part of a regulatory effort to address an uncertain area of the federal tax law (that is otherwise ripe for abusive tax schemes):

Abusive Tax Schemes Involving Claims of Virgin Islands
(or other US Possessions) Residency-IRS Notice 2004-45

In IRS Notice 2004-45, the IRS announced that it was undertaking a major crackdown on abusive tax schemes involving fraudulent claims of residency in the U.S. Virgin Islands and warned that promoters and participants in the schemes could be subject to criminal prosecution. BNA, Daily Tax Report, No. 122, at GG-1, ISN 1522-8800 (June 25, 2004).

According to this report, the IRS is targeting promotions of a scheme that purports to run a taxpayer's salary or business income through a limited liability entity in the U.S. Virgin Islands, as part of an effort to claim certain tax benefits (i.e., credits). Quite often, an alleged termination of U.S. employment occurs and there are a chain of payments between the U.S. employer, the taxpayer, and the Virgin Islands entity. Promoters are reported to approach taxpayers living and working in the United States and advise the taxpayer that they purport to become a Virgin Islands resident by establishing certain contacts there, then purport to terminate their existing employment relationship in the United States, and then, purport to have become a bona fide partner or member in a Virgin Islands limited liability entity. This Virgin Islands entity then purports to enter into a contract with the United States employer to provide substantially the same services the taxpayer previously provided directly to the United States employer. For more on how this type of approach to employment might conflict with the true earner theory, please see our Worker Classification practice area.

When the employer then pays the Virgin Islands entity for the taxpayer's services, these payments are claimed to be exempt from treatment as wages under applicable tax laws. The IRS further reports that the promoter may serve as the general partner or manager of the Virgin Islands limited liability entity and thereby, retain a percentage of amounts paid to the entity, as guaranteed payments for services or as distributions of an allocable share of the entity's income. The Virgin Islands limited liability entity attempts to secure a reduction of up to 90% of its income tax under the Virgin Islands Economic Development Program, with a corresponding deduction for any Virgin Islands income tax paid (which is about 10% of the United States income tax liability otherwise imposed). A further effort is made to claim that the taxpayer's gross income does not include payments received from the Virgin Islands limited liability entity.

Participants in these transactions are warned that they will face substantial penalties, including possible criminal prosecution. The IRS announced further that it will challenge the use of this type of scheme with respect to other U.S. possessions, as well.

Split-Dollar Life Insurance Arrangements

Significant changes have been made in the area of split-dollar life insurance. These arrangements are now covered by final regulations, which detail the income, employment, and gift tax consequences of these arrangements (i.e., arrangements entered into after September 17, 2003 (and those split-dollar arrangements in existence at that time which are materially modified thereafter)). For arrangements entered into prior to September 17, 2003, taxpayers will have to work closely with their tax advisors to determine how such arrangements are impacted by IRS Notice 2002-8. If any taxpayer (company or individual) is involved in any kind of split-dollar plan (including, those involving an endorsement or collateral assignment, private, or reverse split-dollar plan), this taxpayer needs to work closely with their tax advisors to ensure that they are in compliance with these regulations. Time-sensitive deadlines exist, so taxpayers must not delay in making a review of these arrangements.

Companies governed by Sarbanes-Oxley must be careful, given the possible classification of an arrangement as having characteristics of a "loan"; this is because, as a general rule, under this law, publicly traded corporations are prohibited from making personal loans to a director or executive, and may make it criminal for doing so. Corporate counsel and their legal advisors need to closely examine all of the benefits they are providing to their executives and directors, to ensure compliance with Sarbanes-Oxley.

Abusive/Improper Charitable Contributions
of Easements to Charities-IRS Notice 2004-41

In IRS Notice 2004-41, the IRS announced that it is looking to crack down on what it believes are certain improper charitable contributions of easements on real property, as well as certain transfers incidental to purchases of real property from charities. In these settings, the IRS has learned that a given charitable organization purchasing property may believe that if they place a conservation easement on the property, later to sell it to a buyer at a reduced price, a contemplated second payment may then follow, disguised as a charitable contribution. IRS Commissioner Mark Everson is quoted in the July 1, 2004 BNA Daily Tax Report as having stated that the IRS "has uncovered numerous instances where the tax benefits of preserving open spaces and historic buildings have been twisted for inappropriate individual benefit" and "taxpayers who want to game the system and the charities that assist them will be called to account." BNA Daily Tax Report, No. 126, at G-1 (ISSN 1522-8800)(July 1, 2004). The IRS warns that it may apply substance-over-form arguments to treat the total amount of the buyer's payments to the charitable organization as the de facto purchase price paid by the buyer, disregarding the purportedly separately-made charitable contribution.

Not only does the IRS warn that it may impose penalties on promoters, appraisers, and other persons involved in these transactions, but that in appropriate cases, the IRS may challenge the tax-exempt status of the charitable organization, based on the organization's apparent operation for a substantial non-exempt purpose or the generation of an impermissible private benefit.

Other Abusive Uses Made of Charitable Organizations

The IRS is making it clear that the misuse of charitable organizations is one of its top priorities. See, also, Listed Transactions, Listed Transaction #30 (IRS Notice 2004-30; SC2). Also, during the summer of 2004, Congress began conducting hearings on abusive uses made of charitable organizations. Taxpayers and advisors need to closely monitor this area for further development.

TAKING LEGAL ACTION FOR FAILING TO ADVISE ABOUT FORM 8886 PENALTIES

Quite often, taxpayers feel that they have been unfairly penalized because of the failure on the part of advisors to have alerted them to the filing of IRS Forms 8886.  The issues there often will further include when the IRS has audited, and assessed this penalty, as compared to the overall tax shelter aspects of the plan being addressed.  A careful review of the entire facts and circumstances is necessary as statute of limitations issues may also need to be considered.  See, e.g., Choi v. Sagemark Consulting, 18 Cal. App. 5th 308 (6th DCA, 11/16/2017).

At the Tufts Law Firm, we are continuing in our efforts to monitor all of the above mentioned areas, as well as many others, in keeping with our efforts to assist our client taxpayers in their efforts to comply with Federal disclosure law requirements.

If you have any questions with regard to any of the above transactions or any other transactions of concern, please contact us.