|ARE YOU A CHUMP?|
ARE YOU A CHUMP?Forbes Magazine, March 5, 2001
by: Janet Novack
Illustrations by Viktor Koen
Billionaire Peter R. Kellogg, the Former head of Wall Street's top marketmaker, Spear, Leeds & Kellogg, has a tax goodie that you don't have. Since the mid-1990's Kellogg has used an obscure provision in the tax code to shield hundreds of millions of collars of investment earnings from taxes. Unlike ordinary mortals, he can move in and out of stocks and bonds without an annual tax bill cutting returns.
Kellogg's secret? Section 602(c)(15) of the code allows an insurance company taking in less than $350,000 a year in premiums to be tax exempt. The section, which was originally enacted to help farm cooperatives, neglects to limit how much capital investment income such a firm can have. So Kellogg controls a Bermuda-based "insurance company"; in 1999 his company wrote $3,300 in premiums, earned $179 million on investments and ended the year with $330 million in net assets. If Kellogg ever dissolves the shell and takes out the cash, taxes will be due only at the long-term gains rate of 20%. Unless, of course, he manages to find a way around the tax as well.
Kellogg, who sold Spear, Leeds to Goldman Sachs for $3.5 billion last year, wouldn't talk to FORBES, so we don't know how he found this amazing shelter. But if you want your own 502(c)(15), check out www.strategicadvisors.com. It promises: "for the first time, individuals can get advantages reserved for years by big insurance companies and the superrich.
In December 1998 FORBES shone a bright light on the murky world of corporate tax shelters, which were being hustled to large companies by supposedly respectable firms. Now the Internal Revenue Service has an even bigger problem: the marketing of push-the-edge and over-the-edge-shelters to the masses.
It isn't the promotion of outrageous shelters that is tearing this country's tax system apart. It is also the proliferation of conventional cheating--padded deductions, omitted income, inflated costs for assets sold at a gain. All told--shady shelters and good old-fashioned fudging--the tax cheating appears to be costing the Treasury $200 billion a year, a devastating sum in relation to the $1.1 trillion of income tax collections. Underpayment of taxes begets more of the same--Americans are becoming ever more shameless about how they dodge the IRS, and ever more confident that the IRS can't keep up with them.
Are you still paying every penny due? You may wake up someday and decide that you are a sap. You are surrounded by tax evaders. Your neighbor has her nanny off the books to avoid payroll taxes. Your friend the small-business owner has company employees doing work at his house. Your brother-in-law writes off a family dinner as a business expense. The radio ad for car donations promises a deduction receipt for whatever you think you car is worth. Hint: Think high.
When there are fewer tax shelters being passed around, the government could stop a lot of them and put the worst offenders in jail. Now it's a rout. Last June the IRS' large-company division set up a hotline for whistle-blowers to leave tips on shelters. Surprisingly, a majority of the tips have been about schemes being peddled to individuals and small businesses. Lots of these new shelters make extensive use of entities, such as trusts and partnerships, that make them hard to find. And many, like their corporate counterparts, manipulate inconsistencies or ambiguities in the code.
The array of these new shelters is impressive. There are partnerships that play off technical terms like "contingent liability" to produce fictitious losses. There are Irish employee-leasing companies that supposedly enable high earners to create huge tax-deferred savings plans to Caribbean havens. And there are lots of trust scams in which taxpayers, many of them upper middle class, shift income and assets among foreign, domestic and charitable trusts in the belief they can avoid tax, or at least detection by the IRS.
It's also no coincidence that these ploys are proliferating at a time when the IRS is on the ropes.
Enforcement? It took a dive after Congress'
hearings into IRS abuses. Yes, IRS agents got out of control at
times--and this magazine did more than its share of exposing their
mischief. But the legislators went way overboard in their
reaction. In 1998 Congress ordered 72 new taxpayer rights
protections--great news for taxpayers afraid of mistreatment, but also to
those interested in flouting the law. The IRS' depleted and
demoralized staff became consumed with following the new rules.
Enforcers were temporarily reassigned to customer service. Property
seizures from delinquents came to a virtual halt
Audits? The chance that an individual taxpayer had to look an auditor in the eye (as opposed to answering a letter) dropped to 1 in 500 last year from 1 in 143 in 1995. Jail? Last year auditors referred for criminal investigation just 409 taxpayers whose income was from legal sources, about a fourth of the number they referred in 1997. Despite big growth in high-income individual, partnerships and corporate returns, the IRS had 21% fewer auditors at the end of fiscal 2000 than at the end of 1995.
During the 1980s and the early 1990s, the IRS made up for the falling audit rate by using computers to match billions of 1099s and W-2s with taxpayers returns, and also by treating those taxpayers it did audit harshly. Now, a chastened IRS inspires less fear and the latest shelters use layers of trusts and partnerships that computer matching doesn't yet reach.
"People think, 'The politicians are not going to let the IRS beat up on me now,'" says former IRS commissioner Lawrence B. Gibbs, now with Milner & Chevalier in Washington. "But how can the IRS assure folks who are paying their fair share that they're not chumps?"
The nation has long prided itself on having high "voluntary" tax compliance, compared with, say, Italy. But it's always been backed up with muscle. "Voluntary is an interesting term. It means. "I'll do it because there's a downside if I don't,'" says Joseph Kehoe, a commissioner of the IRS' Small Business/Self-Employed Division.
Now, many taxpayers think there's not much downside. When one Florida lawyer recently told a client that the foreign currency phony-loss scheme he wanted to use wouldn't hold up in court, the man was unfazed. "I'll play the audit lottery," the client said.
You can rationalize tax fudging just by taking a look at the 15,100-page tax code (statute and regulations combined). It is choked with exemptions, preferences, credits, subsidies, special interest favors, phase-ins, phase-outs and grandfather clauses. It is a big joke. There is not much shame, it seems, in dodging it.
In 1997 the IRS estimated that Americans paid 83% of the individual income tax they owed voluntarily, with enforcement bringing in another 3%. By that measure, with enforcement on the wane, the IRS will miss $200 billion this year. But the real tax gap is probably bigger. The 83% estimate is based on special exhaustive audits of 1988 returns. And the world and the IRS have changed a lot.
Using the Internet, the average Joe can now--from the den of his home--set up a company in Nevada (whose state Web site even boasts that it doesn't share information with the IRS) and a bank account in the Caribbean that is conveniently linked to a charge card to tap into his expatriated funds. Offshore accounts are supposed to be reported to the IRS, of course. But many aren't. In October the IRS submitted an affidavit in federal court estimating that legal offshore schemes cost $70 billion in lost tax revenues a year.
Then there are stock options. In the course of a conversation with Red Bank, N.J. CPA Douglas Stives, one tech executive confided he was the only one in his office planning to report his incentive options honestly for 2000. He said his co-workers know employers don't list these options on the W-2 reports they send the IRS and don't want to pay the alternative minimum tax that can hit option holders. "People don't think the tax is fair and don't think they'll be audited," say Stives.
An even greater problem for the IRS is the spread of self-employment. The number of self-employed taxpayers rose 26% between 1988 and 1998, while those reporting wage income grew just 14%. But the IRS estimates that self-employed folk who work for cash report less than 20% of their earnings and those who work more formally, less than 70%.
Take the case of Michael Yang. Yang left his job as a programmer at Hughes Aircraft in 1992. In 1996 he applied for a mortgage on his Bellevue, Wash. home. He told the bank he had a thriving business consulting on software for Taiwanese companies. But he told the IRS that for all of 1995 and 1996 he had just $5,500 in interest and capital gains and no consulting income.
In August a U.S. Tax Court judge ruled that $300,000 of deposits into Yang's bank accounts during that period were consulting income. (Yang now says he lied on his loan application and the deposits were gifts from his father in Taiwan. But he hadn't, as required, reported his foreign bank account.)
At least Yang filed a return. Millions of folks with taxable income don't even do that. Albert Snow, of Medway, Mass., didn't file income or payroll returns for 1993 through 1999, despite netting as much as $580,000 a year from his three health food and book stores. He even set up a side business counseling others on how to avoid the IRS. Now is is doing 43 months in the federal pen. Getting caught makes him unusual, and being behind bars makes him something of a freak.
That old standby, skimming form a cash-based business, is also alive and well. It is so rampant among laundry owners that the IRS now publishes a guide telling the auditors how to figure underreporting based on water use.
Ditto for folks who write off personal expenses as business costs. In a case decided in Tax Court last year, the owners of Holland America Bulb Farms of Woodland, Wash. deducted $34,000 of family grocery bills in one year as business expense. (No way, said the judge.) A Sacramento dentist is now in court defending his writeoff of a Porsche, a Lexus, his daily Starbucks fix and subscriptions to Sotheby's catalogs. Where's the shame? There isn't any.
Traditionally, ordinary workers were at a disadvantage in this game, since unreimbursed employee business expenses are harder to deduct than Schedule C expenses. But promoters have a solution: Topeka, Kan.-based Renaissance, TTP (The Tax People) Inc. says 55,000 customers bought its "tax Relief System," a $300 set of tapes, forms and workbooks that shows how to turn nondeductible personal expenses for food, housing, travel and the like into deductible business costs.
In October IRS criminal investigators raided Renaissance and state officials won a court order restraining it from further sales. Renaissance defends its approach and says competitors are still marketing similar products.
While "the little people"--in Leona Helmsley's famous phrase--angle to write off home offices, the wealthy "farm" their estates. Kenneth A cherry, chairman of American Frozen Foods in Stratford, Conn., and his wife, Joanne, wrote off a half-million in farm expenses, against just $23,000 in farm revenues for 1995 through 1997 for their New Milford, Conn. spread (Cherry says he's farming for profit, but the IRS calls the expenses personal.)
There's also a new enforcement headache for the taxmen: an explosion of newly enacted credits--for college, urban investments, you name it. Credits have high fraud rates and distract the IRS from other auditing. The IRS estimates that in 1997, $8 billion worth of earned income credits, a quarter of the total, went to folks who didn't qualify.
Far and away, however, the most striking evidence of the decline in compliance is the proliferation of suspect shelters being hustled to a wide range of taxpayers. "The sophisticated practitioners know the IRS isn't auditing and so it seems, it's the scheme du-jour," says Bryn Mawr, Pa. trust lawyer Stephan Leimberg.
Individual shelters were peddled widely in the late 1970s and early 1980s, of course. Back then the affluent fell for partnerships promising outsized writeoffs for cattle breeding, oil wells and the like.
This time around the shelters are spread more widely across the tax code and income lines. The big accounting, law, securities and insurance firms target mainly the wealthy. But smaller firms left out of the big-company shelter game are now happily pitching their own clientele--the small-business owner, the dentist, the retiree with the $1.5 million IRA. At the other end of the income scale, promoters--some with roots in the tax protester movement (see box)--are using the Internet to spread their schemes.
In the old days lawyers and accountants were the ones who curbed their clients' tax-evasive urges. Now its some advisers who are pushing the clients, with a new ethic: Anything that isn't specifically prohibited by the IRS is fair game, even if it is clearly not what Congress intended.
One tax adviser who is aghast at what his profession is doing is Walter Lee Davis, Jr., an estate attorney in Johnson City, Tenn. A client wanted to transfer his auto dealership into Guam trust to avoid U.S. tax on the $2 million he nets a year. At the heart of the shelter was a kickback: the taxpayer avoided taxes on U.S. income because the income was supposedly being taxed in Guam, when in reality, the territory had agreed to rebate the tax after six months.
The scheme works only if a trust held in Guam is treated just like an individual who lives there--an interpretation not prohibited under U.S tax law but not endorsed either, according to a tax attorney's memo used to sell the scheme. The memo did warn that if the IRS becomes aware of the ploy, it would shut it down. It also said promoters could sidestep rules requiring registration of corporate tax shelters, because the scheme was being sold to individuals. Who would sell this stuff? Davis' client got the idea from a respected Memphis accounting firm, which was working with national accounting firm Grant, Thornton, which created the ploy. (Shelters, it seems, are now franchised like McDonald's) "My clients say, 'If the big boys say this is okay, its' got to be. Why don't you go along?'" sighs Davis. To his relief, Treasury did shut the Guam trust down in November. Grant Thornton declines to comment.
Are you tempted? Do you feel like a chump for paying what you owe?
If so, remember that although the probability that you will be caught is low right now, that could change. And if you are caught, you will pay. The IRS though weakened, is fighting back. In its 2001 budget, it got enough funds to keep the audit rate from falling further and begin a modest comeback. For year 2000 returns, it plans to start computer matching 1040's with K-1s, the forms reporting distributions from partnerships, trusts and S-corporations. This should help it spot suspicious patterns involving partnerships and trusts.
IRS Small Business/Self Employed Chief Kehoe and Dale Hart, his deputy, are vowing to revamp the audit process and shift resources into audits of shelters, partnerships, trusts, limited liability companies and high-income returns. In recent years only 1 in 170 partnerships ahs been audited, and Kehoe worries that partnership income may be underreported by as much as 40%.
The IRS has also gone after blatantly phony trusts. In the last two years its criminal division has launched more than 100 trust investigators and has sent several high-income trust users to jail along with the promoters. It now touts these convictions on the Web. (A Texas physician got 37 months and a Michigan dentist 27 months).
Criminal Investigative Chief Mark Matthews is trying to revive the system for getting leads from IRS auditors on ordinary tax cheats who deserve criminal prosecution, too.
More: In October a federal judge approved a sweeping summons requiring MasterCard and American Express to turn over records of thousands of U.S. citizens with charge cards issued on bank accounts in the Bahamas, the Cayman Islands, Antigua and Barbuda. The IRS plans to compare these records with 1998 and 1999 tax returns. The new tax-shelter hotline is also reeling in tips.
So the IRS has plenty of leads. It just lacks the manpower to pursue them all, let alone keep on top of people engaged in traditional forms of tax evasion.
If you are tempted, keep in mind that what you do today is audit bait until at least 2005 and in many cases, much longer. Thousands of taxpayers, in fact, are still paying for 1980s shelters. As these cases wend their way through court, interest has been accruing at special penalty rates.
Consider the plight of Gary Blackburn. In 1984 he was earning $120,000 a year as a nuclear plant consultant and hoping to retired by 55. He invested in a cattle-shelter partnership only after watching buddies participate for five years without problems. When he first invested, Blackburn carried back large losses and filed for three years of refunds, which he received. "I assumed when you sent in the refund claim, the IRS looked at it and said, 'This is a legitimate deal' before they sent you back the money," he says.
Now the 56-year old Nevada resident faces a $1 million plus IRS bill and the prospect of working until he drops. It turns out that for years the IRS allowed Walter J. Hoyt III, the promoter of Blackburn's shelters, to go on selling to him and thousands of others, even as its criminal division investigated him.
Put it this way: If you do not decide to fiddle, at least stay away from the promoters. When the IRS targets a scheme, it demands the name of everyone the shelter has been sold to. In August the Treasury changed its tax shelter rules to require that promoters maintain lists of buyers of individual, as well as corporate, shelters.
And while its true that some outrageous-sounding deals--such as the 501(c)(15) gambit--seem to be allowed by law, you're not home free. Congress could change the law and make the change retroactive. Or the IRS might find legal grounds to attack. For example, to qualify for the 501(c)(15) tax exemption, a company's primary business is supposed to be insurance. The IRS might argue that billionaire Kellogg's 501(c)(15), with investment income 54,000 times its premium income, wasn't primarily in the insurance business.
High-end individual shelters are often sold with customized legal opinions, costing as much as $50,000 per customer, predicting they will "more likely than not" be upheld in court. These opinions are supposed to protect participants from the worst penalties if the IRS challenges a shelter and wins. But the judges needn't feel bound by them, especially if they've been provided by promoters themselves or ignore the real problems with a deal.
And these "more likely than not" opinions are pushing the envelope as well. It used to be that many of them simply assumed a key point, which is that transactions were entered into for nontax reasons. Now, in a new twist, taxpayers seeking these opinions are asked to sign statements asserting detailed economic motives that are, to put it politely, hard to believe. Example: "On date x, I thought interest rates would to y." In other words, if you want into this game, be ready to fib.
Also be aware that the dodges sold to individuals are likely to be shakier, on average, than those peddled to corporations. "The best products go to the high-end corporate users. After that, you open in Peoria, in the individual market," says Stanford University Law Professor Joseph Bankman, who has studied the corporate-shelter industry.
In addition to "used" shelters, marketers often sell retooled ones. As soon as the IRS, Congress or the courts nix some gambit, promoters come back peddling a slightly different version, such as the shelter describe din the box entitled Hide the Baby.
And with all the competition, promoters keep adding new twists that may increase grounds for an IRS attack. Example: The owner of a small southern manufacturing company recently capitalized his new tax-exempt 501(c)(15) with his company's patents. The idea: to siphon off taxable profits by converting them to tax-deductible royalty payments.
There's yet another problem with many individual shelters. Some arrangements that might hold up if used by big corporations are dubious if an individual or small business tries the same maneuver.
A good example is the Irish employee-leasing company scheme. Here a dentist, doctor or small-business owner signs an employment contract with a foreign (usually Irish) employee-leasing company, which then leases his services to a U.S. leasing company, which in turn leases his services back to his business or practice. As part of his employee contract with the Irish company, most of his salary is diverted into a nonqualified deferred-compensation plan, and held in a so-called Rabbi trust in a Caribbean tax haven, where it grows tax free.
Deferred compensation plans can be legal. but normally an employer can't deduct deferred pay until it's paid to the employee and reported on his tax return. In this deal the business deducts the full pay package now--it has, after all, paid the Irish company the full amount. Yet the "leased employee" only reports the income he currently receives, which doesn't include the deferred comp. One "more likely than not" opinion written for his shelter ignores what experts call its Achilles' heel: the relationship between the leased employee and the organization he's ultimately leased to.
The shelter promoters are shameless with their fees. One Chicago-area CPA was horrified to find that, after being flown to Florida for a sales pitch, a doctor-client had paid a rich $55,000 to set up the plan. In his scheme, both the leasing companies and the trust manager also claim fat annual fees.
Or consider a new plan that attempts to end-run the rule barring IRAs from being invested in insurance. It also, not coincidentally, produces a big insurance commissions and lawyers' fees. An IRA, its owner and an insurance trust set up by the IRA owner for his heirs, all invest in a partnership, which buys the insurance. "An elaborate mechanism is being set up from which the client will receive minimal economic benefit," says St. Louis estate lawyer Russell Willis III.
Perverse but true: The complexity of these arrangements and of the tax code itself is good for sales, as is Congress' constant fiddling --9,500 code changes since 1986. Each change provides fresh fodder for the shelter creators. And with the code so confusing, a taxpayer can rationalize that maybe a plan works, or that everybody else must be getting around the rules, too.
The sense that "everybody does it" has been fed by the growth of corporate tax shelters, as one Web-site pitch shows (the promoter also advertises in FORBES): "Have your supplier invoice your Nevada Corporation for products that you normally purchase. Let's say that the invoice is for $50,000. Your Nevada corporation will pay the bill and bill your local company $75,000. Bingo! $25,000 of profits have been shifted to a tax-free state. These tactics have been used by major U.S. corporations for years. Not only within the U.S. but worldwide."
Yes, big corporations use income shifting schemes. But grossly overcharging for a product won't hold up in court. And the big boys can also get burned when playing with shelters. Dozens of companies face a combined $6 billion in back taxes, plus interest and penalties, because they bought a "corporate-owned life insurance" shelter. Insiders report that after a string of court losses on this and other schemes, big firms are becoming leery of code stretching shelters.
Blame it on Congress. It has created a tax code that is an incomprehensible mess, playing into the hands of shelter promoters and cheats. And it has overreacted to past IRS excesses by hobbling the agency. Until something changes, honest taxpayers will have good reason to feel like chumps.