Step 4-4

Identifying an Abusive Tax Shelter

The IRS says abusive tax shelters are "marketing schemes that involve artificial transactions with little or no economic reality. They often make use of unrealistic allocations, inflated appraisals, losses in connection with nonrecourse loans, mismatching of income and deductions, financing techniques which do not conform to standard commercial business practices, or the mischaracterization of the substance of the transaction. Despite appearances to the contrary, the taxpayer generally risks little. Abusive tax shelters commonly involve package deals that are designed from the start to generate losses, deductions, or credits far in excess of present or future investment, or that promise investors at the start future inflated appraisal to enable them, for example, to reap charitable contribution deductions based on those appraisals. They are commonly marketed in terms of the ration of tax deductions allegedly available to each dollar invested. This ratio (or "write-off") is frequently said to be several times greater than one to one."

The IRS has also issued the following as a checklist for determining whether a particular offering is an abusive tax shelter. These questions will help to provide a clue as TO THE abusive nature of the plan:

• Do the benefits far outweigh the economic benefits?
• Is this a transaction you would seriously consider, apart from the tax benefits, if you hoped to make a profit?
• Do shelter assets really exist and, if so, are they insured for less than their purchase price?
• Is there a nontax justification for the way profits and losses are allocated to partners?
• Do the facts and supporting documents make economic sense? In that connection, are there sales and resales of the tax shelter property at ever increasing prices?
• Does the investment plan involve a gimmick, device, or sham to hide the economic reality of the transaction?
• Does the promoter offer to backdate documents after the close of the year and are you instructed to backdate checks covering your investment?
• Is your debt a real debt or are you assured by the promoter that you will never have to pay it?
• Does the transaction involve laundering United States-source income through foreign corporations incorporated in a tax haven and owned by the United States shareholders?

Determining Economic Reality

In recent years, many tax shelters have been formed solely for tax advantages. Investors enter into the venture with little or no promise of a gain, aside from the anticipated tax benefits. The rate of return on investment for an abusive tax shelter is much lower than for other types of investments. The investor is willing to accept this low return because the reduction in taxes which otherwise would be paid is the equivalent of a profit. While the Code allows deductions for losses arising from transactions entered into for profit, losses are not allowed for transactions entered into for loss, since these are losses for tax avoidance.

Benz v. Commissioner, 63 T.C. 375, 384 (1974):

While losses often occur during the formative years of a business...the goal must be to realize a profit on the entire operation, which presupposes not only future net earnings but also sufficient net earnings to recoup the losses which have meanwhile been sustained in the intervening years.

The structuring of abusive tax shelters is often highly sophisticated, requiring a broad analysis of intricate interrelationships. From an IRS point of view, the basic question is: "What criteria can be used in determining if a shelter was structured primarily for tax avoidance, that is, how can we recognize a transaction that lacks economic reality?" From an economic point of view, the key to this determination is a computation that compares the present value of all future income with the present value of all the investments and associated costs of the shelter.

Present Value:

The discounted value of an income stream if obtained by investing money at the current investment rate rather than in the activity. The present value is the amount of investment required to generate the expected income. This computation compares the amounts invested with the income received or to be received, in terms of current dollars not considering any distortion caused by inflation.

If the present value of all future income is less than the present value of the money invested, the tax shelter may be abusive. In an abusive tax shelter, the primary gain is the tax advantage.

In extreme cases in which economic reality is lacking, the issue often is relatively easy to pinpoint. However, the entire tax shelter area is one of continuing complexity and evolvement, making it difficult to determine the degree of economic reality present in the transaction, though, the IRS will try to answer these three questions:

• Does the price of the asset, together with its related elements, bear a relationship to fair market value?
• Does the transaction provide any true equity build up, thus creating a value to forfeit upon possible termination?
• Does the transaction transfer the burdens and benefits of ownership?

For example:

Roger P. entered into a tax shelter scheme in which he purchased 10 head of cattle for $3,000 each, paying cash of $3,000 and giving a note of $27,000. The current market price for live cattle is $1,600 per head.

The validity of the transaction is questionable as the purchase price exceeds the fair market value. Therefore, the IRS wants to know: Is the note valid?

Assume further that the note is a nonrecourse note. The terms of the agreement state that the note will be paid off through the sale of the cattle. Mr. P. has nothing more to pay in. Thus, he has no real equity build up. He can walk away from the scheme leaving only his $3,000 initial investment. This initial investment, however, would have been recovered through tax write-offs, thus leaving him with no economic losses at all.

Assume further that Mr. P. is protected from losses by a guarantee that any of the cattle that die or become ill will be replaced, so that their full fair market value will be received upon sale. In this case, it is indicated that Mr. P. does not really have the burdens and benefits of ownership. It is not likely he will receive any profits from the sale because the FMV of the purchase is excessive. he will not incur any economic losses.

Overvaluation of the tax shelter product is perhaps now the biggest fraud perpetrated on the government by abusive tax shelters. A sales price totally unrelated to the fair market value of the item being questioned is a major sign of an abusive tax shelter. By purchasing an asset at an inflated value the TAXPAYER attempts to claim larger deductions for such items as depreciation, interest expenses, and the investment credit. It is usually the deductions of these items that makes the tax shelter program attractive TO THE taxpayer in the first place.

Overvaluation is typically accomplished through self-serving appraisals. Very often, in charitable contributions schemes, the donee will accept the donor's valuation of the gift (such as a work or art) and have no real knowledge of the item's worth. The IRS is most likely going to rule out as worthless a letter from the donee to the donor valuing the gift.

AUDIT-PROOFER'S STRATEGY RULE

Be aware of the potential abuse indicators which IRS examiners are instructed to watch for before you enter into any tax shelter.

Tax examiners are taught to investigate the following situations for possible abusive financial maneuvers.

• Investments made late in the tax year indicate there may be deductions for prepaid expenses that are not allowable.
• A very large portion of the investment made in the first year indicates the transaction may have been entered into for tax purposes rather than economic motivation.
• A loss exceeding a taxpayer's investment indicates the possibility of a nonrecourse note.
• If the burdens and benefits of ownership have not passed to the taxpayer, the parties have not intended for ownership of the property to pass at the time of the alleged sale.
• A sales price that does not relate comparably to the fair market value of the property indicates the value of the property has been overstated.
• If the estimated present value of all future income does not compare favorably with the present value of all the investment and associated costs of the shelter the economic reality of the investment may be questionable.

IRS Tax Shelter Targets

Although tax shelters involve a wide variety of business, according to the IRS abusive tax shelters are frequently found in the following areas.

Real Estate:

This industry requires the commitment of large sums of capital over a long period of time for the construction of apartment buildings, shopping centers, office buildings, and other structures. Many real estate ventures are profit oriented with tax benefits only a secondary consideration. The IRS will challenge those operations which are not based on providing rue economic benefits. Some expenses which may indicate an abusive tax shelter are current deductions for construction period expenses and rapid write-offs of depreciation. Nonrecourse financing is used to provide the needed capital.

Oil and Gas:

Oil and gas drilling shelters provide tax benefits through the deduction of intangible drilling costs. These costs may actually represent prepaid expenses when little or no actual drilling is done in the year of payment. Also, deductible expenses paid to related contractors may be inflated.

Farms:

Farm tax provisions are intended to benefit the legitimate farmer. Some of these provisions are misused by taxpayers who enter into farming transactions mainly for the tax advantages. One such provision allows the use of the cash method even though inventories are material income-producing items. Another provision allows prepaid feed and herd management fee deductions in the year paid. If these expenses are paid and deducted late in the year, and the goods or services are to be delivered at a later time, the transaction may lack substance and be an abusive shelter.

Motion Pictures:

Motion picture and videotape shelters use a combination of leveraging and inflated purchase prices to generate tax benefits. A film is purchased at an inflated price. The cash down payment usually represents the true value of the film. The balance of the purchase price is financed by a nonrecourse loan, repayment of which is often contingent on the earnings of the film. Depreciation and investment credit are then based on the inflated price. The seller of the film reports income on the installment method, so the only gain reported is based on the cash down payment. if no actual profit is likely to result from the venture, it is an abusive tax shelter.

The following list of other tax shelter targets was found in the Internal Revenue Manual:

• TV Video Tapes.
• Commodities.
• Master Recordings.
• Leasing.
• Books.
• Cable TV.
• T-Bill (other Federal instruments) Futures/Options.
• Contributions.
• Foreign Trusts. * Mining (all kinds).
• Patents.
• Lithographs.
• Research and Development.

Next Section: IRS's Tax Shelter Program

Audit Proofing Main | Home

© 1986, 1998 to 2002, Jack Warren Wade, Jr.