For High-Income and International Taxpayers: Defensive Tax Planning

by M. Robinson & Company, P.C.
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The Importance of Defensive Tax Planning

IRS audit criteria target high-income taxpayers, especially those with reported foreign income or foreign financial assets. Targeted high income taxpayers include:

  • Individuals
  • Trusts and Estates
  • Corporations
  • Partnerships and LLCs

What these targeted high-profile taxpayers share are:

  • Incomes in excess of $1 million; and/or
  • Assets in excess of $10 million.

Skilled tax lawyers can reduce, but not eliminate, the exposure of these taxpayers to tax audit. In addition, skilled tax lawyers can minimize the nominally-high tax rates imposed by the Internal Revenue Code.

We begin this blog with an overview of current IRS auditing criteria. We continue with an overview of our overly-complex income federal income tax regime along with thoughts of the current federal tax reform efforts by President Donald Trump and Congress. We end with a brief overview of how a boutique tax law firm, such as our firm, can assist targeted high-profile taxpayers, while allowing these taxpayers retain their present legal advisors and tax accountants.

Current Tax Audit Criteria and the Ever-Widening “Tax Gap”

For many years, Congress has starved IRS for operating funds. As a result, IRS has lost thousands of auditors and simply does not have the resources to audit all income tax returns that should be audited. IRS therefore focuses its limited auditing capacity “where the money is.”  Specifically,

(1) High Incomes. As a high-income earner your chances of being audited by IRS are approximately: [2]

  • 1 in 6 for incomes over $10 million
  • 1 in 16 for incomes over $1 million

(2) Foreign Income and International Returns. You have a nearly 1-in-20 chance of being audited:

  • If you are the recipient of significant foreign income;
  • If you are the owner of significant foreign financial assets;
  • If you have a foreign mailing address.

(3) High Income AND Foreign Income. Taxpayers with high incomes from foreign sources are particularly vulnerable, with perhaps a 1-in-5 or a 1-in-6 chance of being audited.

(4) Wire Transfers. International wire transfers are often an important factor in triggering IRS audits. For example, in our experience, several wire transfers from abroad to United States accounts, each just under $50,000 were factors in targeting a taxpayer for an IRS tax audit. Also, outbound and inbound wire transfers to and from the identical foreign account may target a taxpayer for an IRS audit.

Meanwhile, most other taxpayers with lower incomes are not likely to be audited at all. The result of these skewed auditing criteria is a huge, ever-widening “tax gap,” where, according to IRS, almost $1 in $5 in income taxes is currently not being collected.

Our Overly-Complex Income Tax System

The following description provides a sense of the complexity of our current tax regime. The tax minimization and tax audit defense abilities of our firm’s professionals come from their mastery these complexities.

  1. Taxation of Individuals

The complexity of the current income tax Code and Treasury Regulations is stunning. The individual income tax alone (Form 1040) now contains five separate but intricately-interrelated income taxes imposed on individuals and married couples:

  • The Regular Income Tax
  • The Alternative Minimum Tax
  • The Self-Employment Tax
  • The Net Investment Income Tax
  • The Additional Medicare Tax

This intricate web of five interrelated tax regimes forms the framework for a bewildering array of exemptions, exclusions, deductions, credits and deferred losses. In our experience, the IRS agents who audit individual income tax returns rarely understand the tax law completely and often rely on “industry specialists” in areas such as real estate. Our tax professionals are familiar with many of these industries, including the real estate industry.

  1. Taxation of Entities

There are presently five separate taxing regimes for the taxation of entities.

  • C” corporations always pay income taxes on all of their income.
  • “S” corporations typically do not pay income taxes on any of their income, but sometimes pay taxes on income arising from the recognition of “built-in gains.”
  • Partnerships never pay income taxes.
  • “Disregarded Entities” never pay income taxes.
  • Estates and Trusts allocate the income tax between the fiduciary and its beneficiaries based on such criteria is (1) whether the income arises from fiduciary income (e.g., dividends and interest) or from transactions involving trust principal (e.g., capital gains); and (2) whether the income was required to be distributed to the beneficiary or was, in fact, distributed to the beneficiary.

The idiosyncratic taxation of entities interacts intricately with the complex rules governing the taxation of individuals, discussed above. For example, it is typically advisable to terminate the existence of an S corporation in the same year that it completes the sale of its assets and distributes the proceeds of sale to its shareholders.

Is it any wonder that in our experience the IRS agents who audit corporations, fiduciaries and partnerships rarely understand these entities completely and typically work with IRS entity specialists such as “partnership specialists?” Our tax professionals are very familiar with the intricacies of corporations, partnerships, estates and trusts and so-called “disregarded entities.”

  1. Taxation of Foreign Income

Another area of significant complexity involves the taxation of United States citizens and residents (such as Green Card holders) who have income from:

  • Foreign Pension Plans
  • Foreign Insurance Policies
  • Foreign Mutual Funds.

Sometimes the United States foreign tax credit provides relief from double taxation, sometimes not. Sometimes income tax treaties provide relief from double taxation, sometimes not. Sometimes, there are dedicated forms, such as Form 8621 for foreign mutual funds (PFIC’s), sometimes not. Our tax professionals are familiar with these types of income and have participated in seminars and webinars where we have explained the intricacies of how to report these types of income to other tax practitioners.

  1. Disclosure of Foreign Assets and Income

The failure to disclose foreign assets and income can result in substantial civil and even criminal penalties, even if no additional income taxes are due. The failure-to-file-timely penalties typically range from between $10,000 to $25,000 per form per year. Failure-to-disclose penalties can amount to as much as 50 percent of the value of the undisclosed foreign assets. Important foreign disclosure forms are identified below. These delinquent filer penalties can often be avoided if all foreign income was timely reported.

(a) Foreign Trusts

Our experience with foreign trusts includes:

  • Dealings with Foreign Trusts – such as contributions made to foreign trusts and loans (“qualified obligations”) made to or received from Foreign Trusts (Form 3520)
  • Receipts of Foreign Gifts and Inheritances (Form 3520)
  • Income Earned by Foreign Trusts (Form 3520)
  • Distributions of Untaxed Foreign Income Received from Foreign Trusts (Form 3520)

(b) Foreign Corporations

Our experience with foreign corporations includes:

  • Transfers of money and property to Foreign Corporations (Form 926)
  • Income earned by Controlled Foreign Corporations (Form 5471)

(c) Disclosure of Significant Foreign Interests in U.S. Corporations

We have experience with foreign individuals and entities who own 25 percent or more of a United States corporation (Forms 5472).

(d) Disclosure of Foreign Financial Assets

Our experience with the disclosure of foreign financial assets includes:

  • The reporting of “Certain Foreign Financial Assets” (Form 8938)
  • The report of “financial interests” in or “signature authority” over foreign financial accounts (FBARs: Foreign Bank Accounts Reports – FinCEN Form 114)

Some Thoughts on Tax Reform

Tax reform is in the news again. Comprehensive tax reform may be beyond the abilities of the current administration and Congress, where every tax loophole has its ardent and vocal defenders. It may be possible, however, to simplify the Internal Revenue Code along the lines suggested by President Donald Trump by lowering rates and broadening the tax base for both individual and business taxes.

The rate reductions along with the elimination of deductions may result both tax simplification and an overall reduction in income taxes. The revenue shortfall could and perhaps should be made up with a consumption tax, such as the Value Added Tax (VAT) that is imposed by many European countries and Israel. For an interesting article on tax reform written by a non-specialist, I recommend David Brooks’ article entitled “Can Elephants Learn from Failure” published on March 28, 2017 on the Opinion Pages of the New York Times. https://www.nytimes.com/2017/03/28/opinion/can-elephants-learn-from-failure.html?_r=0 

Comprehensive tax reform demands more than simplification. Tax reform must also include a commitment to close the “tax gap” and to collect the taxes imposed on the American people.  All of this will take time. Meanwhile, targeted high-income taxpayers will want to work with specialized tax firms that can minimize their clients’ effective tax rates and plan defensive tax returns. If audited, these taxpayers will want to be represented by specialized tax firms that can mount an effective tax-audit defense.

 

 

 

[1] Attorney Morris N. Robinson is President of M. Robinson Tax Law, a tax boutique located at The Landmark Building in Boston’s Financial District.

[2] Based on 2014 IRS statistics.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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