The Importance of Defensive Tax Planning and Defensive Tax Return Preparation

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

Tax reform is in the news again. But until we achieve significant tax reform it is essential that individuals, trusts and estates, and businesses with incomes in excess of $1 million and/or assets in excess of $10 million work with skilled tax lawyers to minimize their effective tax rates, their tax liability and their exposure to potential audits. We begin this blog with an overview of current IRS audit criteria which disproportionately target high-income taxpayers, especially those with reported foreign income or foreign financial assets. We continue with an overview of our overly complex income federal income tax regime for individuals and entities. We complete this blog with thoughts of federal tax reform along with a brief overview of our firm.

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

For many years, Congress has starved IRS for 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 uses the following criteria for carefully choosing their audit targets:

  • High Incomes. As a high income earner, your income tax returns are targeted by the IRS computer algorithms. This means that based on income alone your chances of being audited by IRS are approximately: [1]
  • Just over 1 in 6, for incomes over $10 million;
  • 1 in 16 for incomes over $1 million
  • 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, an owner of significant foreign financial assets or you have have a foreign mailing address.
  • High Income AND Foreign Income. Taxpayers with high incomes who also report significant income from foreign sources and/or significant foreign assets are particularly vulnerable, with perhaps a 1 in 5 or a 1 in 6 chance of being audited.
  • Wire Transfers. International wire transfers are often a key 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.

Thus, individuals, fiduciaries and businesses with incomes in excess of $1 million require specialized defensive tax planning and tax compliance services. Their need for defensive planning and compliance services is intensified where some of the taxpayer’s income is foreign-source income; where the taxpayer reports foreign financial assets; or where the taxpayer sends and/or receives foreign wire transfers. Meanwhile, taxpayers with smaller 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.

An Overview of Our Overly Complex Income Tax System 

The following provides a sense of the complexity of our current tax regime. Our tax minimization and our tax audit defense abilities come from our mastery these complexities along with the ambiguities contained in the Internal Revenue Code.

  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. We are, of course, completely familiar with most of industries, including the real estate industry. Thus, our mastery of the tax law gives us a significant advantage in planning a strong, defensive income tax return or an effective tax audit defense.

  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 realization of “built-in gains.” Partnerships and “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 in fiduciary principal (e.g., capital gains). There is no rational justification for having five separate and distinct income taxing regimes, other than the quirks of tax history.

This 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. 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?” We are, of course, completely familiar with the intricacies of corporations, partnerships, estates and trusts and so-called “disregarded entities.”

  1. Taxation of U.S. Citizens and Residents with Foreign Income and Assets

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 provides relief from double taxation, sometimes not. Sometimes, there are dedicated forms, such as Form 8621 for foreign mutual funds (PFIC’s), sometimes not. We 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 file foreign asset and foreign income disclosure forms can result in both substantial civil and even criminal penalties, even if no additional income taxes are due. These penalties typically range from between $10,000 to $25,000 per form per year. Some of the major disclosure forms are listed below.

  • Foreign Trusts

Our experience with foreign trusts includes:

  • Dealings with Foreign Trusts – such as contributions made to 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)
  • 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)
  • 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).

  • 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)

Thoughts on Tax Reform

Comprehensive tax reform is likely beyond the abilities of the current administration and Congress, where every tax loophole has its ardent and vocal defenders and lawmakers lack both unity and deep vision. 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 that is imposed in 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 in the Opinion Pages of the New York Times. https://www.nytimes.com/2017/03/28/opinion/can-elephants-learn-from-failure.html?_r=0

Clearly, comprehensive tax reform demands more than simplification. It must also include a commitment to actually collect the taxes imposed on the American people and thereby begin to narrow the “tax gap”. All of this will take time. Meanwhile, taxpayers with high incomes or significant assets currently targeted by IRS will want to work with tax firms that know how to minimize their effective tax rates today. If audited, these taxpayers will look to a tax firm that can mount an effective tax audit defense through its mastery of the complexities and ambiguities contained in our tangled tax code.

 

 

 

[1] 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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