Preface: Tax shelters are financial vehicles individuals and corporations incorporate to minimize tax liabilities. Shelters range from employer-sponsored 401(k) programs to overseas bank accounts. The phrase “tax shelter” is often used as a pejorative phrase, but a “tax shelter” can be also be a uniquely legal way to permissibly reduce tax liabilities.
Managing Euroclydon Risks with Corporate “Tax Shelters”
This blog is posted to address corporate concerns regarding the IRS’s continuing campaign to identify and shut down abusive corporate tax shelters, many of which involve transfers of rights or property to foreign entities.
In recent years, offshore asset reporting has become one of the IRS’s primary areas of focus as it seeks to increase tax revenue. In 2010 Congress addressed the significant issue of international tax compliance, enacting the Foreign Account Tax Compliance Act (FATCA). FATCA imposes more stringent reporting requirements and, in many cases, increased tax liability on U.S. taxpayers—many of whom are corporations—with investments in offshore accounts. Since then, the Treasury Department and the IRS have issued new regulations to implement FATCA and its reporting and disclosure regime.
The IRS is cracking down on tax shelters in other ways as well. Many employees of publicly traded companies are taking advantage of the tax whistleblower provisions of the Tax Relief and Health Care Act of 2006, which often enable the IRS to provide a hefty reward to those who report tax evasion. Additionally, the Treasury Inspector General for Tax Administration has recommended that the IRS improve its audits of small corporations, meaning that corporations with assets of $10 million or less may begin to feel a squeeze from examiners in upcoming tax years.
Large Business & International
As part of its initiative to increase international corporate tax compliance, the IRS has reorganized its 600-employee Large and Mid-Size Division (LMSB) into the Large Business & International Division (LB&I). The IRS more than doubled the number of employees, many of them industry experts and practitioners, and made in-roads to improving employee education and skill sets. LB&I’s expanded purview includes LMSB’s original jurisdiction over corporations, S corporations, and partnerships with assets of $10 million or more and also the implementation of the FATCA provisions.
Annual Reporting for Reportable Transaction Disclosure
Any taxpayer, including an individual, trust, estate, partnership, S corporation, or other corporation, that participates in a reportable transaction and is required to file a federal tax return or information return must file Form 8886 disclosing the transaction. The IRS maintains a list of the abusive transactions which must be reviewed annually by the taxpayers. The taxpayer must attach a Form 8886 disclosure statement to each tax return reflecting participation in the reportable transaction. The taxpayer must also send a copy of the Form 8886 to the Office of Tax Shelter Analysis (OTSA).
Offshore Voluntary Disclosure Program
In 2011, the IRS relaunched its Offshore Voluntary Disclosure Program (OVDP), which rewards taxpayers who disclose unreported foreign accounts with a reduced penalty framework. The revived OVDP has no official end date but the IRS has cautioned that it may terminate the program at anytime.
In addition to requiring certain U.S. taxpayers holding financial assets outside the United States to report them to the IRS, FATCA generally require foreign financial institutions to report certain information about financial accounts held by U.S. taxpayers or foreign entities in which U.S. taxpayers hold a substantial ownership interest. Non-compliant foreign financial institutions could be subject to a 30% withholding tax on all U.S. sourced payments.
The IRS has stressed its intent that FATCA be a reporting regime rather than a penalty regime, and that it is eager to work with industry professionals and experts into ease the law into implementation. Nevertheless, the effect of FATCA on corporate offshore tax shelters is meant to be severe on the numerous abusive tax shelters that take advantage of lower or non-existent corporate income tax rates abroad through the dubious transfer or licensing of assets.
IRS’s Small Business/Self-Employed division, which holds in its jurisdiction all small businesses with assets of less than $10 million, plans to be more proactive in its field audits this year, concentrating in particular on stopping line-item schemes such as inflated business deductions or false earned income credit claims. SB/SE is currently at work expanding the knowledge and skill set of its examiners, matching exams to those examiners with the greatest knowledge of the subject matter involved, and producing online materials that will better educated taxpayers on their responsibilities. For the long-term, the SB/SE may update the index by which it selects tax returns for audit so that exams are targeted to returns likely to contain underreported tax.
The whistleblower rules encourage individuals to report any tax abuses or corporate fraud through generous reward offers. In 2012, the IRS paid out its largest award, more than $100 million, to an individual who disclosed tax evasion by a foreign bank.
The IRS has also maintained its campaign against accounting and law firms that design or promote tax shelters. The “anything goes” attitude of past years ago is a long faded memory. And while the IRS has been enforcing the law, Congress is looking to close as many loopholes as possible to prevent tax evasion. IRS examiners are still directed to look for the checklist of characteristics common in abusive corporate tax shelters. These include:
- A reported transaction has no business purpose or economic substance other than to minimize taxes;
- Investments made late in the tax year that indicate there may be deductions for prepaid expenses that are not allowable.
- A 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.
Some businesses are concerned that the IRS’s focus on tax shelters will mean increasing scrutiny of other aspects of their business operations as well. Others want to undertake internal protective audits to set up a strategy against IRS involvement before the IRS sends out audit letters.
If you would like a further analysis of how the IRS assault on tax shelters may affect you, directly or indirectly, please call your trusted tax advisor.