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Tax Court Sides with IRS, Penalizes Couple for Tax Avoidance in Tax Shelter Scheme

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    The U.S. Tax Code is full of credits and deductions that savvy taxpayers can use to lawfully minimize their tax liabilities that our office routinely assists our client’s with. Nonetheless, countless taxpayers pursue risky avenues to evade or avoid the duty to pay income tax – and in most cases, the end result is at best a hefty civil penalty, or at worst, a lengthy prison sentence. Spouses Robert and Angela Smith learned this the hard way in Smith v. Commissioner, T.C. Memo. 2017-218. The United States Tax Court found the couple liable for the 20% penalty established by 26 U.S. Code § 6662(a) after determining the Smiths, with assistance from a Houston-based attorney-CPA, unlawfully organized a tax shelter “for the sole purpose of tax avoidance.” The Tax Court also determined that the Smiths, contrary to their arguments, were not entitled to deduct hundreds of thousands of dollars in losses.

    Tax Court Rules Against Business Owners in Tax Avoidance Scheme

    Prior to 2009, Mr. Smith spent 36 years working for a company called National Coupling, Inc. When the business was sold in 2009, Mr. Smith retired, accepted a bonus of roughly $600,000, surrendered his life insurance policies for approximately $180,000, and sold his stocks for approximately $250,000. Combined with other sources of income, Mr. Smith’s total income surpassed $1 million upon retirement.

    Like many recent retirees, the Smiths subsequently hired a CPA-attorney, Houston-based Richard Shanks, to help manage their assets. However, rather than exploring lawful venues for managing their wealth effectively, the Smiths instead chose to engage in a complicated tax avoidance scheme revolving around an impermissible tax shelter.

    The scheme involved creating an S corporation (“RACR Ventures, Inc.”), which would route assets into a limited partnership (“RACR Partnership, Ltd.”) in exchange for partnership shares, before being liquidated. Upon liquidation, the shares would be distributed to the Smiths, who claimed an ordinary loss of $749,852.

    In order to understand why the Smiths’ actions violated the U.S. Tax Code, it is necessary to understand some background information about tax shelters. Though the term “tax shelter” has developed negative connotations, tax shelters are not inherently illegal. In reality, a “tax shelter” is merely a vehicle used to minimize a taxpayer’s tax liability. To use a common example, if you have a 401(k) plan through your employer, you already have access to a tax shelter.

    While tax shelters can be used in a lawful manner consistent with the Internal Revenue Code, there are also unlawful or “impermissible” tax shelters, such as the shelter used by the Smiths. Thus, it is crucial for taxpayers to understand what delineates permissible tax shelters, which can help taxpayers save money, from impermissible tax shelters, which can lead to costly penalties.

    The difference between a permissible and impermissible tax shelter lies in the economic substance doctrine, which is sometimes called the “sham in substance doctrine.” In short, a transaction has economic substance only when, under 26 U.S. Code § 7701(o)(1)(A) and 26 U.S. Code § 7701(o)(1)(B), the following criteria are met:

    1. “[T]he transaction changes in a meaningful way (apart from Federal income tax effects) the taxpayer’s economic position.”
    2. “[T]he taxpayer has a substantial purpose (apart from Federal income tax effects) for entering into such transaction.”

    The Tax Court found that “that the RACR structure lacked economic substance” after the Smiths failed to convincingly demonstrate that the S corporation was established for any purpose other than moving assets into the partnership. The Court pointed to, among other details, the dubious timing of the liquidation in relation to an expected patent, stating that “according to his testimony [Mr. Smith] should have expected the U.S. patent to be issued shortly after October 2009. However, [the Smiths] began to dissolve Ventures,” referring to the S corporation, “only one month later.”

    Despite its convolutions, the tax avoidance scheme ultimately failed to deceive the Tax Court. Judge Joseph Goeke wrote in the Court’s opinion that the Smiths “did not have a genuine business purpose for Ventures or the RACR structure,” adding, “They organized Ventures and implemented the RACR structure solely for tax-motivated reasons.” As the opinion also stated, the Smiths “continued to perpetuate their tax-avoidance scheme through their testimony at trial” despite the existence of damaging evidence against them, including a handwritten note by Shanks describing Ventures as a “vehicle to minimize tax event this year.”

    Ultimately, the Court’s findings led to two consequences for the Smiths:

    1. The Court held they were “not entitled to deduct any loss for 2009 relating to Ventures or the RACR structure.”
    2. The Court also held that the Smiths “are liable for the section 6662(a) penalty with respect to this portion of the underpayment unless they establish a defense of reasonable cause.” For context, the “section 6662(a) accuracy penalty” amounts to 20% of the tax underpayment.

    The financial repercussions? An income tax deficiency of $623,795 in addition to the 20% underpayment penalty, which amounted to $124,759.

    California Tax Planning and Defense Attorneys for Individuals and Businesses

    This case can teach taxpayers two lessons. The first lesson is to focus exclusively on legal tax shelters, such as 401(k) plans, which do not flout the economic substance doctrine or contradict 26 U.S. Code § 7701. In light of the devastating consequences which can result from tax avoidance or tax evasion, the gamble is not worth the risk – particularly because an experienced tax attorney can identify credits, deductions, and other tax breaks that safely and lawfully reduce a taxpayer’s liability.

    This segues into the second lesson, which is to select representation with extreme care when choosing a Tax Attorney, CPA, or Attorney-CPA to provide tax planning or wealth management services. For better or worse, Shanks was not penalized by the Tax Court for his involvement in the Smiths’ tax avoidance scheme.

    At the Tax Law Office of David W. Klasing, our California Tax Attorneys have decades of experience assisting taxpayers, including retirees and business owners, with tax preparation, tax transactions, and other tax planning services. Our knowledgeable Tax Defense Attorneys also assist taxpayers charged with tax evasion or tax avoidance, and are ready to provide aggressive yet meticulous representation. For a reduced-rate legal consultation concerning tax shelter questions, an IRS tax audit, an IRS criminal investigation, or general tax planning for businesses or individuals, contact us online or call (800) 681-1295 today.

    Also, we’ve expanded our offices! In addition to our offices in Irvine and Los Angeles, the Tax Law Offices of David W. Klasing now have offices in San BernardinoSanta BarbaraPanorama City, and Oxnard! You can find information on all of our offices here.

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