6 WAYS TO KEEP IRS AT BAY

IRS has decided to focus its limited resources on the tax returns of those who earn more than $100,000. Are you vulnerable? Here are smart ways to minimize your exposure.

They’re coming to get you . . . ha, ha!

After years of ignoring the ability of the rich to get around the tax code, the IRS now plans to crack down on abuses by the wealthy.

One of the reasons for making a move on the wealthy is that the abuses have been so flagrant that now even Congress is offended. Plus, the federal deficit is swelling quickly, and the government needs the cash.

One way to get it is to make sure everyone pays his or her fair share — including the rich, who can afford to pay high-priced tax attorneys to find the cracks in the tax code. These tax experts design investments for their clients and structure their financial situation so that much of their income is sheltered from tax.

They do a great job.

For tax year 2000 — filed in 2001 — 2,328 returns with incomes of $200,000 or more showed no income tax liability. That was up from 1,605 returns in the prior year. Plus there are a lot people making a lot more money. The Washington Post reported that the number of people who report more than $1 million a year in adjusted gross income has more than tripled in recent years — to 239,258 in 2001 from 66,485 in 1993. Worse, cheating by corporations and individuals is worse than was once thought.

So, what are the consequences to you of this shift in priorities? If it’s legal, a move that reduces taxable income is called tax avoidance, and everyone just calls it a “loophole.” But, if it’s not legal, that’s tax evasion and could land you in jail.

Unless you look really good in stripes, here are six suggestions about what to be aware of, and what to run from:

1. Reduce Your Exposure

DUH! I’ll tell you a little, but true, story. In 1976, Congress asked the American Statistical Association to suggest ways to improve the effectiveness of the Internal Revenue Service. I was honored to serve with the commission (there were more that 1,200 of us statisticians who so served). After more than a year of hearings and painstaking examination of the guys who examine Americans’ income tax returns, we gave Congress a 500 page long report that strongly emphasized the facts and the numbers — exactly the reason Congress asked a group of mathematicians and process theorists what to do. We found that audit yield of individual personal income tax returns was a paltry $0.30 for every $1.00 expended on the audit process. Not surprisingly, we also found that the audit yield of Subchapter C corporations was $11.00 for every $1.00 expended on the audit process. Our suggestion to Congress: eliminate examination of individual returns and focus limited IRS resources on corporations. The net effect would be additional annual collected taxes from audits of $125,000,000,000 (in 1976 dollars, unadjusted for inflation). Treasury Department reaction was surprising and unexpected: if that were done, there would be little reason for ordinary taxpayers NOT to cheat on their tax returns! RESULT: more than a quarter century in which “small peanuts” taxpayers like you and me — the “easy” targets of unscrupulous and heavy-handed tax examiners — have borne the brunt of IRS intimidation, utterly contrary to logic and sound tax management.

“The fact is,” former IRS Commissioner Charles O. Rossotti says, “people who make more than $100,000 pay more than 60% of the taxes, and we need to focus there.”

Double DUH! But still small peanuts compared to large global organizations.

If you’re making more than $100,000 a year, your risk and probability of an audit has increased. That means that it’s even more important now to keep adequate records to substantiate your deductions.

It also reinforces the benefits of income allocation. That’s where you view your family as a single economic unit, obviating the issue of who actually generated the income. You can then, within the law, allocate income from a higher bracketed family member to a lower bracketed one, and save the difference in tax dollars.

Putting investments in a child’s name makes the income generated from those investments taxable to the child, rather than to the higher bracketed parent. Be aware of the “kiddie-tax” rules on investments and the issues relating to how to structure the investments so that they’re taxed to the child. Generally, the first $750 in investment income for a child under age 14 is untaxed. The next $750 is taxed at the child’s rate. Anything over $1,500 is taxed at the parents’ marginal tax rate.)

If the situation is warranted, it may be appropriate for a couple to file separately. Even if the numbers are close, or it cost you more, remember that filing separately insulates the other spouse (and his/her assets) from claims against your return. It also lowers each filer’s income, potentially below the $100,000 target threshold.

2. Keep Your Money at Home

When the IRS announced its new audit priorities, Number 1 on its hit list was “offshore credit-card users.” Here’s how the game was played. In its most simple form, you’d open up an account overseas with unreported income and attach that account to a credit card with the foreign bank. You’d then use the card for easy access to your offshore funds. You’d open your account in a tax haven country that allows such income to be hidden.

Not anymore.

The IRS has demanded and received records from American Express, VISA and MasterCard. If you have an offshore credit card, the IRS is going to find out and draw concentric circles around your wallet. You may be innocent, but they’re going to take a long and hard look at your finances.

The IRS also issued summonses to America Online, The Gap, Mary Kay Inc., Southwest Airlines, BellSouth, AT&T, Old Navy, Hertz, Avis and even Microsoft. The latest round of summonses went to 40 vendors, anyone whom the IRS thinks may be paid by these offshore credit-card tax cheats. You know who actually pays for these IRS extravagances. Not the tax cheaters. You and me, the guys who always wind up paying. To whom do you think the vendors pass along ALL their costs of indulging IRS witch hunts, anyhow? DUH!

“Our goal is simple and straightforward,” Rosotti said at the time: “identify the people who may be using these offshore cards to evade paying their taxes.” Start to get your house in order . . . and watch how you use that credit card.

3. Trust Nobody!

“I swear to God . . .” I said, “Nobody!” Never brag about how you put one over on the IRS! Internal Revenue Service informers can earn a reward of as much as 10% of the additional tax collected. They file Form 211. (If you see fraud, you can also report it on the IRS Hotline at 1-800-829-0433.)

4. Be Skeptical

And be skeptical that there’s a secret vehicle or structure that can insulate your income from tax. All of these claims have been rejected so often that if you just make these frivolous return arguments in tax court, you’ll be hit with a penalty of as much as $25,000! The court’s time is limited and valuable. They shouldn’t have to waste it on issues that have been settled for decades.

The reason so many of these tax protesters are still on the street is the IRS’s limited resources. It’s only a question of time, and money. And it looks like the IRS is now reallocating its resources to directly target these scams.

5. Avoid “Family Trust” Schemes

These run the gamut from claims that if you put your income into a trust, such income is taxed to the beneficiaries of the trust, to claims that if you put your personal assets into a “business trust” they become business assets and your costs for them business or investment deductions. Ain’t gonna work . . . and any claims that they do are half-truths or outright lies.

6. Don’t Mess Around With “Business Expenses”

Also avoid schemes that claim you can convert personal expenses into allowable business expenses just by calling them business expenses. If you’re “in business,” if you have a “profit objective” that you can substantiate, then the conversion potential is legal. But you really have to be “in business.”

Recent IRS statistics show a substantial decrease in the percentage of returns audited. Only 0.57% of all returns filed were audited in fiscal year 2002. That’s only about half the 0.99% audited in 1998 and only about a third of the 1.67% audited as recently as 1996. It’s simply a question of money and resource allocation. The IRS audit staff is down 29% from 1995, while the number of returns filed has grown by 13%. But the IRS has been redeploying those resources, however limited, to focus on business owners, those with investments and partnerships, and those with the big bucks.

After all, $100 disallowed to a taxpayer in the 35% bracket generates $35.00 in additional tax as opposed to only $10 from someone in the 10% bracket. That’s why 0.86% of returns with income of $100,000 or more were audited in fiscal 2002. But, that’s still way below the 3.21% audited back in 1996.