TypewriterFrom The Urbach Letter – April 2003

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Tax Scams – How to Protect Yourself and Stay Out of Trouble
April. The month when good ol' Uncle Sam has his palm out… and you're probably thinking that you're paying WAY too much in taxes. The con artists and scamsters know you're feeling that way, and are now more receptive to tax-related con games: hustles that will take your money and land you in a heap of trouble with the tax man.

Not long ago, promoters of fraudulent tax shelters exclusively targeted the relatively small number of very wealthy people. However, the popularity of the Internet has enabled the scam artists to reach millions with a new class of rip-offs. While the individual transactions may only yield a few hundred or a few thousand dollars, promoters use the Internet's economy of scale to reap large revenues – and quickly disappear when the schemes inevitably fail.

The IRS is wise to many of these scams, and releases its annual list of the "Dirty Dozen," the twelve most common tax scams. Even if they don't apply in your situation, simply by knowing about them, you might be able to keep a friend out of trouble.

(1) Offshore transactions. The word "offshore" raises a big IRS red flag these days. The service is coming down hard on people who engage in foreign transactions to avoid paying U.S. income tax. Two areas in the spotlight: offshore credit cards and foreign-country-based trusts. However, the IRS has an offshore amnesty program in place through April 15th. Come clean by tax day to avoid civil fraud charges and criminal prosecution.

(2) Identity theft. Unethical tax preparers use client supplied information to access bank and brokerage accounts, run up credit card charges, get cell phone accounts, access benefits, and do other nasty things. Your defense: know whom you're disclosing privileged information to. Just about anybody can call himself a "tax preparer;" a Certified Public Accountant is held to much higher standards and is usually the best choice.

(3) Phony tax payment checks. Con artists sell discounted "sight drafts" to taxpayers so they can pay taxes due, or for other purposes. While these "financial instruments" look like real checks, they're actually worthless pieces of fancy paper. The scammers also advise people to use these drafts to overpay their taxes so they can get an IRS refund check. As you can imagine, the penalties for passing fraudulent payment checks are severe – and ignorance is no defense.

(4) African Americans qualify for special tax refund. Unscrupulous promoters offer to file for tax credits/refunds as slavery reparations – for a fee, of course. Problem is: there's no provision in the tax code for reparations. Not only are people ripped off for the "fees," they can face a $500 penalty if they don't back away from the frivolous claim.

(5) No employer withholding of taxes from wages paid to employees. Based on an incorrect interpretation of the tax code, promoters (for a fee) provide employers with instructions on how to avoid withholding federal income taxes or employment taxes from wages paid to their employees. This is bad. Uncle Sam has no sense of humor about employers who fail to remit withholding taxes. Otherwise law-abiding businesses have been summarily shut down for doing this. The IRS has repeatedly won in tax court. At the very minimum, they collect back taxes plus interest and substantial penalties.

(6) Bogus home-based business scam. Promoters sell a "package" of advice and "tools" with the claim that individual taxpayers can use their home-based business to deduct nearly all of their personal expenses. While it's true there are some tax advantages of a home-based business*, doing what these promoters advise is illegal tax avoidance and can subject you to stiff penalties. There's a world of difference between tax minimization (which is something you should do) and tax avoidance. While it's incumbent upon you to use every legal technique available to minimize the amount of taxes you must pay each year, don't cross the line. If something seems too good to be true, or if it is a scheme based on a very narrow interpretation of the tax code, you need to be highly suspicious of its legality. *You must prove – to the IRS's satisfaction – that your business has legitimate purpose and that a profit motive exists, in order to deduct business (not personal) expenses.

(7) You've won a prize. A classic telemarketing scam. The caller enthusiastically informs you that you've won a big prize and will ship it to you. However… "Federal Law" requires you to remit the income tax due on the value of the prize before it can be released for delivery. While it's true you do have to pay income tax on the actual cash value of things you've won in a contest or drawing – you pay those taxes directly to the IRS, not the "prize giver." In reality, there is no prize (or it's an ersatz item bearing no relation to the value claimed), and your "tax payment" disappears into thin air. In a legitimate contest or drawing, the prize is awarded without conditions. However, the prize giver usually sends both you and the IRS a 1099 form showing the total prize value that you'll need to report on your tax return.

(8) Frivolous arguments. "I don't pay taxes – why should you?" A person claims he doesn't file tax returns or pay any income tax. He says he's discovered a "secret loophole" in the tax code that enables him to legally avoid paying taxes. He then offers (for a fee) to share his secret with you. What he won't share with you is the real truth: he really does file returns and does pay taxes. People who don't (even if they're acting on "good" advice) end up facing civil penalties and sometimes criminal prosecution. Also in the frivolous category are the "untax yourself for only $49.95" packages. Heavily promoted on the Internet, these "untax packages" can get you in big trouble. Promoters claim that paying taxes is "voluntary," but that's not true. (Can you imagine…) If caught, sellers of these bogus schemes can be brought up on criminal tax charges – while buyers face civil penalties or possible criminal prosecution. Stay far away.

(9) Social Security "refund." Many people (including this writer) who are now paying FICA (Social Security) taxes doubt they'll ever see a dime of their money returned to them when they retire. It's therefore quite tempting to fall for a pitch to apply for a refund – right now – of the money in our Social Security "account." The scam artists charge a "paperwork fee" of about $100, plus a percentage of any refund received, to file an IRS refund claim. Of course, there's no such refund provision, and the scammers make their living off the non-refundable $100 fees.

(10) Income tax refund schemes. Most folks have taxes withheld from their paychecks – and look forward to receiving a refund check each year – as if it was somehow "free money" from the government (instead of what it really is: just payback of a zero interest loan made to Uncle Sam). So, it's tempting to entertain the idea of getting an even bigger refund (more free money!) than you'd ordinarily be entitled to. Scam operators and unethical tax preparers will sometimes offer to give you a phony W-2 to make it appear you qualify for a big refund. However, the IRS is very good at matching documents and usually catches these phony refund claims. The IRS is also very good at making your life a living hell if they catch you doing something stupid like this.

(11) Dependent claim fraud. You only need to list two children to claim the maximum Earned Income Tax Credit (EITC). If you have more than two dependents, some unscrupulous tax return preparers will propose that you "lend out your extras" to another taxpayer who needs them to claim max EITC – in return for a fee. As you can imagine, Uncle Sam doesn't like this one bit, and aggressively prosecutes the culpable parties. As with many of these tax schemes, this one entails a big risk for not that much gain.

(12) IRS "Agent" arrives to collect tax owed. Although it's pretty rare for an IRS agent to actually appear at your front door without warning, it does happen. IRS Special Agents, field auditors, and collection officers occasionally make in-person visits to collect money due. However, they usually try to make contact by phone or letter before visiting a home or place of business – and they *always* carry picture ID and badges. I hope it goes without saying that you shouldn't let anyone into your home or private office without confirming their identity first. You may think that impersonating an IRS agent would be too risky, even for a seasoned con man, but it happens frequently enough to make the "dirty dozen list."

In addition to the IRS's Dirty Dozen, two other tax scams are widespread:

Pay phone scam. Lowlifes promote this scam by claiming an individual can get a $5,000 Disabled Access Credit (DAC) on their tax return if he or she buys expensive coin-operated pay phones with volume controls for the hard-of-hearing. Unfortunately, the credit is denied because the DAC is only available to bona fide businesses coming into compliance with the Americans with Disabilities Act.

Abusive trust schemes. A legal trust is a very powerful tax planning device – if it's set up properly, and for the right reasons. There are highly sophisticated tax planning structures involving multiple trusts that can achieve significant tax advantage, but they must be designed with a great deal of legal expertise. However, some unethical advisors structure abusive trust schemes to in order to collect large fees. These abusive schemes are currently attracting intense IRS scrutiny. A trust is supposed to completely separate responsibility and control of assets from enjoyment of all the benefits. Be suspicious if the "plan" being presented to you:

(A) Allows you to have your cake and eat it too (i.e. allows full unfettered control *and* full enjoyment of the assets placed in the trust).

(B) Involves foreign (offshore) entities and/or multiple "cascading" trusts with the ultimate goal of sweeping income under the rug.

Nobody enjoys paying taxes. We work hard for our money and it's natural to want to keep as much of it as we can. While there exist certain little-known, yet legal, strategies to minimize tax (especially for bona fide business owners), you should assume "guilty until proven innocent." It's up to you to fully satisfy yourself that you're doing something smart… instead of risky and foolish. Avoiding the Dirty Dozen is a good start.

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