Why is This Topic Important to Wealth Managers? Today we discuss one issue that is a concern to most taxpayers. The Tax Gap—The difference between the amount of taxes due and those actually paid. The blogticle provides information and facts which makes for interesting discussion among wealth managers and clients.

The Government Accountability Office (GAO) recently released a report on the tax gap and taxpayer compliance and complexity. The report summarizes that the tax code compliance issues caused by complexity resulted in an increase to the overall tax gap.

It is no surprise that the federal tax system contains complex rules. These rules may be necessary, for example, to ensure proper measurement of income, target benefits to specific taxpayers, and address areas of noncompliance. However, these complex rules also impose a wide range of recordkeeping, planning, computational, and filing requirements upon businesses and individuals.

It has been shown in the past and is also no secret that complying with these requirements costs taxpayers time and money. In 2005 GAO reported that even using the lowest available compliance cost estimates for the personal and corporate income tax, combined compliance costs would total $107 billion (roughly 1 percent of gross domestic product) per year; other studies estimate costs 1.5 times as large. In addition, economic efficiency costs, which are reductions in economic well-being caused by changes in behavior due to taxes, are estimated to be even larger.

Although many taxpayers have simple forms of income, others do not—especially those who receive income from capital gains, rents, self-employment, international and other sources—and they may be required to do complicated calculations and keep detailed records.

Tax expenditures add to tax code complexity in part because they require taxpayers to learn about, determine their eligibility for, and choose between tax expenditures that have similar purposes. Tax expenditures also complicate tax planning because taxpayers must “predict” their own future circumstances as well as future tax rules to make the best choice among provisions.

Taxpayer errors also contribute to the tax gap. For example, in 2001 taxpayers underreported $6.3 billion in net income due to misreported Individual Retirement Arrangement (IRA) distributions. In addition, taxpayers may underclaim benefits to which they are entitled. According to GAO’s past  analysis, of tax filers who appeared to be eligible for a higher-education tax  credit or tuition deduction in tax year 2005, about 19 percent, representing  about 412,000 returns, failed to claim any of them.

The Internal Revenue Service (IRS) has estimated that the gross tax gap—the difference between taxes owed and taxes paid on time—was $345 billion in 2001.

The gross tax gap is an estimate of the difference between the taxes—including individual income, corporate income, employment, estate, and excise taxes—that should have been paid voluntarily and on time and what was actually paid for a specific year.

Of the estimated $345 billion tax gap for tax year 2001, IRS estimated that it would eventually recover about $55 billion of that through late payments and enforcement actions, for a net tax gap of $290 billion.

The estimate is an aggregate of estimates for the three primary types of noncompliance: (1) underreporting of tax liabilities on tax returns; (2) underpayment of taxes due from filed returns; and (3) nonfiling, which refers to the failure to file a required tax return altogether or on time.

Tomorrow’s blogticle will discuss issues related to life insurance.

We invite your opinions and comments by posting them below, or by calling the Panel of Experts.

Why is this Topic Important to Wealth Managers? This blog presents discussion on generally unsound tax positions. Wealth managers who hear clients discussing positions herein or similar arguments should be cautious, warning their clients of the severity in which the Government goes after tax “protesters”, which the government perceives as just another form of tax evasion.  Thus, diligent wealth managers should be aware of common myths regarding the tax code.

In the mist of the tax filing season, the Internal Revenue Service last week released the 2011 version of its discussion of many of the more common “frivolous” tax arguments made by individuals and groups that oppose compliance with federal tax laws. [1]

The Service suggests that “anyone who contemplates arguing on legal grounds against paying their fair share of taxes should first read their 84-page document, The Truth About Frivolous Tax Arguments.”  Here at AdvisorFYI, we are not contemplating any particular legal grounds for not paying a “fair share of taxes”, whatever that may be, but rather are interested in presenting some of the frivolous positions argued and how the Government generally responds. We’ve presented a few select ones below.

The 2011 IRS document explains many of the common “frivolous” arguments made in recent years and it presents a legal position that attempts to refute these claims.  The IRS claims, the document “will help taxpayers avoid wasting their time and money with frivolous arguments and incurring penalties.”

Congress in 2006 increased the amount of the penalty for frivolous tax returns from $500 to $5,000.[2] The increased penalty amount applies when a person submits a tax return or other specified submission, and any portion of the submission is based on a position the IRS identifies as frivolous.

Here are some of positions we found to be commonly marketed to the public, and how the IRS responds to the positions:

Contention:  The filing of a tax return is voluntary.

Some taxpayers assert that they are not required to file federal tax returns because the filing of a tax return is voluntary.  Proponents note the Supreme Court’s opinion in Flora v. United States [3], which is often quoted for the proposition that “[o]ur system of taxation is based upon voluntary assessment and payment, not upon distraint.”

The IRS Response:  The word “voluntary,” as used in Flora and in IRS publications, refers to our system of allowing taxpayers initially to determine the correct amount of tax and complete the appropriate returns, rather than have the government determine tax for them from the outset.  The requirement to file an income tax return is not voluntary and is clearly set forth in the Code.

Any taxpayer who has received more than a statutorily determined amount of gross income is obligated to file a return.  Failure to file a tax return could subject the non-complying individual to criminal penalties, including fines and imprisonment, as well as civil penalties.

Contention:  Only foreign-source income is taxable.

Some maintain that there is no federal statute imposing a tax on income derived from sources within the United States by citizens or residents of the United States.

The IRS Response: The premise for this argument is a misreading of sections 861, et seq., and 911, et seq., as well as the regulations under those sections.  For federal income tax purposes, “gross income” means all income from whatever source derived and includes compensation for services. [4] Further, Treas. Reg. § 1.1-1(b) provides, “[i]n general, all citizens of the United States, wherever resident, and all resident alien individuals are liable to the income taxes imposed by the Code whether the income is received from sources within or without the United States.”  These frivolous assertions, the IRS states, are clearly contrary to well-established legal precedent.

And our favorite “frivolous” tax position of 2011 goes to:

Contention:  Federal Reserve Notes are not income.

Some assert that Federal Reserve Notes currently used in the United States are not valid currency and cannot be taxed, because Federal Reserve Notes are not gold or silver and may not be exchanged for gold or silver.

The IRS Rebuttal:  This argument misinterprets Article I, Section 10 of the United States Constitution. Congress is empowered “[t]o coin Money, regulate the value thereof, and of foreign coin, and fix the Standard of weights and measures.” [5] Article I, Section 10 of the Constitution prohibits the states from declaring as legal tender anything other than gold or silver, but does not limit Congress’ power to declare the form of legal tender.  [6] In United States v. Rifen, [7] the court affirmed a conviction for willfully failing to file a return, rejecting the argument that Federal Reserve Notes are not subject to taxation.  “Congress has declared federal reserve notes legal tender . . .  and federal reserve notes are taxable dollars.”

To determine the tax liability of a transaction, individual, business, trust or estate, please see AdvisorFX Main Libraries, Income Taxes.

Tomorrow’s blogticle will present discussion on planning tips.

We invite your questions and comments by posting them below, or by calling the Panel of Experts.

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[1] IR-2011-23, March 4, 2011

[2] The Tax Relief Health Care Act of 2006 amended section 6702 to allow

imposition of a $5,000 penalty for frivolous tax returns and for specified frivolous

submissions other than return

[3] 362 U.S. 145, 176 (1960),

[4] Citing, I.R.C. § 61.

[5] Citing, U.S. Const. Art. I, § 8, cl. 5.

[6] Citing 31 U.S.C. § 5103; 12 U.S.C. § 411.

[7] 577 F.2d 1111 (8th Cir. 1978).

Why is this Topic Important to Wealth Managers? Many US expats who do not work for a US headquartered company are failing to report pensions they are accruing from the companies they are working for overseas.  These clients may incur large reporting penalties.

Submission by Thomas Carden, IRS Enrolled Agent

Many expats that do not work for a US based company are failing to report pensions they are accruing from the overseas companies they are working for. They often disregard the pension because they incorrectly assume that it is not taxable in the US.

However, the vast majority of foreign pension plans are not considered to be qualified by the IRS.  Consequently, these foreign pension plans do not enjoy any tax mitigation – the plans are taxable.

The IRS has very rigorous regulations for plan reporting and for the criteria to be a qualified plan, and thus foreign employers rarely seek such plan qualification.   Compounding the problem is that most financial professionals are rarely asking their clients with foreign employers “Do you have a foreign pension that contributions are being made to?”

Because of this mistaken belief that such foreign pension plans are to be treated like those in the US, many expats are incorrectly reporting their income net of any pension contributions.

Before FATCA (the  Foreign Account Tax Compliance Act of 2010) the pension contributions were generally not being reported to the IRS, thus they were incorrectly escaping taxation on US returns.  The goal of FATCA is to substantially capture information on the number of these accounts and many other foreign account types turning that information over to the IRS.  The act puts onerous penalties on financial institutions that do not report accounts that are in the names of US citizens and other US taxable persons.

Any foreign institution that does not agree will be subject to a thirty percent withholding rate on payments made to it.  Because of the penalties and the general move toward cross border reporting in financial transactions, the IRS will be receiving a large amount of information on these previously unreported accounts.   The act also requires individuals to disclose any foreign accounts with a balance that exceeds $50,000.  Failure to do so may result in an initial fine of $10,000 plus additional penalties.

The good news is that the acts reporting requirements are set to begin on January 2nd of 2012.  Thus, expats have time to address the issue of unreported foreign pensions. The problem for expats with these unreported accounts is that the contributions are counted as taxable income in the US for the year they were made to the pension.  If the IRS receives information about such an account, it is highly probable that it will send a “deficiency letter” stating that tax is due on the unreported amount.  At worst, finding an unreported account may trigger an arduous audit.

The solution for the problem is for expats with any unreported pension accounts to amend the returns and restate the income received, for any years that contributions were made to the accounts.  Such disclosures for past non-reporting should probably be handled by a expert in this area to avoid any unnecessary penalties.

Submission by Thomas Carden, a IRS Enrolled Agent and Expatriate Tax Specialist with 15 years of Tax and Financial Services Experience.  He is currently enrolled in the Diamond Program at Thomas Jefferson School of Law while also studying to sit for the ATT tax designation in the UK.  You may contact him via his email – tmcarden@yahoo.com.

Why is this Topic Important to Wealth Managers? Provides a brief discussion on the difference between tax avoidance versus evasion, the former earns wealth managers checks and the latter can send them to jail.  Knowing the difference, when to spot it, and how to “avoid evasion” is essential to any wealth manager’s tool kit.

Tax avoidance is “The act of taking advantage of legally available tax-planning opportunities in order to minimize one’s tax liability.” [1] On the other hand, tax evasion is the “willful attempt to defeat or circumvent the tax law in order to illegally reduce one’s tax liability. [2]

From the above definitions, and the function of the tax code itself, the line becomes blurred between taking advantage of legally available planning opportunities and a willful attempt to circumvent the tax law.  A well known quote often attributed to Will Rogers speaks to this point.  “The income tax has made more liars out of the American people than golf has. Even when you make a tax form out on the level, you don’t know when it’s through if you are a crook or a martyr.” [3]

Today’s advanced transactions are even more difficult to understand in regards to an ever expanding tax code.  Even over 50 years ago, (well before the Revised 1983 Code) it was said by one of the world’s most famous scientists, Albert Einstein, “The hardest thing in the world to understand is the income tax.” [4] So if Einstein had trouble with calculation of income tax liability, in the 30s-40s what can wealth managers do to not only keep their clients safe, but also maximize every opportunity?

• Stay Informed – A plan that may have been okay last year may be under attack currently.  Some forms of retirement plans were the classic example of this.
• Ask an Attorney and/or Accountant– If a wealth manager is planning a transaction that he/she is not absolutely sure of the consequences, in other words willing to risk licensing and professional liability, then it would be prudent to seek tax and/or legal advice for the client.  A small amount of billable time now can go a long way later, even if to just confirm initial conclusions.
• Don’t Stay too Limited – If a wealth manager hears of a beneficial concept for a client that makes sense, it may be worth exploring.  As we continue further into a global economic climate, many more international opportunities are becoming available.  Just with any other investment opportunity, risk levels vary based on various factors.
• Don’t Cheat – Know the rules of the game, and play the game the best it can be played within those rules.  Take for example, the recent “Father & Son” Cohen tax evasion case in South Florida.  The Times reported [5], “Prosecutors said the Cohens used offshore companies, friends and family posing as owners, and forged documents to cheat on their taxes. They said the Cohens should have declared income from their use of mansions and luxury cars that the father and son said were owned by corporations.”

Whomever was advising the Cohens, based on the information provided, was not doing a good job.  The Cohens were convicted at trial of “hiding a $33 million hotel sale from federal tax authorities while living a lavish lifestyle.”

It should be quite clear from the above example that forged documents are obviously illegal and wealth managers should make every attempt to avoid participating with anyone who has an intent to defraud.  There is always a line in the law, and although what the line is, or where it lies is not always clear, wealth managers should be able to distinguish clearly illicit activity.  With that in mind, it has long been the reasoning of the High Courts that for the reason and in favor of the “astuteness of taxpayers in ordering their affairs so as to minimize taxes we have said that ‘the very meaning of a line in the law is that you intentionally may go as close to it as you can if you do not pass it.’ ” [6]

Tomorrow’s blogiticle will discuss tax advantageous solutions such as bonds.

We invite your questions and comments by posting them below, or by calling the Panel of Experts.

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[1] Black’s Law Dictionary (8th ed. 2004), tax avoidance.

[2] Black’s Law Dictionary (8th ed. 2004), tax evasion.

[3] See generally, Charlie Kelliher, PhD.  Associate Professor, Dixon School of Accounting – University of Central Florida.   http://www.bus.ucf.edu/ckelliher/tax_5015/examples/tax_quotes.htm.  Last Accessed 10/6/10.

[4] Id.

[5] “Father and Son Found Guilty of Tax Evasion.” New York Times crediting Bloomberg News.   http://www.nytimes.com/2010/10/07/business/07tax.html?_r=1&src=busln.  Published: October 6, 2010.  Last Accessed 10/6/10.

[6] Atlantic Coast Line R. Co. v. Phillips 332 U.S. 168, 172-173, 67 S.Ct. 1584, 1587 (U.S. 1947) citing,  Superior Oil Co. v. State of Mississippi, 280 U.S. 390, 395, 396, 50 S.Ct. 169, 170, 74 L.Ed. 504.