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Tax Avoidance and Evasion – Where is the line drawn?

Understanding Tax Avoidance and Evasion: Where is the Line Drawn?

Federal tax law makes an attempt to delineate a very clear distinction between tax avoidance, which at worst only exposes the Tax Practitioner and his or her client to possible civil penalties, and tax evasion, for which criminal penalties could apply to all parties involved. In Gregory v. Helvering, 293 U.S. 465 (1935), the Supreme Court defined permissible tax avoidance as actions that “reduce, avoid, minimize, or alleviate taxes through wholly legitimate means”. In contrast, evasion is about tax avoidance that is ordinarily accomplished by way of an element of deceit or concealment and at times patently illegal avenues. Taxpayers are legally entitled to select the most tax efficient alternative to structure any transaction. In the Helvering case, it was stated that “[t]he legal right of a taxpayer to decrease the amount of what otherwise would be his taxes, or altogether avoid them, by means which the law permits, cannot be doubted”…

Although it is generally agreed that taxpayers are entitled to avoid taxes, this historical controversy stems from the fact that in order for the structuring of a tax avoidance transaction (or transactions) to hold up to governmental scrutiny and thus fend off being recharacterized or just disregarded, the transaction structure hast to be compliant with the totality of tax law as currently enacted which includes statutory and common-law requirements such as the Economic Substance, Sham Transaction, Step Transaction, and Substance Over Form Doctrines, and the Business Purpose Test.

The Statutory and Judicial Restraints on Tax Avoidance

There are judicial and statutory constraints on tax reduction strategies of general application. These include the Economic Substance, Sham Transaction, Step Transaction, and Substance over Form Doctrines, and the Business Purpose Test. These can all be traced back to the Supreme Court’s holding in the landmark Gregory v. Helvering case. This case was about a taxpayer who formed a corporation chiefly for the purpose of exploiting the tax-free reorganization provisions so as to avoid gain recognition on a planned subsequent sale of stock to be transferred to the newly formed Corporation. In Gregory v. Helvering, the Court in found that the taxpayer was in compliance with each and every element required by statute and so a statutory reorganization was achieved. The judge held that the motive of the taxpayer to avoid tax in and of itself was not enough to render impermissible what the reorganization statute clearly allowed. It went on to focus on whether what was done, apart from the tax motive, was the act that the statute intended. Ultimately, the court answered that question in the negative, holding that reorganization was not accomplished, but it was simply “a transfer of assets by one corporation to another in pursuance of a plan having no relation to the business of either”.

Use of Tax Shelters

Tax Court consistently frowns upon losses, deductions and credits from transactions that it deems to be tax shelters via attack as a sham transaction, or by not respecting the form the transactions takes and determines the associated income tax consequences accordingly. For a transaction to be respected, it must be motivated by business considerations instead of by attractive tax avoidance benefits gained via the use of meaningless labels.

The definition that the tax court a generic tax shelter as a tax shelter that lacks statutory authority and has the following characteristics:

  • The main intention of the associated promotional materials surrounded tax benefits.
  • The taxpayers using the shelter accepted the terms of purchase in the absence of price negotiation.
  • The assets that were purchased consist of prepackaged property rights which are difficult to value in the thin air environment in which they were sold and, invariably, are substantially overvalued in relation to the property rights actually purchased.
  • The property rights have been acquired or created at a comparatively low cost shortly before the transactions under scrutiny.
  • The consideration was deferred via promissory notes which are often nonrecourse in form or in substance. Transactions that are identified as generic tax shelters in the past have included investments in the cable television industry, master music recordings, inventions, mining activities, films rights, art packages, videotape recordings, and luxury yacht leasing arrangements.

The Civil Penalties Related to Tax Shelters

There are penalties surrounding reportable transaction understatements, which increase when the underreporting is coupled with non-disclosure and in which fraud is deemed to have occurred. Civil penalties may be levied against taxpayers who participate in reportable transactions or abusive tax shelters, and thus understate their tax liability.

The fine for failure to disclose a reportable transaction is $10,000. Should the shelter be a listed transaction, the penalty goes up as high as $200,000 ($100,000 for individuals).

Possible Criminal Liability for Tax Practitioners

It is important to emphasize the obvious detail that tax evasion is a rather different situation than tax avoidance is. Tax avoidance involves the meditated legal structuring of one’s financial affairs so his or her tax liability is legally reduced or minimized. Tax avoidance is not against the law. As one famous judge said it, “one may so arrange his affairs that his taxes shall be as low as possible; he is not bound to choose that pattern which will best pay the Treasury; there is not even a patriotic duty to increase one’s taxes.” Helvering v. Gregory, 69 F.2d 809, 810-11 (2d Cir. 1934). Tax evasion, in contrast, is against the law. It involves the willful attempt to avoid paying tax liabilities after it has been incurred.

A tax practitioner may be found guilty to the same extent as the taxpayer themselves. This is because in Section 7201, the scope of tax evasion is rather broad. Specifically, Section 7201 provides that tax evasion includes a individual’s attempt “in any manner”—including helping someone else—“to evade or defeat any tax” or its payment. Therefore, the statute allows the IRS to prosecute any taxpayer for the evasion of another person’s tax liability. The defendant does not have to be the taxpayer in question themselves.

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