When Does the IRS Call a Tax Strategy an Illegal Tax Scam?

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New rules have given the IRS even more power in striking down transactions that save taxes. The issue is something called “economic substance.” Basically, the doctrine of economic substance means that the tax strategy must have an economic reason, not just a tax reason.

In 2006, the IRS won an additional $62 million in taxes from a single corporate transaction that flunked the economic substance test. So, how can you make sure the strategy you’re using will pass IRS muster?

Court cases that favor the IRS seem to largely be the case of “tax packages” that have been designed as “one size fits all” type of strategies. For example, a very large CPA firm put together a complicated structure that kicked off tax losses to offset income. They then proceeded to sell that same structure, again and again. The structure cleared didn’t pass the smell test in one case and that meant all of the cases were subsequently disallowed, even if the facts were different.

Other packages are allowed, almost endorsed, by the IRS.. For example, it seems that they are particularly fond of strategies involving life insurance. The bottom line is that it boils down to economic substance. Is there a chance for the taxpayer to gain from the transaction? This could be through asset protection, estate planning or additional income. But there has to be something more than just saving on taxes when you put a strategy in place.

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