Tax fraud and tax protesters.

One of the Internet's many effects is more widespread exposure to fraudulent tax avoidance schemes, as well as what the Federal judiciary has repeatedly described as "frivolous tax protester theories." The Internet provides two opportunities for tax fraud schemes. First, it is a place to sell them. Second, it serves as a library for people looking for new fraudulent ideas.

Until recently, many tax practitioners had neither heard of most of these so-called "opportunities" or "theories" nor encountered a client who believed a particular contention's validity. However, practitioners are describing more encounters with these positions. A better understanding of the various arguments will help practitioners refute them and deal with client questions.

This column is not a complete list of tax fraud schemes or tax protester theories; however, it does present some of the more prevalent ones.

Tax Fraud Schemes

Slavery reparation credit. Some newspapers have referred to this as "The Tax Scare for the Ages." Promoters of this scare claim that Congress has authorized a slavery reparation tax deduction, credit or rebate. The promoters are generally tax preparers who, while advising ill-informed clients, offer to prepare the paperwork for a refund--for an additional charge.

The IRS received nearly 80,000 claims for slavery reparations in 2001, totaling $2.7 billion. What's worse? The June 2002 issue of Kiplinger's Personal Finance (www.kiplinger.com/ magazine/archives/2002/June/ managing/digest.html) reported that the IRS had "paid out more than $30 million to taxpayers who claimed a nonexistent slavery-reparation tax credit ..."

Social Security refund. This scam is one of the stand-alone steps in a "detaxing" fraud. Promoters tell potential victims that they can recover all of their FICA and Medicare taxes paid. A typical additional charge would be $100 plus 10% of the refund amount. The taxpayer never sees the refund, but does get to meet with the IRS.

Home-based businesses. A number of these schemes exist. New ones crop up, often with the same players, as state or Federal authorities eliminate old ones. The general approach is to claim that thousands of dollars in tax deductions can be realized by starting a home-based business. Ignored in the promotional materials are the Sec. 183 hobby loss rules and the Sec. 162 ordinary and necessary business expense tests.

As these schemes almost always double as multilevel marketing "opportunities," scheme promoters have a ready-made business for their victim--selling the opportunity to others. Of course, there are up-front fees and monthly membership fees. Promoters will have their accounting staff (replete with CPAs and former IRS agents) prepare the returns and represent "clients" before the IRS.

A major operation being sold over the Internet was terminated in Kansas by the combined efforts of the Kansas Attorney General and several Federal agencies.

IRS Pub. 4035, Home Based Tax Avoidance Schemes, warns of these scams, asking "is it too good to be true?" It provides facts on home-based business deductions that refute the promotional claims.

Abusive trusts. Abusive trusts fall into two broad categories, foreign and domestic. Domestic trusts take a variety of forms directed at either deducting personal expenditures or evading income taxes. Foreign trusts promise the same and "guarantee" privacy.

Promotional materials for such trusts often use phrases like "asset protection" or "tax minimization" While there are solid personal or business reasons for creating a trust, tax avoidance is not one of them. Amounts charged for creating the trusts, according to the IRS, range from $5,000-$70,000. IRS Pub. 2193, Should Your Financial Portfolio Include "Too Good To Be True Trusts?" addresses this problem.

Frivolous Tax Protester Theories

"Tax protesters" as used here, means "illegal tax protesters (i.e., those who argue that the Code does not apply to most individuals residing in the U.S.). All of their "theories" have been tested in Federal courts and have been found wanting. The individuals who promote such theories have been previously convicted or are under indictment.

The 16th Amendment was not properly ratified. Tax protester theories are inspired by the continuous distribution of tax protester publications. This theory holds that, for various reasons, the 16th Amendment is not part of the Constitution, due to perceived nonratification; see Thomas, 788 F2d 1250 (7th Cir. 1986).

No liability exists in the law. Tax protesters often argue that the Code does not specifically state that individuals are liable for the taxes imposed on their income. They point to alcohol tax sections, which do specify exactly who is liable for that tax.

Part of the problem is the Code's complexity; three sections are needed to show liability for income taxes:

* Sec. 1(a) imposes a tax on every individual's income;

* Sec. 6012(a)(1)(A) describes who must file a return ("Every individual having for the taxable year gross income which equals or exceeds the exemption amount ..."); and

* Sec. 6151(a) specifies that the person filing the return must pay the tax ("... the person required to make such return shall, without assessment or notice and demand from the Secretary, pay such tax ....").

The alcohol tax rules are specific because of potential ambiguity about who would be liable for the tax (e.g., distiller, wholesaler, retailer or consumer) if the law were not clear. Despite the use of multiple Code sections, no such ambiguity exists for the income tax.

Sec. 861. The "Sec. 861 argument" is currently one of the most popular with tax protesters. Their position requires misinterpreting Sec. 861 and studiously ignoring portions of that section and its regulations, as well as Sec. 61 (which defines gross income). They use language from Sec. 861(a) ("The following items of gross income shall be treated as income from sources within the United States"), coupled with the absence of the word "wages" in Sec. 861(a)(3), which uses "compensation for labor or personal services" instead. Because Sec. 861 describes geographic sources of income for one purpose and does not specifically use the word "wages" tax protesters maintain that wages are not taxable to U.S. citizens for any purpose.

Proponents of this point of view also ignore the fact that U.S. citizens and residents are taxed on their worldwide income, and that Sec. 861 is primarily of interest to nonresident aliens and to those U.S. citizens and residents eligible to exclude earned income under Sec. 911. A number of small business owners have used the "Section 861 argument" to justify their failure to withhold taxes from their employees' salaries.

Paying income taxes is voluntary. Nothing in the Code, regulations or cases remotely supports this contention. The argument is based on public statements by various government officials, about "voluntary compliance," in the sense that the Federal income tax is self-assessed and paid. "Voluntary" in this context does not mean the individual has a choice of whether to pay taxes owed.

Wages are not taxable. A number of theories have been advanced to support this assertion; all have been refuted in the courts. Tax protesters sometimes argue that the omission of the word "wages" in Sec. 61 supports their view. (This would mean, of course, that "compensation for services" does not include wages.)

Other arguments assert that the receipt of wages is a tax-free exchange of labor for money and, thus, is not income. If this view were accepted, the property (i.e., labor) would have to have a basis above zero for there to be no income.

How to Respond

When a client presents one of these theories or something similar, it is crucial to respond in terms he or she can understand. For example, "Section 861 only makes a difference for some noncitizens or for people living and working outside the U.S. I am sorry, but it does not help your tax position." Or, "If your home business is profitable, your taxes will go up. If your only intent is to generate tax losses, the law will not let you use those deductions." The more sophisticated the client, the more complex the response can be.

It may be necessary to tactfully explain to a client the difference between a legitimate tax reduction strategy and breaking the law.

Practice Management

A client who asks questions such as "Can you show me the specific section that makes me liable for taxes?" or "Isn't it true the 16th Amendment gave Congress no new powers to tax?" has likely already concluded that one of these theories is valid, All the facts and circumstances must be considered in deciding to accept a new client or end an association with an existing one. However, it may also require considerable time and effort to dissuade an individual who has already decided and is now simply shopping for a complicit tax preparer.

More Information

As it does with tax protester theories and tax fraud schemes, the Internet also makes the truth about these issues more easily available. Listed in the resource box on p. 791 are websites with useful information. Also provided are means of obtaining other material on tax fraud schemes and tax protester theories.

Online fraud and tax protester resources *

* The "Tax Fraud Alert" page of the IRS Criminal Investigation can be reached at www.irs.gov/ newsroom/article/O,,id=98269,00.html, then click on "Tax Fraud Alert." These pages describe various tax fraud schemes.

* The Tax Protester FAQ (maintained by Daniel B. Evans, Esq., at http://evans-legal.com/ dan/tpfaq.html) is an excellent resource (complete with citations) that effectively shows how tax protester theories have been refuted and rejected.

* Web pages maintained by Professor William Brown (www.longwood.edu/staff/wpbrown/ InternetFraud.htm and www.longwood.edu/staff/wpbrown/wpbtax.htm#protest) provide links to the above and other information sources.

* "Quatloos!," at www.quatloos.com, presents information on an extensive assortment of scams and frauds, including tax protesters, off-shore scams and others.

* Keyword searches using online search engines such as Ixquick (www.ixquick.com) or Google (www.google.com) can provide valuable information. Search results often list sites with the truth about a topic, as well as those promoting the fraud or tax protester theory of interest.

* The URLs are linked in The Tax Adviser online. To access, see "TTA Online," on the first page of this issue, for details.

Editor's note: Steve Holub is former chair of the AICPA Tax Division's Tax Practice Management Committee. Dick Adams is a member of the Member Tax Practice Improvement Committee. If you would like further information about this column, please contact Mr. Holub at [phone] or [e-mail], Mr. Adams at [phone] or [e-mail] or Dr. Brown at [phone] or [e-mail].

FROM WILLIAM P. BROWN; PH.D., CPA, ASSOCIATE PROFESSOR OF ACCOUNTING, LONGWOOD UNIVERSITY, FARMVILLE, VA, AND RICHARD D. ADAMS, CPA, ASSISTANT PROFESSOR OF ACCOUNTING, UNIVERSITY OF BALTIMORE, BALTIMORE, MD