Distinguish Tax Loopholes and Tax Scams

If you think the tax loophole you've heard aboutrecently sounds too good to be true, chances are itis. Developers and promoters of tax avoidanceschemes are running rampant, and busy physicianslooking for a tax break are easy targets.

"Tax loophole" refers to steps that result in tax benefitsthat are permitted by law, but were not intended orforeseen by Congress or the IRS. Many of these, however,are really tax scams. Sly developers commonly promotetax schemes under the guise of a tax loophole inorder to dupe the unsuspecting investor.

Life Insurance Loop

American Association ofIndividual Investors Journal

According to a report in the (AAII; www.aaii.com), permanentlife insurance is often associated with variousloopholes. The article notes that a common life insurancetax loophole is the use of permanent insurance cashvalues to fund retirement income via policy loans thatare never included in the policy owner's income.

Withdrawals of cash value are taxable when theyexceed cost basis, but not when these withdrawals arepolicy loans. Insurance companies take advantage of thisloophole by designing policies that have net-zero loaninterest (ie, crediting the loaned funds with the same loaninterest rate so there is no net cost to borrow). Thisattracts consumers to policy loans for retirement income.

However, the article points out that some cutting-edgelife insurance tax planning employs tax scams, notloopholes. It involves a critical step that has no authorityin tax law, but that isn't explicitly prevented. This criticalstep is usually hidden, while many other steps orissues that are perfectly legitimate are used to defend thetax plan's legitimacy. The IRS is actively pursuing varioustax avoidance schemes that use this clever catch-us-if-you-can approach.

Doctors' Nightmare

AAII Journal

Neonatology v Commissioner

The article offers the following real-lifeexample to explain how catch-us-if-you-can planningoperates. In , a recent USTax Court case, New Jersey doctors were promised a setamount of tax-free retirement income and paid-up lifeinsurance in exchange for specified tax-deductible contributionsto a particular type of employee benefit plan.

The duplicity was the representation of permanentlife insurance as term insurance with a conversion right.The overpaid term insurance premiums were fullyexpensed as a benefit plan of death-only contribution.But the Tax Court judge ruled that it was 1 policy with2 components, and the excessive premiums could not beexpensed. The court reproached the doctors for theiractions and denied their defense that they merely reliedon professional advisors' advice.

The doctors were denied their deductions, hit withdouble taxation (because the excess contributions wereconsidered constructive dividends), and assessed interestand negligence penalties. These costs exceeded the originalcontributions many of the doctors had made whenthey signed up for the retirement plan. To add insult toinjury, the plan developers continued to encourage thedoctors to pursue their tax fight because the plan was alegitimate loophole. In the end, the doctors were takenfor a ride a second time.

Other Scams

New York Times

A article discusses another taxscam involving life insurance, which was recentlybanned by the US Treasury Department. Thousands ofthe wealthiest Americans used a technique to escape billionsof dollars in gift and estate taxes.

Bottom line:

They bought huge life insurance policies on themselves,purposely paying the highest rates they could find.Each dollar spent on this insurance can typically eliminate$9 in taxes. If you paid a $10-million premium onthis insurance, you could avoid $90 million or more intaxes. Experts predict that people who have boughtthese policies will face years of litigation. Bewell advised before attempting to leverage a tax loophole.It may be a scam in disguise.