27 March 2020 - Article
It is no secret the US government needs more revenue to balance its budget. To narrow the gap, the Obama administration consistently has focused its revenue raising efforts on the richest among us. The Administration, among other ideas:
- proposed (unsuccessfully so far) to allow the Bush tax cuts to expire for families earning more than $250,000;
- proposed (unsuccessfully so far) to cap the benefit of itemized deductions for high income taxpayers to a 28% tax rate regardless of the taxpayer’s actual marginal rate;
- enacted additional reporting obligations on taxpayers using non-US accounts and significant penalties for failing to comply; and
- paid for its landmark federal health reform law (at least in part) with a 3.8% tax on the investment income (interest, dividends, capital gains) of families earning more than $250,000.
The Administration’s revenue raising efforts have not been limited to tax rate increases. High net worth taxpayers are squarely within the IRS’ audit crosshairs.
It is not usual for high net worth taxpayers to use sophisticated financial, business and investment structures to achieve their goals. The goal could be asset protection, confidentiality, succession planning, and, of course, tax reduction. Typical structures may involve irrevocable trusts, private trust companies, pooled family investment vehicles, closely-held business interests, private foundations and derivative transactions. The IRS is focusing its efforts on such structures.
New High Net Worth Audit Group
Over a year ago, IRS Commissioner Douglas Schulman, speaking at a tax conference, sent a warning shot to high net worth taxpayers that the IRS is fine tuning its audit machine and high net worth taxpayers are the target. According to Commissioner Schulman, “you cannot assess compliance among the nation’s wealthiest individuals by looking only at their 1040s. Their tax picture is much more complicated than this.” A more ‘holistic’ approach is required.
And so, the IRS’ Global High Wealth Industry Group was born. The High Wealth Group’s purpose is to conduct “tax compliance reviews of high net worth individuals and the networks of enterprises and entities they control.” Although created at the end of 2009, the group is expected to hit its stride this spring.
In developing the group’s structure, the IRS looked at the experiences of tax authorities in other countries and decided a team-based multi-disciplinary approach would be most effective. This approach moves away from ‘silo-type’ audits.
The High Wealth Group is an elite group of tax examinersfamiliar with complex audits and possessing varying skills. The High Wealth Group includes flow-through specialists, international practitioners and other tax experts. In addition, it is expected that the group will consult with tax experts in the IRS’ other divisions. Such a ‘team approach’ is expected to allow the IRS to pull apart the complex web of entities, trusts, businesses, non-US properties, transactions and multiple accounts associated with the high net worth taxpayer.
Devil in the Details
To say an IRS tax audit is unpleasant is an understatement. It can be a stressful, anxious time and not because the taxpayer has anything to hide. Uncertainty exists and confidentiality is compromised. No one likes third parties reviewing personal files and records, including family trusts and succession plans. The High Wealth Group and its expanded reach can only heighten this stress.
An IRS audit begins with an information document request (IDR). Although compliance is not mandatory, it is usually advisable to cooperate and provide all non-privileged documentation in a timely manner. In a typical audit, the IRS often requests tax returns, supporting documentation and the taxpayer’s relevant books and records. The sample IDR from the High Wealth Group makes a typical audit look like a walk in the park.
The scope of the IDR is extremely broad and requests virtually every conceivable document regarding the taxpayer and his or her entities. The IDR will request the ‘traditional items’ such as sources of income, properties owned or leased, etc. Additionally, the IDR requests significant information about entities affiliated with the taxpayer such as the names of current and former officers, trustees and managers, assets of the entities, minutes, resolutions and records of the entities and even a description of work provided by tax advisors. The request and process can be daunting and intrusive.
As an added challenge, we are likely to see more use of the IRS new ‘economic substance’ penalty as part of these audits. The IRS typically challenges transactions that lack ‘economic substance.’ The parameters of the economic substance doctrine historically have been developed through the courts. However, the application was not always consistent.
Last year, Congress codified the economic substance doctrine in an effort to bring uniformity and raise revenue. Unfortunately, there is not a clear understanding of how the IRS will apply the doctrine. However, it is important to realize the new law imposes a 20% (or 40% in certain cases) strict liability penalty if a transaction is found to lack economic substance. It does not matter whether the taxpayer believed (including based on advice from counsel) there was a reasonable basis for the transaction. The strict liability penalty can apply. We expect the IRS to make significant use of this new tool in its audit of high net worth taxpayers.
What Should I Do?
Suffice to say, high net worth taxpayers may feel as though they have a bulls-eye on their back. They are probably right. Given this, we believe the best time to prepare for the audit is now – prior to the commencement of the audit and preferably when the planning is undertaken. Keep diligent records; like a diary explaining the basis and reason for complex high dollar transactions. Individuals, like the IRS, need to take a holistic approach to their finances.