IRS Closes Tax Shelter Loophole

The Internal Revenue Service issued Notice 2002-65 that will close the tax loophole that enables certain types of tax shelters that have gained publicity lately. The IRS estimates that last year alone approximately 87,100 taxpayers used a tax device such as the one addressed in this Notice.

The premise behind this tax avoidance device is to move income through various entities such as partnerships and S corporations in such a way as to defer tax payment and in some cases avoid taxes altogether. An individual taxpayer forms a taxable entity with another owner, such as a foreign bank, someone or some entity not subject to U.S. taxes. The two owners then engage in currency trades that result in gains and losses. The gains are channeled to the foreign partner while the losses are passed through to the U.S. taxpayer, who then uses the losses to offset otherwise taxable income. In some situations, several layers of partnerships or S corporations are used so that the trading transactions are not easily detected in a review of the U.S. taxpayer's tax return.

Earlier this year, The New York Times reported that Ernst & Young was involved in selling such tax shelters to clients. In some cases, taxpayer/clients paid E&Y a fee of $5 million to set up the shelter and avoid as much as $20 million in taxes.

In July, the IRS filed suit against BDO Seidman and KPMG, attempting to gain access to records of clients who participate in questionable tax shelters. That suit is still pending. Recently, the IRS announced plans to target tax shelters and taxpayers who report more than $100,000 in income in an effort to focus efforts and catch tax evaders. This IRS Notice is one step in that process.

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