Financial Management Steer Clear of Abusive Tax Shelters to Stay Off the IRS Radar

By Wesley W. Lyon II, CPA, CFP®

The IRS recently released its annual “dirty dozen,” an annual list comprised of some of the most common tax scams and fraudulent schemes. Based on this list, I want to turn my attention to the four most common abusive tax shelters that target dentists.

Syndicated Conservation Easements

A conservation easement is simply a deed or legal agreement between a landowner and a nonprofit organization or government agency that restricts the use of the land. In return, a landowner is allowed to take a charitable contribution deduction equal to the difference in value of land before and after the easement, so long as certain requirements are met.

The key to this strategy is to ensure there is a difference in the value of the land, which causes many conservation easements to not be worthwhile. For example, if you purchase hunting land worth $800 per acre, but the land is still worth $800 per acre with a conservation easement in place since the land’s highest and best use is hunting, no charitable deduction will be granted. On the other hand, if a dentist purchases a lake home with 10 acres and decides they do not want neighbors, placing an easement on nine acres of the land could substantially reduce the value of the land since lake homes can no longer be developed.

As with any good abusive tax shelter, the strategy is based on something that is perfectly legal and achievable. However, syndicated conservation easements use a few tricks to inflate valuations. In a syndicated easement, a partnership purchases land with the intent of maximizing charitable contributions for the partners. Once purchased, valuations are obtained in the form of greatly inflated appraisals that claim the land could be used for developmental purposes such as ski resorts, neighborhoods, etc., that would dramatically increase the value. The charitable deduction is then applied to the higher valuation, not the purchase price. However, these transactions lack economic substance and are a target of the IRS. Additionally, the IRS now limits the deduction to no more than 2.5 times the investors’ actual cash outlay.

Micro-Captive Insurance Companies

A captive insurance company is a licensed insurance company formed by a business to provide risk mitigation services for its parent company or related entities. For example, some large companies decline going to market for health insurance and instead “self-insure” against their risk. This can be achieved by creating a captive insurance company that is typically administered by a larger insurance company.

Many promoters of using a micro-captive insurance company sell dentists on the tremendous tax benefits that can be achieved by deducting insurance payments against practice income, since insurance companies do not need to claim premium payments as taxable income. The money can then be invested at favorable tax rates or loaned out to the doctor to avoid taxes. However, most of these captives formed to save tax money instead of providing insurance benefits aren’t following the rules. Often, they are found to have excessive premiums in relation to the risks being insured against, and very few — if any — claims are ever paid out.

These abusive captive insurance arrangements have been successfully targeted by the IRS previously, making their resurgence a bit surprising. Do yourself a favor, and avoid the excessive startup and management fees associated with tax deductions that will not stick if audited.

Research and Development Tax Credits

Research and development (R&D) tax credits are paid to companies that meet certain requirements in order to stimulate R&D in the United States. The credit can be taken if four tests are passed to prove that the expenses relate to the elimination of uncertainty, are technological in nature, involve a process of experimentation, and have a qualified purpose to design a new process or improve a current process. Under these rules, some dental practices do qualify to take the R&D tax credit.

However, as with the first two scams, the devil is in the details. While some practices have real research to improve a process or product, most do not. Furthermore, the tax credit is only calculated on the additional expenses related to the research. Many promoters try to convince dentists that everything they do is experimental and technological in nature, allowing them to qualify for inflated R&D tax credits. These promotors are most often misleading dentists that they qualify based on the four tests, while also miscalculating the attributed expenses, leading to inflated tax credits sometimes exceeding $200,000.

Abusive Trust Tax Shelter

Over the past few years, client questions regarding setting up trusts to hide income have increased substantially. I suspect this has been driven by a craze of social media influencers claiming they use multiple trusts to avoid paying income taxes. This is about as far-fetched as thinking income taxes are voluntary. Promoters of the trust scheme encourage dentists to place their assets into irrevocable trusts that then pay out expenses such as home mortgages, car payments, sporting event tickets, etc.

See a problem? Just because an asset is in a trust doesn’t mean a personal expense is now a business expense and can be deducted. To make matters worse, the trustee is supposed to take control over the assets in these situations. However, in almost every case, it is found that the original owner still maintains complete control. Just because an expense is incurred in a trust does not mean that it is a legitimate tax deduction.

What Should You Do?

Dentists should seek to eliminate any illegal strategies from their tax plan. However, this does not mean dentists should fear trying to lower their tax bill. As a tax professional, I rely on two basic principles to guide my advice. The first is that no taxpayer shall be required to pay more than legally necessary. In the 1935 case Gregory v. Helvering, Supreme Court Justice George Sutherland wrote, “The legal right of a taxpayer to decrease the amount of what otherwise would be his taxes, or altogether avoid them, by means which the law permits, cannot be doubted.”

The second principle is that all expenses that are ordinary and necessary in conducting a trade or business shall be permitted as a deduction against income.

In short, maximizing legal tax deductions should be your goal. In my next column, I’ll review the top strategies to maximize your legitimate business tax deductions.

Wesley W. Lyon II, CPA, CFP, is president and CEO of McGill and Lyon Dental Advisors. For more information on his firm’s comprehensive tax and business planning services for dentists and specialists, contact Danielle Fitzgerald at 877.306.9780, or email consulting@mcgillhillgroup.com. To comment on this article, email impact@agd.org.