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Federal court in California invalidates DAD tax shelter

The Internal Revenue Code sets up a system of incentives for taxpayers relating to the payment and minimization of taxes. Payment is encouraged through the threat of penalties, while the Code dangles various carrots in front of taxpayers that can reduce their final tax bill. Examples include popular deductions, such as those for charitable donations and home mortgage interest payments.

There are perfectly legal ways to lower one's taxes, but at times people try to game the system, often through the use of esoteric tax shelters. The Internal Revenue Service typically has little tolerance for such schemes, and those who promote them and use them can face significant penalties, including incarceration.

Some of these tax shelters are known by an alphabet soup of acronyms, such as BOSS, its related progeny Son of BOSS, CARDs and DAD. The last type of shelter stands for "distressed asset/debt" and functions by acquiring bad foreign debt through a partnership. The losses inherent in the debt are transferred to a U.S. taxpayer who uses the paper losses to offset gains and income. This strategy has the potential to vastly reduce a person's tax bill, but the IRS prohibited the use of DAD shelters in 2004.

A DAD shelter was recently the subject of a court case in California. One man purchased foreign debt to save roughly $78 million in taxes, but the IRS refused to allow him to claim the losses. In response, the man filed suit, claiming that the deductions were permissible and the debt was acquired for a proper purpose.

Last week, however, the man lost his case when a federal judge ordered that the case be dismissed on the government's motion for summary judgment. A court grants a motion for summary judgment when there are no genuine issues of material fact in the case. In effect, the case ends before reaching the jury because there are no facts for the jury to determine.

In particular, the court said that the man had not demonstrated that the partnerships were created for legitimate aims or that they were not shams. This is far from the first time that a court has invalidated a DAD tax shelter, although the man's attorneys had argued that the facts of this case made his investment in foreign debt distinguishable from prior cases. The man has indicated his intent to appeal the ruling.

Source: Forbes, "Judge Shoots Down Another Forbes 400 Member's Tax Shelter," Janet Novack, Sept. 25, 2012

• The IRS aggressively pursues those it believes have avoided paying taxes. If you would like to learn more, please visit my Irvine tax evasion page.

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