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Last week we discussed the government crackdown on “distressed asset debt” tax shelters. A tax shelter is a tax plan whose primary purpose is avoiding federal income taxes. The difference between a tax shelter and a tax-efficient business plan is that a business plan’s goals are not primarily the evasion of tax. A DAD tax shelter is a tax plan that allows wealthy taxpayers to shield income by buying junk foreign assets. The problem with many DAD tax shelters is that most participants have no reasonable expectation of profit from buying junk foreign assets and the primary reason for the purchases is to avoid paying taxes on other income. There are many variants of the DAD tax shelter model and users of different tax shelter models have suffered from IRS penalties.

The Texas-based banker that we discussed in our last post was not assessed tax penalties for using the so-called DAD tax shelter primarily because he had bought distressed foreign assets in the past could make a profit from the deal. The court did however consider the deal abusive because it allowed the banker to claim $1.1 billion as his basis for assets that he invested only $19 million in.

Another group of DAD tax shelters was marketed by a Chicago tax lawyer primarily to professionals such as doctors. This variation of the DAD tax shelter plan involved buying Brazilian debt and assets through a U.S. company that paid 1 to 2 percent of the value of the junk debts. The company would then place the bad debts in a trust and then sell the trusts to taxpayers based on how many losses the assets would generate. The government accuses the Chicago-based tax lawyer who created these assets of generating over $370 million in false tax deductions using these shelters for over 100 clients.

Participants in DAD tax shelters often do not know that what they are doing is considered abusive by the IRS. Many of the investors in these tax shelters are swayed by tax preparers and financial planners and then find themselves in trouble with the IRS. An experienced California tax litigation attorney can help those who unwittingly invest in DAD tax shelters deal with the IRS and will work to reduce the amount of possible penalties associated with a tax shelter-related audit.

Source: Forbes, “Appeals Court Nixes Billionaire Beal’s $1.1 Billion Tax Shelter,” Janet Novack, Oct. 2, 2011