Is this tax-dodge really legal?

[ryanf1475]

In the wake of the recent headlines about billionaires paying almost no taxes, I have been wondering what constitutes "tax evasion," exactly. I understand it's distinct from its legal cousin, tax avoidance. But, for example, one of the biggest loopholes I can think of is the stepped-up basis upon inheritance and the various ways this can be taken advantage of. For instance, if a child owns a lot of stocks and transfers them to a dying parent to then inherit them with the stepped-up basis, is that really legal?? It seems hard to believe.

 

[Zigner]

In the wake of the recent headlines about billionaires paying almost no taxes, I have been wondering what constitutes "tax evasion," exactly. I understand it's distinct from its legal cousin, tax avoidance. But, for example, one of the biggest loopholes I can think of is the stepped-up basis upon inheritance and the various ways this can be taken advantage of. For instance, if a child owns a lot of stocks and transfers them to a dying parent to then inherit them with no cost basis, is that really legal?? It seems hard to believe.

 

[LdiJ]

In the wake of the recent headlines about billionaires paying almost no taxes, I have been wondering what constitutes "tax evasion," exactly. I understand it's distinct from its legal cousin, tax avoidance. But, for example, one of the biggest loopholes I can think of is the stepped-up basis upon inheritance and the various ways this can be taken advantage of. For instance, if a child owns a lot of stocks and transfers them to a dying parent to then inherit them with no cost basis, is that really legal?? It seems hard to believe.

It could happen, but only at fairly small levels. It also would not be "inheriting them with no cost basis". It would be inheriting them with a stepped up cost basis to fair market value. No cost basis would mean having to pay capital gains tax on the entire amount. In addition, any scheme like that is a cumbersome way to attempt to avoid tax. If someone owns lots of stock, it far simpler to sell some underperforming stock in the same year other stock is sold with high gains, so as to lessen the overall capital gains.

Tax avoidance is legal. Tax avoidance means using the laws in a legal manner to lessen someone's tax burden. It is basically a form of financial planning.

Tax evasion is breaking the law.

 

[Taxing Matters]

In the wake of the recent headlines about billionaires paying almost no taxes, I have been wondering what constitutes "tax evasion," exactly.

There are a number of federal tax crimes. But as to federal tax evasion, the applicable statute is Internal Revenue Code (IRC) section 7201, which reads:

Any person who willfully attempts in any manner to evade or defeat any tax imposed by this title or the payment thereof shall, in addition to other penalties provided by law, be guilty of a felony and, upon conviction thereof, shall be fined not more than $100,000 ($500,000 in the case of a corporation), or imprisoned not more than 5 years, or both, together with the costs of prosecution.​

The Supreme Court has spelled out the three elements the government must prove to win a conviction of IRC § 7201:

As has been held by this Court, the elements of s 7201 are willfulness; the existence of a tax deficiency, Lawn v. United States, 355 U.S. 339, 361, 78 S.Ct. 311, 323, 2 L.Ed.2d 321; Spies v. United States, supra, 317 U.S. at 496, 63 S.Ct. at 366; and an affirmative act constituting an evasion or attempted evasion of the tax, Spies v. United States, supra.​

​

Sansone v. United States, 380 U.S. 343, 351, 85 S. Ct. 1004, 1010, 13 L. Ed. 2d 882 (1965). Thus, actions like failing to file federal income tax returns along with concealing your income from the government, knowingly failing to report all your income on a return you do file, and knowingly taking deductions and credits on your return that you are not entitled to take are all acts of tax evasion.

But, for example, one of the biggest loopholes I can think of is the stepped-up basis upon inheritance and the various ways this can be taken advantage of. For instance, if a child owns a lot of stocks and transfers them to a dying parent to then inherit them with the stepped-up basis, is that really legal?? It seems hard to believe.

Whether it is legal depends on how this is done and how the child and parent report it on their various federal tax returns. Understand that this transaction may well be challenged by the IRS as not being bona fide gift to the parent causing it to fail in achieving the stepped up basis unless carefully done. It also comes with the downside of (1) requiring the child to file federal gift tax returns if the stock involved (along with any other gifts the child gives the parent during the year) exceeds the gift tax exclusion for the year and (2) adds the stock to the parent's gross estate for federal estate tax purposes. Thus for the very wealthy this would not be worth doing as the gift and estate taxes involved would exceed the benefit of any stepped up basis, even assuming they could withstand IRS challenge.

 

[ryanf1475]

There are a number of federal tax crimes. But as to federal tax evasion, the applicable statute is Internal Revenue Code (IRC) section 7201, which reads:

Any person who willfully attempts in any manner to evade or defeat any tax imposed by this title or the payment thereof shall, in addition to other penalties provided by law, be guilty of a felony and, upon conviction thereof, shall be fined not more than $100,000 ($500,000 in the case of a corporation), or imprisoned not more than 5 years, or both, together with the costs of prosecution.​

The Supreme Court has spelled out the three elements the government must prove to win a conviction of IRC § 7201:

As has been held by this Court, the elements of s 7201 are willfulness; the existence of a tax deficiency, Lawn v. United States, 355 U.S. 339, 361, 78 S.Ct. 311, 323, 2 L.Ed.2d 321; Spies v. United States, supra, 317 U.S. at 496, 63 S.Ct. at 366; and an affirmative act constituting an evasion or attempted evasion of the tax, Spies v. United States, supra.​

​

Sansone v. United States, 380 U.S. 343, 351, 85 S. Ct. 1004, 1010, 13 L. Ed. 2d 882 (1965). Thus, actions like failing to file federal income tax returns along with concealing your income from the government, knowingly failing to report all your income on a return you do file, and knowingly taking deductions and credits on your return that you are not entitled to take are all acts of tax evasion.

Whether it is legal depends on how this is done and how the child and parent report it on their various federal tax returns. Understand that this transaction may well be challenged by the IRS as not being bona fide gift to the parent causing it to fail in achieving the stepped up basis unless carefully done. It also comes with the downside of (1) requiring the child to file federal gift tax returns if the stock involved (along with any other gifts the child gives the parent during the year) exceeds the gift tax exclusion for the year and (2) adds the stock to the parent's gross estate for federal estate tax purposes. Thus for the very wealthy this would not be worth doing as the gift and estate taxes involved would exceed the benefit of any stepped up basis, even assuming they could withstand IRS challenge.

Thank you--I think this question of bona fidelity gets at the heart of my question--is it legal to make this maneuver overtly for the purpose of avoiding taxes? Or, is it only legal if it was in fact a good faith gift? If that's the case, then it seems it can't be classified as tax avoidance but instead, either a bona fide gift, OR, tax evasion? So interesting...

 

[Taxing Matters]

Thank you--I think this question of bona fidelity gets at the heart of my question--is it legal to make this maneuver overtly for the purpose of avoiding taxes? Or, is it only legal if it was in fact a good faith gift?

It only really works if it's a bona fide gift to the parent. If it fails as a real gift, then the transaction won't get the child the stepped up basis, which could lead to civil penalties imposed, in addition to the tax on the stock gain and interest. And there is the potential for criminal prosecution for tax fraud or tax evasion if it's blatant enough.

If it's a bona fide gift, then the child runs a variety of risks here. With a bona fide gift, the stock truly belongs to the parents and they'd be free to do whatever they wanted with it. They could sell it, give it to someone else, or whatever. Also, creditors of the parents could attach the stock to pay the bills of the parents. So if the parents became ill, for example, and ran up a whole lot of medical bills, the stock may end up having to be liquidated to pay those bills. In short, there is a risk that the stock could be lost entirely by doing this, which of course is much worse than having to pay tax on gain based on the child's cost cost basis when the child sells the stock later.

As a tax lawyer, this is not a technique I would recommend to clients.