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Chasing the Tax Fairy

-Joe Kristan is a founding member of Roth & Company P.C.

There is no Tax Fairy, but there are many believers. 

Tax-fairyTaxes hurt. It's human nature to want to believe in something that stops the pain. That's why clients regularly ask their tax pros why they haven't recommended some foolproof plan discovered at the gym, or on the golf course, or on Reddit. They really want their tax pros to introduce them to the Tax Fairy.

Belief in the Tax Fairy takes many forms. Let's cover some commonly-told Tax Fairy tales.

The ESOP Tax Fairy. Employee Stock Ownership Plans, done properly, can be a useful tax tool, though one with compliance risks and costs. But it isn't a Tax Fairy. You can't use an ESOP to hide all of the income of a profitable family-owned business and still keep the business all in the family. You certainly can't use an ESOP if for a business that isn't a corporation. You can't keep your personal investments in an ESOP. Nor can you keep your house, your cars, your snowmobiles, or your vacation cottage in an ESOP. If you are doing any of these things, you're looking for the Tax Fairy in the wrong place, and you need to talk to a specialist practitioner right away.

The Home-based Business Tax Fairy. We've all seen versions of this. My favorite was one from the 1990s based on selling golf equipment. It was touted as making all of one's golf costs -- tee times, new clubs, trips to nice courses in warm places -- tax deductible. Because you were in the golf business! It didn't much matter whether you made a profit from selling golf things, because the tax savings from your golf deductions made it pay.

In real life the tax authorities don't look at it that way. The tax law requires you to have an objective of making money before taxes. Deductions that look too much like fun come in for special scrutiny. If the tax man determines you aren't really in it for a pre-tax profit, there go your deductions, and here come penalties and interest. Whether it's golf gear, vitamins, or household cleaners, Uncle Sam doesn't want your tax refund to be your business plan. 

The Pennies-on-the-Dollar Tax Fairy. This particular Tax Fairy cult singlehandedly supported dozens of talk-radio shows and late-night TV reruns in the past decade. Celebrity tax practitioners promised to reduce your IRS debt to "pennies on the dollar." But despite the ads' promises and the up-front payments made by desperate or deluded tax debtors, the Tax Fairy never showed up. Big settlement firms like TaxMasters, Roni Deutch, and J.K. Harris collapsed in bankruptcy, and the only "pennies-on-the-dollar" settlements many customers received were their bankruptcy recoveries on fees paid to the settlement outfits. In real life, "pennies-on-the-dollar" settlements happen, but only when you convince the IRS that you really are too broke to pay what you owe. Whatever it accomplishes in reducing your tax debt, poverty has compelling non-tax drawbacks.

The "Classic 105" Tax Fairy. This apparition of the fairy emerges from the mists of fringe benefit law. Hank Stern of Insureblog saw it described this way:

My employer claims that signing up for this "105 Classic Plan" will allow me to make 30%+ of my income tax free. The jist [sic] of it is that they will take $560 per (bi-weekly) pay period out of my check, somehow "make it tax free" and refund most of it back through some vague "loan" that I apparently don't have to pay back.

This will reduce my income taxes pretty massively... but not only that, the company making my money untaxable claims it will pay 75% of all my out of pocket medical expenses up to $12,000

So: some employer really believes you can call part of what you pay to your employees a "loan," with no requirement to repay it, and therefore make it tax-free to the employee, while still getting a deduction? Rather than getting into the (many) technical reasons this doesn't work, let's just use common sense. The income tax has been around since 1913, and it funds the majority of a trillion-dollar federal budget. Do you think it would still work after over 100 years if it were this easy to avoid? Do you think they would wait 102 years to fix a loophole this big?

The Tax Fairy appears in multitudes of ways. We won't even talk about the VEBA Tax Fairy, The offshore employee leasing Tax Fairy, or the great Turn-of-the-century Tax Fairy Mania. But most versions of the Tax Fairy myth contain a few common elements. They promise an easy way to make your taxes go away. They tell you that your regular tax pro is a milquetoast or a charlatan for not embracing their wonderful tax-saving qualities. And if they ever get looked at by the IRS, they all fail.

If someone tells you that they have found the Tax Fairy, check with your tax pro. In the long run, it's a better bet than the Tax Fairy.

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