Tax Fraud – Terminology

Use these terms and definitions on tax fraud, scams and schemes to better understand some of the articles you see on Fraud Guides

If you’ve ever had your eyes glaze over while people talk about taxes part of the reason may be that you don’t understand tax terminology. We’ve pulled together some of our favorite tax fraud terms from the IRS website (www.irs.gov) to create the following “guide”.

We hope this list of common terms helps remove some of the mystery surrounding tax fraud and results in increased understanding. This is only a partial list but we’re sure you’ve heard many of the terms on this page before. Now is a great time to brush up on your tax lingo.

Administration Expense

Ordinary and necessary expenses of trust management that typically are allowable under IRC section 212, such as fiduciary fees, accounting fees, and fees relating to maintaining trust property. Does not include costs incurred in creating a trust. Administration expenses for sham trusts would not be considered ordinary and necessary and should not be allowed as an IRC section 162 or IRC section 212 expense, but are non-deductible personal expenses.

Adverse Party

Any person having a substantial beneficial interest in the trust that would be adversely affected by the exercise/non-exercise of their power with respect to the trust. A person having a power of appointment over trust property is deemed to have a beneficial interest in the trust. A related party to the grantor, such as the grantor’s spouse, is generally considered to be subservient to the grantor, and therefore a nonadverse party. IRC § 672(c).

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Bearer Shares

Many offshore financial secrecy jurisdictions permit the issuance of bearer shares by corporations chartered in their jurisdiction. The bearer (the holder, or the one with possession of) the share certificate(s) is the owner of the share(s). Only the bearer knows that he/she owns stock in the offshore corporation. Therefore, the ownership of this offshore corporation (IBC) remains private. Bearer shares may be bought, sold, or exchanged in complete privacy.

Beneficial Ownership

This term refers to the true owner of an entity, asset, or transaction as opposed to any stated ownership provided in documents or oral representations. The beneficial owner is the one that receives or has the right to receive proceeds or other advantages as a result of the ownership. It is common practice in offshore financial secrecy jurisdictions to interpose entities, individuals, or both as stated owners. The beneficial or true owner is contractually acknowledged in side agreements, statements or by other devises.

Charitable Remainder Annuity Trust

A type of charitable remainder trust requiring a specified amount be paid from the trust to the non-charitable income beneficiaries at least annually.

Charitable Remainder Unitrust

A type of charitable remainder trust requiring payments that are based on a fixed percentage of the net fair market value of the trust’s assets be made from the trust to the non-charitable beneficiaries at least annually. Also see charitable remainder trust.

Corpus

The principal or capital of a trust, as distinguished from the income of a trust.

Custodian Services

This is a service whereby a person or entity agrees to hold and manage assets on behalf of another person or entity.

Distributable Net Income

Distributable net income is a tax concept and is commonly referred to as “DNI.” It limits and characterizes income that will be taxed to the beneficiaries, if distributed or required to be distributed, rather than to the trust. It is the taxable income of the trust modified by generally excluding dividend distributions, personal exemptions, capital gains and losses, extraordinary dividends and taxable stock dividends, and including tax-exempt interest. IRC § 643(a).

Donee

One who receives a gift (in reference to beneficiary).

Donor

One who makes a gift (in reference to grantor).

Fictitious Invoices

It is common practice in the offshore industry to issue false invoices as a means to transfer money to an offshore jurisdiction, while at the same time achieving a tax deduction for the paying entity. Commonly an entity associated with an offshore promoter will issue the invoice.

Ficuciary Accounting Income

Fiduciary accounting income (FAI) does not refer to income for tax purposes; instead, it refers to receipts allocated to income rather than to corpus. It is the amount of income determined under local law or under the specific terms of the governing trust instrument. It is similar, but not identical, to the concept of book income. IRC § 643(b).

Financial Secrecy

This term refers to the confidentiality afforded to financial transactions either by enactment of law or by other means. There are many forms of financial secrecy. Financial secrecy can be a part of an agreement between the institution and the client. Law can impose it with either criminal or civil sanctions. Financial secrecy can be operationally given by the financial institution whereby the institutional practices call for only top management to know who owns the account or no bank official knows who owns the account, such as a numbered account. It can also be obtained by the imposition of an attorney, nominee, or entity between the bank and its client.

Income Distribution Deduction

A deduction allowed to a trust for distributions to beneficiaries sometimes referred to as “IDD.” It is limited to distributable net income and is designed to avoid double taxation on income flowing from the trust to its beneficiaries. IRC sections 651 and 661.

International Business Corporation (IBC)

The term international business corporation or IBC refers to a corporation formed in an offshore financial secrecy jurisdiction which is afforded certain tax advantages and protection as to the disclosure of its beneficial owner. Depending on the offshore financial secrecy jurisdiction, shareholders of the IBC may remain confidential through the use of bearer shares. Just as with U.S. corporations, the same person may act as a shareholder, director, president, agent, or as any other officer within the company. Generally, however, the beneficial owner(s) will appoint resident officers and directors for the IBC. Typically an IBC is authorized to do business anywhere in the world except in its home country where it was incorporated (i.e. an IBC formed in The Bahamas may do business anywhere in the world except The Bahamas). The IBC may purchase real estate, cars, businesses, etc. The beneficial owner may act as an agent of the IBC to purchase assets on its behalf. By this means, assets are held under a corporate name, thereby helping to protect the beneficial owner’s privacy. It has been reported that there are over one million IBCs formed in offshore jurisdictions worldwide.

Letter of Wishes

A letter of wishes is a document that purportedly has no legal status. In fact the document is used to transmit the wishes of the creator or the alleged owner of the trust to the trustee. A letter of wishes is a separate document and not a part of the trust instrument. Letters of wishes are generally used by the beneficial owner of the trust assets to retain some control over the trust assets. Trustees normally welcome this tool. It enables them to exercise their discretion having in mind the wishes of the grantor. The trustee may consider the letter but is not bound or otherwise accountable by its terms. In reality the letter of wishes will be honored as if it were a binding legal document. Although a letter of wishes is frequently associated with abusive trusts, both domestic and offshore, it is also used as a part of normal estate planning and in other contexts for legitimate purposes.

Life Estate

A legal arrangement whereby the beneficiary (the “life tenant”) is entitled to the use of or the income from a particular property during the lifetime of the beneficiary. Upon the death of the life tenant, the property will go to the holder of the remainder or reversionary interest.

Nominee

A nominee is an individual or entity, which acts on behalf of a beneficial owner. Most often the nominee pretends to be the owner of an entity, asset, or transaction to provide a veil of secrecy as to the beneficial owner’s involvement. Many offshore entities provide nominee services whereby they will provide a nominee to act as owner of your arrangement but generally will not act unless instructed to by the beneficial owner.

Nominee Director

Every IBC must have a Board of Directors. The Board may consist of one person or many people. For instance, the beneficial owner of the IBC may appoint himself/herself as the director and sole officer of the corporation. However, most IBCs are formed with a nominee director. The nominee may be, but does not have to be, an individual who works and/or resides in the country where the IBC was formed. The nominee may be used to sign (contracts, loans, etc.) for the IBC should the beneficial owner not want his/her signature to be connected with the corporation. Typically, the nominee director will have no knowledge of the IBC’s affairs or accounts, cannot control or influence the IBC, and will not act unless instructed to by the beneficial owner.

Nonadverse Party

Any person who is not an adverse party. IRC § 672(b). A person who is nonadverse and who has a certain relation to the grantor is termed a “related or subordinate party.” Such party is considered to be subservient to the grantor in most instances with regard to the exercise of power, unless a preponderance of the evidence indicates otherwise. IRC § 672(c)

Offshore

This term, when used in this context, and when referring to a country, means a jurisdiction that offers financial secrecy laws in an effort to attract investment from outside its borders. When referring to a financial institution, “offshore” refers to a financial institution that primarily offers its services to persons domiciled outside the jurisdiction of the country in which the financial institution is organized.

Offshore Mail Forwarding Address

Often an IBC’s offshore address is nothing more than a mail drop (P.O. Box) assigned to the IBC. Bank and brokerage statements and any other type of company mail may be sent to this address. The mail will typically be picked up twice monthly by the offshore facilitator. The IBC’s mail will be put into a plain, brown envelope and mailed to the address of the beneficial owner’s choice. Only the domestic return address and the recipient’s address appear on the envelope. Thus, the discrete envelope arrives with the offshore IBC’s mail inside. Using offshore mail forwarding insures that the wrong eyes will never view sensitive offshore mail.

Offshore Promoter

An offshore promoter is a person or entity who markets offshore arrangements to the public. The promoter can be a financial institution, lawyer, accountant, broker, financial planner, or other individual.

Offshore Trustee

A trustee has a fiduciary duty to manage and conserve the assets of a trust over which he or she has control. The offshore trustee has an additional duty to maintain the financial privacy of the beneficial owner of the trust assets.

Personal Investment Corporation (PIC)

A PIC is a term used in the banking industry to refer to an IBC. PICs are generally created for the private bank’s client in order to hold the client’s investment assets. A PIC and an IBC are analogous.

Private Banking

Offshore banking services are most commonly handled by the private banking departments of commercial banks or by private banks that cater solely to private banking clientele. Private banking is a relatively recent term that refers to a higher level of financial services afforded to a bank’s wealthiest clients. The private banking department of a commercial bank has been described as functioning as a bank within a bank, maintaining its own separate books and records, and subject to separate operating procedures. Private banking activities are conducted through relationship managers and marketing officers who have access to a team of specialists around the world in order to provide personal money management, financial advice, and investment services to their high net worth clients. Private bankers are in a unique position of having knowledge and understanding of their client’s personal and business backgrounds, sources of wealth, and uses of private banking accounts. Our use of this term doesn’t imply that private banking is a term usually associated with abusive tax schemes. It is a commonly used term to describe many of the services discussed above.

Power of Appointment

The right given to a person to control the disposition of property from a trust or estate. The power may be very broad or limited depending on the trust terms.

Power to Control

Defined in IRC § 674 as the ability of a grantor or nonadverse party to control the beneficial enjoyment of the corpus or the income therefrom without the approval of any adverse party. This results in the grantor being treated as the owner of the portion of the trust to which this beneficial enjoyment applies.

Probate

This term is generally used to refer to the entire process of administration and distribution of a decedent’s estate. This process takes place under state law, not federal law, and the rules may vary from state to state.

Protector

A term used in some abusive trust schemes that refer to a person who is delegated powers in the trust instrument to replace/appoint trustees. Protectors are often used with foreign trusts. Its explanation in this context is not meant to imply that a “protector” isn’t used in some legitimate trust arrangements as well.

Red Cross Scheme

This is a scheme that uses a charitable entity to disguise a transfer of funds offshore. For example, $1,000,000 is donated to a charitable organization. The charitable organization then remits a portion of the “donation” to an account offshore and retains a portion of the initial donation. The orchestrator takes a $1,000,000 donation and also has the benefit of transferring a portion of the “donation” to the orchestrator’s offshore account.

Remainder

A right of a third party to receive the use or control of property after termination of an intervening interest in that property, usually a life estate.

Reversionary Interest

A transferor’s right to have property returned after the termination of an intervening estate or interest. IRC § 673

Settlor

One who creates and/or funds a trust. See grantor.

Sham Trust

Generally used by the courts to describe an abusive trust that serves no legitimate purpose and lacks economic substance. The trust is disregarded for tax purposes, and all income and expenses are assigned to the true owner of the activity.

Strawman

The person whose trust receives another grantor’s assets to be passed through the original trust to a second, or possibly more, trusts for the purpose of disguising the true identity/ownership of the assets.

Tax Haven

A tax haven is a country, which provides a no-tax or low-tax environment. The U.S. is considered a tax haven by some countries. In some offshore jurisdictions the reduced tax regime is aimed towards entities organized in the country with all operations occurring outside the country. These countries seek to encourage investment and make up revenue losses by charging a variety of fees for the start up of the entity and on an annual basis.

Throwback Rules

Rules that equitably tax the beneficiary of a trust that accumulates all or part of its income (rather than distributing it currently). It is an attempt to tax the beneficiary as if the income had been distributed currently. IRC § 665(b). For taxable years beginning after August 5, 1997, the throwback rules apply only to foreign trusts and certain domestic trusts. IRC § 665(c)

Trust Arrangement

Refers to the total number of trusts purchased and the flow of income and expenses to and from the related entities. The related entities may include businesses that are not trusts, such as Limited Liability Company (LLC), Limited Liability Partnership (LLP), corporations, S Corporations, partnerships, and sole proprietorships.

Trust Instrument

Refers to the document created by a grantor to establish the trust. It provides the governing guidelines, identifies the grantor(s), identifies the beneficiaries, and identifies the powers of the trustees and others involved with the trust. It should also include a listing of the assets that were transferred to the trust and constitute the corpus of the trust. Also referred to as “trust document,” “trust indenture,” or “governing instrument.”

Units of Beneficial Interest (UBI)

A term used by some trust promoters to identify interests in a trust and to disguise events surrounding the formation of the trust. It is not a term used by the Internal Revenue Code, but is used by trust promoters in an attempt to gain tax advantages (such as a tax-free exchange). The use of this term does not require the Service to grant favorable tax treatment to any transaction.

Upstreaming

Refers to a scheme used by abusive trusts in which taxable income is reduced or eliminated by moving the income through a series of related trusts. For example, a separate trust may be set up to rent business equipment to the business trust at excessive amounts. The equipment trust then distributes any remaining income to another trust that deducts personal or unallowable expenses, and so forth.

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