June 25, 2004 – A notice from the U.S. Internal Revenue Service this week could spell big trouble for the territory's Economic Development Program beneficiaries who aren't playing by the rules. What makes the IRS warning particularly troublesome for some in the arena is a lack of certainty about what the rules are.
Adding to the confusion locally concerning the notice is the fact that the IRS issued it without giving the V.I. government any warning, despite assurances to local officials as recently as a couple of weeks ago that this would not be the case.
The notice takes the form of a warning shot over the bow to people the IRS believes to be using the EDC program as an illegal tax shelter — people who don't live in the Virgin Islands and people who don't make their money in the Virgin Islands but still utilize the program to garner tax breaks of as much as 90 percent on their income. It is also a warning to those who are deemed "promoters" of such fraudulent tax schemes.
The notice says the V.I. government may not offer tax breaks to "U.S. citizens or residents who are not bona fide residents of the USVI." And for those who are bona fide residents, "it may reduce their tax liability only with respect to income from sources in the USVI or income effectively connected with the conduct of a trade or business within the USVI."
According to the notice, a common tactic of "promoters" is to advise a U.S. taxpayer "to purport to become a partner of a Virgin Islands limited liability partnership" that is an EDP beneficiary. The taxpayer's employer would then make payments to the LLP for the taxpayer's services, no longer treating the payments as wages "subject to the withholding and payment of employment taxes and reporting on taxpayer's Form W-2."
The LLP in turn would make payments to the taxpayer that it treats for tax accounting purposes as distributions of allocable shares of partnership income or guaranteed payments for services. And the taxpayer would claim the LLP's reduction in income tax liability on his or her income-tax return.
The IRS will challenge all of these practices, the notice states: "Where taxpayers … enter into arrangements such as the ones described in this notice, the Internal Revenue Service may disregard such arrangements on the grounds that they lack economic substance or that they have no purpose other than tax avoidance or evasion."
Further, the notice states, "persons who participate in the promoting or reporting of these positions may be subject to aiding and abetting penalties."
The IRS is not only prepared to impose penalties, interest and fines for civil fraud. The notice states additionally that "anyone who willfully counsels or advises such evasion … may be guilty of a criminal offense" under federal law.
One legal expert in the territory, who wished to remain anonymous, said the IRS is misinterpreting the law regarding "income effectively connected with the conduct of a trade or business" and the issue of whether income from business conducted on the U.S. mainland is eligible for tax breaks in the territory if the businesspeople are bona fide V.I. residents.
According to Bruce Friedland of IRS media relations, the warning is not intended for legitimate beneficiaries of the Economic Development Program. Friedland was unable to answer any legal questions or explain why the IRS had issued the notice without discussing it first with local officials.
Both Gov. Charles W. Turnbull and Delegate Donna M. Christensen issued strongly worded statements Friday noting the failure of the IRS and Treasury to notify local officials of their intention to release the notice.
"The advisory sent out by IRS and Treasury yesterday came without warning or prior consultation as promised in numerous conversations, and before we could complete the ongoing work here in Congress to clearly define residency," Christensen said.
Similarly, Turnbull said in a Government House release on Friday: "The government was not consulted prior to the issuance of the IRS notice, contrary to the representations made by certain federal officials that such consultations would, in fact, be made."
The 1986 act that established the tax break program to encourage the development of new businesses in the territory called for the IRS to work with the V.I. Internal Revenue Bureau to define the residency requirement clearly. In the ensuing 18 years that has not happened.
A local businessman speculated that a narrowing federal interpretation of the Economic Development Program laws could wipe out as many as 90 percent of the beneficiaries.
However, one beneficiary expressed the view that "it's a few greedy people" who are "making the program look bad and causing problems for the rest of us who are adhering to the boundaries of the program."
None of the business people contacted wanted to speak on the record.
Marjorie Rawls Roberts, a local tax attorney considered an expert in the field of EDP benefits, said Friday afternoon that "it is very important to have clear guidance." She described the IRS notice as the "first guidance effectively" given since the 1986 act that set up the program.
According to Friedland, the notice is part of an attempt by the IRS to offer such guidance.
Friedland could not identify specifically who the IRS thinks of as "promoters," except to say they are consultants who, for a fee, might purport to show interested parties how to set up a tax shelter in the Virgin Islands without being a resident or otherwise adhering to the law.
The notice says the promoters are pushing the idea to taxpayers that "you can continue to live and work in the United States and, nevertheless, be a bona fide resident of the USVI."
"Promoters typically represent that a taxpayer need not make major lifestyle changes in order to become a bona fide resident of the USVI, and may represent that the taxpayer need only spend a few weeks or less out of the year in the USVI to become a resident for income tax purposes," the notice states.
Friedland said the notice "is not geared to legitimate EDC claims. This has to do with questionable claims for tax credits."
"The program as it exists is legal," Christensen pointed out. "It's the gaming that the IRS is clamping down on." And in Congress, she added, "that's what we've been working on. And they know very well what we've been working on."
Christensen expressed optimism about the program. "I have met some of these people on planes and at social events," she said of EDP beneficiaries. "I have not met any that are not playing by what they perceive as the rules. It's in their best interest to do that."
She pledged continuing efforts to protect and strengthen the program and to work with "the various EDC companies and their representatives … as this issue unfolds."
Frank Schulterbrandt, chief executive officer the Economic Development Authority, did not return a telephone call for comment Friday afternoon.
The Source has posted the full text of the IRS notice as a pdf document.
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