More on Sheltering Business Income

From commenter Dave Walser, a tax professional:

That's not perfectly true, but it's close enough. We tax professionals are able to legitimately help taxpayers reduce their exposure to income taxes, but we cannot eliminate income taxes (unless the taxpayer decides to quit making money). However, the tax code is so complex and enforcement is so lax a lot of tax myths are able to flourish. For example, a few years ago my brother-in-law asked if he could "hire" his wife and kids and funnel most of their wages into a 401(k) plan. (This would allow whatever he paid them to escape current income taxation while giving his business a tax deduction.) I said, "Sure. What are they going to do to earn their wages?" He was shocked that there might be some requirement his wife and kids had to actually do something to earn the money that would be salted away into a 401(k) account. He was even more shocked to learn the money, once in the 401(k) plan, could not be used by him for his own business and investment purposes. Why was he shocked by these rather obvious (to a tax professional at least) requirements? He has friends who claim they were hiring family in their businesses and doing precisely what he'd described to me. So far, his friends have gotten away with it (not surprising given the low audit rate). Eventually, those friends will be audited and the IRS hammer will fall -- hard! In the mean time, a tax myth has been created that this kind of thing is appropriate tax planning.

The same thing was true, only on a much larger scale, with the tax shelters of the late 1990s and early 2000s. Lots of individuals and businesses participated in the shelters because they'd heard that everyone else was and the IRS had blessed the transactions. It was an easy thing to believe. If you'd heard of dozens of people selling their business who'd avoided tax on several million dollars of gains and none of those people had gotten in trouble with the IRS, why shouldn't you believe that you, too, could avoid the tax on your large transaction? In this case, silence from the IRS was not the same as permission. It just took the government a decade to catch up with what was going on. Much grief and anguish followed.