According to IRS, during the mid- to late-1990s, abusive tax schemes reemerged across the country after last peaking in the 1980s. As previously mentioned, during hearings held in 2001, several witnesses testified about the increased promotion and use of such tax schemes. Marketing of these schemes by promoters through the use of the Internet was mentioned as giving them a thriving new life by making them available to millions of taxpayers easily and inexpensively. Schemes run from simple to very complex, from clearly illegal to those carefully constructed to disguise the illegality of the scheme. Furthermore, users of schemes can range from those believing their position is correct to those who knowingly and willfully file incorrect tax returns. Some schemes are created by tax professionals such as accountants, lawyers, and paid tax preparers, and by groups and individuals. Tax schemes are offered to taxpayers using various means, including conferences or seminars, publications, advertisements, and the Internet. Others are promoted by word-of-mouth. To determine the types of activities IRS considers to be abusive tax schemes, we interviewed cognizant IRS officials from SB/SE, who have specialized expertise in abusive tax schemes issues. In addition, we obtained pertinent IRS documents related to abusive tax scheme activities, including information from IRS’s CI Internet site and the Small Business and Self-Employed Strategic Assessment Report. To determine the extent or magnitude of the abusive tax scheme issue, we obtained and reviewed estimates from IRS’s SB/SE division for the identified abusive tax scheme categories—Frivolous Returns, Frivolous Refunds, Abusive Domestic Trusts, and Offshore Schemes. The estimates include the number of taxpayers involved in each scheme category; in conjunction, the estimates report the amount of tax revenue protected by the identification of frivolous returns and refunds and the amount of potential revenue lost in abusive trusts and offshore schemes. To determine the actions IRS takes to identify and deal with abusive tax scheme activities, we interviewed officials from IRS’s SB/SE division and CI. Additionally, we obtained and reviewed relevant documents related to the organizations and programs involved in addressing IRS’s abusive tax scheme activities. To determine how IRS coordinates its actions with other federal agencies, we interviewed cognizant officials within CI and at several federal agencies. The federal officials we interviewed were from the FTC, the SEC, the Financial Crimes Enforcement Network (FinCEN), DOJ, the Federal Bureau of Investigation (FBI), and the Executive Office for United States Attorneys. You also expressed interest in IRS’s coordination efforts with state agencies. We are not reporting on this topic because many of the states contacted did not consider abusive tax schemes to be a major issue for them. Due to their limited resources, states focused on noncompliance issues that were more directly related to the types of taxes they collect such as sales and employment taxes. This review primarily focuses on abusive tax schemes that are used by individuals rather than those that are used by corporations. Although some overlap may exist between the schemes used by individuals and corporations, our focus was on schemes that are generally used by individuals to inappropriately reduce the taxes they owe or to generate refunds to which they are not properly entitled. We performed this work from July 2001 through April 2002 in accordance with generally accepted government auditing standards. Abusive tax schemes, which are generally used by individuals, fall into four major categories. For the first two, frivolous returns and frivolous refunds, taxpayers submit a tax return that either states an argument that IRS can readily identify as frivolous or a tax return with characteristics IRS has identified as reflecting a frivolous argument. For the other two, abusive domestic trusts and offshore schemes, taxpayers’ returns are less likely to reveal the use of a clearly abusive tax scheme. These schemes generally use any number of anti-tax arguments to incorrectly claim that income is exempt from taxation or that IRS otherwise lacks authority needed to tax income. These arguments have been well litigated in the courts and consistently ruled to be without merit. Examples include the following: Form 2555 Scheme: In this scheme, individuals file an IRS Form 2555, Foreign Earned Income, and claim that their income was not earned within the United States. This is also known as the “not a citizen” argument in which taxpayers file returns stating they are citizens of the “Republic of ” and not citizens of the United States, and thus, their income is not taxable. Section 861: Individuals using this scheme claim that under Internal Revenue Code Section 861 income tax must only be paid on foreign income and, therefore, their income is not subject to tax or withholding. In these cases, taxpayers file a tax return and show a zero amount for wages. According to IRS, this argument has spread to some employers who are using it to avoid withholding and paying payroll- type taxes on their employees. According to IRS, credit and refund abusive tax schemes are designed to substantially reduce taxes or create a refund for the taxpayer, generally by claiming eligibility for a credit that does not exist or to which the taxpayer is not properly entitled. One such scheme that has received much attention is the Slavery Reparation Refund scheme. According to IRS, promoters circulate or publish information claiming African Americans are eligible for slavery reparations. Taxpayers claiming this credit generally enter a significant amount on their tax return as a credit that results in a taxpayer realizing a refund if not detected by IRS. A trust is a legitimate form of ownership that completely separates asset responsibility and control from the benefits of ownership. As such, trusts are commonly used in matters such as estate planning. An abusive domestic trust scheme usually involves a taxpayer creating a trust that does not meet the Internal Revenue Code requirements that the assets and income of the trust not be subject to the control of the taxpayer. Once such an improper trust is established and the taxpayer has transferred business or personal assets to it, the scheme may involve further abuses, such as offsetting income of the trust by overstating its business expenses or including the taxpayer’s personal expenses—like a home mortgage—as an expense of the trust. The taxpayer will often use multiple entities such as partnerships, limited liability companies, or secondary level trusts that can be tiered or layered to mask the taxpayer’s continued ownership or control of the trust’s income or assets. Abuses that involve foreign locations can take a wide array of forms and attempt to use a number of techniques to improperly avoid paying taxes. One common technique is simply to use foreign locations to add another level of complexity in obscuring the true ownership of assets or income and thus obfuscating whether taxes are owed and by whom. Use of foreign locations, for instance, can be combined with use of trusts to make unraveling the true ownership of assets and income more difficult for IRS. According to IRS, criminals long have used offshore schemes to disguise the true nature of their enterprise and the resulting income. Promoters of abusive tax schemes have, according to IRS, increasingly devised schemes that in some fashion involve transferring income or title to assets to foreign locations. Often, foreign locations are selected because they are tax havens with little or no taxation on income in their jurisdiction, have privacy rules that help schemers hide what they are doing, or have other characteristics favorable to carrying out the schemes. According to IRS, once such transfers are established, income is often repatriated back to the U.S. owners through loans, credit cards, or debit cards. By using complex transactions and multiple entities, the individuals using these schemes attempt to hide their income and avoid potential tax liabilities. Of the approximately 130 million individual income tax returns filed annually yielding about a trillion dollars in revenue, approximately 740,000 taxpayers used abusive tax schemes in tax-year 2000 according to IRS estimates. According to IRS’s fiscal year 2003-2004 Small Business and Self-Employed (SB/SE) Division Strategic Assessment Report, abusive tax schemes represent a rapidly growing risk to the tax base. IRS estimates the potential revenue loss from these schemes to be in the tens of billions of dollars annually. According to an IRS official, to make accurate estimates in this area of noncompliance is difficult. Despite the difficulties in accurately estimating the significance of abusive tax schemes, IRS provided us with estimates in four major scheme areas— Frivolous Returns, Frivolous Refunds, Abusive Domestic Trusts, and Offshore Schemes. According to IRS, its estimates were made in February 2002 and were derived from information gathered during tax return processing and examination activities and from the work of IRS’s Criminal Investigation (CI), the law enforcement arm of IRS. According to an IRS official, these estimates were derived from tax-year 2000 information, the last full year for which data were available. IRS’s estimates are as follows: Frivolous returns: about 62,000 taxpayers with associated tax amounts approximating $1.8 billion. Frivolous refunds: about 105,000 taxpayers with associated tax amounts approximating $3.1 billion. Abusive domestic trusts: about 65,000 taxpayers with tax losses approximating $2.9 billion. Offshore schemes: about 505,000 taxpayers with tax losses ranging from $20 billion to $40 billion. IRS’s estimates for the numbers of taxpayers and taxes in connection with frivolous returns and frivolous refunds, although not precise, likely have less uncertainty than its estimates of the numbers of taxpayers and taxes at risk in connection with abusive domestic trusts and offshore schemes. IRS’s estimates for frivolous returns and frivolous refunds are based in large part on returns and refund claims that IRS has identified while processing tax returns and has addressed by pulling the associated returns and notifying the taxpayers that their returns contained a frivolous position that needed to be corrected by submitting a revised return. Thus, in these cases, IRS has a fairly direct basis for counting the number of taxpayers involved and the amount of tax involved.