Do Not Do This — Schemes to Refuse

NOT LEGAL OR TAX ADVICE. DRAFT — pending professional review. Circular 230 notice applies.

The following schemes are common in entrepreneur and "wealth coach" circles. Each is illegal or so aggressive that the civil penalties would erase the purported benefit. Refuse to advise on any of them; refer cohort members to a licensed CPA for any related question.

1. Circular payment schemes ("send each other tax-free money")#

Pitch. "We all set up LLCs and pay each other for services we never actually deliver. The payments are deductible to the payer and 'tax-free' to the recipient because we're a network."

What catches it.

• IRC § 7701(o) — codified economic substance. 20% strict-liability penalty (40% if undisclosed); no reasonable-cause defense.
• Sham transaction doctrine (Knetsch) — disregards the transaction.
• Step transaction doctrine (Court Holding) — collapses the loop.
• IRC § 7201 if implemented willfully — criminal evasion, 5 years prison, $100K fine.

2. "Service-for-service barter without reporting"#

Pitch. "If I bake your cakes and you do my marketing, neither of us has to report it. It's a wash."

What catches it.

• Treas. Reg. § 1.61-2(d)(1) — barter income is taxable at FMV on both sides.
• Form 1099-B filing requirement for organized barter exchanges (IRC § 6045(c)(3)).
• 1099-K cross-checks on PayPal / Venmo / Zelle / cash apps catch the unreported equivalents.

3. "Loans" with no notes, interest, or repayment#

Pitch. "I'll just call this transfer a loan. There's no note, no interest, no repayment — it's a friendly loan. Loans aren't income."

What catches it.

• IRC § 7872 — below-market loans imputed at AFR; recharacterized as compensation, gift, or distribution.
• Sham transaction doctrine — without bona fide loan indicia, the IRS recharacterizes principal as compensation or constructive dividend.
• Knetsch analog — circular borrowing with no economic effect.

4. "Charitable contribution" laundering through a friendly nonprofit#

Pitch. "Pay your cohort tuition through HigherSelf Nonprofit and call it a donation. Deductible to you, tax-free to the nonprofit."

What catches it.

• IRC § 170 — to be a charitable contribution, the payment must be made with donative intent, and any quid pro quo (like cohort coaching the donor receives) reduces the deduction by the FMV of the benefit.
• IRC § 4958 — excess-benefit transaction tax: 25% on disqualified person, 10% on knowing manager, 200% if uncorrected.
• IRC § 6115 — quid pro quo disclosure rules.
• Private inurement / private benefit doctrines under § 501(c)(3) — could cost the nonprofit its exemption.

5. ROBS done wrong (excluded employees, deficient valuation)#

Pitch. "Use your 401(k) to fund the business. Just set up a C-corp, roll the money in, buy stock. Easy. No tax."

What catches it (when done wrong).

• Treas. Reg. § 1.401(a)(4)-4 — BRF nondiscrimination. If the plan is offered only to the owner and not to subsequently hired rank-and-file employees, the plan fails nondiscrimination testing.
• Deficient stock valuation — overstating value at issuance triggers prohibited-transaction excise tax (15% / 100%) under § 4975.
• Peek, Ellis — personal guarantee or salary from plan-owned LLC = prohibited transaction; plan or IRA disqualified.
• Plan disqualification consequence: deemed distribution of the entire balance, ordinary income, plus 10% early-distribution penalty if under 59½.

ROBS is legal when done right. It is catastrophic when done wrong. Do not advise without engaged ERISA counsel.

6. "S-corp distributions instead of W-2 wages"#

Pitch. "Take all your S-corp earnings as distributions. Skip the payroll. Saves you 15.3% in SE tax."

What catches it.

• Watson v. United States, 668 F.3d 1008 (8th Cir. 2012) — IRS reclassifies distributions as wages where W-2 compensation is not reasonable.
• IRC § 1402 — SE tax applies to recharacterized wages.
• IRC § 6651, § 6656 — failure-to-deposit and failure-to-pay penalties on the recharacterized wages.
• Industry benchmarks (RCReports, BLS OES, Salary.com) make underpayment trivially provable.

7. "Augusta Rule abuse — rent your home 14 days at $5,000/day"#

Pitch. "Rent your home to your business 14 days at $5,000 per day. That's $70K of tax-free income."

What catches it.

• IRC § 280A(g) requires fair market rental value — supported by comparable hotel meeting rooms or event venues.
• Treas. Reg. § 1.62-2 (accountable plan) — substantiation required.
• Substance over form (Gregory v. Helvering) — if the "meeting" was not actually held or was a sham.
• Constructive dividend (§ 301) — corporate deduction recharacterized.

The Augusta Rule is real. The rate must be defensible. $5,000/day for a typical residence is not defensible without unusual venue features. The IRS examines this when the only "renter" is the owner's own business.

What to do when a cohort member arrives with one of these#

1. Listen. The instinct that there's something to learn is usually right; the specific scheme is usually wrong.
2. Translate to the legitimate version (see worked-example-bakery and intercompany-transactions).
3. Hand the cohort member a list of licensed CPAs and ERISA attorneys.
4. Document the conversation. Mark "research only — not advice."
5. If the cohort member persists, escalate to Lumina + Grace Fields per the escalation gates in data/decision-tree.json.

Bottom line#

The Code is public. So are the cases. So are the IRS audit memos. The schemes above persist because someone is selling them — not because they work.

NOT LEGAL OR TAX ADVICE. Circular 230 notice applies.