For more than 20 years, the IRS has published an annual list of its “Dirty Dozen” tax scams and potentially abusive tax avoidance arrangements. According to IRS Commissioner Chuck Rettig, “Taxpayers should stop and think twice before including these questionable arrangements on their tax returns. Taxpayers are legally responsible for their return, promoters making promises and charging high fees are not. Taxpayers can help stop these arrangements by relying on reputable tax professionals they know they can trust.”
The Dirty Dozen is broken down into three types of transactions or scams: Potentially abusive transactions that are heavily promoted; consumer targeted fraud and pandemic-related scams, and abusive or fraudulent tax avoidance strategies mostly used by high net-worth individuals. Here we’ll discuss all 12 on the IRS list – plus add one that’s not on their list (but should be).
Potentially Abusive Transactions that are Heavily Promoted
1 – Use of Charitable Remainder Trust (CRAT) to Eliminate Taxable Gain
In this transaction, appreciated property is transferred to a particular type of trust, a CRAT. Taxpayers improperly claim the transfer of the appreciated assets to the CRAT results in a “step-up” in tax basis to fair market value as if the property had been sold to the trust. The CRAT then sells the property but does not recognize gain due to the claimed step-up in basis. The CRAT then uses the proceeds to purchase a single premium immediate annuity (SPIA) and the beneficiary reports only a small portion of the annuity received from the SPI as taxable income. The beneficiary treats the remaining payment as a non-taxable return of their investment. This strategy is based on a misapplication of the tax rules for charitable remainder trusts and annuities.
2 – Maltese (or Other Foreign) Pension Arrangements Misusing Treaty
In these transactions, U.S. citizens or U.S. residents attempt to avoid U.S. tax by making contributions to certain foreign individual retirement arrangements in Malta (or possibly other foreign countries). The individual typically has no local connection, and local law allows contributions to such arrangements in a form other than cash or does not limit the amount of contributions by reference to income earned from employment or self-employment activities. By improperly asserting the foreign arrangement is a “pension fund” for U.S. tax treaty purposes, the U.S. taxpayer misapplies a relevant tax treaty to improperly claim an exemption from U.S. income tax on earnings in, and distributions from, the foreign arrangement.
3 – Puerto Rican and Other Foreign Captive Insurance
Here, the U.S. owners of closely held entities participate in a purported insurance arrangement with a Puerto Rican or other foreign corporation with “cell” arrangements or segregated asset plans in which the U.S. owner has a financial interest (Generally, a cell captive is a segregated piece – or “cell” – of an existing captive insurance company). The U.S.-based individual or entity claims deductions for premiums paid to secure “insurance coverage” provided by a fronting carrier, which reinsures the “coverage” with the foreign corporation. The characteristics of the purported insurance arrangements typically will include one or more of the following: implausible risks covered, non-arm’s-length pricing, and lack of a business purpose.
4 – Monetized Installment Sales
These involve the inappropriate use of the installment sale rules by a seller who, in the year of the sale, effectively receives the sales proceeds through what is purported to be a loan. In a typical transaction, the seller executes a contract to sell appreciated property to a buyer for cash and then purports to sell the same property to an intermediary in return for an installment note. The intermediary then claims to sell the property to the buyer and receives the cash purchase price. Through a series of related steps, the seller receives cash equivalent to the sales price, less various transactional fees, in the form of an alleged loan that is non-recourse and unsecured.
Consumer Targeted Fraud and Pandemic Related Scams
5 – Pandemic-Related Scams Including Theft of Benefits and Bogus Social Media Posts
Economic Impact Payment and tax refund scams – The IRS will never initiate contact by phone, email, text, or social media asking for Social Security numbers or other personal, financial information related to stimulus payments or tax refunds.
Unemployment fraud leading to inaccurate taxpayer 1099-Gs – During the pandemic, scammers filed numerous fraudulent claims for unemployment compensation using stolen personal information. Taxpayers should be on the lookout for a Form 1099-G reporting unemployment compensation they did not receive since the IRS will expect to see this reported as income.
Fake employment offers posted on social media – The pandemic created many newly unemployed people eager to seek new employment. These fake posts entice their victims to provide their personal financial information.
Fake charities that steal your money – Between Ukraine and many relief efforts, scammers have created fake charities with which to profit from donated money. Taxpayers should ask the fundraiser for information about the charity to confirm its legitimacy – the IRS website is a good start – and be wary of charities that request payment via gift cards or wired funds.
6 – Offer in Compromise Mills
We’ve all seen ads on TV claiming to help people erase huge portions of their tax debt. The IRS urges taxpayers to contact the IRS directly regarding unpaid tax bills rather than contact tax settlement companies that use local advertising and falsely claim they can resolve unpaid taxes for pennies on the dollar. These “mills” get the same Offer in Compromise the taxpayer would if they contacted the IRS themselves. Instead, the taxpayer generally ends up paying the mill an additional fee. In addition to the OIC mills, the IRS warns against using tax preparers who will not sign the return as a paid preparer, which should be an immediate red flag.
7 – Suspicious communications designed to fool someone into responding before thinking
The IRS warns taxpayers that scammers will use every trick in their communications arsenal to steal your identity, personal financial information, and money. The IRS will never use text messages or email to discuss personal tax issues or personal identifying information. Moreover, the IRS will never leave pre-recorded, urgent, or threatening phone messages. And the IRS will never call and threaten to bring in the police to have the taxpayer arrested for not paying. Generally, the IRS will first mail a bill to any taxpayer who owes taxes. If a taxpayer hasn’t first been contacted by letter, it’s likely a scam.
8 – Spear phishing
The latest phishing emails use the IRS logo and a variety of subject lines such as “Action Required: Your account has now been put on hold.” The IRS has observed similar bogus emails that claim to be from a “tax preparation application provider.” One such variation offers an “unusual activity report” and a solution link for the recipient to restore their account. These are all scams.
Abusive or Fraudulent Tax Avoidance Strategies
9 -Concealing assets – offshore accounts and improper reporting of digital assets
U.S. persons are taxed on worldwide income. Simply parking money in an offshore account does not put it out of reach of the U.S. tax system. Unscrupulous promoters continue to assert that taxpayers can easily conceal their cryptocurrency holdings overseas. The IRS urges taxpayers to not be misled into believing this storyline about digital assets. Failure to report transactions involving digital assets could expose taxpayers to civil fraud penalties and even criminal charges. And there are severe penalties for not reporting foreign bank accounts to the Treasury department.
10 – High-income individuals who fail to file
The IRS continues to focus on people who choose to ignore the law and not file a tax return, especially individuals earning more than $100,000 a year. No one can avoid paying taxes by simply failing to file a return.
11 – Syndicated Conservation Easement Transactions
In a syndicated conservation easement transaction (SCET), promoters take a provision of the tax law allowing for conservation easements as charitable contributions and twist it by using inflated appraisals of undeveloped land (or, for a few specialized ones, the facades of historic buildings), and by using partnership arrangements devoid of a legitimate business purpose. These abusive arrangements do nothing more than game the tax system with grossly inflated tax deductions and generate high fees for promoters. The IRS has been aggressively going after SCETs for several years now. Besides having deductions disallowed, taxpayers can be subject to substantial penalties for over-valuing the contributed property. In addition, there are significant penalties for not reporting a SCET with the tax return or the required filing with the IRS Office of Tax Shelter Analysis.
12 – Abusive Micro-Captive Insurance Arrangements
This is like the captive insurance company issue discussed earlier but differs in that the captive, in this case, qualifies as a “small company” under a provision in the Internal Revenue Code that only subjects investment income to tax. In abusive “micro-captive” structures, promoters, accountants, or wealth planners persuade owners of closely-held entities to participate in schemes that lack many of the attributes of insurance. Recently the IRS has stepped up enforcement against a variation using potentially abusive offshore captive insurance companies. Abusive micro-captive transactions continue to be a high-priority area of focus and the IRS has had recent success in Tax Court and appellate court cases.
13 – Employee Retention Credit Mills
One of the more significant relief provisions in pandemic-related legislation was the Employee Retention Credit (ERC), designed to help businesses that stayed open and kept their employees on the payroll during periods of shutdown. The rules for eligibility for the ERC have been widely misinterpreted and in some cases largely disregarded. As a result, some taxpayers are claiming this refundable credit when they do not actually qualify because their business was not shut down due to a government order, or for other reasons are not eligible.
Some third-party consulting firms performing calculations for taxpayers are taking very aggressive positions on ERC and making claims about eligibility that are improper. For example, it is accepted that CDC and OSHA guidelines are not “government orders” for purposes of claiming the credit, but some of these credit mills are taking that position. Another position that is difficult to support is where supply chain disruptions are involved. The IRS has stated this is a major area of focus for enforcement. The statute of limitation for the IRS to audit the ERC claims can be as long as 5 years, and it may well be that these credit mills will disappear before the IRS shows up.
What To Do Now
Taxpayers who have encountered any of these tax scams should carefully consider the potential consequences and consult independent, competent tax advisors. They may not be able to claim the purported tax benefits on a tax return. Taxpayers who have already claimed tax benefits for any of the abusive transactions described above should consider taking corrective steps, such as filing an amended return and seeking professional advice, since the IRS is very likely to challenge these arrangements. Besides having to repay the tax benefits claimed (plus interest), the IRS may assert accuracy-related penalties ranging from 20% to 40% of the underpaid tax, or a civil fraud penalty of 75% of the underpayment.
If you’d like to discuss any of these topics further, please contact us to see how we can help.
The information provided in this communication is of a general nature and should not be considered professional advice. You should not act upon the information provided without obtaining specific professional advice. The information above is subject to change.