Collectively, Americans lose millions of dollars and troves of invaluable personal data to scams. Tax season, in particular, is prime time for scammers, fraudsters, and those looking to make a quick buck at someone else’s expense.
Scams are definitely not a new phenomenon, but they are a moving target. As soon as consumers have learned to avoid one type of scam, a new-and-improved version is deployed. Plus, as their tactics become more technologically sophisticated, those who are less tech-savvy become ever more vulnerable.
To provide taxpayers with another line of defense, for over 20 years the IRS has put together an annual “Dirty Dozen” list of the year’s most common tax scams. The list is intended to help taxpayers identify and avoid tax-related schemes, scams, and fraud.
The items in this year’s list can be divided into two camps based on how they work and whom they target.
- “Classic” scams that aim to actively defraud or steal from taxpayers, and
- Schemes pushed by unethical profiteers to help individuals avoid paying taxes.
We are going to focus on the latter group as they can often be sold as estate planning or asset protection measures. In particular, these transactions tend to involve the movement of assets in and out of trusts, and trusts can be legitmate estate planning tools if used properly.
So, let’s look at a few of the abusive tax-mitigation or tax-avoidance arrangements flagged by the IRS this year.
Questionable and Abusive Transactions
While not necessarily unlawful, these transactions are potentially abusive and are likely to be scrutinized by the IRS. Therefore, taxpayers should think twice before employing any of these four arrangements.
- Charitable remainder annuity trusts (CRATs),
- Maltese individual retirement arrangements,
- Foreign captive insurance, and
- Monetized installment sales.
These schemes are often promoted and advertised online, with a marked uptick during tax season.
Eliminating Taxable Gain with a Charitable Remainder Annuity Trust (CRAT)
This transaction operates by a misapplication of tax laws to reduce or eliminate taxable income. The transaction involves transferring (not selling) an appreciated asset to a CRAT, claiming a step-up in basis, and reselling the asset without realizing the gain. The proceeds from the asset’s sale are used to purchase a single premium immediate annuity (SPIA), only a small portion of which the beneficiary will report as “income.”
Avoiding Income Tax with a Maltese “Pension Fund”
Often tax-avoidance schemes funnel assets through foreign tax systems to circumvent the US tax code.
In these retirement-related transactions, US residents make contributions to foreign retirement accounts (often, but not exclusively, in Malta) in which there are no contribution limits. Then, by alleging (wrongly, of course) that the arrangement should be treated as a “pension fund” for US tax purposes, the earnings and distributions from the foreign retirement arrangement are considered excluded from US income tax.
Deducting the Cost of Captive Insurance Arrangements
In this scheme, a US-based owner of a private company enters into an insurance arrangement (usually for implausible risks or at non-market rates) with a Puerto Rican or other foreign business entity in which the US owner has some financial interest. The US owner then deducts the cost of the insurance coverage provided by a fronting carrier, which reinsures the “coverage” with the foreign business entity.
Definition: A captive insurer is an insurance company that is wholly owned and controlled by the individuals or entities insured by it.
Monetized Installment Sales
This is a complex, multi-level transaction pushed by aggressive promoters that involves the sale of property in such a way as to skirt US income tax liability through an inappropriate reading of the installment sale rules (§453 of the Internal Revenue Code).
To keep things simple, an installment sale allows a seller to defer the tax on the sale of appreciated property, but the seller doesn’t have access to the funds immediately. Some promoters will push monetized installment sales as a means to defer taxes and have access to the sales proceeds. In this scenario, the seller defers recognition of tax on the sale payments while also gaining access to the sale proceeds by borrowing against the installment note.
Unfortunately, there’s a catch: The IRS has ruled that these transactions are abusive. It gets complicated quickly, but in short you can defer the tax on the sale until you receive the actual proceeds, but if you borrow against the installment note to monetize the sale, you have triggered the tax because you have the cash.
Tax Avoidance Schemes Targeting High-Income Earners
Some promoters approach high-net-worth individuals with schemes to hide their assets and avoid taxation. Due to the wealth requirements, these scams tend to be highly targeted unlike typical robocall scams. Their personalized nature can lend them a false sense of legitimacy, though, that can override the initial qualms of victims.
Other high-net-worth individuals are perfectly happy to undertake aggressive or unlawful tax-avoidance schemes of their own accord or even to not file taxes altogether.
Pro Tip: It should go without saying, but I will anyway: You should not break the law! There are plenty of legitimate and perfectly lawful ways to protect your assets and mitigate unnecessary taxes.
Either way, it’s important to know that the IRS has made combatting these types of abusive schemes a key part of its mission, and it has begun to hire a slew of new attorneys to help thwart even the most elaborate and sophisticated transactions.
In particular, the IRS is focusing on:
- Failure to file tax returns: Although the IRS is concerned about anyone who chooses to ignore the law and not file a tax return, it has begun to focus its enforcement efforts on individuals earning over $100,000 a year.
- Off-shored assets and unreported digital assets: For decades individuals have attempted to circumvent US taxes by hiding their assets in offshore accounts, even though US taxpayers are required to report income from offshore funds and other foreign holdings, as well as digital asset transactions. These methods have become more sophisticated and complex, especially with the rise of cryptocurrencies, but the IRS is committed to stopping tax avoidance by those who hide assets in offshore accounts and in accounts holding cryptocurrency or other digital assets.
- Syndicated conservation easement deals: Aggressive promoters might try to convince taxpayers to game the system by artificially inflating appraisals of undeveloped land to garner massive tax deductions—and, of course, to pay them high fees to structure the deal. Syndicated conversation easements are considered abusive by the IRS. The IRS states that it examines 100% these deals, so the risk of punishment for engaging in a syndicated conversation easement is quite high.
- Micro-captive insurance arrangements: Unscrupulous promoters or wealth planners might suggest a micro-captive insurance arrangement to owners of privately held businesses as a means of skirting US tax law. Schemers benefit by deducting the (often excessive) “premiums.” The coverage is often a sham, though, insuring against implausible risks, failing to have a legitimate business purpose, or duplicating existing policies.
Start Planning for 2023
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