IRS Dirty Dozen – 2022 Edition
Every year, the IRS releases what it calls its "Dirty Dozen" tax scams as a warning to unsuspecting taxpayers about schemes they need to know about so as not to get taken. Scammers have gotten evermore clever, so over the next few articles, I will lay these out for you so you don't fall victim too.
The IRS began its cautionary tale by warning of abusive tax transactions and scams, with four, in particular, they advise us to steer clear of.
These four arrangements "are very much on our enforcement radar screen," said IRS Commissioner Charles Rettig. The IRS reminded taxpayers that they remain legally responsible if they adopt one of these schemes, even if duped, so if you have entered one of these transactions, you should consider taking corrective steps, such as consulting a competent tax professional and filing an amended return.
As for those that promote these things, the IRS sternly warned that its Office of Promoter Investigations will find them.
These arrangements are sophisticated and complex, and a thorough examination of each is beyond this article's scope. Still, it's important that you know about them to avoid falling victim. They are:
Abusive Charitable Remainder Annuity Trusts, or CRATs
The IRS warns about a CRAT to which someone transfers appreciated property and improperly claims a step-up in basis to its fair market value on the date of the transfer. The CRAT does not recognize gain when it sells the property and, with the proceeds, purchases a single-premium immediate annuity. The annuity beneficiary then recognizes only a small portion of the annuity payments as income, improperly claiming that the remainder represents a return of principal.
Maltese (or other foreign) IRAs
In the second scheme warned about, a U.S. citizen or resident makes a contribution to an IRA in Malta or some other foreign country. Why Malta?
The reason is because authorities became aware "that U.S. taxpayers with no connection to Malta were misconstruing the pension provisions of the Treaty to avoid income tax on the earnings of, and distributions from, personal retirement schemes established in Malta". As a result, the US and Malta recently signed what is called a "competent-authority arrangement" recognizing the issue and the understanding of what constitutes a pension fund for purposes of their tax treaty.
The IRS warned, however, that similar abusive transactions can occur anywhere in the world where local law allows IRA contributions to be made using assets other than cash or does not limit those contribution amounts to the person's earned income (as required under US law), and the individual improperly claims a tax treaty exemption.
Puerto Rican (and other foreign) captive insurance
Microcaptive insurance arrangements have been on the IRS radar before. A captive insurance arrangement is described by the IRS as a closely held entity with a Puerto Rican or other foreign corporation with "cell arrangements" or "segregated asset plans" in which a U.S. owner of the entity has a financial interest. A U.S.-based "fronting carrier" of the insurance reinsures the risks with the foreign corporation. But the arrangements typically include such questionable features as insuring against implausible risks, pricing that is not at arm's length, and a lack of business purpose.
Monetized installment sales
Monetized installment sales have been on the IRS's list before as well. These involve an abuse of the installment sale rules under Section 453 of the Internal Revenue Code, which in some cases allows a seller of property to self-finance a sale via an installment loan, and pay income tax on the gain only as the loan payments are received, rather than all upfront.
The abuse comes when a seller, in the year of a sale of property, effectively receives the sales proceeds through supposed loans. In this scheme, the seller enters into a contract with the buyer for cash, but then receives an installment note from an intermediary for the amount of sale proceeds in exchange for the sold property. The intermediary then sells the property to the buyer and receives the cash purchase price. The seller ultimately receives the proceeds as a nonrecourse, unsecured purported loan, effectively getting all their money up front, while attempting to defer gain taxation until the "loan payments" are made.
In short, if you got the money, you have to pay the tax, so don't fall for this scheme.
Next week, round two of our three-part series on the IRS Dirty Dozen, where we'll tackle issues five, six and seven.