Every year, the IRS releases its “Dirty Dozen” list of the biggest potentially abusive arrangements that they recommend taxpayers avoid. This week, they released the first four of this year’s twelve transactions that taxpayers should look out for.
These four items have to do with tax schemes some taxpayers fall prey to in an effort to reduce their tax liability.
"Taxpayers should stop and think twice before including these questionable arrangements on their tax returns," said IRS Commissioner Chuck Rettig. "Taxpayers are legally responsible for what's on their return, not a promoter making promises and charging high fees. Taxpayers can help stop these arrangements by relying on reputable tax professionals they know they can trust."
The first four on the “dirty dozen” list are:
- Using Charitable Remainder Annuity Trusts (CRAT) to Eliminate Taxable Gain
During this arrangement, appreciated property is transferred to a Charitable Remainder Annuity Trust (CRAT). Taxpayers improperly claiming the transfer of assets to the CRAT gives those assets a step-up in basis to fair market value as if they 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). The beneficiary reports, as income, only a small portion of the annuity received from the SPIA. Through a misapplication of the law relating to CRATs, the beneficiary treats the remaining payment as an excluded portion representing a return of investment for which no tax is due. Taxpayers seek to achieve this inaccurate result by misapplying the rules under sections 72 and 664.
- Maltese (or other Foreign) Pension Arrangements Misusing Treaty
For this questionable arrangement, U.S. taxpayers attempt to avoid federal tax by making contributions to certain foreign individual retirement arrangements in Malta (or possibly other foreign countries).
Typically, taxpayers lack a local connection, and local law allows contributions 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 labeling this arrangement as a "pension fund" for U.S. tax treaty purposes, the U.S. taxpayer misconstrues the relevant treaty to improperly claim an exemption from U.S. income tax on earnings in, and distributions from, the foreign arrangement.
- Puerto Rican and Other Foreign Captive Insurance
This arrangement occurs when 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. The U.S. based individual, or entity, claims deductions for the cost of "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
- lack of business purpose for entering the arrangement.
- Monetized Installment Sales
These transactions involve the inappropriate use of the installment sale rules under section 453 by a seller who, in the year of a sale of property, effectively receives the sales proceeds through purported loans.
Typically, the seller enters into 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 purports to sell the property to the buyer and receives the cash purchase price. Through a series of related steps, the seller receives an amount equivalent to the sales price, less various transactional fees, in the form of a purported loan that is nonrecourse and unsecured.
If you have been presented with one of these “tax benefits” as an way of reducing your tax bill, be sure that you have competent legal representation to review the underlying legal requirements of these actions. If you have already engaged in any of these arrangements, consult an attorney today to explore the corrective steps that you should take immediately. If it is not voluntarily corrected, the IRS can assess accuracy-related penalties ranging from 20% to 40%, or a civil fraud penalty of 75% of any underpayment of tax, not to mention criminal prosecution for tax evasion and/or tax fraud.
Stay up to date on the latest IRS and tax news with our weekly blog posts and social media accounts. We have offices in Lafayette, Shreveport, Baton Rouge, New Orleans, Covington, Metairie, Houston, and Austin. Give us a call today to schedule your FREE consultation.