The Internal Revenue Service (IRS) released a warning on June 1, 2022, to alert taxpayers to the first four “potentially abusive arrangements” on its Dirty Dozen list for the year. The Dirty Dozen, published to promote vigilance, identifies emerging threats, informs taxpayers so they do not become victims, and educates tax professionals to best advise their clients against these pitfalls when submitting their tax returns.
As listed in the IRS’s news release
, the first scams announced involve charitable remainder annuity trusts, Maltese individual retirement arrangements, foreign captive insurance, and monetized installment sales. Soon, the IRS will release information about eight more scams, including some that target the average taxpayer and some that pertain to high-net-worth individuals.
Tips for taxpayers on emerging scams
To avoid compromising themselves with these “too good to be true” tax-saving schemes, taxpayers should stay wary, as these scams adopt a wide range of communication methods ranging from seemingly harmless emails to direct phone calls to alluring targeted online advertisements. They should also consider each source before putting any of these arrangements on their tax returns — because ultimately, they are the ones who are responsible for what is on the return, not the promoter who reached out to them and made a promise they did not uphold. To mitigate risks, it is crucial that anxious taxpayers should turn to trustworthy tax professionals to assist with their returns.
Read on to learn about each of the four now-public Dirty Dozen scams.
Scam #1: Use of Charitable Remainder Annuity Trust (CRAT) to Eliminate Taxable Gain
In this transaction, taxpayers wrongly claim the transfer of appreciated property assets to a CRAT, giving the assets a bump in fair market value, as though they had been sold to a trust. Then, after actually selling the property (and not netting a gain because of the claimed “step-up”), the CRAT uses the proceeds to buy a single premium immediate annuity (SPIA). The beneficiary then reports a small amount of the annuity received from the SPIA as income and mistreats the remaining payment as an excluded portion representing a return on investment — with no associated tax due, which is a misapplication of the rules under sections 72 and 664.
Scam #2: Maltese (or other Foreign) Pension Arrangements Misusing Treaty
These transactions see U.S. citizens or residents try to avoid paying taxes by contributing to certain foreign individual retirement arrangements in Malta (but it is possible this pertains to other foreign countries too). A warning sign here is the individual’s lack of a “local” connection because local law allows contributions in a form other than cash, or just does not limit the amount of contributions at all by reference to income earned through employment or self-employment. The foreign arrangement is then named as a “pension fund” for U.S. tax treaty purposes, and the thus the taxpayer wrongly claims an exemption from their income tax on earnings in and distributions from the foreign arrangement.
Scam #3: Puerto Rican and Other Foreign Captive Insurance
Here, the owners of U.S. closely held entities engage in an insurance arrangement with someone from Puerto Rico (or another foreign corporation) who has segregated asset plans or cell arrangements. Typically, the U.S. owner has a vested financial interest in these plans and claims deductions for the insurance coverage provided by a fronting carrier, reinstating the “coverage” with the foreign corporation. There are several things to look for here: non-arm’s length pricing, no actual business purpose for entering the arrangement, and implausible risks covered.
Scam #4: Monetized Installment Sales
These transactions violate the installment sale rules under section 453 by a seller who receives the proceeds from a sale (in the same year of the sale) through purported loans. This happens when the seller enters in a contract to sell appreciated property to a buyer for cash, and then intends to sell that same property to an intermediary in return for in installment note. The intermediary then plans to sell the property to a buyer and receives the cash purchase price. The seller ends up receiving an amount equal to the sales price minus the transactional fees in the form of a purported loan that is unsecured.
Consequences of falling for a Dirty Dozen scheme
It is important for taxpayers who have already taken part in transactions like these — or those who are thinking about doing so — to consult tax professionals before claiming any tax benefits they think they are owed.
Those taxpayers who have already claimed the purported tax benefits of one of these four “Dirty Dozen” arrangements on a tax return should take the proper steps to amend their actions. These include filing an amended return and going to an independent professional for guidance. If necessary, the IRS will examine the tax benefits from transactions like the ones depicted in the list and inflict penalties related to accuracy ranging from 20% to 40%, or a civil fraud penalty of 75% on any taxpayer who underpaid.
Our perspective on the "Dirty Dozen"
This is not, of course, an exhaustive list of every scam the IRS has its eye on this year. But it does include some of the more common trends that appear like they will peak this year as returns are filed. The best advice we can give? If something looks too good to be true…it probably is. Consult your tax professional for guidance and know that it is in your best interest to stay aware of these nefarious arrangements, so you do not fall susceptible to additional penalties.
MGO’s Tax team
brings more than 30 years of experience and is well versed in ensuring your tax returns are compliant. We also stay up to date on the risks, pitfalls, and warnings issued by the IRS so you don’t have to. If you think you have been involved in or are in the process of being involved in one of the Dirty Dozen scams, we can help. Contact us today