Authored by Mark Lobb
Through a series of notices published by the Internal Revenue Service starting on June 1 and ending on June 10, 2022, the IRS lists what it deems to be “potentially abusive arrangements that taxpayers should avoid.” The list of arrangements is identified by the IRS as “The Dirty Dozen” (the “TDD”).
The IRS has been publishing such a list for over 20 years. By identifying an “arrangement” as a TDD, the IRS is signaling that “additional agency compliance efforts” will be required by the IRS in the future. These compliance efforts come in different forms, but often require taxpayers or their CPAs to report such arrangements with a taxpayer’s tax filings as a suspect transaction to the IRS. The IRS Office of Chief Counsel announced earlier 2022 it will hire up to 200 additional attorneys to combat abusive syndicated conservation easements and micro-captive transactions as well as other transactions deemed abusive by the IRS.
IRS Commissioner Rettig notes the IRS views the TDD transactions as potentially abusive, and on the IRS “enforcement radar screen.” The use of “Dozen” is misleading this year as the IRS identifies about 17 items of scorn. This article focuses on eight transactions or actions which the IRS deems to be subject to abuse. The eight include:
- Charitable remainder annuity trusts,
- Maltese individual retirement arrangements,
- Foreign captive insurance,
- Monetized installment sales,
- Concealing Assets in Offshore Accounts and Improper Reporting of Digital Assets,
- High-income individuals who don’t file tax returns,
- Abusive Syndicated Conservation Easements, and
- Abusive Micro-Captive Insurance Arrangements.
Eight Transactions Deemed Dirty
If you see a transaction you have done or you have advised someone else to do, do not panic. It may be that the version of what you have done is not abusive, or the manner in which you have handled or reported the transaction eliminates any potential abuse. The important takeaway is for you or your client to have the transaction, handling of the transaction and reporting of the transaction reviewed by a qualified professional to determine if the transaction falls into what the IRS would deem to be abusive.
- Charitable Remainder Annuity Trust (CRAT) to Eliminate Taxable Gain.
There is nothing inherently wrong with a CRAT. If you have a CRAT, do not panic.
A CRAT is a type of gift transaction in which a grantor contributes assets to an irrevocable trust. The trust then donates to one or more charities while also paying a fixed income to one or more designated noncharitable beneficiaries in the form of an annuity. The value of the annuity is calculated as a fixed percentage of the initial value of the trust’s assets.
The transaction of interest to the IRS starts with the transfer of appreciated property to a CRAT. The taxpayer/grantor claims the transfer of the appreciated 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 assets but does not recognize gain due to the claimed step-up in basis. The CRAT then uses the proceeds from the sale to purchase a single premium immediate annuity (“SPIA”). The non-charitable beneficiary of the CRAT reports only a small portion of the annuity received from the SPIA as income. The non-charitable beneficiary treats the remaining payment as an excluded portion representing a return of investment for which no tax is due. Taxpayers taking part in this transaction rely on the rules under IRC sections 72 and 664. Obviously, the IRS disagrees with the application of those code sections to the transaction which has elevated the transaction to dirty dozen infamy.
- Maltese and Other Foreign Pension Arrangements Misusing Treaty.
In these transactions, U.S. taxpayers attempt to avoid U.S. tax by making contributions to foreign individual retirement arrangements in Malta or other foreign countries. In these transactions, the U.S. taxpayer typically lacks 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 asserting the foreign arrangement is a “pension fund” for U.S. tax treaty purposes, the U.S. taxpayer claims an exemption from U.S. income tax on earnings in, and distributions from, the foreign arrangement.
Non-U.S. pension promoters claim U.S. taxpayers can dramatically lower U.S. taxes on the sale of highly appreciated assets such as stock, real estate or cryptocurrency. The promoters claim U.S. taxpayers aged 50 and older can avoid owing federal capital-gains tax by funding the non-U.S. pension plan with the appreciated assets and then selling the assets. After the sale of assets, the U.S. taxpayers are informed they can withdraw the sale proceeds tax-free.
In December of 2021, officials of the U.S. and Malta signed an agreement to crack down on Maltese pension maneuvers. The IRS also said it was “actively examining” taxpayers who set up Maltese pensions. Any other foreign jurisdiction partaking in such pension transactions will likewise be scrutinized by the IRS. The pension transactions are now a part of the dirty dozen.
- Puerto Rican and Other Foreign Captive Insurance.
Puerto Rican cell captive insurance arrangements are the main target. However, if a cell captive arrangement as the attributes identified below, the transaction likely will fall under IRS scrutiny. The structure has the following pieces:
- S owners of closely held entities participate in an 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. The fronting carrier then reinsures the coverage with the foreign corporation.
- In drilling down on the validity of the insurance structure, the IRS will look at whether the insurable risks being covered are plausible, whether the pricing for the policies is based on market rates so as to reflect arm’s-length pricing, and whether there is a business purpose behind the arrangement other than to avoid tax.
There is no reason to feel the IRS is picking on Puerto Rica. The IRS does not like micro-captive arrangements in general as discussed in number eight below.
- Monetized Installment Sales.
These transactions involve what the IRS deems to be the inappropriate use of the installment sale rules under IRC Section 453 by a seller who, in the year of a sale of property, effectively receives the sales proceeds through loans. The seller commits to sell appreciated property to an unrelated buyer for cash. The seller then sells the same property to an intermediary and not the original unrelated buyer in return for an installment note. The intermediary then sells the property to the original unrelated 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.
There is nothing wrong with selling property to an unrelated third party on an installment basis. Likewise, there is nothing wrong with the unrelated third party then selling to another party at a later date. The IRS is not comfortable with the seller committing to sell to one unrelated third party for cash, and then to defer taxation on the gain, selling to an intermediary on an installment basis with the intermediary then selling to the original buyer.
- Concealing Assets in Offshore Accounts and Improper Reporting of Digital Assets:
In February of 2022, A self-described whistle-blower leaked data on more than 18,000 Swiss bank accounts, collectively holding more than $100 billion in deposits, to a German newspaper. The media nicknamed the 2022 leak “Suisse Secrets.” Roughly 100 U.S. citizens were account holders. This is not the first leak of the identities of foreign bank account holders but one of the largest. The list included common citizens along with villains.
So, do not be surprised to receive a notice from the IRS proclaiming that the IRS “remains focused on stopping tax avoidance by those who hide assets in offshore accounts and in accounts holding cryptocurrency or other digital assets.”
As the IRS properly notes, individuals have been evading U.S. taxes by hiding income in offshore banks, brokerage accounts or nominee entities for decades. The account holders access funds using debit cards, credit cards, wire transfers or other arrangements. To conceal the true owner of the account or accounts, individuals use foreign trusts, employee-leasing schemes, private annuities, structured transactions and insurance plans.
Simply because the funds are in an account out of the U.S. does not mean the accounts do not need to be identified to the U.S. government or taxes do not need to be paid on income.
Digital assets are being adopted by mainstream financial organizations. Simply holding digital assets in accounts or structures offshore does not shield them from U.S. reporting. Don’t be shocked by falling under the moniker of “dirty” if you do not report your income, digital assets or the existence of offshore accounts. If you have not disclosed accounts, you most definitely need to consult with a professional to make sure you become compliant.
- High-income individuals who don’t file tax returns:
Some U.S. Citizens continue to choose to not file a tax return. The IRS is especially interested in those individuals earning more than $100,000 a year.
The Failure to File Penalty is generally 5% of the unpaid taxes for each month or part of a month that a tax return is late. The penalty generally does not exceed 25% of unpaid taxes.
If a person’s failure to file is deemed fraudulent, the penalty increases from five percent per month to 15 percent for each month or part of a month the return is late. The maximum penalty increases from 25 percent to 75 percent if fraud is found to exist.
- Abusive Syndicated Conservation Easements:
Syndicated conservation easements have been subject to scrutiny by the IRS for many years. Promoters take a provision of the tax law allowing for conservation easements and use inflated appraisals of undeveloped land and partnership arrangements devoid of what the IRS deems to be a legitimate business purpose. These arrangements allow for inflated tax deductions and generate high fees for promoters. If you are approached by a promoter pushing syndicated conservation easement planning, it is likely a scam.
- Abusive Micro-Captive Insurance Arrangements:
The analysis here is not much different than the analysis for number item three above. The focus here is on micro-captives in general and can include a U.S. domestic captive. The IRS is of the opinion these captives are created to avoid tax and not for a legitimate insurance purpose.
The IRS is concerned the coverages insure implausible risks and do not match genuine business needs or duplicate existing commercial coverages. The “premiums” paid under these arrangements are often deemed by the IRs to be excessive.
The IRS notes: “The IRS’s activities have been sustained by the Independent Office of Appeals, and the IRS has won all micro-captive Tax Court and appellate court cases, decided on their merits, since 2017.” Most of our clients have discontinued their micro-captives. If you have an active micro-captive, you may wish to discuss the continued viability of using the captive and the associated reporting requirements and risks involved.
Client and Professional Advisor Takeaway
The IRS often projects that “if the tax consequences seem too good to be true, the transaction being proposed is likely a scam.” This statement is rubbish. A college savings account under IRC 529 grows tax free and if the funds are used for education, no tax is paid on the growth. That sounds pretty good. Is it an abusive transaction? If you answered “no,” you are correct. During the pandemic, private companies received hundreds of billions of dollars from the U.S. government and under rules issued by the IRS paid no tax. That sounds pretty good. Was it an abusive transaction? Is a retirement plan which grows tax free under IRC 401K an abusive transaction? If you sell qualified “C” corporate stock under IRC 1202 and pay no federal tax up to $10 million have you taken part in a scam. No, no and no.
The real message to taxpayers and advisors is to do your due diligence and make sure the rules behind the proposed transaction are not overly contorted. If you do not understand the transaction, do not do it. You should be cautious and measured and make sure the transaction makes sense.
Once you do a transaction, make sure it is reported on tax returns properly and that you are following all of the rules guiding the transaction. I have seen many transactions put in place which were not abusive which the IRS determined to be abusive because the transaction was not handled properly and was not reported properly.
If someone is urging you to do a transaction which will affect taxation, feel free to reach out to our firm to help guide your analysis of the proposed transaction. If you enter into a transaction which affects tax, we can also assist in making sure the details to the transaction are followed properly or if the transaction is truly abusive, we can guide you on next steps. If you are in an audit concerning what the IRS deems to be an abusive transaction, we can represent you in the audit and tax court if necessary.