IRS Releases First of “Dirty Dozen” Tax Scams
By Michael D’Addio, Principal, Tax & Business Services
On May 31, the IRS issued the first four of its “Dirty Dozen” list of tax scams for 2022.
The IRS reminds taxpayers of their responsibilities for the contents of their tax returns. Where appropriate, the IRS may assert accuracy-related penalties ranging from 20% to 40% as well as a civil fraud penalty of 75% on underpayment of tax with respect to these questionable tax strategies. The Service suggests that taxpayers who have already utilized one of these schemes consult an independent and competent advisor and consider filing an amended return.
1. Use of Charitable Remainder Annuity Trust (CRAT) to Eliminate Taxable Gain
Under this plan, a taxpayer transfers appreciated property to a CRAT and improperly claims that the transfer provides a stepped-up basis to fair market value (as if the assets had been sold) to the trust. The CRAT then sells the property to a buyer reporting no gain (due to the improper step-up) and purchases a single premium immediate annuity (SPIA). The annual payments from the CRAT to the taxpayer are treated as nontaxable returns of principal. This strategy misapplies several sections of the tax code.
2. Maltese (Other Foreign Jurisdiction) Pension Arrangements that Misuse Treaty Provisions
A U.S. citizen or resident attempts to avoid U.S. tax by making contributions to foreign individual retirement arrangements in Malta (or certain other foreign jurisdictions). The law of the foreign jurisdiction permits non-cash contributions or does not limit the amount of contributions by reference to income earned from employment or self-employment. The U.S. person claims the foreign arrangement is a “pension fund” for U.S-Malta treaty purposes and improperly claims exemption from U.S. income tax on the earnings in and on a lump-sum distribution from the foreign arrangement. The IRS put taxpayers on notice earlier in the year that it was reviewing the use of Maltese personal retirement schemes if the arrangement allows contributions of property other than cash or does not limit contributions by reference to income earned from employment or self-employment activities.
3. Puerto Rican and Other Foreign Captive Insurance
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. A deduction is taken for insurance cost provided by a fronting carrier that reinsures the coverage with the foreign corporation. Effectively, the U.S taxpayer is insuring its own risk. The IRS notes that characteristics of these arrangements are: implausible risks covered, non-arm’s-length pricing and lack of business purpose for entering the arrangement.
4. Monetized Installment Sales
This plan allows sellers access to cash on a sale of property under the installment sale rules, through purported third party loans without a direct pledge of the installment note. Under a typical monetized installment sale structure:
- The seller (S) sells property (P) to dealer (D) for an installment note, which provides for interest-only payments for a term (e.g., 30 years) and a lump-sum principal payment at the end of the term.
- A third party lender (L) extends a loan (generally for between 93.5% and 95% of the sales price) on a nonrecourse and unsecured basis, which provides for interest-only payments and principal payments at the end of the term (which matches the term of the installment sale note).
The expected tax results are that the seller gets the use of 93.5%-95% of the sales cash tax-free, and the tax is deferred until the payoff of the installment note in 30 years. Care must be taken so that the installment note is not pledged as security, as there is an anti-pledging rule in the Internal Revenue Code stating that if the note is so pledged, the principal will be deemed to have been paid, causing an immediate recognition of the gain.
Promoters of this strategy reference Chief Counsel Memorandum (CCM) 20121, which appeared to approve the use of a monetized installment sale structure. However, last year, the IRS issued another Advice, which provides insight into the Service’s current position on this arrangement stating:
- The theory on which this strategy is based is flawed, and
- Where the lender loan is unsecured and nonrecourse, it does not constitute debt and will be income.
More to come…
As the IRS updates guidance on these particular arrangements and makes additions to the Dirty Dozen list, we will keep you updated.
If you have utilized one of these tax strategies, contact your Marcum tax professional to review your situation and conclude whether corrective action should be taken.