IRS begins release of annual "Dirty Dozen" list: tax avoidance schemes likely to trigger an audit

Each year the Internal Revenue Service releases its "Dirty Dozen," referring to transactions and arrangements that taxpayers should avoid. This past week, the agency focused on four potentially abusive transactions/arrangements that are more than likely to draw "additional agency compliance efforts." In other words, you can expect to see an IRS auditor come knocking at your door in the not-too-distant future if you have participated in any of these.

Those four abusive transactions involve charitable remainder annuity trusts, Maltese individual retirement arrangements, foreign captive insurance, and monetized installment sales.

The agency will focus on eight additional scams in the near future, with some focused on the average taxpayer and others focused on more complex arrangements that promoters market to higher-income individuals.

The IRS reminds taxpayers to watch out for and avoid advertised schemes. Many of these schemes are now promoted online. They promise tax savings that are too good to be true and will likely cause taxpayers to legally compromise themselves.

The agency cautions taxpayers, tax professionals, and financial institutions that they must be vigilant and watch out for scams, from simple emails and calls to highly questionable but enticing online advertisements.

2022 IRS Dirty Dozen #1 – use of Charitable Remainder Annuity Trust (CRAT) to eliminate taxable gain.

In this transaction, the appreciated property is transferred to a CRAT. Taxpayers improperly claim the transfer of the appreciated assets to the CRAT in and of itself 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.

2022 IRS Dirty Dozen #2 – Maltese (or other foreign) pension arrangements misusing treaty. 

In these transactions, U.S. citizens or U.S. residents attempt to avoid U.S. tax by contributing to certain foreign individual retirement arrangements in Malta (or possibly other foreign countries). In these transactions, the individual typically lacks a local connection. In addition, 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 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.

2022 IRS Dirty Dozen #3 – Puerto Rican and other foreign captive insurance.

In these transactions, 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 into the arrangement

2022 IRS Dirty Dozen #4 – 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.

In a typical transaction, 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 non-recourse and unsecured.

IRS Dirty Dozen Guidance: engage in the transactions at your own risk

The IRS warns that taxpayers who have engaged in, or are considering engaging in, any of these transactions should carefully review the underlying legal requirements and consult independent, trusted advisors before claiming any purported tax benefits.

Those taxpayers who have already claimed the "tax benefits" of one of these four transactions on a tax return should consider taking corrective steps, such as filing an amended return and seeking independent advice.

The IRS likely will challenge claimed benefits from the transactions on this list and may impose accuracy-related penalties ranging from 20% to 40%, or a civil fraud penalty of 75% of any underpayment of tax.

Dirty Dozen list represents the more common transactions the IRS will scrutinize

This list is not intended to be an exclusive list of transactions that the IRS will examine closely – they have made this clear.

This list represents some of the more common trends and transactions IRS officials are seeing as they examine returns. 

IRS Commissioner Charles Rettig cautions that "taxpayers should stop and think twice before including these questionable arrangements on their tax returns. 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."

In short, like most things in life, anything that seems "too good to be true" most often is.