The Internal Revenue Service has announced the first installment of its annual “Dirty Dozen” list of tax scams.  Published every year, the “Dirty Dozen” comprises the twelve most prevalent tax scams that taxpayers may encounter, and is a strong indicator of where the IRS will concentrate its enforcement resources.  The first four entries on the “Dirty Dozen” are potentially abusive arrangements involving charitable remainder annuity trusts, Maltese individual retirement arrangements, foreign captive insurance, and monetized installment sales.  In the coming days, the IRS will announce the eight additional tax scams that round out the “Dirty Dozen” for 2022.

In a press release, IRS Commissioner Chuck Rettig warned that “[t]axpayers 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.” 

The first four scams on the “Dirty Dozen” list are described by the IRS as follows:   

Use of Charitable Remainder Annuity Trust (CRAT) to Eliminate Taxable Gain.  In this transaction, appreciated property is transferred to a CRAT.  Taxpayers improperly claim 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 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.  The beneficiary treats the remaining payment as an excluded portion representing a return of investment for which no tax is due.

Maltese (or Other Foreign) Pension Arrangements Misusing Treaty.  In these transactions, U.S. citizens or residents attempt to avoid U.S. tax by making contributions to certain foreign individual retirement arrangements in Malta (or possibly other foreign countries). In these transactions, the individual 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 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.

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 insurance arrangements typically will include one or more of the following: implausible risks covered, non-arm’s-length pricing, and lack of business purpose for entering into the arrangement.

Monetized Installment Sales. These transactions involve the 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 loans. In a typical transaction, the seller enters into a contract to sell appreciated property to a buyer for cash and then sells the same property to an intermediary in return for an installment note. The intermediary then sells 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 loan that is nonrecourse and unsecured.

The IRS recommends that taxpayers who have already claimed tax benefits from any of these four transactions should consider taking corrective steps, such as filing an amended return and seeking independent advice.  Where appropriate, the IRS will challenge the purported tax benefits from the transactions on this list, and may assert accuracy-related penalties ranging from 20% to 40%, or a civil fraud penalty of 75% of any underpayment of tax.

To combat the evolving variety of these potentially abusive transactions, the IRS created the Office of Promoter Investigations to coordinate enforcement activities and focus on participants and the promoters of abusive tax avoidance transactions.  The IRS has a variety of means to find potentially abusive transactions, including examinations, promoter investigations, whistleblower claims, data analytics and reviewing marketing materials.