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Watch out for schemes aimed at high-income filers

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As part of the IRS annual Dirty Dozen, the IRS is cautioning taxpayers to resist questionable tax practitioners and independent promoters selling schemes aimed at wealthy taxpayers. These potentially abusive arrangements involve Charitable Remainder Annuity Trusts and monetized installment sales, tools that can be misused by promoters who advertise these schemes to attract clients. The promoters misapply the rules and leave the filers vulnerable.

The Dirty Dozen is a list of 12 scams and schemes that put taxpayers and the tax professional community at risk of losing money, personal information, data, and more. Some items on the list are new and some are making a return visit. While the list is not a legal document or a formal listing of agency enforcement priorities, it is intended to alert taxpayers and the tax professional community about various scams and schemes at large.

Schemes aimed at high-income filers

Charitable Remainder Annuity Trust

Charitable Remainder Trusts are irrevocable trusts that let individuals donate assets to charity and draw annual income for life or for a specific time period. The IRS examines charitable remainder trusts to ensure they correctly report trust income and distributions to beneficiaries, file required tax documents, and follow applicable laws and rules. A charitable remainder annuity trust (CRAT) pays a specific dollar amount each year.

Unfortunately, these trusts are sometimes misused by promoters, advisors, and taxpayers to try to eliminate ordinary income and/or capital gain on the sale of property. In abusive transactions of this type, property with a fair market value in excess of its basis is transferred to a CRAT. Taxpayers may wrongly claim the transfer of the property to the CRAT results in an increase in basis to fair market value as if the property 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. Next, the CRAT purchases a single premium immediate annuity with the proceeds from the sale of the property.

By misapplying the rules under Sections 72 and 664, the taxpayer or beneficiary treats the remaining payment as an excluded portion representing a return of investment for which no tax is due.

The IRS reminds taxpayers that they are legally responsible for what is on their tax return, not the practitioner or promoter who entices them to sign on to an abusive transaction.

Monetized installment sales

In these potentially abusive transactions, promoters find taxpayers seeking to defer the recognition of gain upon the sale of appreciated property. They facilitate a purported monetized installment sale for the taxpayer in exchange for a fee. These installment sales occur when an intermediary purchases appreciated property from a seller in exchange for an installment note. The notes typically provide for payments of interest only, with principal being paid at the end of the term. In these arrangements, the seller gets the lion’s share of the proceeds, but improperly delays the recognition of gain on the appreciated property until the final payment on the installment note, often years later.

These are examples of potentially abusive arrangements that taxpayers should avoid, many of which are now advertised online. The IRS recommends that taxpayers considering these types of arrangements carefully review the legal requirements underlying them and consult with competent, independent, qualified advisors before engaging or claiming any purported tax benefit.

Where appropriate, the IRS may assert accuracy-related penalties ranging from 20% to 40% of an underpayment of tax, or a civil fraud penalty of 75% of any underpayment of tax related to transactions like those listed here. However, this is not an exclusive list of transactions the IRS is scrutinizing, and taxpayers and practitioners should always be wary of participating in transactions that seem “too good to be true.”

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