As part of the Dirty Dozen campaign, the Internal Revenue Service warned wealthy individuals about three tax traps designed for them by dishonest promoters and shady tax practitioners.
For those with high incomes, they can be tempting targets for a variety of schemes and aggressive tax strategies designed to reduce taxes. These can take many different forms, ranging from inflated art donation deductions to aggressive charitable remainder annuity trusts and detailed shelters that maneuver to delay paying gains on property.
“High-income taxpayers can be vulnerable to being pulled into these aggressive schemes and scams,” said IRS Commissioner Danny Werfel. “Taxpayers should be extra careful on tax maneuvers that seem too good to be true. Beware of advertisements for seemingly ideal tax structures that distort tax laws and leave victims with civil or criminal tax penalties.”
“There’s growing risk for taxpayers pulled into aggressive schemes as the IRS continues to accelerate and expand our compliance work involving high-income individuals,” Werfel added. “The IRS reminds taxpayers that relying on an independent tax or legal professional can help avoid problems with aggressive promoters.”
This marks the tenth day of the special Dirty Dozen series. The annual Dirty Dozen list comprises a list of scams and schemes that can put taxpayers and tax professionals at risk. The list is not a legal document nor a formal enforcement priority. The education effort is designed to raise awareness and protect taxpayers and tax pros from common tax scams and schemes.
Improper Art Donation Deductions
There are ways for taxpayers to properly claim donations of art. But some unscrupulous promoters use direct solicitation to promise values of art that are too good to be true.
These promoters encourage taxpayers to buy various types of art, often at a “discounted” price. This price may also include additional services from the promoter, such as storage, shipping and arranging the appraisal and donation of the art. The promotor promises the art is worth significantly more than the purchase price.
These schemes are designed to encourage purchasers to donate the art after waiting at least one year and to claim a tax deduction for an inflated fair market value, which is substantially more than they paid for the artwork. Promoters may suggest taxpayers donate art annually and allow them to buy a quantity of art that guarantees a specific deductible amount. Promoters may even arrange for certain charities to take the donations.
The IRS has a team of professionally trained Appraisers in art appraisal services who provide assistance and advice to the IRS and taxpayers on valuation questions in connection with personal property and works of art.
“Creativity in art is a beautiful thing, but aggressive creativity in art donation deductions can paint a bad picture for people pulled into these schemes,” Werfel said. “This is another example where people should be careful when it comes to aggressive marketing and promotions. There are legitimate ways to claim an art donation, but taxpayers should be careful to understand the rules and watch out for inflated values or questionable appraisals. Beauty is not always in the eye of the beholder when it comes to tax deductions of art.”
Charitable Remainder Annuity Trust
Charitable remainder trusts (CRAT) are irrevocable trusts that let persons 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 CRAT pays a specific dollar amount each year.
Unfortunately, these trusts are sometimes misused to eliminate capital gain.
Here’s how it works. The appreciated property is transferred to a CRAT. Taxpayers wrongly claim the transfer of the appreciated assets to the CRAT, which 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 then 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 who seek to achieve this inaccurate result do so by misapplying the rules.
Monetized Installment Sales
In these frequently shady deals, promoters look for taxpayers seeking to defer the recognition of gain upon the sale of appreciated property and then organize an abusive shelter through selling them monetized installment sales. These transactions occur when an intermediary purchases appreciated property from a seller in exchange for an installment note, which typically provides 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 gain recognition on the appreciated property until the final payment on the installment note, often slated for many years later.
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