The Focus - Our Tax E-Newsletter
Using CRATs to Eliminate Capital Gain— A 'Dirty Dozen' Debut
For more than two decades, the IRS has published a list known as “The Dirty Dozen” with the goal of raising awareness of tax-related scams and fraud schemes for both taxpayers and tax professionals. The list is not all-inclusive, but rather changes and evolves from year to year to include what the IRS deems to be the most serious and pervasive fraud methods and occurrences of that time. Many tax fraud schemes and methods, such as the impersonation of charitable organizations, phishing, identity theft, and return preparer fraud first appeared over a decade ago and have made multiple appearances over the years.
Beginning in 2021, the ‘Dirty Dozen’ list began to look different than it has in prior years. Since its inception, scams such as charitable organization fraud, phishing, and identity theft have been staples of the list. Beginning in 2021, the IRS began shifting its attention to more sophisticated methods of committing tax avoidance and defrauding taxpayers. The IRS divided the list into categories to group related tax scams instead of just listing them individually. The categories for 2022 are Potentially Abusive Arrangements, Consumer-Focused Fraud, and High-Net-Worth Scams. In both 2021 and 2022, there were also a larger number of appearances by newcomers than in years past. One of these newcomers in the “Potentially Abusive Arrangements” category is Charitable Remainder Annuity Trusts, or CRATs.
The use of Charitable Remainder Annuity Trusts is a legitimate tool used in both estate and tax planning meant to make assets transferred into trust exempt from federal income and estate taxation. By the terms of a CRAT, the grantor (or other non-charitable income beneficiary or beneficiaries) is entitled to an annual fixed payment based from the trust calculated on the initial fair market value of the assets placed into the trust. The amount of the payment is expressed as either an amount or a percentage by the terms of the trust agreement (to be determined by the grantor), however, in no event may the payment be less than 5% of the initial value of the trust assets. Upon the death of the income beneficiaries, the full balance of principal (the remainder interest) passes to a qualified charitable organization.
The potential tax benefits of using a CRAT are substantial. At the time the trust is formed, the grantor is entitled to a charitable income tax deduction equal to remainder interest discounted to its present value. Any appreciation in value of trust assets from the time the trust is funded until the death of the income beneficiaries is exempt from federal tax. Throughout the duration of the trust, only the income paid out to the income beneficiaries is subject to federal income tax. It is because of these significant potential tax advantages that CRATs have been identified as a tool to effectuate abusive tax-avoidance schemes.
To summarize the steps of this particular fraud:
- A grantor sets up a charitable remainder annuity trust and funds it using highly appreciated assets.
- The grantor determines that the value of the donated property is equal to the fair market value of the property, in violation of carryover basis rules.
- The grantor calculates a charitable income tax deduction based upon an inflated present value of the donated asset.
- The CRAT liquidates the donated property and uses the total proceeds to purchase an annuity contract, all while recognizing no capital gain from the transaction(s).
- The annuity payment to the income beneficiary is made using the proceeds of the annuity payment to the CRAT.
- Because the annuity has a high investment value relative to its return, the majority of the payment made to the income beneficiary is considered a return of investment principal and is exempt from federal income taxation.
- Upon the death of the income beneficiary, the assets held in the trust are almost (if not entirely) fully excludable from their gross taxable estate.
The use of CRATs for estate and tax planning is fairly common and, as mentioned previously, the tax savings from utilizing even a legitimate CRAT can be substantial for taxpayer’s with both charitable intent and a desire to maintain an income stream from donated assets during their lifetime. For these reasons, it is no surprise that the IRS is putting taxpayers on notice that it is keeping a close watch for abusive charitable trust arrangements. But the IRS will not only be keeping a closer eye on CRATs in the future—below is a summary of other tax avoidance schemes cited in this year’s ‘Dirty Dozen’ list.
Potentially Abusive Arrangements:
- Maltese (or Other Foreign) Pension Arrangements Misusing Treaty. A U.S. taxpayer designates a foreign IRA as a “pension fund” and wrongfully claims an exemption from U.S. income tax on the retirement earnings and distributions.
- Puerto Rican and Other Foreign Captive Insurance. A U.S. taxpayer and owner of a closely-held entity purports to have an insurance arrangement with another foreign corporation and claims a deduction for the cost of the coverage. The terms of the arrangement are usually not bona fide terms and generally lack any real business purpose.
- Monetized Installment Sales. A seller of property misapplies section 453 installment sale rules by selling appreciated property to an intermediary, who then sells the property to a separate buyer and issues an installment note to the original owner. The seller then accounts for the sale as the issuance of a loan.
- Economic Impact Payment and tax refund scams. Identity thieves contact individuals alerting them to the availability of a payment or tax refund in attempt to collect personal information. Contact can come in the form of text messages, telephone calls, and emails. Note that the IRS will never use one of these methods to contact an individual for personal information.
- Unemployment fraud leading to inaccurate taxpayer 1099-Gs. Identity thieves used stolen personal information to apply for and collect unemployment compensation. If you receive a Form 1099-G reporting unemployment payments that you did not collect, contact the issuing agency as soon as possible and only report the unemployment compensation that you actually received on your tax return.
- Fake employment offers posted on social media. This is another ploy for identify thieves to collect personal and financial information that can then be used to file fraudulent tax returns, or for other fraudulent purposes.
- Fake charities that steal your money. This scam has been included in every ‘Dirty Dozen’ list issued in at least the last decade. The IRS warns that there tends to be an uptick in these scams following a natural disaster or national crises, like the COVID pandemic. Be careful only to donate to organizations that you have personally confirmed to be legitimate. One useful tool for doing is the IRS Tax Exempt Organization Search, which can be accessed at https://www.irs.gov/charities-and-nonprofits.
- Offer in Compromise Mills. Fraudsters misrepresent programs that the IRS offers to help taxpayer’s settle unpaid income tax debt. They collect excessive fees from individual taxpayers, sometimes with the knowledge that the taxpayers do not qualify for certain programs or have little chance of actually being granted relief.
- Suspicious Communications. These scams can come in the form of text messages, emails, and telephone calls. The communications may leaf the victim to believe that they are titled to an additional stimulus or larger refund, or may threaten taxpayers with lawsuits and arrests due to supposed unpaid taxes. The IRS does not communicate with taxpayers in this way, nor leave voice messages, and will never threaten a taxpayer and demand payment over the telephone.
- Spear phishing. Spear phishing is an email scam often perpetrated to steal the software preparation credentials of tax preparers. Forms of spear phishing can target any type of business or organization, and individuals are cautioned against responding to or clicking on links contained in suspicious communications.
- Concealing Assets in Offshore Accounts and Improper Reporting of Digital Assets. Concealing assets in offshore accounts is not a new tax avoidance strategy; however, this method of fraud is now expanded to include accounts holding cryptocurrency and other valuable digital assets.
- High-income individuals who do not file tax returns. The IRS reiterates this year that it will continue to focus on non-filers earning more than $100,000 per year. Failing to file a tax return can result in significant penalties, especially if the failure to file is deemed fraudulent.
- Abusive Syndicated Conservation Easements. With this scam, inflated appraisals of undeveloped land and partnerships are used to inflate tax deductions for conservation easements.
- Abusive Micro-Captive Insurance Arrangements. The IRS is increasing enforcement against these types of abusive tax arrangements in which owners of closely-held entities participate in offshore insurance schemes, such as “Puerto Rican and Other Foreign Captive Insurance” arrangements as previously described.
If you have any questions regarding this year's 'Dirty Dozen' list, or contact your tax advisor at Dermody, Burke & Brown.
The information reflected in this article was current at the time of publication. This information will not be modified or updated for any subsequent tax law changes, if any.