IRS Dirty Dozen List and Other Audit Triggers
Earlier this year, the IRS released its 2022 Dirty Dozen, the top twelve scams or potentially abusive transactions that could trigger an audit. This list is not exclusive and is not a list of top priorities. Rather, it is the IRS’ attempt to alert taxpayers of potentially abusive tax reporting practices or scams by third parties.
Charitable Remainder Annuity Trusts (CRATs)
In the past, the IRS has heavily scrutinized anyone using CRATS to avoid taxes. Taxpayers will transfer appreciated property to a CRAT. Taxpayers then claim a step-up in basis as if the property were sold. The CRAT sells the property, reports no gain due to the step-up, and uses the proceeds to purchase a single-premium immediate annuity. 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.
Treaty Benefits for Pensions
Taxpayers make contributions to a foreign retirement arrangement with no local connection and liberal contribution rules. By improperly asserting the foreign arrangement is a “pension fund” for U.S. tax treaty purposes, the taxpayer takes an exemption on the earnings and distributions of the “pension.” The IRS warns that these earnings should be taxable, and it will strictly enforce this.
Foreign Captive Insurance
U.S. owners of small businesses will buy insurance from frontage carriers that reinsure the coverage with a foreign entity with cell arrangements or segregated asset plans in which the U.S. owners have an interest. The purported insurance arrangements typically include coverage of implausible risks, non-arm’s length pricing, and/or a lack of business purpose. However, the taxpayers take a deduction on this insurance expense which is not allowed.
Monetized Installment Sales
Taxpayers will perform an installment sale in which, through related transactions, the taxpayer sells a property through an intermediary in return for a note. The intermediary then sells the property to a buyer in exchange for cash. The intermediary pays the cash to the seller in the form of a non-recourse loan. The IRS treats this as a regular sale and does not allow deferral of any gain.
The IRS is issuing warnings about potential fraud related to COVID-19. Be wary of attractive offers where fraudsters claim to be the IRS. Many times, these offers will ask for personal information in order to steal your identity or money. Ignore these offers or call the IRS directly if you are unsure about the authenticity of such offers.
Offer in Compromise (OIC) Mills
The IRS also warns taxpayers to be wary about local advertisements claiming to help settle debts with the IRS for pennies on the dollar. In many cases, the taxpayer can get the same deal without the professional fees if they work directly with the IRS instead of going through an intermediary. The IRS warns that these businesses prey on vulnerable taxpayers with disproportionate fees, and often mislead people with no chance of meeting the requirements for an OIC. The IRS has an Offer in Compromise Pre-Qualifier Tool taxpayers can use to help ensure they’re eligible to file an OIC.
The IRS warns taxpayers to be on the lookout for bogus calls, texts, emails and posts online to gain trust or steal information. Also, taxpayers are highly cautioned not to respond to communications or click on links or attachments from unknown sources. Even if you recognize numbers or email addresses, be wary if the message seems suspicious as fraudsters can easily spoof contact information.
The IRS warns that fraudsters will often communicate during tax season using IRS logos and catchy or urgent subject lines. The IRS does not send unsolicited communications by email. If you did not initiate contact with the IRS via the internet, do not expect an email from them. Therefore, do not respond to such emails or click on any links contained therein.
Offshore Accounts and Digital Assets
The IRS is seeing a rise in offshore accounts and digital assets such as NFTs and crypto. The existence of, or transactions in, these accounts often require reporting to the IRS. Individual income tax returns include questions on the face of the 1040 that must be answered regarding the existence of these accounts and/or any transactions within that must be reported. The lack of awareness regarding these requirements or the unsuccessful attempts to hide these accounts from the IRS can lead to major tax penalties.
High Earner Failure to File
The IRS reminds taxpayers that the failure to file penalty is substantially higher than the failure to pay penalty and can be up to 25% of the unpaid taxes (75% if the failure to file is deemed fraudulent, based on the circumstances). If you don’t have the cash to pay the penalty, the IRS recommends filing an accurate return and setting up a payment plan. Do not ignore filing obligations due to your inability to pay. The IRS receives records of your earnings and matches those records to tax filings each year. Missing returns trigger alarms.
Abusive Syndicated Conservation Easements (SCEs)
Unscrupulous promotors of SCEs often combine partnership arrangements lacking a legitimate business purpose and highly inflated appraisals of undeveloped land or other real estate to provide improper charitable contributions to taxpayers. If this dirty dozen were listed in the order of attention devoted by the IRS, SCEs might very well be at the top.
Abusive Micro-captive Insurance Arrangements
The IRS has already included foreign captive insurance arrangements on its dirty dozen. To emphasize the abuse potential in this area, the IRS has a separate reference to abusive “micro-captive” structures, in which promoters persuade owners of closely held entities to participate in schemes that lack many of the attributes of insurance. Taxpayers often purchase ingenuine insurance at excessive prices in order to claim large tax deductions. Some arrangements include the micro-captive making available to the taxpayer some portion of the premiums paid through a loan or other transfer.
Additional Red Flags
In addition to the “dirty dozen”, the following are more commonly used deductions and credits that the Wall Street Journal identified as potential red flags for IRS audits when taxpayers use them incorrectly or inaccurately.
- Education Tax Credits: There are two types of tax credits for education (the American Opportunity Credit and Lifetime Learning Credit). Be sure that you qualify for the credit, choose the right one, and do not use both in the same tax year. These credits are commonly confused, thus, creating a top ten trigger for IRS audits.
- Small businesses that are cash intensive should pay particular attention that they do not underreport taxable income and that they report debt forgiveness. The IRS will focus heavily on compliance within restaurants, bars, and grocery stores since these entities, quite often, received pandemic-related relief.
- Child Tax Credit: The advance child tax credit related to the American Rescue Plan Act has increased compliance issues due to the complexity of reporting. The IRS should send notices that state the amount of credit each person or couple received during the tax year. Be sure to reconcile this amount with your documents and report your income correctly. If your income went up significantly this year, you should likely expect to pay some of this credit back. Failure to reconcile with the IRS notice will likely trigger an audit.
- Cryptocurrency Transactions: While the IRS has not given much clear guidance on crypto, it is scrutinizing crypto transactions with a fine-tooth comb. Every crypto transaction needs to be reported individually. The IRS has a mandate to collect a certain amount from crypto transactions. Thus, it is very important that you track your transactions thoroughly.
- Earned Income Tax Credit: This credit is available to more people than ever before, creating a greater potential for fraud. The IRS has always kept a close eye on this credit, and it is a long-time favorite audit trigger. Be sure that you are not erroneously claiming this credit.
- Charitable Contributions: Keep receipts of all contributions and accurately track amounts. The IRS heavily scrutinizes large contributions, especially if they exceed a certain percentage of your income.
- Rental Income: Make sure to track all rental income and associated expenses. Keep in mind that rental income is generally passive income, although exceptions to passive treatment can apply depending on a taxpayer’s circumstances. Passive treatment means that if your rental expenses exceed your rental income, you cannot deduct the portion that exceeds your rental income. However, you can carry this deduction forward to future years to offset a passive gain.
- Home Office Deduction: This deduction is often taken in error due to the pandemic. Many taxpayers think they qualify for this deduction since they work from home. Under current law, this deduction is not available to individuals that work from home unless they are self-employed. Furthermore, the area claimed must be used exclusively for business.
- Early Withdrawals from IRAs or 401(k)s: Except for some COVID-related relief, early withdrawals are subject to regular income tax and a 10% penalty. Be sure to report all IRA-related distributions and include documentation with your 1040.
- Health Premium Tax Credit: More people now qualify for health premium tax credits. Therefore, the IRS is monitoring this credit closely due to increased risk of noncompliance and abuse.
In summary, the above schemes, deductions, and credits draw the IRS’ attention and may lead to an audit if deemed abusive. Taxpayers should hire qualified and skilled tax professionals so that they do not fall into the common traps listed above. Unscrupulous promotors will charge exorbitant fees to create these arrangements under the false narrative that they are completely legal. The IRS warns that taxpayers are ultimately responsible for these schemes and not the promotors that set them up. Therefore, please contact your BMSS professional if you have questions or believe that any of these transactions apply to you. Visit our website or call (833) CPA-BMSS.