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IR-2019-47, March 19, 2019
WASHINGTON — The Internal Revenue Service today warned taxpayers to steer clear of abusive tax avoidance schemes and the unscrupulous individuals who promote them. Three variations of these schemes – abusive trusts, abusive micro-captive insurance shelters and abusive syndicated conservation easements -- are featured in the final installment of this year's "Dirty Dozen."
Taxpayers are reminded that those who participate in illegal schemes may face prosecution, civil litigation and ultimately having to pay all taxes owed along with stiff penalties and interest. Participants who utilize such schemes for tax evasion also risk imprisonment.
The three schemes described in today's release all start with a legitimate tax-planning tool that is improperly distorted almost always by a promoter to produce benefits that are too good to be true and ultimately seriously compromise the taxpayer. Taxpayers should be highly skeptical of such claims.
Abusive tax evasion schemes involving trusts
Changes in bank secrecy laws of foreign jurisdictions have revealed a plethora of foreign tax evasion schemes involving trusts, and the IRS is actively examining these cases, as well as a variety of tax evasion schemes involving the use of domestic trusts.
Abusive trust arrangements often use multiple layers of trusts as well as offshore shell corporations and entities that are disregarded for U.S. tax purposes to attempt to hide the true ownership of assets and income or to disguise the substance of transactions. Although these schemes give the appearance of separating responsibility and control from the benefits of ownership, such as through the use of purported mortgages or rental agreements, false invoices, fees for services never performed, purchase and sale agreements and distributions, the taxpayer in fact continues to control the structures and directs any benefits received from them.
Taxpayers should be aware that abusive tax evasion arrangements involving trusts will not produce the tax benefits advertised by their promoters. U.S. taxpayers engaged in transactions with foreign trusts may be subject to significant information reporting penalties for failure to file Forms 3520/3520A, as applicable. For more on penalties, see Abusive Trust Tax Evasion Schemes - Law and Arguments (Section VII) on IRS.gov.
Form 14242, Report Suspected Abusive Tax Promotions or Preparers (PDF), contains a questionnaire that should be used to record informant contacts and to facilitate referrals to the Internal Revenue Service Abusive Schemes Lead Development Center.
Abusive micro-captive insurance tax shelters
Micro-captives are on the Dirty Dozen list again, reflecting IRS’s commitment to curbing abusive arrangements through audits, investigations, and litigation. The IRS has devoted substantial resources with more than 500 docketed cases in Tax Court and is conducting numerous income tax examinations of the participants in these arrangements, as well as promoter investigations.
Tax law generally allows businesses to create “captive” insurance companies to insure against risks. The insured business claims deductions for premiums paid for insurance policies. Those amounts are paid, either as insurance premiums or reinsurance premiums, to a “captive” insurance company owned by the insured or related parties and are used to fund losses incurred by the insured business. Traditional captive insurance typically allows a taxpayer to reduce the total cost of insurance and loss events.
Insurers that qualify as small insurance companies can elect to be treated as exempt organizations or to exclude limited amounts of annual net premiums from income so that the captive insurer pays tax only on its investment income. In certain “micro-captive” structures, promoters, accountants or wealth planners persuade owners of closely-held entities to participate in schemes that lack many of the attributes of insurance.
In recent years, the IRS has been successful in litigating these transactions. In 2017, the U.S. Tax Court disallowed the “wholly unreasonable” premium deductions the taxpayer had claimed under a section 831(b) micro-captive arrangement, concluding that the arrangement was not “insurance” under long established law. (Avrahami v. Commissioner, 149 T.C. No. 7 (2017).) In 2018, the Tax Court concluded that the transactions in a second micro-captive arrangement were not “insurance”. (Reserve Mechanical Corp. v. Commissioner, T.C. Memo. 2018-86.)
The IRS in 2016 issued guidance advising that micro-captive insurance transactions have the potential for tax avoidance or evasion. The notice designated transactions that are the same as or substantially similar to transactions described in the notice as “Transactions of Interest.” Notice 2016-66 established reporting requirements for those entering into such transactions on or after Nov. 2, 2006, and created disclosure and list maintenance obligations for material advisors. Taxpayers who fail to report these arrangements may be subjected to significant penalties.
Syndicated conservation easements
Generally, a charitable contribution deduction is not allowed for a charitable gift of property consisting of less than the donor’s entire interest in that property. However, the law provides an exception for a “qualified conservation contribution” that meets certain criteria, including exclusive use for conservation purposes. If taxpayers meet the criteria in the tax code and regulations, they may claim charitable contribution deductions for the fair market value of conservation easements they donate to certain organizations.
Some promoters are syndicating conservation easement transactions that purport to give investors the opportunity to obtain charitable contribution deductions and corresponding tax savings that significantly exceed the amount an investor invested.
Typically, promoters of these schemes identify a pass-through entity that owns real property or form a pass-through entity to acquire real property. The promoters syndicate ownership interests in the pass-through entity or tiered entities that own the real property, suggesting to prospective investors that they may be entitled to a share of a charitable contribution deduction that greatly exceeds the amount of an investor’s investment. The promoters obtain an inflated appraisal of the conservation easement based on unreasonable factual assumptions and conclusions about the development potential of the real property.
In Notice 2017-10 (PDF), the IRS advises that certain of these transactions are tax avoidance transactions and identifies them and similar transactions as “Listed Transactions.” The notice applies to transactions in which the promotional materials suggest to prospective investors that they may be entitled to a share of a charitable contribution deduction that equals or exceeds two and a half times the amount invested.
Individuals entering into these and substantially similar transactions must disclose them to the IRS. In addition, material advisors in those transactions may have disclosure and list maintenance obligations.
In December 2018, the Department of Justice sued to shut down promoters of a conservation easement syndicate scheme. For more see DOJ Press Release 18-1672.