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Abusive CRATs and Maltese IRAs among ‘Dirty Dozen’ tax scams

The IRS on Wednesday began its annual “Dirty Dozen” series, warning of
abusive tax transactions and scams, with four schemes the Service
advised taxpayers to shun.

The four arrangements the IRS described as potentially abusive “are
very much on our enforcement radar screen,” a news release quoted IRS
Commissioner Charles Rettig as saying. The release also reminded
taxpayers that they remain legally responsible if they adopt a
promoter’s too-good-to-be-true arrangement and its promised but
illusory tax savings. As for those promoters, the IRS warned that its
Office of Promoter Investigations will detect and examine their
activities.

Taxpayers who have engaged in the transactions should consider taking
corrective steps, such as consulting a competent tax professional and
filing an amended return, the IRS advised.

Wednesday’s installment of the Dirty Dozen discussed misusing a
charitable remainder annuity trust (CRAT); engaging in specious
transactions with an individual retirement arrangement (IRA) in Malta
or another foreign country; maintaining certain captive insurance
arrangements through a Puerto Rican or other foreign corporation; and
camouflaging, or “monetizing,” an installment sale as a series of
loans.

Abusive CRATs

The IRS described a CRAT to which a taxpayer transfers appreciated
property for which the taxpayer improperly claims a step-up in basis
to its fair market value on the date of the transfer. The CRAT does
not recognize gain when it sells the property and, with the proceeds,
purchases a single-premium immediate annuity. The taxpayer or other
beneficiary then recognizes only a small portion of the annuity
payments as income, improperly claiming that the remainder represents
a return of principal.

For the proper establishment of CRATs and tax treatment of their
distributions, see Ellentuck, ed., “Case Study: Computing the
Charitable Tax Deduction for a Charitable Remainder Trust,” The Tax
Adviser (March 2014), and Testa, “Charitable Planning: CRTs, CLTs, and
the Increasing Payment CLAT,” JofA (July 2010).

Maltese or other foreign IRAs

In the second arrangement described in the Dirty Dozen, a U.S. citizen
or resident makes a contribution to an IRA in Malta or other foreign
countries.

The focus on the island nation off the coast of Sicily comes only
months after it signed a competent-authority arrangement with the
United States confirming the two nations’ joint understanding of a
pension fund for purposes of their tax treaty after their respective
competent authorities became aware “that U.S. taxpayers with no
connection to Malta were misconstruing the pension provisions of the
Treaty to avoid income tax on the earnings of, and distributions from,
personal retirement schemes established in Malta” (IRS News Release
IR-2021-253).

A similarly worded item, mentioning only Malta, also figured among the
2021 Dirty Dozen. But a similarly abusive transaction can occur
anywhere in the world where local law allows IRA contributions to be
made in a form other than cash or does not limit those contributions’
amount, as does U.S. law, by reference to the individual’s earned
income and the individual improperly claims a tax treaty exemption,
the IRS said.

Puerto Rican and other foreign captive insurance

Micro captive insurance arrangements more generally also appeared in
last year’s Dirty Dozen, as well as in an IRS enforcement campaign
highlighted most recently in News Release IR-2021-82. They were also
designated reportable “transaction of interests” in Notice 2016-66
(although that notice has recently been held invalid under the
Administrative Procedure Act in CIC Services, LLC, No. 3:17-cv-110
(E.D. Tenn. 3/21/22)).

The IRS described a captive insurance arrangement by a closely held
entity with a Puerto Rican or other foreign corporation with “cell
arrangements” or “segregated asset plans” in which a U.S. owner of the
entity has a financial interest. A U.S.-based “fronting carrier” of
the insurance reinsures the risks with the foreign corporation. But,
like other abusive captive insurance arrangements, the IRS has
described, the arrangements typically include such questionable
features as insuring against implausible risks, pricing that is not at
arm’s length, and a lack of business purpose.

Monetized installment sales

This item also reprised from 2021, concerns abuse of the installment
sale rules under Sec. 453 by a seller who, in the year of a sale of
property, effectively receives the sales proceeds through purported
loans. In the year of the purported sale, the seller enters into a
contract with the buyer for cash but then receives an installment note
from an intermediary for the number of sale proceeds in exchange for
the sold property. The intermediary then sells the property to the
buyer and receives the cash purchase price. The seller ultimately
receives the proceeds as a nonrecourse, unsecured purported loan.

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