Last on the 2019 IRS Dirty Dozen list of tax scams are abusive tax shelters, trusts, and conservation easements. In this post we describe the difference between the valid uses of these tax savings vehicles, and the illegal ones.
For its last item on this year’s Dirty Dozen list, the IRS describes three otherwise legitimate tax planning tools that are being manipulated by promoters of tax avoidance schemes.
Tax shelters – the good and the bad
Despite their reputation, not all tax shelters are illegal. For example, most people shelter themselves from some taxes by investing in a retirement account to defer income until they are in a lower tax bracket, or by utilizing a charitable giving vehicle such as a charitable remainder trust.
The use of captive insurance companies is also perfectly legitimate, to cover risks that are too expensive to insure or which are otherwise not readily available through commercial insurance. Even micro-captives (small captive insurance companies taxed under 26 U.S. Code § 831(b)), which have been on the IRS hit list for a number of years now, are legal as long as they operate as set forth under the law. Unfortunately, some micro-captive schemes are set up merely to create artificial tax deductions – if there is no real insurance and/or the premiums are unreasonably high, the IRS is likely to disregard the entire arrangement. And prosecute the taxpayer who uses it.
Abusing an otherwise valid trust arrangement
A trust is an arrangement in which one person holds property for the benefit of another. There are many valid reasons to establish a trust – probate avoidance, securing funds for a minor or special needs child, protecting certain assets from creditors, etc.
Foreign trusts are also good asset protection devices. They are established in other countries and can help to diversify your portfolio, among other things. However, when multiple layers of trusts are used to hide true ownership of an account, disguise transactions, and avoid filing Form 3520, Annual Return To Report Transactions With Foreign Trusts and Receipt of Certain Foreign Gifts, then everyone involved may be subject to significant penalties.
The IRS actively investigates these schemes, which usually involve:
- a fake mortgage or rental agreement
- fake invoices
- invoices for services that were never performed
- phony purchase and sale agreements
These schemes are illegal and get taxpayers into a great deal of trouble with the federal government. The penalty for failure to report the transfer of property to a foreign trust or a foreign trust distribution is subject to a 35% penalty on the gross value of the transaction.
Conservation easements: Taking a great thing and turning it on its head
The conservation easement is an excellent estate planning tool that enables owners of significant property to protect their land or buildings for future generations. The owner donates a portion or specific right in their property (land or buildings) for conservation purposes, retains ownership over the rest, and gets a charitable deduction.
Unfortunately, some taxpayers are falling for schemes advertised by promoters in which multiple, tiered entities or pass-through entities are used to generate an inflated charitable deduction. These “syndicated conservation easement” schemes utilize exaggerated appraisals of the conservation easement based on unreasonable assumptions of their development potential.
The Treasury Department and the IRS are aware that some taxpayers may have filed their tax returns under the mistaken impression that they were entitled to the full tax benefits they claimed for their conservation easement. The government is urging taxpayers to take corrective action and ensure proper disclosure.