IRS Warns of Tax Traps

The Internal Revenue Service (IRS) has recently highlighted new concerns through its annual Dirty Dozen campaign, a cautionary list aimed at educating the public on common tax scams and schemes. This year, a specific focus has been placed on complex tax strategies that target wealthy individuals, signaling the need for heightened vigilance among taxpayers. The 2024 campaign emphasizes the pitfalls of certain tax traps. We would like to discuss three of these issues, including improper art donation deductions, issues surrounding Charitable Remainder Annuity Trusts (CRATs), and monetized installment sales.

Charitable Remainder Annuity Trust (CRAT)

CRATs are an area of concern. These allow a donor to transfer assets into an irrevocable trust, sell the assets, and then receive a stream of cash payments from the trust over time. While the trust itself is exempt from income tax, and therefore does not pay tax on capital gains from the sale of the transferred assets, the cash payments to the donor carry out those gains, offering a form of tax deferral. However, abuses occur when the basis of the assets transferred is misrepresented as the fair market value, thereby avoiding capital gains when the trust sells the assets. Additionally, if the trust’s proceeds are used to purchase single premium immediate annuities and the distributions are incorrectly characterized for income tax purposes, the taxpayer can face serious penalties.

Improper Art Donation Deductions

One of the emphasized traps is the misuse of art donation deductions. Art can be a legitimate avenue for charitable giving that benefits both the donor and the recipient organization. However, problems arise when art is purchased at a “discounted” rate, possibly in bulk, with the intent to donate after a short holding period at inflated values. These transactions often involve hefty fees for storage and shipping, which further complicate the donation’s legitimacy. The IRS cautions that such practices can be indicative of tax evasion schemes. They suggest that significant art donors seek advice from the IRS’ team of professionally trained appraisers to navigate these waters safely.

Monetized Installment Sales

The third major concern involves monetized installment sales. This method typically targets taxpayers looking to sell highly appreciated property. An intermediary purchases the property in exchange for an installment note, which then pays only interest to the taxpayer. The taxpayer, meanwhile, borrows against this installment obligation, receiving most of the property’s value upfront. However, the taxpayer will claim deferral of the capital gains tax due on the property’s sale until the installment note’s maturity, which could be many years in the future. The IRS frowns on this methodology of deferring gains.

IRS’s Commitment to Combating Fraud

The Dirty Dozen list is part of the IRS’s broader educational effort to protect taxpayers from fraud and ensure compliance with tax laws. High-income taxpayers, in particular, are often targets for these aggressive schemes, which can lead to serious legal and financial consequences.

The IRS emphasizes the importance of consulting with independent tax or legal professionals when considering complex tax strategies. This step is crucial in avoiding the pitfalls set by aggressive promoters who may misrepresent the tax code to the detriment of the taxpayer.

For more information or questions, you may have, please reach out to your LMC professional.