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

By Paul Bonner

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 country.

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

Microcaptive 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 an 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 amount 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.

— To comment on this article or to suggest an idea for another article, contact Paul Bonner at Paul.Bonner@aicpa-cima.com.

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