“Dirty Dozen” Tax Scams and Recent Policy Developments: Part 2

For many years, the Internal Revenue Service (IRS) has compiled an annual “Dirty Dozen” list of tax schemes in an effort to warn taxpayers about common scams that should be avoided. The first issue brief in this two-part series discusses three of the tax schemes that have been featured on the list: the compromise of sensitive taxpayer information, return preparation by unscrupulous providers, and the abuse of (“syndicated”) conservation easements.

This issue brief continues the review of fraudulent tax structures, focusing on four arrangements that topped the list in 2022. This group of tax schemes consists of abusive transactions that involve complex avoidance strategies. Generally, promoters — who may or may not possess knowledge in the fields in question — market these deals to taxpayers, encouraging them to secure tax savings through wrongful, abusive maneuvers. Although these structures are convoluted, they are not novel or innovative — the IRS simply cannot shut them all down because there are so many and because promoters have engaged in lengthy legal battles to delay the process.

Charitable Remainder Annuity Trusts

One abusive arrangement involves charitable remainder annuity trusts (CRATs). A charitable remainder trust is a popular estate-planning tool that lets taxpayers donate assets to charity and draw annual income during their lifetime.[1] The intent is to allow donors to plan and pledge to charities they would like to support, while still receiving annual payments. There are two major tax benefits for donors: First, they can defer income taxes on the disposal of assets transferred to the trust. In addition, they may be able to deduct part of the charitable contribution — up to the present value of the donated property minus the present value of the annuity.[2]

Typically, a taxpayer transfers assets into an irrevocable trust. The trust’s tax basis is on a carryover basis, meaning that the donor and the trust have the same cost basis. The trust pays income to one or more beneficiaries, either for a specific number of years or the life of the beneficiary. At the end of the term, the remainder of the assets in the trust pass to a charitable organization. The annual payments from charitable remainder trusts to beneficiaries are taxable, with tiered rules governing the distributions: The distribution is first treated as ordinary income, later as capital gains, and then as other income. After that, the distribution is treated as “corpus,” meaning it is the return of principal and not subject to tax.

The most common abuse of CRATs involves misusing the trust to avoid taxes for beneficiaries. This primarily involves the following steps: First, promoters get donors to contribute appreciated property (usually real properties) to a CRAT. Next, they record the tax basis at fair market value, triggering a step-up to the cost basis of the property. Then, they sell the property to purchase an annuity, and report the annuity payments received by the beneficiary as tax-free distributions.

The misapplications of the law occur at almost every step of the process. The rules clearly state that inflating the cost basis from carryover to step-up basis is not permitted. Under current tax laws, basis step-up only occurs when the donor passes away. In addition, when promoters sell the property to purchase annuity, they are wrongly concluding that there is no gain in the trust to be taxed. Moreover, the annual distributions to beneficiaries are not immediately considered as returns of principal — the payments need to first exhaust the other three current and accumulated income streams before being treated as tax-free.

Recent notices and enforcement actions have made clear that these schemes are unlawful. A 2020 IRS Office of Chief Counsel (OCC) memorandum specifically indicated that the outlined structure is abusive and does not meet the requirements of the Internal Revenue Code.[3] The U.S. Department of Justice has also continued to investigate similar “tax elimination” schemes, aiming to shut down these arrangements.[4]

Maltese Individual Retirement Accounts

The 2011 U.S.-Malta tax treaty created a loophole through which a U.S. taxpayer could set up an individual retirement account (IRA) in Malta without even having the slightest connection with the jurisdiction. Some tax practitioners have called this strategy a “supercharged cross-border Roth IRA.”[5] Although tax avoidance strategies exist around Roth IRAs, these accounts are generally subject to more regulations with strict contribution limits.[6] Use of the Maltese retirement account loophole was once so prevalent that promoters created YouTube videos and posts on Facebook and other social media networks to solicit clients.

Before the loophole was closed, the Maltese pension plans allowed U.S. taxpayers to contribute assets and property (generally highly appreciated ones such as real estate, stocks or cryptocurrencies) to the accounts, instead of limiting them to cash contributions like traditional U.S. pension accounts. The contributions were not limited to labor income resulting from employment or self-employment, and furthermore, these appreciated assets did not need to be located in Malta, meaning they could be U.S.-managed assets.

This arrangement allowed U.S. taxpayers to avoid paying capital gains tax, which can be up to 23.8% for wealthy taxpayers. The Maltese pension rules require a certain amount of payout from the account to support account holders’ living expenses. However, the amount is not high, and the assets remaining in the account can grow tax-free. In addition, local rules allow large lump-sum withdrawals for taxpayers over 50 years old if there are sufficient assets saved in the account to meet income distribution requirements. Because of the reciprocal nature of the treaty, neither the U.S. nor Malta taxes these large lump-sum distributions. For a taxpayer who reaches retirement age, the tax savings for the first five years could be $17 million for a $100 million contribution.[7]

The lax treaty standards that allowed for the classification of noncash, non-labor income as contributions to non-locally connected “retirement accounts” were the root cause of the problem. As a result, in 2021 the U.S. Department of the Treasury amended the treaty language to clarify the definition of “pension funds.” The revised Competent Authority Arrangement formally closed the loophole and limited contributions to cash, with the requirement that the funds be connected to employment or self-employment income.[8]

One might wonder why this scheme appeared on the 2022 Dirty Dozen list, given that the amended treaty has been in place since December 2021. One potential reason is that, because this scheme was so widespread, the IRS wanted to publicize the new rules and alert taxpayers that such arrangements are no longer beneficial. In addition, there could be other treaties with similarly loose language creating loopholes that have not yet been detected. The shutdown of the Maltese pension loophole warns taxpayers and promoters against entering into any substantially similar arrangements.

Monetized Installment Sales

Generally, a taxpayer recognizes income from selling a property in the year when payment is received. An “installment sale” is a sale that the seller receives at least part of the payment for after the end of the year of sale. In these cases, the seller’s income for that year is the payment received as a share of the total contract price.[9]

This arrangement matches a seller’s economic benefit to their ability to pay taxes. However, through an abusive tax strategy called a monetized installment sale (MIS), income recognition can be stretched a lot further than the law originally intended. In short, the goal of an MIS is for a seller to receive the full market value of the property in cash today, and defer capital gains taxes for 30 years.[10]

These arrangements typically involve five parties: a property seller, an intermediary (promoter), a buyer, a lender and an escrow agent.[11] Different from traditional arrangements in which a buyer purchases property from a seller in exchange for cash, in an MIS, a promoter comes in between the buyer and the seller. The transaction flow is as follows: The seller sells the property to the promoter in exchange for a 30-year note. The promoter then immediately sells the property to the buyer, receiving cash. Because the cost basis for the property is the same, the promoter recognizes no gain on the sale. The 30-year note is typically structured as interest only (e.g., an X% interest rate), and the principal is set up as a balloon payment at the end of the term. An escrow agent will manage both the interest and principal payments. Up to this point, the tax benefit is that the seller does not recognize the gain on the property sale until he receives the principal in year 30. However, not many sellers are willing or able to wait for 30 years to collect the proceeds. Consequently, the promoter brings in a lender to monetize the transaction.

The lender lends the seller the vast majority of the proceeds on the 30-year note, most commonly an amount equivalent to 95% of the property’s sales price. The seller-borrower pays interest to the escrow agent on this loan (e.g., an interest rate of Y%). As a result, the payments from the seller-borrower to the lender (Y%) and payments on the 30-year note from the promoter to the seller (X%) will offset each other in the account maintained by the escrow agent. The interest rates on the 30-year note (X%) and on the loan (Y%) can be structured to match exactly, or a small payment can be left for the escrow agent. After this step, the seller will have the majority of the sales proceeds shortly after the property sale, essentially receiving the proceeds through the loan. However, the seller is able to defer the capital gains tax for 30 years, until the final principal payment is made on the note.

In 2021, the OCC released an analysis listing several major issues that make these transactions problematic.[12] For instance, in some cases, the loan between the seller-borrower and the lender is structured as an unsecured, nonrecourse loan — two conditions that are generally mutually exclusive. An unsecured loan normally does not require collateral and simply relies on a borrower’s creditworthiness. By contrast, a nonrecourse loan is typically secured by collateral. In the event of default, the nonrecourse-loan-lender seizes the property and absorbs any unpaid balance, but the borrower is not personally liable for the loan. As such, if the seller-borrower is not personally liable for the loan and there is no collateral, failing to repay the loan generates no consequences. Therefore, as the OCC analysis indicated, the loan proceeds should be considered income.

Some promoters have argued that the lender can resort to the escrow account for payment. If this is the case, the debt is actually secured by escrow funds. Another way to view this is that the seller-borrower has indirectly pledged the installment note and therefore benefits from the loan. As such, the payment from the loan is taxable.

Another issue the OCC raised is that the promoter is not the true economic buyer of the asset, and debt instruments issued by a non-acquirer cannot be treated as part of the installment arrangement. Hence, the proceeds are considered payment, and the seller is required to recognize gains in the current year.

The OCC analysis also provided clarification for promoters who may have misunderstood the circumstances described in a 2012 memo on monetization transaction. That memo is only applicable to farm properties and does not involve an intermediary. In addition, the 2012 memo reviewed the fact patterns and concluded the described seller had a bona fide business purpose and that the transactions had genuine economic consequences.[13] As such, the rationale that applies to farm properties in the 2012 memo cannot be generalized to all properties.[14]

Some practitioners have observed that the popularity of MIS transactions tends to increase when the capital gains tax rate is high. Recent proposals from the Joe Biden administration may thus generate interest in MIS arrangements. Although the IRS has taken a strong stance against these transactions, similar arrangements, including those that try to blur the lines between a sale of property and a loan secured by the property in order to defer gains, may still occur.[15]

Puerto Rican and Other Foreign Captive Insurance

Businesses often purchase several types of insurance to protect themselves from risks. Generally, premiums paid to third-party insurers are deductible business expenses. However, some companies may have unique risks or may not fit into a common risk profile, potentially making it prohibitively expensive to get coverage from the commercial insurance market. Because of this, businesses may choose to create their own insurance companies to insure themselves.

A captive insurer is an insurance company that is wholly owned and controlled by its insured. In other words, the company writes insurance policies for its owners and affiliates. A recent estimate showed that 85% of Fortune 500 companies utilized captive insurance arrangements to some extent in 2020.[16]

A “micro-captive,” or a small captive insurance company, is one form of captive insurance.[17] It became popular after the Tax Reform Act of 1986 amended the tax rules governing captive insurance companies. If a taxpayer makes an election, the micro-captive will be taxed on its investment income but not its premium income, as long as the premium from underwriting is below a certain threshold. (In 2022, the annual premium limit is $2.45 million.[18]) Similar to the thinking underlying captive insurance in general, the original congressional intent was to help smaller businesses gain tailored risk coverage to better meet their needs and achieve greater monetary savings than would be possible with commercially available policies. When a micro-captive insurance entity is offshore, additional benefits may include less onerous insurance regulations and lower taxes. These arrangements can generate legitimate cost-savings.

Because the insurer and the insured are related entities, a major issue is whether the captive insurance program sufficiently resembles a third-party insurance arrangement. A captive insurance program has to be genuine insurance to allow insurance premium deduction. In one common abusive arrangement, a taxpayer designs a program to insure against risks that are highly unlikely to happen, so no claims will ever be paid. They may also charge high premiums to insure against these risks. Several well-known cases include a taxpayer insuring against the risk of a terrorist attack at a specific dental office, and a jeweler insuring his store against dirty bomb attacks. In the IRS’ words, the promoters write policies to “cover ordinary business risks or esoteric, implausible risks for exorbitant premiums, while maintaining their economical commercial coverage with traditional insurers.” The excessive premiums are deducted at ordinary income tax rates, which eventually benefits the business owners and their families.[19] Some have also used this strategy to generate estate-planning benefits.[20]

The IRS has fought captive-insurance tax-avoidance schemes for decades.[21]  The tax laws do not formally define insurance; this factor, together with the highly individualized nature of insurance products, increases the resource requirements for review. The policing of offshore insurance-related tax schemes is especially resource-intensive. Besides the highly technical nature of these arrangements, data-sharing restrictions and bank secrecy laws in foreign jurisdictions can add another layer of challenges. 

Over time, various court cases have shaped a common insurance framework, and a captive insurance program generally needs to meet several criteria to be considered genuine insurance. First, only premiums paid for insurable risks are deductible. Insurable risks are risks that can only have negative results. Risks that can lead to either positive or negative outcomes, such as investments in new equipment, are not insurable.[22] Second, the insurance must shift the risk from the insured to the insurer. This normally means that the insured pays a premium to transfer the potential negative financial consequences to the insurer. A micro-captive that only insures its parent company usually fails this test, because when the micro-captive pays out claims, the negative financial outcomes will still appear on the parent company’s financial statements.

Third, the insurance risk must be sufficiently distributed. This is also known as risk pooling, which allows the insurer to avoid the possibility that claims resulting from one catastrophic event will exceed the premium paid by the insured. Achieving risk distribution requires distributing many independent risks among a large number of related entities or third parties. In several cases, courts decided the micro-captives in question failed to distribute risks sufficiently because there were not enough insured entities.

Finally, the program must reflect insurance in its commonly accepted notions. There are various factors to consider, including whether the micro-captive is properly formed and regulated, whether it operates like a normal insurance company, and whether it pays reasonable premiums. The court may give these factors different weights depending on the facts and circumstances.

The IRS issued a notice in 2016 that required taxpayers to report captive insurance transactions.[23] However, the notice was challenged in court by taxpayers who claimed the IRS had failed to observe notice-and-comment procedures as required by the Administrative Procedures Act. Amid the legal battle, the IRS informed taxpayers in a follow-up announcement that the agency was aware of a Puerto Rican variant designed to bypass reporting requirements.[24]

The Puerto Rican and other foreign variants are somewhat unique in that they involve a reinsurance company that has no operational substance and simply functions as a pass-through. In genuine arrangements, some captive insurance companies have a limited insurance license and can only insure related entities or transfer underlying policies to fully licensed insurers. As such, if the operating business wants to cover certain third-party supplier risks or workers’ compensation liability through its micro-captive, the entity will need to outsource such underwriting to a licensed carrier.

The abusive side of the arrangement usually entails a promoter’s arranging for a licensed foreign insurance company (known as a “fronting company”) to underwrite third-party risks. The taxpayer’s operating company buys insurance from the fronting company, paying premiums that are deductible in the United States. Then, the business owner’s captive insurance company enters into a reinsurance arrangement with the fronting company, and receives all the premiums. The arrangement thus bypasses the licensing issue. However, the deal is not legitimate, because the insurance risk is still not sufficiently distributed.[25] 

In March 2022, a district court ruled to vacate the 2016 notice.[26] The court also noted the IRS had simply included cases in its administrative records that suggested certain tax structures could be abusive, but had failed to identify specific data or facts. Although the invalidation of the notice may slow down enforcement, some practitioners believe the IRS’ notice was only flawed in the failure to follow the notice-issuing procedure, and that the agency was not wrong to conclude that abusive micro-captives exist and should be shut down.[27] A recent U.S. Government Accountability Office study concurred with this view, and urged the IRS to improve enforcement on offshore micro-captive insurances.[28]

Indeed, the IRS has had multiple court victories in micro-captive cases in recent years. In most of the cases, the courts found the taxpayers did not engage in genuine insurance and that the insurance premiums were therefore taxable. There are typically high penalties (20% to 40%) if transactions are deemed to have no economic substance.[29]

Conclusion

The vast majority of taxpayers and tax professionals follow the IRS’ rules in good faith. However, as misconduct becomes more prevalent, the government loses not only tax revenue, but taxpayers’ trust in the integrity of the tax system. As the tax gap gains more attention and the IRS increases its budget, fraudulent and harmful tax schemes are also more likely to attract the spotlight.

For many taxpayers, taxation is a highly technical and complicated field, and qualified professionals who can provide unbiased opinions are often needed when dealing with certain tax structures. As many practitioners would say, if a tax arrangement is too good to be true, it probably is.

Endnotes