“Dirty Dozen” Tax Scams & Recent Policy Developments: Part 1

For the 19 million U.S. taxpayers who requested an extension for their 2021 tax filing, the October 17 deadline is quickly approaching.[1] This means tax scammers are also actively looking for opportunities.

The Internal Revenue Service (IRS) has been publishing its annual “Dirty Dozen” list for many years as a way of alerting taxpayers to the most common, offensive tax schemes by scammers, whose tactics range from simple techniques to trick taxpayers into revealing their personal information to the use of complicated, systematically marketed offshore tax loopholes.[2] The list has evolved over time, but it has featured several repeat offenders. Fully aware of these schemes, the IRS has made tremendous efforts to shut them down; however, due to a lack of legal authority, obscure foreign rules and limited resources, some of them have remained prevalent, and taxpayers have continued to fall victim. As such, the IRS has continued to put these scams on the list.

This issue brief, the first in a two-part series, explains three types of common fraudulent tax schemes featured on the Dirty Dozen list: the compromise of sensitive taxpayer information; return preparation by unscrupulous providers; and the abuse of (“syndicated”) conservation easements. The second brief includes four additional potentially fraudulent arrangements that are more technical in nature: the abuse of charitable remainder annuity trusts; the Maltese individual retirement account loophole; monetized installment sales; and the abuse of foreign captive insurances. Both briefs review the proper applications of IRS rules and corresponding misapplications. The briefs also discuss recent policy developments and enforcement efforts.

The Compromise of Sensitive Taxpayer Information

In any given year, a significant portion of the Dirty Dozen list serves to remind taxpayers of identity theft scams conducted via phone or phishing, including email, or by criminals posing as charities seeking donations. As such, the Dirty Dozen lists published from 2014 through 2019 looked highly similar.[3] In the most recent three years, pandemic-related scams also appeared on the list, as fraudsters took advantage of the social and economic turmoil.

Over time, these schemes have evolved in various ways. The offenders’ approaches have become more devious; instead of asking directly for bank account numbers or money, for instance, criminals may seek to collect enough sensitive information to file fake tax returns on victims’ behalf and indirectly gather the financial benefits.[4] In certain cases, they have compromised company email systems to access Form W-2 data and filed fraudulent returns with the stolen taxpayer information.

Scammers have also targeted specific groups. For instance, they often focus on tax professionals, pretending to be their tax software vendors. In addition, as senior citizens have become more comfortable with digital technology, scammers have increasingly preyed on them. The IRS has observed that the likelihood of elder fraud goes down substantially when seniors have a trusted friend or family member they can involve in their affairs.

The fraudulent schemes have been carried out through all types of communications, including email, social media, text messages and phone calls. For example, a scammer may leave a voice message indicating that a tax matter is urgent and that if not resolved right away, a warrant for the taxpayer’s arrest or other law enforcement action will follow. The IRS has cautioned that it generally mails paper notices to taxpayers regarding amounts due, and will not demand immediate payment from a taxpayer without giving them an opportunity to question or appeal the amount owed. Nor does the agency initiate contact with taxpayers or ask for sensitive information through email, text message or by phone. In most cases, the agency initiates contact by regular mail.

Deceptive tactics like these peaked during the pandemic, and the 2021 Dirty Dozen list consisted almost entirely of pandemic-related scams. As pandemic-related assistance programs gradually expire, criminals will likely continue to target unclaimed Economic Impact Payments (i.e., pandemic relief payments), unemployment benefits or other tax refunds. In addition, given Congress’ recent tendency to use the IRS to distribute disaster-related relief payments and issue tax refunds to fulfill social objectives,[5] criminals will likely have further incentive to target unwary taxpayers.

Unscrupulous Return Preparers

A substantial number of taxpayers enlist tax return preparers to help with compliance. Most tax professionals provide honest, accurate and high-quality services, but dishonest ones remain. For many years, the IRS has specifically warned of unscrupulous return preparers, listing them as major offenders on the Dirty Dozen list. Although the issue was not separately recognized in 2022, these so-called “ghost preparers” could be behind other abusive schemes, such as pandemic relief payment fraud. Recent news has shown that the U.S. Department of Justice is continuing to identify tax preparation frauds across the country.[6]

Unscrupulous preparers often want to remain behind the scenes. Ghost preparers do not sign the returns they prepare; instead, they simply print the finished returns and ask the taxpayers to sign them and mail them to the IRS, or they fail to digitally sign the returns as paid e-file preparers. Even worse, they may print blank returns and ask taxpayers to sign them before the returns are prepared. By law, a paid preparer must sign the prepared tax return and include their Preparer Tax Identification Number (PTIN), which is a number similar to a Social Security number for tax-return-filing purposes.

Because ghost preparers cannot be associated with the returns, they cannot be held accountable for abuse. These preparers tend to expose their clients to serious filing mistakes or frauds, such as illegitimate tax credit claims. However, taxpayers are ultimately responsible for the accuracy of their returns, and they often must deal with costly audits as a result of unscrupulous preparers’ aggressive tactics and errors.

It might surprise some that the IRS does not have the power to regulate paid tax return preparers. This is not for lack of trying. In 2010, the IRS launched the Tax Return Preparer Initiative, which required paid preparers to pass a certification exam, pay yearly fees, and complete continuing education hours annually to stay up-to-date on tax rule changes.

Many industry participants supported this initiative.[7] However, a group of smaller return preparers filed a lawsuit to challenge the regulation in 2012. They argued the IRS did not have the authority to regulate paid preparers.[8] The court agreed, and the IRS stopped the initiative.

One element of the program that survived the legal battle is the requirement that paid tax preparers register with the IRS and obtain a PTIN. This is generally quite easy to do. It involves a 15-minute process on the IRS website and a $36 fee, although applicants with felony convictions or unsatisfied federal tax obligations are not eligible.[9] Currently, anyone with a PTIN can prepare federal tax returns as a paid preparer.

The low entry threshold for paid preparers means there are diverse experiences, skills and educational backgrounds across the field. Generally, enrolled agents (EAs), certified public accountants (CPAs) and attorneys — collectively referred to as “enrolled preparers” — are subject to specific requirements. They also have unlimited rights to practice and represent their clients in front of the IRS. On the other hand, PTIN-holders and people who voluntarily finish a certain number of continuing education hours, i.e., unenrolled preparers, have limited practice rights.[10] In 2014, there were slightly more unenrolled preparers than enrolled ones: EAs, CPAs and attorneys collectively accounted for 45% of all preparers, and unenrolled preparers constituted about 55%.[11]

Some practitioners have argued regulations are necessary and help elevate return preparer standards. During the short period before the IRS shut down its preparer oversight initiative in 2013, 1 in 4 of the 84,000 unenrolled preparers who took the competency test required through the program failed. The vast majority (roughly 320,000 unenrolled preparers) had yet to take the test prior to the end of the program.[12] A recent U.S. Treasury Inspector General for Tax Administration report showed a fair number of tax return preparers who helped clients prepare tax returns did not file their own returns; a substantial majority of them were unenrolled preparers.[13]

In addition to helping curb tax abuse, regulating paid return preparers could yield fiscal benefits. One recent estimate showed that giving the IRS additional oversight could generate $479 million over 10 years.[14] President Joe Biden and former Presidents Donald Trump and Barack Obama all expressed support of some regulations. On the legislative front, several congressional proposals were introduced over the years. However, none was passed, due to a lack of interest.[15]

Tax rules, in general, change frequently. In recent years, the pandemic relief programs enabled not only more frequent modifications, but also changes that were more extensive and affected more taxpayers. This means it is time for lawmakers to revisit return-preparer credibility requirements.

Syndicated Conservation Easements

The tax code provides benefits that incentivize property owners to preserve the natural environment and historic structures. The original congressional intent was for owners to contribute real properties to nonprofit organizations or trusts for conservation purposes and get a charitable contribution deduction in return. The outcomes of such “conservation easements” are mutually beneficial: the underlying property is preserved, and the owner gets a tax deduction for their contribution.

The abuse arises when promoters market these opportunities as investment vehicles, known as “syndicated” conservation easements. The promoters first form a pass-through entity that owns the real property and then entice investors to purchase interests in the pass-through. Next, they have an appraiser evaluate the fair market value of the underlying property. The appraisal usually significantly inflates the value, relying on unsupported assumptions about the development potential and commercial outcomes of the property. After the investor funds are in place, the pass-through entity donates the easement property to a tax-exempt entity. The promoters get a fee, the investors receive over-valued tax deductions, and the IRS is shortchanged.[16]  

The IRS is well aware of the misuse. Between 2010 and 2017, syndicated conservation easement transactions claimed roughly $27 billion worth of deductions on federal income tax returns, which translated to $10.6 billion in tax nonpayment.[17] Despite the IRS’ enforcement efforts, similar deals have continued to flourish. In 2018, approximately 2,000 traditional easement transactions accounted for $1 billion in annual deductions. By contrast, 296 syndicated transactions produced $9.2 billion in deductions. Such an imbalance implies a high chance of abuse.

Over the years, there have been plenty of media reports of developers purchasing remote acres of land and marketing them as highly valuable properties, or touting abandoned properties as vastly profitable investments — only to obtain tax deductions. A recent bipartisan Senate Finance Committee report highlighted several cases. In one, a promoter indicated to an investor that if he invested $3 million in a conservation easement, the appraised value would be a guaranteed $81 million. There were also examples of correspondence showing that the process was driven by first reducing taxes for a specific amount, and then backing into an appraisal value.[18] In addition, there have been numerous lawsuits involving a variation of syndicated conservation easement known as façade easement, which allows taxpayers to claim a deduction in exchange for agreeing not to modify the façade of their historic houses. In some of these cases, the façade was already subject to restrictions under local zoning ordinance — meaning the taxpayer did not have the right to grant the easement in the first place, but still claimed a tax deduction on their return. [19]

The IRS has attempted to shut down these deals for quite some time, and it has intensified its efforts in recent years. In 2016, the agency issued a formal notice to taxpayers that syndicated conservation easement transactions are “listed transactions,” meaning that taxpayers need to report them explicitly to the IRS.[20] The agency also stated it would audit almost every syndicated conservation easement transaction and transactions that are substantially similar in nature. In 2020, the agency published various forms of guidance and settlement offers, encouraging taxpayers in these questionable transactions to come forward.[21]

The Charitable Conservation Easement Program Integrity Act, a bipartisan proposal, has been introduced numerous times in Congress but has not gained much traction. This bill mainly seeks to limit the tax deduction to 2 1/2 times the original investment. The White House’s Office of Management and Budget estimates over $12 billion of tax revenue would be generated over a decade if the limit were in place.[22]

In May 2022, IRS Commissioner Charlies Rettig testified in Congress. He indicated the agency’s recent enforcement efforts have yet to stop the growth of these lucrative deals[23] and, as such, suggested that the best approach to close the loophole would be for Congress to change the law and limit the tax benefits. Although a recent related proposal has gathered some momentum, the debate has centered on whether the law, if passed, should be applied retrospectively and claw back benefits claimed over the past few years. Meanwhile, several groups of promoters have advocated for a tax deduction ratio higher than 2 1/2 times the original investment.[24]

The second brief in the series, which reviews four other arrangements featured on the IRS’ Dirty Dozen list, is available here.