The use of abusive tax shelters and structures to avoid paying taxes made the annual “Dirty Dozen” tax scam list at the IRS this year.
Examples cited include misuse of trusts, including private annuity trusts and foreign trusts, and abusive use of small or “micro” captive insurance companies. That’s in addition to the use of abusive tax structures.
The federal agency made a distinction between legitimate use of structures such as trusts and captives versus an abusive use of such structures. The IRS is concerned with the abuse.
That’s an important distinction for insurance professionals to see in print, because many professionals in the life and annuity industry regularly work with legitimate trusts of their clients and also do business with companies that have legitimate captives.
The warning comments about abusive structures appeared in this week’s IRS Newswire, an e-newsletter published by the IRS. The “Dirty Dozen” list identifies common tax scams that that IRS says often peak during filing season as people prepare tax returns or hire others to help with their taxes.
Regarding trusts, the IRS noted that there are legitimate uses of trusts in tax and estate planning. However, it said it also “commonly sees highly questionable transactions” involving trusts.
The questionable transactions “promise reduced taxable income, inflated deductions for personal expenses, reduced (even to zero) self-employment taxes, and reduced estate or gift transfer taxes.” The unscrupulous promoters urge taxpayers to transfer large amounts of assets — including cash, investments and even successful on-going businesses — into the trusts, the federal agency said.
Such transactions “commonly arise when taxpayers are transferring wealth from one generation to another,” it said. But the “questionable trusts rarely deliver the tax benefits promised and are used primarily as a means of avoiding income tax liability and hiding assets from creditors, including the IRS.”
The IRS said it also has seen an increase in improper use of private annuity trusts and foreign trusts to shift income and deduct personal expenses, as well as to avoid estate transfer taxes.
Taxpayers should seek the advice of a trusted professional before entering a trust arrangement, it said.
Captive insurance companies are also a legitimate tax structure. The IRS noted that tax law does allow businesses to create captive insurance companies to protect against certain risks.
In these instances, the insured claims deductions under the tax code for premiums paid for the insurance policies. The premiums end up with the captive insurance company owned by same owners of the insured or family members. The captive, in turn, can elect (under a separate tax code section) to be taxed only on the investment income from the pool of premiums, “excluding taxable income of up to $1.2 million per year in net written premiums.”
In abusive structures, however, “unscrupulous promoters” persuade closely held entities to participate in schemes using captives, the IRS said.
They assist the entities to create captives onshore or offshore, draft organizational documents, and prepare initial filings to state insurance authorities and the IRS.
This assistance includes creating and selling to the closely held entities “insurance” binders and policies that the IRS said are often “poorly drafted.” These documents purport to cover ordinary business risks or “esoteric, implausible risks” for “exorbitant ‘premiums,’” while maintaining economical commercial coverage with traditional insurers, the IRS continued.
Total amounts of annual premiums often equal the amount of deductions the business entities need in order to reduce income for the year, the IRS said. “Or, for a wealthy entity, total premiums amount to $1.2 million annually to take full advantage of the Code provision.”
Meanwhile, underwriting and actuarial substantiation for the insurance premiums paid are “either missing or insufficient.”
The promoters manage the entities’ captives year after year for what the IRS said are “hefty fees.” These firms essentially assist taxpayers who are unsophisticated in insurance to “continue the charade,” it said.
As for abusive tax structures — another area addressed in the recent IRS e-newsletter — these are usually complex schemes involving multi-layer transactions. Their purpose is to “conceal the true nature and ownership of the taxable income and/or assets,” the agency said. They often employ financial instruments, but the instruments are used for improper purposes including tax evasion.
The IRS is “warning everyone to watch out for people peddling tax shelters that sound too good to be true,” IRS Commissioner John Koskinen said in a statement.
IRS Criminal Investigation (CI) works with the Department of Justice on shutting down abusive tax scams. The CI unit’s primary focus is on promoters of the schemes and those who facilitate them, such as accountants or lawyers. It also investigates investors who knowingly participate.
Scammers can face “significant penalties and interest and possible criminal prosecution,” the IRS said.
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