Abusive Tax Shelters, Return Preparer Fraud, and Offshore Tax Avoidance Among IRS’ “Dirty Dozen” Tax Schemes for 2019
With April 15th rapidly approaching, the Internal Revenue Service recently finished releasing its annual series of “Dirty Dozen” press releases, warning taxpayers of the twelve most prevalent “tax scams” and reminding the public “to remain vigilant to these often aggressive and evolving schemes.” Evoking the Lee Marvin film of the same name, the IRS hopes to convince would-be tax scofflaws that engaging in any of the Dirty Dozen schemes would be a suicide mission. Here are the twelve schemes that the IRS lists as the worst of the worst:
Return Preparer Fraud
Inflated Refund Claims
Falsifying Income to Claim Credits
Falsely Padding Deductions on Returns
Excessive Claims for Business Credits
Offshore Tax Avoidance
Frivolous Tax Arguments
Abusive Tax Shelters
The Service’s now long-running focus on offshore tax avoidance has been well-documented. Likewise, tax return preparers and owners of tax preparation business have long found themselves the targets of criminal prosecutions and civil injunction cases brought by the U.S. Department of Justice, Tax Division, as discussed in more detail here.
Increasingly, taxpayers and tax professionals, including accountants, estate planners, and other tax advisers, should also be prepared for civil injunction cases, and criminal charges in select cases, targeting promoters of “abusive tax shelters.” The IRS Dirty Dozen series of press releases in 2019 dedicated an entire release to warning taxpayers and promoters about the perils of so-called abusive tax shelters. Specifically, the Service zeroes-in on abusive trusts, micro-captive insurance tax shelters, and syndicated conservation easements. IRS notes that each of these three tactics can be used as a “legitimate tax-planning tool” but are prone to become “improperly distorted almost always by a promoter to produce benefits that are too good to be true and ultimately seriously compromise the taxpayer.”
Syndicated Conservation Easements
The conservation easement provisions of the tax code permit taxpayers to claim a deduction for donating a conservation easement associated with land owned by the taxpayer. These easements can be used to preserve wildlife habitat, scenic landscapes or views, and bodies of water from full development. The intended purpose is to promote environmental conservation by allowing taxpayers to take a charitable deduction for the diminution in value of the property with the conservation restrictions compared to the value of the property with no restrictions. The IRS notice focuses on so-called syndicated conservation easements, which involve several investors joining together to purchase real property through a pass-through entity, such as a partnership. The entity creates a conservation easement on the land and the investors allocate the tax benefits amongst themselves. IRS scrutiny into these arrangements focuses on the potential for inflated appraisals and the potential for investors to enjoy tax benefits that exceed the value of their initial investment. Syndicated conservation easements have been designated as “listed” tax avoidance transactions since December 2016, requiring heightened disclosure requirements for taxpayers who utilize them. Taxpayers interested in learning more about syndicated conservation easements should review IRS Notice 2017-10 and consult a tax professional.
Both the Department of Justice’s Tax Division and Congress are interested in the potential for taxpayers to abuse the conservation easement provisions. The government filed a complaint for permanent injunction in the Northern District of Georgia in December 2018 seeking to stop a number of individuals and entities from promoting and selling allegedly abusive syndicated conservation easements. The accusations include that the promoters made false or fraudulent statements to customers about the tax benefits of the structures which, in truth, lacked economic substance and were shams. The complaint alleges that the abusive syndicated conservation easements resulted in over $2.0 billion of improper tax deductions.
On March 27, 2019, Senators Chuck Grassley and Ron Wyden of the Senate Finance Committee sent letters requesting documents and information to 14 people allegedly involved in syndicated conservation easement deals. While congressional action on these arrangements is likely in the early stages, it is always a significant development for high-ranking senators to publicly name private citizens linking them to an allegedly abusive tax shelter. Chairman Grassley described the committee’s goal: “[t]his is just our first step in getting to the bottom of how these tax provisions are being abused, and it will inform what else ought to be done to fix the problem.”
Captive insurance companies are often formed by corporate entities to insure risks that would be too expensive to insure on the commercial market or are commercially unavailable. The insured entity pays premiums for coverage to the captive insurance company which uses those funds to pay claims should any losses be incurred. The insured business typically would claim a deduction on its tax return for the premiums paid as ordinary and necessary business expenses. Captive insurance companies are a legitimate insurance vehicle and used by some of the world’s largest corporations to reduce the total cost of insurance.
In the Dirty Dozen release, IRS focuses on micro-captive insurance arrangements which the Service believes to be rife for abuse by taxpayers. Micro-captive structures take advantage of Section 831(b) of the Internal Revenue Code which allows captive insurance companies with $2.2 million or less in premium income to be taxed only on investment income. The IRS crackdown relates to abusive micro-captive arrangements where the Service believes the captive is not serving a legitimate business purpose, i.e. insuring actual business risks, but merely serving as a tax avoidance vehicle. To qualify as insurance for federal tax purposes, the arrangement must have risk shifting, risk distribution, insurance risk, and meet commonly accepted notions of insurance. As discussed here, the IRS is already auditing and litigating against micro-captive promoters and the taxpayers who availed themselves of the strategy. The likelihood of civil injunction cases, including actions seeking disgorgement of proceeds, and criminal prosecutions targeting micro-captive promoters is far from remote.
An example of a tax avoidance scheme deemed too good to be true by the government was on display in United States v. Crithfield and Donaldson, whose convictions were recently affirmed by the Eleventh Circuit. See 2019 WL 1313400 (11th Cir. Mar. 22, 2019). Though not specifically promoted as a micro-captive insurance arrangement, the Business Protection Plan (“BPP”) in that case was marketed and sold as a “lawful, insurance-based tax shelter.” Id. at 1. As described by the Court of Appeals:
The BPP effectively operated as follows: a closely held business paid a lump–sum premium in exchange for an insurance policy issued by either Fidelity Insurance Company (“Fidelity”) or Citadel Insurance Company (“Citadel”), two entities within Appellants’ commercial enterprise. That business then deducted that premium from its taxable income as an “ordinary and necessary” business expense. After collecting the premium, Appellants’ enterprise charged the business either 15% or 17% of the premium, a rate ostensibly lower than the business’s nominal marginal tax rate, and then allocated the remaining 83% or 85% to a segregated trust or limited liability company (“LLC”) set up solely for that business. The business then assumed control of that trust or LLC, which contained the remaining portion of its premium, without paying any tax or interest on that premium.
Id. at 2-3. The Eleventh Circuit held that evidence introduced at the bench trial supported the district court’s finding that the BPP “had no economic substance independent of a taxpayer’s federal income–tax considerations, and was thus a substantive sham.” Id. at 11. Furthermore, the Court of Appeals found that Crithfield and Donaldson “conceived, designed, constructed, marketed, and otherwise fully implemented and executed the BPP, . . . to defeat the federal income tax” otherwise owed by their clients. Id. at 14. The appellants were sentenced to 54 and 76 months of imprisonment, respectively. Id. at 3.*
While overall rates of audit and traditional criminal tax prosecutions may be down in recent years, taxpayers and tax professionals should expect the IRS to focus its enforcement resources on the areas listed in the Dirty Dozen press releases and discussed by the IRS and DOJ in other public forums. For more information, please contact Matt Mueller at firstname.lastname@example.org or 813.347.5142. Matt is a former federal prosecutor in Tampa and Washington D.C. focusing his practice on the defense of white collar matters, including criminal and civil tax cases.
*The author was involved in the investigation and prosecution of this case while serving as an Assistant United States Attorney in Tampa.