On April 10, 2024, as part of the Dirty Dozen campaign, the Internal Revenue Service warned the public about three tax traps specifically targeted at wealthy individuals. The three tax traps include:
- Improper art donation deductions
- Charitable remainder annuity trust
- Monetized installment sales
Improper Art Donation Deductions
While there are many legitimate ways for taxpayers to claim donations for art, the IRS warns that promoters may encourage taxpayers to buy “discounted art,” sometimes in bulk, pay large fees to store and ship the art, and then recommend donation after a short holding period at significantly higher prices than were paid for the original purchase. Taxpayers making significant charitable contributions of art can contact the IRS’ team of professionally trained appraisers who can provide assistance and advice.
Charitable Remainder Annuity Trust
Charitable Remainder Annuity Trusts (CRATs) can provide a tax-efficient means for taxpayers to donate to charity in the future while retaining a stream of cash payments for a period of time. A legitimate CRAT strategy involves a donor transferring appreciated assets into an irrevocable trust, after which the trust sells the assets. Because the trust’s basis in the transferred assets is the same as donor’s, the trust incurs capital gains on the sale of the transferred assets, but the trust is itself exempt from income tax, so it does not pay tax on those capital gains. Instead, the cash payments made by the trust to the donor carry out those gains over time, so the donor gets to benefit from tax deferral. At the end of the payment term, the remainder of the trust passes to a qualified U.S. charitable organization.
However, CRATs can be abused if taxpayers claim that the basis of the assets transferred to the trust is the fair market value of those assets, so that when the trust sells the assets, it does not incur capital gain.
A further abuse involves the trust using the proceeds of sale of the transferred assets to purchase a single premium immediate annuity (SPIA) but improperly characterizes the distributions of the SPIA for income tax purposes by ignoring the mandatory CRAT taxation rules.
Monetized Installment Sales
The IRS also warns taxpayers to watch out for promoters who target taxpayers who are looking to sell appreciated property and set up a transaction allowing them to receive income through monetized installment sales. Intermediaries purchase the appreciated property from the taxpayer in exchange for an installment note, which pays the taxpayer interest only. The taxpayer then borrows against the installment obligation, allowing the taxpayer to receive a majority of the value of the sold property up-front, but claiming that the capital gains tax due on the sale can be deferred until the final installment note is paid, sometimes many years down the road.
About the Dirty Dozen
The annual Dirty Dozen is an annual education effort by the IRS designed to raise awareness and protect taxpayers and tax pros from common tax scams and schemes.
IRS Commissioner Danny Werfel emphasized the commitment of the IRS to address fraud:
“High-income taxpayers can be vulnerable to being pulled into these aggressive schemes and scams. Taxpayers should be extra careful on tax maneuvers that seem too good to be true. Beware of advertisements for seemingly ideal tax structures that distort tax laws and leave victims with civil or criminal tax penalties,” Werfel said. “There’s growing risk for taxpayers pulled into aggressive schemes as the IRS continues to accelerate and expand our compliance work involving high-income individuals. The IRS reminds taxpayers that relying on an independent tax or legal professional can help avoid problems with aggressive promoters.”
For more information on this year’s list, visit www.IRS.gov.
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