By Anthony Diosdi
It’s no secret, the Internal Revenue Service (“IRS”) is auditing fewer tax returns these days, mostly due to federal budget cuts that have affected the IRS’ staff size. Even though IRS has been auditing much fewer tax returns, there are certain things that individual taxpayers can do that will likely certainly result in a costly IRS audit. Below, please find our list of the top four ways to get audited by the IRS in 2020.
1. Invested in a Syndicated Conservative Easement
Over the years, charitable contributions of conservation easements have allowed taxpayers to obtain a federal tax deduction for the purpose of conserving land for public use, public enjoyment, or to preserve historic building structures. For tax purposes, a conservation easement creates a discounted value for the property encumbered by the easement which generates a valuable charitable deduction.
To claim a deduction for a conservation easement, the donation of the easement has to be made to a qualified charitable organization. Treasury Regulation Section 1.170A-14(c)(1) states that the qualified organization must “have a commitment to protect the conservation purpose of the donation, and have the resources to enforce the restrictions.” The contribution must also be exclusively for conservation purposes. Conservation purposes under Internal Revenue Code Section 170(h)(4)(A) are 1) preserving land for outdoor recreational use by, or education of, the general public; 2) protecting relatively natural habitats of fish, wildlife, or plants; 3) preserving open space for scenic enjoyment of the general public or under a governmental conservation policy yielding significant public benefit; and 4) preserving a historically important land area or a certified historic structure.
For individuals, the amount of the charitable contribution deduction from the donation of a conservation easement is limited to 50 percent of the individual’s contribution base (adjusted gross income, computed without regard to any net operating loss carryback), over the amount of all allowable charitable contributions for that year (100 percent for contributions of property by qualified farmers or ranchers).
Recently, however, developers and other promoters have begun using syndicate transactions to expand the tax deductions available from easements. Some promoters and developers have aggressively promoted syndicated easements through promotional materials to would-be investors in real estate. These promoters and developers claim investors can take advantage of charitable deductions for syndicated conservation easements. Investors are offered a substantial return in the form of charitable deduction for investments into the real estate deal. Sometimes, investors are offered the opportunity to buy one of 99 lots (just under the limit for SEC registration of an investment fund) for $36,000 and promised a return charitable deduction of $158,000 from donations of the easement. In other words, investors are offered a deal in which they buy the land for $36,000 but get a charitable deduction which may save them $60,000 in federal taxes. Make no mistake about it, these types of transactions are illegal tax shelters.
In January of 2017, the IRS identified syndicated charitable easement transactions as “listed transactions.” This does not mean that investors are prohibited from participating in a syndicated charitable transaction and claiming the associated deduction. However, the failure to make the proper disclosure to the IRS can result in serious criminal and civil penalties. The problem is, disclosing a syndicated easement (a listed transaction) on a tax return all will all but guarantees an IRS audit. As a matter of fact, IRS Commissioner Charles Rettig has stated in no uncertain terms that IRS will be seeking out the investors of syndicated charitable easements who claimed an improper charitable deduction on their tax returns. If you have participated in a syndicated charitable easement transaction, run, don’t walk to a tax attorney.
2. Utilizing a Micro-Captive Insurance Company
Once upon a time, there was a type of insurance company known as a micro-captive insurance company. The use of micro-captive insurance companies was a very effective vehicle for transferring wealth out of an operating business so that wealth was not trapped and exposed to higher taxation by the IRS. By paying premiums to micro-captive insurance company, wealth was effectively transferred out of the operating business and into the captive. The premiums of the policies were paid with pre-tax dollars by the business. Because micro-captive insurance companies had the benefit of being able to accrue reserves tax-free and other tax advantages available only to insurance companies, micro-captive insurance companies offered huge tax benefits. For example, Internal Revenue Code Section 831(b) permitted micro-captive insurance companies to claim up to $2.2 million tax-free per year.
Unfortunately, micro-captive insurance companies were abused by a number of tax advisors who believed they could be used primarily for tax avoidance. In 2016 the IRS issued Notice 2016-66. This notice requires disclosure to the IRS when a captive insurance company has made a Section 831(b) election and/or the captive owner insures risks of the business owned (or part-owned) by the owner of the captive. Disclosing a micro captive insurance structure to the IRS will certainly draw scrutiny.
The IRS has begun to aggressively audit owners of captive insurance companies. Through audits, the IRS typically disallows any business deductions related to policies issued by micro-captive insurance companies. The IRS has also imputed taxable income to captive insurance company owners and has assessed significant penalties against owners of captive insurance companies. The IRS is also currently aggressively litigating captive insurance company cases in court. With that said, not all micro-captive insurance companies are used for illegal tax avoidance. The Internal Revenue Code allows for the use of micro-captive insurance companies. The problem is the taxation of micro-captive insurance companies is something that is poorly understood by many attorneys. This often results in the misuse of micro-captive insurance companies for tax evasion rather than risk minimization, the very reason captive insurance companies were established to promote. If you have a micro-captive captive insurance company structure, it is critically important that competent tax counsel (who understandings captive insurance taxation) be retained as soon as possible to review your captive arrangement.
3. Fail to Disclose Cryptocurrencies on your Tax Return
Cryptocurrencies have gained significant attention since the 2009 introduction of Bitcoin, the first decentralized cryptocurrency. Many others have followed. The IRS takes the position that virtual currencies are property, rather than currencies, and any transactions in virtual currencies are taxable just like any other transactions in property.
Individuals who acquire cryptocurrencies generally hold it in a “wallet,” which is a program or online service that stores a public key and/or a private key that allows the owner to access, use or transfer the virtual currency. The wallet may be a type of hardware, a type of software, or even paper. The wallet may be held directly by the owner or through a third-party exchange or wallet service provider.
Some time ago, the IRS began a campaign on virtual currency compliance. This new campaign will ultimately result in audits targeting individuals who participated in virtual currency transactions. The IRS has been busy training auditors on all aspects of virtual currency. The IRS’ increased focus on virtual currency has resulted in part from a significant reporting gap identified in 2017 between the number of virtual currency users and the lack of corresponding reporting taxable income on tax returns. As part of a “Joe Doe” summons issued by the United States District Court in the Northern District of California on Coinbase, Inc., the IRS has received, or will receive the names and identification information of more than 14,000 virtual currency holders.
The IRS is also increasing its use of data analytics to identify taxpayers who have potentially failed to properly report virtual currency transactions. Between data analytics and the use of summons, the IRS can very effectively obtain information on global virtual currency transactions. This is even the case in blockchain situations. Even though the blockchain for cryptocurrency should be anonymous, these transactions are traceable. This is because virtual currency or cryptocurrency owners will typically need to produce identification when they want to convert these digital currencies. At this point, the owners of digital currencies can be identified to the IRS. If you have interest in cryptocurrency and did not disclose it, the IRS may have your number. Now is the time to visit a tax attorney who understands virtual currency taxation.
4. Fail to Pay Employment Taxes to the IRS
Employers are required to withhold employment on all wages up to a certain level. The IRS has also aggressively pursued employers that failed to withhold and pay employment taxes to the government. The IRS has a long history of assessing severe penalties against employers that fail to withhold and pay employment taxes to the government. On December 12, 2019, at the Las Vegas ABA Criminal Tax Conference, the IRS leadership delivered a clear enforcement message. The IRS indicated that they will be aggressively pursuing employers who fail to withhold and pay employment taxes to the government. In other words, the IRS may be increasing enforcement efforts in this area. If your business has not made required employment tax deposits, you should immediately seek the advice of a tax attorney.
Anthony Diosdi is a partner and attorney at Diosdi Ching & Liu, LLP, located in San Francisco, California. Diosdi Ching & Liu, LLP also has offices in Pleasanton, California and Fort Lauderdale, Florida. Anthony Diosdi advises clients in tax matters domestically and internationally throughout the United States, Asia, Europe, Australia, Canada, and South America. Anthony Diosdi may be reached at (415) 318-3990 or by email: adiosdi@sftaxcounsel.com.
This article is not legal or tax advice. If you are in need of legal or tax advice, you should immediately consult a licensed attorney.