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Sunday July 14, 2024

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2023 IRS Dirty Dozen - Part II

Each year, the Internal Revenue Service (IRS) publishes the "Dirty Dozen" tax scams. This is a helpful list that benefits taxpayers and tax professionals. While tax scams tend to peak during tax-filing season, it is important to understand them. Scammers could take advantage of taxpayers at any time during the year.

IRS Commissioner Danny Werfel noted, "Scammers are coming up with new ways all the time to try to steal information from taxpayers. People should be wary and avoid sharing sensitive personal data over the phone, email or social media to avoid getting caught up in these scams. And people should always remember to be wary if a tax deal sounds too good to be true."

The 2023 Dirty Dozen includes a variety of new and creative scams. Last week's newsletter covered the first six of the scam list. This week's newsletter covers the remaining half.

7. Social Media Fraud — Millions of Americans have social media accounts. Many individuals spend 30 minutes or more each day on social media and view it as a source for information. With the growth of social media, there has been an increase in inaccurate or misleading tax information. There are also a number of strategies for fraudsters to make contact with individuals through social media in an effort to obtain personal tax information. The fraudster promises a large refund and uses that strategy to gain access to personal information. Individuals should not trust tax advice on social media and instead obtain tax information from or another reputable source.

8. Tax Professionals and Spearphishing — Phishing is a term for emails that are designed to encourage the victim to click on a link and download malware. Spearphishing is a specific strategy directed toward tax preparers and tax professionals. The spearphisher is usually a fraudster who claims to be a potential client. The fraudster engages in a series of emails with the CPA or tax preparer. After a relationship has been established, the fraudster sends a PDF of tax forms to the tax professional. When the tax professional clicks on the PDF, it downloads malware that gives the fraudster access to the tax professional's network. With this access, the fraudster downloads information from many clients and files false returns. The stolen client data is a huge cyber-disaster for the tax professional.

9. Tax Compromise Mills — The IRS has a program for individuals who are behind on their taxes called Offer in Compromise. This is a program for individuals who have genuine financial need and enables them to settle their tax bills with a payment system or a reduced tax amount. The fraudsters create an "Offer in Compromise" mill. After encouraging a taxpayer to make contact, the fraudster builds a relationship and frequently charges a large upfront fee. The fraudster then absconds with the fee and does not provide the promised service. The IRS emphasizes that a taxpayer can use the Offer in Compromise Pre-Qualifier tool on at no cost to determine if he or she is eligible.

10. High Income Frauds — Individuals with higher incomes are vulnerable to specific frauds. A scheme involving Charitable Remainder Annuity Trusts (CRATs) has emerged, which falsely promises individuals the ability to sell appreciated assets without paying any taxes. The promoters claim that the transfer of the assets into a CRAT allows the person to claim a step up in basis and sell it without any tax recognition. However, this violates the basic CRAT rules and distributions from the trust are fully taxable. Scammers have used this strategy to trick victims into transferring their property to the CRAT and not report taxable income. Eventually, the CRAT victim is caught and must pay a large tax and penalties to the IRS. (Editor's Note: A proper use of a charitable remainder trust has many recognized tax benefits, especially for high-income taxpayers.)

11. Micro-Captive Insurance — A micro-captive is an insurance company set up for a private individual. However, many of the micro-captive plans are not qualified and therefore are not legitimate insurance. The failed micro-captive can lead to large fees, an IRS audit and payment of taxes and penalties.

12. Syndicated Conservation Easements — Many landowners properly use conservation easements on real property. The conservation easement is a perpetual limit on the use of the real property and qualifies for a charitable contribution deduction. However, there have been promoters who buy property, sell partnership interests in the property to investors and claim a highly inflated charitable deduction. At least 80 of these syndicated conservation easement cases are being litigated in Tax Court. Many investors have had to pay large taxes and penalties to the IRS. The Inflation Reduction Act also included a new provision that generally limits the charitable deduction for a syndicated partnership to 2.5 times the investment.

The IRS encourages individuals who suspect tax fraud to complete IRS Form 14242, Report Suspected Abusive Tax Promotions or Preparers. This can be sent to the Internal Revenue Service Lead Development Center, Stop MS5040, 24000 Avila Road, Laguna Niguel, CA 92677-3405.

Conservation Easement Inventory Deductible at Basis

In Glade Creek Partners LLC et al. v. Commissioner; No. 22272-17; T.C. Memo. 2023-82, the Tax Court determined that a conservation easement was valid. However, the original $17.5 million charitable deduction was determined to have a fair market value of approximately $8.9 million, but the deduction for an inventory gift was reduced to about $3.7 million to account for the adjusted cost basis.

In 2006, International Land Consultants, Inc. (ILC) purchased approximately 2,000 acres of land in Tennessee. ILC planned to develop the property in three phases and create a master-planned community. After expending approximately $6 million on infrastructure and permits, ILC began to sell lots. However, by 2009 the economic downturn led to serious financial problems. The three owners organized Hawks Bluff Investment Group, Inc. and were involved in multiple financial transactions. In August 2012, two partners organized Glade Creek Partners LLC, and Sequatchie Holdings LLC. Sequatchie purchased the property from Hawks Bluff and sold interests to limited partners. The Sequatchie private placement memorandum (PPM) mentioned that inventory was deductible at cost basis under Section 170(e)(1)(A) but claimed that the parcel of land was a capital asset.

However, the Hawks Bluff 2012 S corporation tax return reported the asset as inventory. In litigation with the IRS, the determination was made that the fair value of the easement would be approximately $8.9 million, but the adjusted basis of Glade Creek was approximately $3.9 million.

Inventory gifted to charity is deductible at cost basis under Section 170(e)(1)(A). Section 724(b) states that inventory transferred to a partnership retains its character for five years. This provision is designed to prevent the conversion of ordinary income property into a capital asset by transfer to a partnership.

The determination of inventory or capital status is based on multiple factors. These include the nature and purpose of the property, the extent of efforts to sell the property, the number and substantiality of sales, the extent of the subdividing, developing and advertising to increase sales, the use of a business office, the character and degree of supervision or control and the time and effort the taxpayer devotes to the project. While there were no lot sales on the easement property, the test involves multiple factors. A major factor was the Hawks Bluff tax return that reported the asset as inventory. While the taxpayer claimed that it should not be bound by the Hawks Bluff tax return, the reported inventory was deemed subject to Section 724(b) and Sequatchie therefore held the asset as inventory for a period of five years.

The claim by taxpayer that the asset was an investment was not supported by the evidence. The initial purchase by ILC involved a substantial expenditure of time and money to develop all three tracts. The platting and sales indicated that this was not property held for investment.

Because the development activities were consistent with the inventory status, the Tax Court determined Hawks Bluff "did not segregate the easement property from tract I in a manner sufficient to meet petitioner's burden to show that the easement property was investment property." Therefore, the charitable easement deduction is limited to adjusted cost basis under Sections 724(b) and 170(e).

Benefits and Duties for Board of Directors

Many professional advisors serve on the Board of Directors of their favorite nonprofits. There are multiple reasons to join a Board of Directors. However, a professional advisor should also understand the duties and responsibilities that come with the role of a director for a nonprofit.

1. Benefits — It is very fulfilling to serve on the Board of Directors of a nonprofit. An individual is coming together with other like-minded people who are seeking to contribute in a positive way to society. This can be a very rewarding and fulfilling activity.

2. Selecting the Board — There are over one million nonprofits in America. Many professional advisors will have the opportunity to participate in several organizations. It is important to focus on the organization that most closely connects with your personal charitable goals. A positive experience occurs when you have a strong desire to assist a nonprofit that is fulfilling an important charitable mission.

3. Effective Board Member — An individual should be aware of the time commitment and expectations for board memberships in a specific nonprofit. Some boards are advisory in nature and there is a very modest time commitment. Other board members (particularly for midsized nonprofits) provide significant support of staff functions. Most professional advisors are quite busy in their primary occupation. While board service is gratifying and enjoyable, it should be done with a goal of excellence. This usually requires you to dedicate significant time and attention to a specific organization. It is much better to be a dedicated and engaged board member of one or two organizations than dividing your volunteer time among multiple organizations.

4. Duties of Care, Loyalty and Obedience — As a professional advisor, other board members will frequently expect you to have primary responsibility for these three specific duties. The duty of care is to ensure appropriate use of the organization's staff, facility and goodwill. The duty of loyalty is to ensure that board members do not have conflicts of interest. Each board member should be acting in the best interest of the nonprofit, not the personal interests of a board member. Finally, the nonprofit exists in a world of complex laws and regulations. The nonprofit must be compliant with federal and state corporate procedures, tax rules and the stated charitable purposes in the Articles of Incorporation.

5. Policy and Management — Boards of Directors have multiple responsibilities. They generally establish the basic policies and management structure of the nonprofit. A key function is to hire and supervise the nonprofit President or CEO. Board members may also be involved in fundraising efforts. It is helpful to have a job description or agreement for board members that explains their policy and management responsibilities.

6. Directors and Officers Insurance — The increase in potential liability requires organizations to provide Directors and Officers liability insurance. This typically covers the actions of the Board of Directors and the officers of the nonprofit. Some states also have greater protection for certain types of nonprofits. In some states, the directors of religious nonprofits may be liable under a gross negligence standard rather than more common liability standards.

Service on a Board of Directors for your favorite nonprofit can be a very rewarding experience. These recommendations can help to make certain this service is both pleasurable and safe.

Applicable Federal Rate of 4.6% for July - Rev. Rul. 2023-12; 2023-27 IRB 1 (15 June 2023)

The IRS has announced the Applicable Federal Rate (AFR) for July of 2023. The AFR under Sec. 7520 for the month of July is 4.6%. The rates for June of 4.2% or May of 4.4% also may be used. The highest AFR is beneficial for charitable deductions of remainder interests. The lowest AFR is best for lead trusts and life estate reserved agreements. With a gift annuity, if the annuitant desires greater tax-free payments the lowest AFR is preferable. During 2023, pooled income funds in existence less than three tax years must use a 2.2% deemed rate of return. Charitable gift receipts should state, "No goods or services were provided in exchange for this gift and the nonprofit has exclusive legal control over the gift property."

Published July 7, 2023

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