As tax attorneys in Columbus, Ohio, Nardone Limited routinely assists individuals and businesses with representation in tax examinations, audits, and civil litigation with the Internal Revenue Service (the “Service”) and state tax authorities. As part of that representation, our tax attorneys keep individuals and businesses informed about new information and guidance provided by the Service and other tax authorities.
The 2019 Service “Dirty Dozen” Tax Scams
Each year, right before tax-filing season, the Service releases what it calls the annual “Dirty Dozen” list of tax scams that taxpayers, tax professionals, and other professionals working with financial information need to watch out for. Although scamming activity peaks during tax-filing season, this year’s Dirty Dozen list includes five scams that taxpayers can encounter at any time during the year. This article gives you background on those five scams and provides you with some tips to help prevent you from falling victim.
Scam 1: Micro-Captive Insurance Entities
Captive insurance entities found their way into the Dirty Dozen for the fifth consecutive year. Specifically, the Service is focusing-in on micro-captives. The Service’s increased focus to curb micro-captive tax abuse is best evidenced by the nearly 500 docketed cases in Tax Court and numerous Service examinations that involve micro-captives. Unlike many of the other Dirty Dozen, micro-captives are different in that the taxpayer knowingly gets involved. However, in many cases the decision to create a micro-captive is based on misinformation and the taxpayer is unaware of the potential consequences. So, what is a micro-captive?
Micro-captives are small, self-owned, non-life insurance entities governed under § 831(b) and offer taxpayers a tax-effective way to self-insure. To qualify as a micro-captive, the entity’s annual net premiums cannot exceed $2,300,000, among other requirements. The taxpayer creates the micro-captive to provide insurance coverage against future potential claims, without losing access to the premiums paid or the investment income generated by the micro-captive’s investments.
Borrowing an example from a Journal of Accountancy article, assume that you are a doctor paying $500,000 per year for malpractice insurance. The annual premiums that you pay go to a third-party insurance provider and are deductible as an ordinary and necessary business expense under § 162. However, once you pay the premiums, you lose access to that money and any future claims against you go through the third-party insurance provider. If you operate a claim-free practice, then you will likely view these premiums payments as a waste of capital potential. Enter the concept of the micro-captive.
The micro-captive allows you to establish a self-owned insurance entity. You continue to pay premiums, but now the premiums are paid to the micro-captive rather than the third-party insurance provider. You are still entitled to take a § 162, however, you now have access to the premium payments and any investment income generated by the micro-captive. When you retire, the micro-captive is liquidated, and you receive any remaining funds from the micro-captive. These funds are taxed at the favorable long-term capital gains rates. The potential upside of micro-captives is obvious, but the risk of abuse is a serious concern of the Service.
Business with high insurance costs are the likely candidates to fall into the micro-captive trap. Taxpayers should remain leery of propositions by promoters or other advisors recommending that a business create a micro-captive. Many times, this is where the abuse begins. Once created, taxpayers find themselves paying premiums to insure against irrelevant risks not previously considered. The additional premium payments lead to larger § 162 deductions, but portions of these deductions do not meet the necessary and ordinary expense standard if the risk is irrelevant. Also, giving the taxpayer direct access to the premium payments creates other concerns. Direct access may result in a taxpayer using the micro-captive reserves for purposes other than coverage for future potential liabilities. Specifically, the Service is concerned about circular lending where the taxpayer over loans the premium payments to themselves and then is unable to pay a claim. The Services is also aware of micro-captives being used to defer the taxation of income for the income to be taxed at the capital gains rate, versus the less favorable individual income tax rates.
In Notice 2016-66, the Service identifies as the “traits” that it identifies with abusive micro-captives. The first trait is that the insurance covers an “esoteric, implausible risk.” The Service warns that a taxpayer must be able to demonstrate that the risk insured against is plausible considering the line of business. The second trait is that the coverage does not match the business’s risks or insurance needs. The Service requires that the risks and premiums are correlated. The third trait is that the contracts governing the insurance coverage are “vague, ambiguous, or illusory.” The Service advises that the premium payments must be broken-down, and the actual risks covered must be clearly described. Finally, the coverage and premium must make sense considering the market. The micro-captive premiums must make economic business sense compared to what the costs for similar coverage that the taxpayer could receive from a third-party commercial insurer.
Not all micro-captives are abusive, but the Service’s increased scrutiny requires that taxpayers seriously consider their intentions before getting involved. The safe bet is to avoid the micro-captive trap all together. But, if you decided to get involved, make sure that you engage the proper advisors to review the potential risks.
Scam 2: Emails and Websites That
Are Phishing for Trouble
Phishing is a scam tactic where scammers use fraudulent emails or websites to steal your personal information. These emails and websites appear to come from reputable sources claiming to need additional personal information in order to help you resolve a financial matter. However, the intent behind these requests is far more sinister. With phishing, scammers often only need you to click a link in the email or enter basic information on their website in order to steal valuable information. The simplest of actions, such as clicking a link, gives the scammer instant access to not only your personal information, but also anyone else’s personal information stored on that computer or network.
Whenever you receive an unsolicited email requesting personal information, it is necessary to take a closer look at the request itself, the email’s content, and the sender’s email address. Just this simple step can help prevent most phishing attacks. An email from a legitimate taxing authority will almost always end in “dot gov.” Many scammers try to take advantage of the fact that most unsuspecting people will overlook a similar, but inaccurate email address. For example, a scammer might send an email from an email address that ends in “@irs.com.”
If you receive an unsolicited email or come across a suspicious website requesting your personal information, you should use great caution. You can learn more by going to the Report Phishing and Online Scams page at IRS.gov.
Scam 3: Beware of Phony Calls
You should also be aware of unexpected and aggressive phone calls coming from scammers claiming to work for the Service or a state tax authority. Scammers make these unsolicited calls or leave voicemails claiming to be government officials and request your immediate action to prevent further penalty. The scammer can sometimes even “spoof” their call ID so that the call looks like it is coming from a legitimate source. The scammer will also usually use false titles or identification numbers. During these calls, the scammer aggressively orders you to make an immediate payment on an alleged tax liability and will request that you pay by a money wire transfer, prepaid debit card, or even gift card. Do not be surprised if scammers even threaten to have local authorities come and arrest you if you do not make an immediate payment. These types of scams have cost over 14,700 victims more than $72 million since 2013.
You should know that the Service or a state tax authority will never do the following: call and demand an immediate payment using a specific payment method (you will usually receive a bill or notice in the mail first); threaten to have local authorities arrest you if you do not immediately pay the tax; demand a tax payment without giving you an opportunity to question or appeal the amount owed; or ask for your debit or credit card number over the phone. If you receive an unsolicited phone call, you should hang up and then contact the purported agency on your own to determine whether the liability exists.
Scam 4: Always Be on The Lookout
for Identity Theft
Identity thieves are constantly developing new methods to steal your personal information. While certain scammers send sophisticated emails or impersonate others over the phone, identity thieves often do nothing more than wait for you to make a mistake regarding your own personal information. Identity thieves look for instances where you leave unprotected access to your Social Security number, bank account information, or usernames and passwords out in the open. Identity thieves will go to great means looking for your information, ranging from digging through trash cans to find confidential documents to finding sophisticated ways to access your personal computers and networks.
It is important that you properly dispose of unneeded financial documents, debit and credit cards, unused checks, and other personal documents. You should always use a personal shredding machine or attend an annual “shred it day” event. You should also be careful where you keep your important information such as Social Security cards, prior tax returns, and other similar documents. These documents contain enough information to allow an identity thief to make a quick run on your bank accounts.
The Service recommends that taxpayers and businesses use security software with firewall and antivirus protection software. Computers containing files with sensitive information should always be password protected. Be sure to use encrypted files or a secured share cite any time that you need to send sensitive information over the internet.
Scam 5: Do Not Donate to Fake Charities
Sometimes it is easiest for scammers to take advantage of your willingness to help others. Scammers do this by creating fake charities that they then use to steal your money and other personal information. These fake charities often use names that are similar or are familiar to well-known organizations. A rise in charity scams typically occur at year-end when taxpayers are more willing to help others during the holiday season while also receiving the benefit of a last-minute tax deduction. The Service warns that you should also be weary of these scams after a significant natural disaster or other devastating event.
The Service recommends using the Tax Exempt Organization Search on its website to confirm whether a particular charity is valid and tax-deductible. There are also reputable private directories, such as GuideStar, that allow you to search for a specific charity to gauge its legitimacy. Keep in mind that a legitimate charity will always provide you with their Employer Identification Number, which you can also use to verify the charity. You should never give personal financial information to anyone who solicits a charitable contribution. For security and tax record purposes, the Service recommends making contributions via check, credit card, or other methods that provide documentation of the donation, rather than giving cash donations.
Contact Nardone Limited
If you are considering creating a micro-captive or if you receive an unsolicited request for personal information related to a tax issue, you should contact the appropriate professionals before taking any further action. The tax professionals at Nardone Limited are willing and able to help you determine the legitimacy of any tax planning decisions and tax communications. We can work with you to ensure that you keep clean of the Dirty Dozen. Contact Nardone Limited today.