From low-income, non-English speaking immigrants to ultra-high net worth families, anyone can fall victim to a tax scheme — or perpetrate one.
Every year, the IRS kicks off tax season with a list of their “dirty dozen” tax schemes and how to avoid them.
The scams take many different forms. They are employed by fraudulent tax preparers and complicit taxpayers. Often, they victimize the unwary. Other schemes are sophisticated and involve wealthy taxpayers and their unscrupulous or ill-informed tax advisors. For example, the IRS has become very assertive in pursuing U.S. citizens or residents who have assets offshore.
“They are as aggressive as they can be,” said John McManus, an estate planning attorney and founder of McManus & Associates.
When the IRS identifies someone with offshore assets, it wants to know whether that is because of convenience, family ties or a business situation, or is an effort to avoid income tax.
“The telltale sign on that is whether the jurisdiction in which they have the assets has its own income tax,” McManus said.
If the individuals are in France or Germany, for example, the U.S. government will assume that even though they may not be compliant at home, they are not trying to evade tax because they are paying in those countries.
“Their view is that this is not the candidate who is necessarily trying to break the law,” McManus said. “The people who are breaking the law are the ones who are moving their money offshore and not paying taxes in the jurisdiction they’re in.”
When it comes to sheltering money from taxes, the line between what is legal and illegal can be very thin and takes an experienced advisor to navigate.
Check out last year's list of scams in IRS’ Top 12 Tax Scams: 2014’s Dirty Dozen.
Keep reading for 12 tax scams the IRS is warning taxpayers about, and how to avoid them:
1. ‘IRS’ Calling
A recent upsurge of calls purportedly from the IRS have targeted vulnerable people, such as the elderly, newly arrived immigrants and those whose first language is not English, threatening police arrest, deportation, license revocation and other horrors if cash were not sent to callers via prepaid debt cards.
Sometimes callers say the victim has a refund due as a way to solicit private information.
Scammers are able to alter caller ID numbers to make it look as if the IRS is calling. They use fake names and bogus IRS badge numbers, and often leave “urgent” callback requests.
The Treasury Inspector General for Tax Administration has received reports of roughly 290,000 contacts since October 2013, and knows of nearly 3,000 victims who have collectively paid more than $14 million as a result of the scam.
The IRS alerted taxpayers that it would never do the following:
- Call to demand immediate payment, nor call about taxes owed without first having mailed a bill
- Demand payment of taxes without giving an opportunity to question or appeal the amount it says is owed
- Require use of a specific payment method for taxes, such as a prepaid debit card
- Ask for credit or debit card numbers over the phone
- Threaten arrest by local police or other law-enforcement groups for not paying
The IRS said it did not use email, text messages or any social media to discuss your personal tax issue involving bills or refunds.
2. Now I’m You
Tax-related identity theft occurs when a scammer uses a stolen Social Security number to file a tax return claiming a fraudulent refund. The IRS said identity theft cases were among the most complex it handled as thieves continued to create new ways of stealing personal information and using it for their gain.
In fiscal 2014, the IRS said, it initiated 1,063 identity theft-related investigations, and enforcement efforts resulted in 748 sentencings, compared with 438 in fiscal 2013, and the incarceration rate rose to 87.7% from 80.6%.
The IRS offered several tips for taxpayers to protect themselves against identity theft:
- Don’t carry your Social Security card or any documents that include your Social Security number or Individual Taxpayer Identification Number
- Don’t give a business your SSN or ITIN just because it asks. Give it only when required
- Check your credit report every 12 months
- Review your Social Security Administration earnings statement annually
- Secure personal information in your home
- Protect your personal computers by using firewalls and anti-spam/virus software, updating security patches and changing passwords for Internet accounts
- Don’t give personal information over the phone, through the mail or on the Internet unless you’ve initiated the contact or know whom you are dealing with
3. Think Before Clicking
The IRS warned taxpayers to watch out for phishing schemes, which are typically carried out with the help of unsolicited email or a fake website posing as a legitimate one to lure in potential victims and prompt them to provide valuable personal and financial information with which a criminal can commit identity theft or financial theft.
The IRS said it generally did not initiate contact with taxpayers by email to request personal or financial information. This includes any type of electronic communication, such as text messages and social media channels.
Recipients of unsolicited email that appears to be from either the IRS or an organization closely linked to the IRS, such as the Electronic Federal Tax Payment System (EFTPS), should send it to email@example.com.
4. Let Me Help You
Dishonest tax preparers hang out a shingle each filing season to perpetrate refund fraud, identity theft and other scams that hurt taxpayers. They promise overly large refunds to their unsuspecting marks.
Scammers have lots of folks to prey on. The IRS said 60% of taxpayers use tax professionals to prepare their returns. The vast majority, it said, provide honest, high-quality service.
The IRS reminded taxpayers that they are legally responsible for what is on their tax return even if it is prepared by someone else. Illegal scams can lead to significant penalties and interest and possible criminal prosecution.
It warned that well-intentioned taxpayers could be misled by preparers who do not understand taxes or mislead people into taking credits or deductions they aren’t entitled to in order to increase their fee.
Every year, these types of tax preparers face everything from penalties to even jail time for defrauding their clients.
The IRS offered several tips when choosing a tax preparer:
- Be sure the preparer has an IRS Preparer Tax Identification Number.
- Understand the qualifications of the preparer you select. A competent tax professional needs to be up-to-date on tax law changes, which can be complex
- Check on service fees upfront
- Always make sure any refund due is sent to you or deposited into your bank account, not into the tax preparer’s account
- Make sure your preparer offers IRS e-file and ask that your return be submitted to the IRS electronically—the safest and most accurate way to file a return
- Make sure you’ll be able to contact the tax preparer after you file your return — even after the April 15 due date — in the event questions come up about your tax return
- Provide records and receipts. Do not rely on a preparer who is willing to e-file your return using your last pay stub instead of your Form W-2, which against IRS e-file rules
- Never sign a blank return
- Review your return before signing, and question anything that is not clear
- Ensure the preparer signs and includes his PTIN as required by law. The preparer must also give you a copy of the return.
5. Maximizing Tax Credits
Some taxpayers inflate or include income on a tax return they never earned, either as wages or as self-employment income, usually in order to maximize refundable credits.
Claiming income not earned in order to secure larger refundable credits such as the Earned Income Tax Credit could have serious repercussions, such as a large bill to repay the erroneous refunds, including interest and penalties. In some cases, the filer can even face criminal prosecution.
The IRS warned taxpayers that they may encounter unscrupulous return preparers who make them aware of this scam. It said taxpayers should remember that they are legally responsible for what’s on their tax return even if it is prepared by someone else.
6. Hide That Income
Filing a phony information return, such as a Form 1099 or W-2, is an illegal way to lower the amount of taxes an individual owes. Scofflaws use self-prepared, “corrected” or otherwise bogus forms that improperly report taxable income as zero. The taxpayer may also submit a statement rebutting wages and taxes reported by a third-party payer to the IRS.
The IRS said it was well aware of this scam, the courts have consistently rejected attempts to use this tax dodge and perpetrators have received significant penalties, imprisonment or both. Just filing this type of return may result in a $5,000 penalty.
Another scheme uses false Form 1099 refund claims on the bogus theory that the federal government maintains secret accounts for U.S. citizens and that taxpayers can gain access to the accounts by issuing 1099-OID forms to the IRS. The perpetrator files a fake information return to justify a false refund claim on a corresponding tax return.
Again, the IRS said it was on to this scam, and was backed by the courts.
7. Claim a Bigger Refund
The IRS warned taxpayers to watch out for unscrupulous tax return preparers who push inflated tax refund claims. Victims include low-income individuals or the elderly, as well as non-English speakers who may or may not have a filing requirement.
Scam artists use flyers, ads, phony store fronts and even word of mouth to throw out a wide net for victims. They may even spread the word through community groups or churches where trust is high.
Scammers dupe people into making claims for fictitious rebates, benefits or tax credits, charging good money for very bad advice or filing a false return in a person's name without that person ever knowing that a refund was paid.
These crooks also victimize people who have a filing requirement and are due a refund by promising inflated refunds based on fictitious Social Security benefits and false claims for education credits and the Earned Income Tax Credit, among others.
The IRS said it sometimes heard about scams from victims complaining about losing their federal benefits—the result of false claims being filed with the IRS that provided false income amounts.
The agency reminded taxpayers who buy into such schemes that they can end up being penalized for filing false claims or receiving fraudulent refunds.
8. Trust Me, I’m Charitable
Groups that masquerade as a charitable organization sometimes attract donations from unsuspecting contributors.
The IRS said taxpayers should be wary of charities with names similar to familiar or nationally known organizations. They should not give out personal financial information to anyone who solicits a contribution. As well, they should not give or send cash, but contribute by check or credit card or some other way that provides documentation of the gift for both security and tax record purposes.
Another longstanding type of abuse or fraud occurs in the wake of significant natural disasters when it is common for scam artists to impersonate charities to get money or private information from well-intentioned taxpayers. Bogus websites may solicit funds for disaster victims.
The IRS encouraged taxpayers to donate to recognized charities when trying to help disaster victims.
9. Stashing Cash Offshore
Over the years, numerous individuals have been identified as evading U.S. taxes by hiding income in offshore banks, brokerage accounts or nominee entities and then using debit cards, credit cards or wire transfers to access the funds. Others have employed foreign trusts, employee-leasing schemes, private annuities or insurance plans for the same purpose.
The IRS said it used information gained from its investigations around the world to pursue taxpayers with undeclared accounts, as well as the banks and bankers suspected of helping clients hide their assets overseas. It works closely with the Department of Justice to prosecute tax evasion cases.
The agency said that although legitimate reasons exist for maintaining financial accounts abroad, reporting requirements need to be fulfilled.
Since 2009, tens of thousands of individuals have come forward voluntarily to disclose their foreign financial accounts.
At the beginning of 2012, the IRS reopened the Offshore Voluntary Disclosure Program following continued strong interest from taxpayers and tax practitioners after the closure of the 2011 and 2009 programs. This program will remain open until otherwise announced.
McManus pointed out another issue with offshore assets in which taxpayers can get caught up, sometimes inadvertently.
The government wants to know about any offshore asset received by a U.S. citizen or resident so that it can track that asset and what the recipient does with it. In the event of a sale, for example, a capital gains tax would be due.
McManus said the recipient must report receipt of the offshore asset within his or her next income tax cycle. Failure to do so can result in a penalty of 30% of the value of that asset.
McManus’s firm is currently advising a U.S. citizen who inherited an offshore hard asset from his father valued in the six figures and brought it into the country. He failed to report the asset to the IRS, McManus said, because his tax advisor at the time was unaware of the reporting requirement. Now, the client faces a $300,000 penalty.
The matter is pending, and his ignorance of the reporting requirement may not win the day.
“The government catches very, very few people who are hiding money offshore, and it will make an example of anyone it catches,” McManus said. “The point here is that they are trying to encourage people to voluntarily disclose, and to let them know that the minute they own an asset offshore, they’ve got to report it.”
10. Abusive Tax Shelters
The IRS said abusive tax schemes have evolved from simple structuring of abusive domestic and foreign trust arrangements into sophisticated strategies that take advantage of the financial secrecy laws of some foreign jurisdictions and the availability of credit/debit cards issued from offshore financial institutions.
McManus said the approach of his clients — and by extension most wealthy taxpayers — to minimizing estate and income taxes is choosing structures that have been tried and tested over time.
In considering a potential tax shelter and working with an advisor, high-net-worth taxpayers should keep several things in mind, he said.
They should not undertake something just because they read an article about it or seen it advertised on the Internet.
The advisors they speak with should have experience and be able to point to specific candidates and clients with whom they have undertaken the particular tax shelter.
Clients should always seek an independent opinion from a person who is not connected with the advisor they are collaborating with to choose a potential tax shelter.
“This is always tricky,” McManus said. “We do things that are considered by 95% of the estate planning world as far reaching. But the 5% who are on the top end of representing very wealthy people say this is right down the middle: it has 20 years of history and here’s how you do it.”
He said it was important to be sure that the firm from which one is seeking the second opinion is not rejecting the tax shelter just because it is outside their area of expertise.
“You want to emphasize people who have the experience to be dealing with more sophisticated estate planning,” he said.
Finally, the last thing the client should ask is whether there has been either a revenue ruling or a private letter ruling on the topic.
The IRS noted that it continued to see an increase in the improper use of private annuity trusts and foreign trusts to shift income and deduct personal expenses, as well as to avoid estate transfer taxes. As with other arrangements, taxpayers should seek the advice of a trusted professional before entering a trust arrangement.
11. Fill ‘Er Up
The IRS said taxpayers should watch for improper claims for fuel tax credits. Fraud involving the fuel tax credit is considered a frivolous tax claim, and can result in a penalty of $5,000. Illegal scams can also lead to significant penalties and interest and possible criminal prosecution.
The fuel tax credit is generally limited to off-highway business use or use in farming, and so is not available to most taxpayers. Yet the IRS said it routinely found unscrupulous preparers who have enticed sizable groups of taxpayers to erroneously claim the credit to inflate their refunds.
Certain commercial uses of fuel, which is taxed by the federal government, are nontaxable. Individuals and businesses that purchase fuel for one of those purposes can claim a tax credit by filing Form 4136, Credit for Federal Tax Paid on Fuels.
The tax is on fuels used to power vehicles and equipment on roads and highways. Taxes paid for fuel to power vehicles and equipment used off-road may qualify for the tax credit and may include farm equipment, certain boats, trains and airplanes.
Improper claims for the fuel tax credit generally come in two forms. An individual or business may make an erroneous claim on an otherwise legitimate tax return. Or an identity thief may claim the credit in a broader fraudulent scheme.
12. Have You Heard the One About…
The IRS wrapped up its 2015 “dirty dozen” tax scams list by warning taxpayers against using frivolous tax arguments to avoid paying their taxes.
It also released the 2015 version of “The Truth about Frivolous Tax Arguments,” which describes and responds to some of the common frivolous tax arguments made by opponents of federal tax law compliance, and includes recently decided court cases.
The IRS said promoters of frivolous schemes encourage taxpayers to make unreasonable and outlandish claims to avoid paying the taxes they owe. These arguments are wrong, and have been thrown out of court.
The penalty for filing a frivolous tax return is $5,000. Those who promote or adopt frivolous positions also risk a variety of other consequences, such as an accuracy-related penalty, a civil fraud penalty, an erroneous refund claim penalty or a failure to file penalty. The Tax Court may also impose a penalty against taxpayers who make frivolous arguments in court.
The IRS said taxpayers who rely on frivolous arguments and schemes may also face criminal prosecution for attempting to evade or defeat tax. Persons who promote frivolous arguments and those who assist taxpayers in claiming tax benefits based on frivolous arguments may be prosecuted for a felony.
--- See related content on ThinkAdvisor’s 22 Days of Tax Planning Advice: 2015 home page.
--- Related on ThinkAdvisor: