Watch Out for These 'Dirty Dozen' Tax Scams

By Marcia Richards Suelzer, Toolkit Staff Writer

Although it's perfectly legal--and commendable--to use every legal means possible to lower your tax bill, some actions you take could result in serious trouble. If you are like most people and don't find tax audits enjoyable, you will want to consult the IRS's "Dirty Dozen" list of tax scams to make sure that you aren't calling attention to yourself by relying on one of them.

Each year, the IRS compiles its list of the most egregious schemes that it has on its radar for that year. The 2012 "Dirty Dozen" includes identity theft, hiding income in offshore accounts, return preparer fraud, and filing false or misleading tax forms. IRS Commissioner Doug Shulman warns: "Scam artists will tempt people in person, online and by e-mail with misleading promises about lost refunds and free money. Don't be fooled by these scams."

And, it's wise to heed that warning because illegal scams can lead to significant penalties and interest, and possible criminal prosecution.

Identity Theft and Phishing

Identity theft tops this year's "Dirty Dozen" list. Identity fraud occurs when someone uses an unsuspecting individual's name, Social Security number, credit card number or other personal information without permission to commit fraud or other crimes. This can pose a danger at tax time because a criminal with your personal information can file a fraudulent tax return and collect a refund, forcing you to untangle the mess--most likely through costly and time consuming administrative and legal proceedings.

In response to growing identity theft concerns, the IRS has embarked on a comprehensive strategy that is focused on preventing, detecting and resolving identity theft cases as soon as possible. In addition to the law-enforcement crackdown, the IRS has stepped up its internal reviews to spot false tax returns before tax refunds are issued, as well as working to help victims of the identity theft refund schemes. In 2011, the IRS protected more than $1.4 billion of taxpayer funds from getting into the wrong hands due to identity theft.

Tip. If you think your personal information may have been stolen, you should immediately contact the IRS Identity Protection Specialized Unit, toll-free at 1-800-908-4490. For more information, visit the IRS identity theft page.

Identify thieves also use spyware, which can be loaded onto an unsuspecting taxpayer's computer by opening an e-mail attachment or clicking on a link, to steal personal information. This presents a special danger if you use public-use computers, such as those in cyber-cafes or libraries. One should avoid using public computers for financial transactions, including tax return preparation and payments.

Phishing is a tactic used to steal your identity by tricking you into revealing personal or financial information online. Phishing involves the use of phony e-mail, web sites, or (increasingly) social media. IRS impersonation schemes are popular year-round, but greatly increase during tax season.

Warning. The IRS never initiates contact with a taxpayer via e-mail, text message or via social media. If you receive an unsolicited electronic communication that claims to be from the IRS, it's not legitimate. It is a phishing scam! The IRS suggests taking the following steps:

1. Do not reply.
2. Do not open any attachments. Attachments may contain malicious code that will infect your computer.
3. Do not click on any links. If you did click on a link and entered confidential information, the IRS identity theft page has information that can help protect you.
4. Forward the e-mail as-is, to the IRS at phishing@irs.gov. (Put "phishing scam report" in the subject line of the forwarded message.)
5. After you forward the e-mail and/or header information to the IRS, delete the original e-mail message you received.

Return Preparer Fraud

While most return preparers are professionals who provide honest and excellent service to their clients, dishonest and incompetent return preparers can cause big trouble for you. To help protect yourself, interview the preparer to gauge his or her understanding of both the tax code and your business. In 2012, every paid preparer must have a Preparer Tax Identification Number (PTIN) and enter it on the returns he or she prepares.

Hiding Income Offshore

The IRS aggressively pursues taxpayers involved in abusive offshore transactions, in addition to the promoters, professionals and others who facilitate or enable these schemes. Taxpayers have tried to avoid or evade U.S. income tax by hiding income in offshore banks, brokerage accounts or through the use of nominee entities. Taxpayers also evade taxes by using offshore debit cards, credit cards, wire transfers, foreign trusts, employee-leasing schemes, private annuities or insurance plans.

Work Smart. Not all offshore accounts and trusts are fraudulent tax evasion: Some offshore strategies facilitate asset protection and lower rates of taxation legally. However, it is essential to work with a reputable tax professional who can leverage the planning opportunities without crossing a line that could result in civil and criminal penalties. It is also essential to select a tax professional who is well versed in the reporting requirements associated with offshore accounts because the penalties for noncompliance can be substantial.

Filing False or Misleading Forms

It should go without saying that it is unwise to claim deductions and credits that you are not entitled to claim. Nevertheless, the IRS reports that many people try and do so. This year they give special mention to these schemes:

• Fake information returns. Issuing phony 1099-OID (Original Issue Discount) and other phony information returns in an attempt to legitimatize an erroneous refund claim. The IRS notes that it takes refund fraud seriously, has programs to aggressively combat it and stops the vast majority of incorrect refunds. It also warns: If you are a party to such schemes, you could be liable for financial penalties or even face criminal prosecution.
• Zero wages. "Zero" wage claims involve filing a phony wage-or-income-related informational return to replace a legitimate information return. Again, the IRS cautions taxpayers should resist any temptation to participate in any of the variations of this scheme and warns that you may end up with a $5,000 penalty.
• Fuel Tax. While farmers and others who need to use fuel for off-highway business expenses are rightfully entitled to fuel tax credits, other taxpayers are claiming the credit erroneously. (Sorry, no matter how many potholes are in the expressway by the end of a Midwestern winter, that driving does not qualify as off-road.) Before you try and make that argument, remember the IRS lacks of a sense of humor and that fraud involving the fuel tax credit is considered a frivolous tax claim and can result in a penalty of $5,000.

Frivolous Arguments

Promoters of frivolous schemes encourage people to make unreasonable and outlandish claims to avoid paying the taxes they owe. The IRS has a list of frivolous legal positions that taxpayers should avoid. Among these frivolous arguments:

• filing a tax return or paying tax is voluntary
• wages and other compensation for services is not income
• the taxpayer is a citizen of a state, not the United States, and
• the Constitutional amendment imposing the federal income tax was never properly ratified

These arguments are false. In fact, they are completely laughable. However, as noted above, the IRS lacks a sense of humor in this regard. If you try to use any of these arguments, they will not laugh: They will assess stiff penalties and may prosecute you.

Nontaxable Social Security Benefits with Exaggerated Withholding Credit

The IRS has uncovered returns where taxpayers report nontaxable Social Security benefits with excessive withholding, which results in no tax due. Because of the numerous matching programs within the IRS, people who try this are very likely to be caught. The IRS points out that this type of fraud may result in a $5,000 penalty.

Abuse of Charitable Contributions and Trusts

The misuse of tax-exempt organizations once again makes it onto the IRS's Dirty Dozen. Abuse includes arrangements to improperly shield income or assets from taxation, and attempts by donors to maintain control over donated assets or income from donated property.

Think Ahead. There are certainly many legal and effective ways to donate property to a charity while retaining income or benefits for yourself. For example, a properly established Charitable Remainder Annuity Trust (CRAT) provides you with a lifetime annuity while ensuring that the charity receives property upon your death. A reputable financial planner has many legal strategies to enable both you and a charity to benefit from your property.

Despite rules requiring appraisals and stringent documentation of non-cash donations, the IRS finds that people still try to claim improper deductions. Failure to provide adequate documentation of non-cash contributions is an audit red flag. Bear in mind, the organization's wrong-doing isn't going to get you off the hook--although it might mean you will face only negligence penalties, rather than the far more painful fraud penalties. Beware of highly over-valued appraisals or suggestions that you can donate the property and repurchase it later at a price you establish.

Fraudulent Use of Trusts

Trusts can play a key role in effective tax and estate planning when established by a knowledgeable, reputable tax professional. Unfortunately, there are dubious scheme out there that promote highly questionable transactions and promise reduction of income subject to tax, deductions for personal expenses, and reduced estate or gift taxes. Not only are these shady trusts unlikely to provide any tax benefits, they may cost you significant amounts of interest and penalties when the IRS invalidates them.

In particular, there's been a recent increase in the improper use of private annuity trusts and foreign trusts to shift income and deduct personal expenses. As a result, private annuity trust arrangements are going to come under strict scrutiny. That is not to say that every private annuity trust is fraudulent and will create problems, but, as with other arrangements, you should seek the advice of a trusted professional before entering a trust arrangement.

Disguised Corporate Ownership

There are many valid reasons to select a state for incorporating your business or forming your LLC. However, you will find yourself on the wrong side of the law if you attempt to camouflage the ownership of the corporation or LLC in order to underreport of income, claim fictitious deductions, not file tax returns, participate in listed transactions, launder money, commit financial crimes or fund terrorist organizations. In recent years, the IRS has stepped up its cooperation and partnerships with state authorities to track down these disguised corporations.