In IR-2023-143, the Internal Revenue Service (IRS) and affiliated Security Summit partners warned tax professionals they must recognize the signs of data theft. Tax professionals are a priority target for data identity thieves because they have valuable client data that is very attractive for identity thieves.

IRS Commissioner Danny Werfel noted, "It is important for tax professionals to protect their systems from identity thieves who always look for new methods to steal data. There are practical ways for practitioners to keep on top of the latest trends and signs of data and identity theft."

Tax professionals should know the warning signs their clients may receive.

1. Notice of IRS Online Account — An identity thief will create an account for a client without his or her consent. The client then receives notice of the account or that an existing account was improperly accessed.
2. Tax Transcript — The client receives a tax transcript that was not requested.
3. IRS Tax Balance Due — The client receives a notice claiming to be from the IRS that they owe additional tax. The tax due is different from the amount reported on his or her tax return.
4. Unexpected Call or Email — A client responds to an email that claims to have been sent by the tax professional but was actually sent by a fraudster.
5. Unexpected Tax Refund — The client has not filed a tax return but receives a large check from the IRS.

There are several red flags related to the business operations of the tax professional.

1. Slow Computer or Network Response — The computer network has slowed down. This may be a sign of malware, which would report all computer activity to a fraudster.
2. Unexpected Computer Actions — The computer cursor moves on its own or numbers change without any action by the tax professional. It may be discovered that the fraudster has locked files or a computer to prevent access to client data.
3. Rejected Tax Return — The IRS informs the tax professional that a return is rejected because it has already been filed using that Social Security Number.
4. Unexpected IRS Letter — The client has not filed a tax return but receives an IRS authentication letter that reports a return was filed.
5. Multiple e-File Receipts — Normally, the tax professional will receive acknowledgments after e-filing a tax return. If you receive more acknowledgments than returns filed, a fraudster may be involved.

Tax professionals should report any fraud to the local IRS stakeholder liaison. An email should also be sent to the Federation of Tax Administrators at [email protected]. In addition, clients should obtain an Identity Protection (IP) PIN or complete IRS Form 14039, Identity Theft Affidavit.

ESOP Abuse Targeted By IRS

In IR-2023-144, the Internal Revenue Service (IRS) warned tax professionals to be careful about abuse of Employee Stock Ownership Plans (ESOPs).

IRS Commissioner Danny Werfel noted, "The IRS is focusing on this transaction as part of the effort to ensure our tax laws are applied fairly and high-income filers pay the taxes they owe. This means spotting aggressive tax claims as they emerge and warning taxpayers. Businesses and individual taxpayers should seek advice from an independent and trusted tax professional instead of promoters focused on marketing questionable transactions that could lead to bigger trouble."

There has been increased abuse by wealthy taxpayers of methods that may hide income and reduce taxes. Werfel continued, "The IRS is now taking swift and aggressive action to close this gap. Part of that includes alerting higher-income taxpayers and businesses to compliance issues and aggressive schemes involving complex or questionable transactions, including those involving ESOPs."

An ESOP is a method for employees to gain ownership in the securities of the employer. The business owner creates the retirement plan, transfers securities to the ESOP and often a loan is used to acquire the securities. The ESOP must invest in qualifying employer securities under Section 4975(e).

The IRS has identified three principal issues for ESOPs: (1) valuation issues with the employee stock, (2) a prohibited allocation of shares to disqualified persons and (3) a failure to comply with the tax requirements for ESOP loans.

An abusive action of particular concern to the IRS is a management S corporation that is wholly owned by an ESOP. The business income of the S corporation is diverted to the ESOP and deducted as a Section 401(a) defined contribution to a retirement plan. The S corporation then provides loans to shareholders in the amount of the deducted contribution to the ESOP. In essence, the business owners have converted taxable income into nontaxable loans.

The IRS notes, "The IRS disagrees with how taxpayers interpret this transaction and emphasizes that these purported loans should be taxable to the business owners. These transactions also impact whether the ESOP satisfies several tax law requirements which could result in the management company losing its S corporation status."

Proposed Safe Harbor for Qualified Appraisals

The California Lawyers Association has encouraged members to submit proposals on important topics to the IRS. Attorney Robin L. Klomparens submitted a proposed safe harbor for qualified appraisals.

A charitable deduction is permitted for the fair market value of property gifts to a qualified charity under Section 170. However, the taxpayer is obligated to substantiate the deduction. Reg. 1.170A-13. A noncash donation of property that exceeds $5,000 requires both a qualified appraisal and a qualified appraiser. However, the Tax Court has determined there is no requirement for strict compliance with Reg. 1.170A-13, but substantial compliance is sufficient.

In Bond v. Commissioner, 100 T.C. 32 (1993), taxpayers donated two blimps to charity. The blimps were valued by an individual with substantial experience and knowledge with airships. This individual did not prepare the written appraisal but completed parts II and IV of IRS Form 8283, Noncash Charitable Contributions. The taxpayers attached the form with the applicable information to their tax return. The appraisal form did state the fair market value and the experienced individual signed the "Certification of Appraiser." However, he did not include his qualifications as required by the regulation.

The taxpayers claimed a $60,000 charitable deduction. The IRS audited and denied the deduction because the taxpayers did not obtain and attach a qualified appraisal to the return as required by Reg. 1.170 A-13.

The Tax Court reviewed the facts and stated, "if the requirements are procedural or directory in that they are not of the essence of the thing to be done but are given with a view to the orderly conduct of business, they may be fulfilled by substantial, if not strict, compliance."

The Bond court determined that the compliance was sufficient and noted that Reg. 1.170A-13 "reporting requirements do not relate to the substance or essence of whether or not a charitable contribution was actually made. We conclude, therefore, that the reporting requirements are directory and not mandatory."

In Bond, there were three deduction requirements that were fulfilled. Taxpayers had clearly donated the blimps, the blimps had been appraised by a qualified appraiser and the donee was an exempt charity. Because the three elements were met, the Court found that the doctrine of substantial compliance applied.

However, there have been multiple cases where substantial compliance was not applicable. In Mohamed v. Commissioner, T.C. Memo. 2012-152, Joseph and Shirley Mohamed donated real property to a charitable remainder unitrust. The unitrust was qualified and there were three qualified exempt charities as remainder recipients.

Joseph Mohamed was a certified appraiser with six decades of experience. He had completed several hundred appraisals. However, Reg. 1.170A–13 does not permit a donor (even though eminently qualified) to complete the appraisal. Even though Joseph complied with Uniform Standards of Professional Appraisal Practice (USPAP) methods and the property sold within three months for a value substantially over the appraised amount, the IRS rejected the appraisal because Joseph Mohamed was a disqualified appraiser.

Klomparens notes that there are many times where CPAs and other tax professionals have good intentions. However, they fail to ensure that the appraisal meets all requirements or that the appraiser is appropriately qualified. A qualified appraisal must include: "(A) a description of the property appraised, (B) the fair market value of such property on the date of contribution and the specific basis for the valuation, (C) a statement that such appraisal was prepared for income tax purposes, (D) the qualifications of the qualified appraiser, (E) the signature and [taxpayer identification number] of such appraiser and (F) such additional information as the Secretary prescribes in such regulations."

The basic problem is that donors and their tax advisors have good intentions, but lose a charitable deduction if they do not jump through the regulation technical valuation hoops. Therefore, Klomparens proposes a three-part "safe harbor" test. The deduction should be permitted if the taxpayer provides sufficient information on the tax return through IRS Form 8283 to show that the charitable contribution has been completed, there is enough information on the tax return to inform the IRS in a reasonable manner so it can understand the type of property and claimed deduction and, most importantly, the appraisal may be supplemented with additional information within 60 days after an audit is commenced if the appraised property sells for 90% or more of the claimed charitable deduction within two years of the donation.

Editor's Note: Unfortunately, there are multiple cases where well-meaning donors and their advisors did not strictly comply with the appraisal requirements and failed the substantial compliance standard. A safe harbor such as proposed in this memorandum would be a welcomed change. Until that is approved by Congress, it is essential for professional advisors to clearly understand the technical requirements of an appraisal and the qualifications of the appraiser.

Applicable Federal Rate of 5.0% for August -- Rev. Rul. 2023-13; 2023-32 IRB 1 (17 July 2023)

The IRS has announced the Applicable Federal Rate (AFR) for August of 2023. The AFR under Sec. 7520 for the month of August is 5.0%. The rates for July of 4.6% or June of 4.2% 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."