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Wednesday July 24, 2024

Washington News

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IRS Cautions Taxpayers About Tax Credits

On May 14, 2024, the Internal Revenue Service (IRS) published a consumer alert. The IRS warned taxpayers that there are thousands of returns that include false claims for the Fuel Tax Credit, the Sick and Family Leave Credit and household employment taxes. These "thousands of dubious claims" may lead to audits. Taxpayers who made these claims will need to show documentation to qualify for the deductions or credits.

The IRS urges taxpayers who potentially have claimed an incorrect credit to have their return reviewed by a trusted tax preparer. IRS Commissioner Danny Werfel stated, "Scam artists and social media posts have perpetuated a number of false and misleading claims that have tricked well-meaning taxpayers into believing they are entitled to big, windfall tax refunds. These bad claims have been caught during our fraud review process. Taxpayers who filed these claims should realize they have been tricked, and they face an extensive review process and a long potential wait if they are owed a refund for other things."

The three primary errors on returns relate to the Fuel Tax Credit, the Sick and Family Leave Credit and household employment taxes.

  1. Fuel Tax Credit — There is a fuel tax credit for contractors, farmers and ranchers who use fuel-powered equipment in fields and construction sites. Because these businesses do not use public roads, they qualify for this credit. There are very few taxpayers who will qualify for this credit.
  2. Sick Leave and Family Leave Credit — In 2020 and 2021, there was a sick and family leave credit for self-employed individuals. This was part of the legislation designed to reduce unemployment during the pandemic. This credit does not apply to 2023 tax returns. The credit is also being incorrectly claimed on IRS Form 7202, Credits for Sick Leave and Family Leave for Certain Self-Employed Individuals, for employee income.
  3. Household Employment — Some taxpayers invent fictional household employees. They then claim to qualify for a refund on Schedule H, Household Employment Taxes. However, they have never paid these amounts and therefore are not qualified.

Commissioner Werfel continued, "Scam artists constantly prey on people’s hopes and try to use the complexity of the tax system to convince people there are secret ways to get a big refund. These three credits illustrate that it is important to carefully review the tax return for accuracy before filing and rely on the advice of a trusted tax professional, not some fly-by-night preparer or a questionable source they hear on social media."

Because of the level of fraud in these three areas, the IRS has frozen refunds for thousands of taxpayers. Many taxpayers receive a letter requesting a verification of their identity. Once you verify your identity through a Taxpayer Assistance Center visit, there may be additional documentation required in a second IRS letter. The letters may include IRS Notice 3176 and could subject taxpayers to a frivolous return penalty. The potential penalty is up to $5,000 for filing a frivolous return.

The IRS urges individuals who receive a letter requesting verification of identity or additional documentation to contact a qualified tax preparer. It may be appropriate to go to and review the "Should I file an amended return?" tool.

Microcaptive Penalty of $5.2 Million

Celia Clark was actively engaged in promoting captive insurance arrangements between 2008 and 2016.

A microcaptive insurer is a small company created to insure companies and partnerships through private means rather than commercial companies. There is potential for abuse by the microcaptive insurers. The insured entity may deduct insurance premiums paid, but the microcaptive will not be required to include those premiums in taxable income.

Some microcaptives serve a qualified insurance purpose, but others simply create deductions for premiums paid and are not operated as legitimate insurance companies.

While the Internal Revenue Code does not define insurance, IRC Section 831(b) does authorize the creation of microcaptives. The IRS claimed, however, that some of the microcaptives promoted by Clark were not qualified as insurance entities. Thus, the IRS denied deductions and engaged in litigation. In Avrahami v. United States, 149 T.C. 144 (2017) and Swift v. Commissioner, T.C. Memo. 2024-13, the courts determined the microcaptives did not have a legitimate insurance purpose and therefore the deductions were not qualified.

Based on the actions of Ms. Clark, the IRS assessed a promoter penalty of more than $11.6 million. Her attorney Derick Vollrath engaged in negotiations with the IRS. Ms. Clark agreed to make payment of $5.2 million to settle the case. Vollrath stated, "Ms. Clark is glad to have the matter behind her."

The United States District Court for the Southern District of Florida issued an order that the parties are required to file the settlement agreement with the Court and Ms. Clark must make payment of $5.2 million. The parties will bear their own costs incurred in the case.

Law and Accounting Firms Use Generative AI

A LexisNexis Legal & Professional survey of large law firms determined that over half of the Am Law 200 firms and other large firms purchased Legal AI tools. More than 30% of the law firms have a budget for generative AI and 90% expect to increase investments in AI technology in the future. The Big Four accounting firms are also using AI for various professional purposes.

Generative AI has multiple functions. Large law firms are using it for legal research, summarizing documents and drafting client alerts. AI proponents claim it increases attorney efficiency by reducing time on repetitive tasks.

There are several cautions that are related to the use of AI. Because the output is dependent upon the quality of the prompt, the AI result can generate "hallucinations" or incorrect information. In June 2023, two trial attorneys submitted a legal brief to a federal judge with fake case citations produced by ChatGPT. The judge admonished them and levied a $5,000 fine for the erroneous information.

If ChatGPT is unable to answer questions, the over 100 million nodes within the AI logic tree may generate false answers. Attorneys are cautioned that a generative AI brief or legal research document must be carefully reviewed. The AI document may seem similar to a draft written by a junior associate, but it should be independently verified.

AI is being used much more widely by both law and accounting firms. Many mid-level firms will benefit because they will have increased capability to conduct advanced legal research and a level playing field in cases with attorneys from larger firms.

The Attorney's Liability Assurance Society Limited has published a bulletin on AI. It warns there are risks to using ChatGPT or other AI programs. A major concern is that the programs gather data into the "large language model" and this could result in disclosure of private client information.

A major law firm has developed an internal version of ChatGPT. It uses all the methodology of AI, but the firm data is blocked from being added to the AI large language model.

Many attorneys are discovering that AI can increase their efficiency in producing materials. Attorneys may include information from multiple sources and use AI to create client alerts. These must be edited, but there is efficiency because AI produces an initial draft.

The American Bar Association task force on law and AI is discussing guidance on the use of AI. However, that project has not been yet finalized.

Editor's Note: There is widespread interest in AI within legal and accounting firms. Many firms will be investing in AI tools in the future. If AI can be used with appropriate safeguards and reviews, it will increase efficiency and profits which will lead to wider use of AI in the future.

Applicable Federal Rate of 5.6% for June: Rev. Rul. 2024-12; 2024-25 IRB 1 (15 May 2024)

The IRS has announced the Applicable Federal Rate (AFR) for June of 2024. The AFR under Sec. 7520 for the month of June is 5.6%. The rates for May of 5.4% or April of 5.2% 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 2024, pooled income funds in existence less than three tax years must use a 3.8% 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 May 17, 2024
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