On January 25 the Internal Revenue Service (IRS) launched a limited version of its Direct File tax software program. The first release is available to federal and state employees in 12 different states. The simplified version of the software is usable by government employees who have a Form W-2 and potentially use the Child Tax Credit or the Earned Income Tax Credit, among other subsidies.

The initial program will be available in 12 states. The states are Arizona, California, Florida, Massachusetts, Nevada, New Hampshire, New York, South Dakota, Tennessee, Texas, Washington and Wyoming. Most of the states were selected because they do not have a state income tax.

IRS Commissioner Daniel Werfel was delighted with the launch of Direct File. He noted, "Direct File walks taxpayers through the complexity of the tax code. At every step it shows the work behind the calculations, so taxpayers can know it is accurate."

The initial version of Direct File has 350 screens and provides the user with multiple taxpayer examples or scenarios. The IRS states that Direct File will be available to additional taxpayers in these 12 states by the middle of March.

One concern for the IRS and tax professionals is there may be changes in the 2023 tax law. The Tax Relief for American Families and Workers Act of 2024 has not yet been passed, but Congress is attempting to create a bill that may change the rules on the 2023 Child Tax Credit. IRS officials have attempted to reassure taxpayers that the Direct File program can be quickly modified to incorporate tax changes. The IRS officials claim the program can be updated in one day to comply with potential 2023 tax changes.

Editor's Note: Many countries offer a government tax-filing solution. The Direct File program is a small and initial start to a multi-year software development process. It has started first with federal and state workers with hopes to expand to all taxpayers. In future years, the simple forms may transition to cover more complex tax returns. A major project will be the addition of over 40 state tax returns to the system. However, it now seems probable that the IRS is committed to providing this Direct File system. Eventually, it will be available to most taxpayers.

Anti-Abuse CRAT Regulations Coming "Very Soon"

At an American Bar Association Section of Taxation meeting on January 19, IRS representative for the Treasury Office of Tax Legislative Counsel, Tabetha Peavey indicated the IRS is working on Charitable Remainder Annuity Trust (CRAT) regulations that would target a specific tax abuse. She suggested these regulations would be published "very soon."

The CRAT regulations are required by an abuse that was listed in the "Dirty Dozen" tax scams last year. The promoters of the abusive CRAT claimed a transfer to the trust resulted in an increase in basis to fair market value. The CRAT funds were often used to purchase a commercial annuity and then promoters claimed the payments from the commercial annuity were not taxable because of the increase in basis.

However, the promoters were ignoring Section 664 and the four-tier requirements. CRAT distribution rules are set forth in Reg. 1.664-1(d)(1). Distributions from charitable remainder trusts must come out in a specific order, first ordinary income, then capital gain, then tax-free income and finally corpus. The distribution method is commonly described as the "Four-Tier" structure.

The CRAT distribution rules have been made somewhat more complex by the different capital gains rules. The capital gain tier is further subdivided into the four levels for capital gain. The actual final structure is as follows: Tier I Ordinary Income taxed at 37% or Dividends taxed at 23.8%, Tier II Capital Gain taxed at 37%, 28%, 25% or 23.8%, Tier III Tax-Free or Tier IV Return of Principal. The trustee of the CRT is required to disclose the taxable nature of the distributions on the IRS Schedule K-1.

Peavey also commented on the present value regulations under Section 2053. The present value regulations will define circumstances in which a future potential expense or obligation may be a deductible estate expense.

The estate interest deductibility is expected to include a list of 11 factors that the IRS and executors can use to determine whether estate interest should be deductible. Estates desiring to deduct interest focus on the case Estate of Graegin v. Commissioner, T. C. Memo. 1988-477, in which the Tax Court determined that the illiquidity of the estate required a loan to pay estate taxes.

Peavey noted, "We are sensitive to the fact that estates face liquidity issues." However, she noted that many executors are attempting to manufacture illiquidity. Peavey continued, "It has got to be bona fide. It has to be actually and necessarily incurred. That is what the rules were trying to get at it."

Editor's Note: The hope is that the regulations on the CRAT, Section 2053 rules on deducting present value of future expenses and the parameters for a qualified interest deduction will be issued this year.

IRS ERC Fraud Campaign Continues

In IR-2024-21, the Internal Revenue Service (IRS) reviewed current efforts to deal with Employee Retention Credit (ERC) fraud.

The IRS encourages all businesses that have claimed or are planning to claim the ERC to review their qualifications and eligibility. The IRS Criminal Investigation (CI) unit will offer a series of educational sessions for tax professionals. These are intended to assist tax professionals in protecting against fraud. Tax professionals should inform their clients there is a March 22 deadline for the Voluntary Disclosure Program, which can help avoid penalties or interest on incorrect claims.

IRS Commissioner Danny Werfel stated, "Our compliance activities involving these payments continue to accelerate, and the IRS urges businesses with concerns about their claims to talk to a reputable tax professional and consider joining one of our special disclosure or withdrawal programs. We saw aggressive marketing around this credit, and well-intentioned businesses were misled into filing claims. There is a limited time window available for these businesses to voluntarily come in and avoid future issues."

The CI special educational sessions will be available in multiple communities and through national webcasts. The IRS CI Section has been working with the tax community to address aggressive marketing by ERC promoters. IRS CI Chief Jim Lee noted, "During the COVID-19 pandemic, tax credits and loans were extended to struggling businesses. We have seen many of these COVID-relief programs and credits misappropriated - sometimes knowingly and in other instances not."

The sessions will educate tax professionals on ERC eligibility, documentation requirements and best practices for compliance and accurate reporting. They are primarily designed to help tax professionals whose clients have previously claimed an ERC.

On September 14, there was a moratorium on processing new ERC claims. The IRS is digitizing all applicable claims and Congress has proposed closing the window on filing new claims on January 31, 2024. The IRS still has a large number of claims in process.

1. ERC Voluntary Disclosure Program (VDP) — The VDP is open until March 22, 2024. If businesses have received an ERC payment and think that it was issued improperly, they can offer to repay 80% of the claim. The 80% amount reflects the fact that most of the ERC promoters took a fee of 20% of the claim.
2. Withdrawal for Pending ERC Claims — Thousands of companies have filed for ERC claims and many are still pending. When their tax professional and business owners review their qualifications, they may decide to withdraw their claim. The IRS has withdrawn over $160 million in pending claims. The IRS anticipates the withdrawal of a substantially larger total number of pending claims.
3. ERC Eligibility — The IRS has been asked multiple times for better information on qualifications. It has created an ERC Eligibility Checklist available as an interactive tool that can be used to help with determining qualification. There is also an ERC frequently asked questions (FAQ) page on IRS.gov to explain the ERC requirements.
4. ERC Audits — The IRS has sent thousands of letters to taxpayers notifying them their ERC claim has been disallowed. Many of the businesses were nonexistent or had no employees and therefore failed to meet basic criteria. The IRS emphasizes that it will continue with audits to recapture erroneous ERC payments. This could result in both penalties and interest for the offending businesses.
5. ERC Criminal Investigations — The IRS CI Section has over 350 investigations pending with approximately $3 billion in fraudulent ERC's. The IRS has filed federal charges in 18 investigations and obtained 11 convictions and four sentencings to date. The average sentence for criminal fraud has been 21 months.

Editor's Note: The IRS is digitizing all ERC claims and is using artificial intelligence (AI) methods to determine the probability of ERC fraud. There will likely be additional criminal charges filed against aggressive promoters.

Applicable Federal Rate of 4.8% for February -- Rev. Rul. 2024-3; 2024-6 IRB 1 (16 January 2024)

The IRS has announced the Applicable Federal Rate (AFR) for February of 2024. The AFR under Sec. 7520 for the month of February is 4.8%. The rates for January of 5.2% or December of 5.8% 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."