We are approaching the time of the year when some taxpayers are just starting to consider making charitable donations while others are finalizing the details on substantial acts of kindness. This is particularly true in the generous yachting community.
However, I want to address something very few tax professionals will ever discuss with their clients, much less when contemplating a “large” charitable donation - and especially for those considering donating a yacht to charity.
Many taxpayers needlessly miss significant benefits derived from making large charitable donations - including yachts - because they continue to remain woefully misinformed about making substantial charitable donations.
Even the most affluent taxpayers with a cadre of the finest tax and wealth advisors are susceptible. Perhaps even more so, as they may be lulled into a false sense of security.
As a result, many misguided tax payers ultimately decide not to make large donations to charity because they are afraid that making large donations might be a red flag to the IRS and possibly increase their chance of an IRS audit. In reality, that is probably not the case for anyone contemplating a yacht donation.
To forgo large charitable donations is likely an extraordinarily costly mistake.
The “conventional wisdom” is large charitable donations - such as yachts - may materially increase the donor’s risk of an IRS audit. However, closer inspection of the statistical evidence suggests such concerns may not actually be warranted in most cases - and especially not for those in a position to donate a yacht.
Such unconfirmed, unsubstantiated and unjustified concerns about a potential increased audit chance- certainly do not seem worth forging the undeniable substantial economic benefits as well as the irrefutable personal, physical, psychological, spiritual and social rewards to the donor and the greater good to society at large.
Practically speaking, of yacht owners and audit risk, that ship has already sailed.
In an effort to mitigate the expense of yacht ownership, most yacht owners attempt to take advantage of various tax incentives. These expected tax benefits are often an essential condition needed to justify the purchase and actually close the deal.
However, due to the very specific, complicated, highly technical, and sometimes
arbitrary rules and regulations of the tax code, the reality is that claiming yacht tax deductions for business, for charter, or as a second home, places yacht owners in a much greater risk of an IRS audit in order to verify compliance with the requirements.
Therefore, if you are considering a large charitable donation to a legitimate church or charity, such as donating a yacht, don't allow the misguided fear of possibly raising a red flag with the IRS prevent you from making a charitable donation and receiving all of the rewards you are entitled and deserve under the law. If you fail to take full advantage of the tax code as Congress intended, not only will you lose out, but so will others that would have otherwise benefitted from your generosity.
NEWS FLASH: Just as a yacht owner, the IRS suggests you're already in line for an audit.
You are likely already queued for an audit, not just because you own a yacht, or had it in charter, or because you may donate a yacht to charity. You are probably in line for an audit simply due to the income and all the other economic activity that allows you to own a yacht in the first place.
Thus, if you own a yacht and you are not audited this year, then the odds are substantial you will be over the next few years – regardless of making that yacht donation or not. Making a large charitable donation such as a yacht is probably not going to be the only potential red flag that might draw the attention of the IRS. Just your income alone is sufficient cause.
So what-if any-is the real practical effect of large charitable donations on audit risks?
Don’t kid yourself into thinking you can escape an IRS audit if you simply decide not to make that yacht donation. By not making a large donation, all you are doing for sure is needlessly overpaying your taxes and deciding not to help others.
Besides, a properly executed yacht donation is fairly simple and straight forward these days - as long as neither you nor the charity try to get too clever or greedy.
The IRS through recent changes in the code has gone a long way to eliminate the ambiguities that used to be fertile ground for abuse which legitimately precipitated the need for follow up audits to verify the accuracy of large charitable donations. At one time large charitable donations frequently required IRS follow up to confirm the donation actually occurred and the correct values of any donation.
A nationally known Christian minister has acknowledged to me that he used to frequently receive inquiries from the IRS about supposed large charitable donations that he never received. It used to be that a tax payer could just "claim" a large charitable donation, but that is no longer the case.
The rules, regulations, and requirements for large charitable donations are very clear and especially for large non cash charitable donations. Donors must provide qualified appraisals with their tax filing documents. Both the donor and the charity must now provide the IRS with written acknowledgments as well. In case you have any questions, there are many competent professional tax advisors that can assist you to assure your full compliance. But as with anything, some are better than others.
As for charitable donations and potential added scrutiny, there is not nearly the opportunity for abuse as before. Thus, years ago large charitable donations might have required additional IRS confirmation, but the relatively recent implementation of new procedures would seem to substantially lessen the need for additional inquiry.
Consequently, what may have been true years ago, does not seem so likely today.
However, when it comes to IRS audits, make no mistake, no one outside of the IRS really knows the exact formulas used to determine why or when anyone is chosen to be audited. Nevertheless, there are many educated guesses that seem reasonable and appear to be supported by the empirical evidence.
For example, it is understandable why the IRS might be curious to confirm the accuracy of a tax return with no Adjusted Gross Income (AGI).
Obviously there is the question of how would one survive if true. But no AGI can legitimately result from unique tax consequences and certain and exact business circumstances - which unfortunately can also be abused. It is not surprising the IRS looks at some of those returns with no AGI.
Likewise, many low end claims contain tax credits where the IRS may verify eligibility.
Returns by Income Percent of total returns Percent audited in 2014
All Returns 100% 0.86%
No Adjusted Gross Income 1.83% 5.26%
$1-$24,999 39.08% 0.93%
$25,000-$49,999 23.32% 0.54%
$50,000-$74,999 13.12% 0.53%
$75,000-$99,999 8.33% 0.52%
$100,000 -$199,999 10.70% 0.65%
$200,000-$499,999 2.87% 1.75%
$500,000 – $1 million 0.48% 3.62%
$1 million – $5 million 0.24% 6.21%
$5 million – $10 million 0.02% 10.53%
Over $10 million 0.01% 16.22%
The growing lists of suspected IRS audit red flags are well documented and the subject of much conjecture by professionals and amateurs on line. Some proposed factors such as the DIF score - the degree one deviates from their peers - would seem to carry more weight than others.
One claimed red flag appears especially difficult to refute.
The greater the income, it seems the greater the chance of being audited in any one year. That seems logical since that would appear to be where the greatest chance of potential recoveries may be for the IRS. The more sophisticated economic activity of the higher earning tax payers suggests the greater likelihood of potential errors.
According to recently IRS published information, tax payers most likely to receive the government’s attention are those that earn more than $10,000,000. I suspect there may be a yacht owner or two in that group – and many will be audited regardless if they have ever donated a yacht or not.
You may have heard that public enemy and thief Willie Sutton, when asked why he robbed banks is credited with the now infamous response “Because that’s where the money is.” Likewise, the IRS now with limited resources is focusing on people with the most money (and they believe the most to potentially hide).
In 2010, then-commissioner Doug Shulman told the New York State Bar Association targeting the wealthy was part of a new strategy to “work smarter.” (It is always encouraging to see our federal government trying to be more economical and increase their efficiencies. Now if they could apply that same enthusiasm for improving the operating efficiencies when it comes to spending our funds.)
“This is a game-changing strategy for the IRS,” Shulman said. “Initially, we will be focusing on individuals with tens of millions of dollars of assets or income. Going forward, we will take a unified look at the entire complex web of business entities controlled by a high wealth individual, which will enable us to better assess the risk such arrangements pose to tax compliance.”
In 2014, the IRS audited more than 16% of returns reporting more than $10 million in income. But even mere single-digit millionaires are also under increased scrutiny.
Clearly, with greater income, the greater the odds of an audit, but do large charitable donations increase the risks? If they do, by how much, for whom, and when?
To properly assess the possibility of being audited as a result of making a large charitable donation, one can’t just consider all tax payers equally or only single year single event probabilities.
For example, what may be true for some, may not be true for others.
Consider the 2014 IRS statistics, 3.62% of tax returns reported income above $200,000 - 96.38% made less. Three quarters of one percent earned more than $500,000 - and 99.25% of all tax payers reported less than $500,000.
Whether it is Jesus and the "Widow's Mite" or Maslow's Hierarchy Of Needs, most people tend to give out of their excess and very few give sacrificially before all of their own needs and wants are fulfilled.
Thus someone of lesser means and income claiming substantial charitable donations might well raise an eyebrow at the IRS.
But for those with substantial financial resources, having all of their needs, wants, and desires fulfilled long ago, and that are now able to in fact give out of their abundance, it should not be surprising for such blessed tax payers to make large charitable donations. The thought being, they can easily afford it, and probably won't miss it as it will not affect their daily life one wit.
Consequently for the 96% or so of tax payers that may still be in the wealth accumulation phase, making excessively large charitable donations might make the IRS curious. But relatively few in that population are considering donating yachts.
But what about the DIF score for those top 1-3% that are more charitable than the average of their peers? Might that materially increase the odds of an audit?
For potential yacht donors, those in the top 1 - 3% of income earners, it could be a mistake to infer any adverse material effect from making a large charitable donation.
It is a bit more complicated than that - as is typical in real world applications.
One needs to consider the likelihood of a single event – an audit- occurring or not occurring over a certain period of time – and given all the other variables and other possible "red flags" did another single event - the large charitable donation- materially change the probability of the other single event - that of being audited over that period of time.
In essence given all the other possible variables and potential "red flags", what if any difference would a large charitable donation really make in the chance of being audited?
But there is even more to consider. The appropriate question then is not- will a large charitable donation, such as a yacht for example, increase the audit probability for that year, but for any year thereafter-or for some reasonable time given existing IRS rules and procedures.
So how long should we consider?
Generally, the statute of limitations for the IRS to assess taxes on a taxpayer expires three (3) years from the due date of the return or the date on which it was filed, whichever is later. A return is considered to be filed on the due date of the return if it was filed on or before its due date. An assessment occurs when an IRS officer signs a certificate of assessment stating the amount owed by the taxpayer.
However, the IRS statute of limitations can be extended for an even longer time when there is a substantial omission (more than 25 percent) of gross income on the return. In these circumstances, the time limit for the IRS to make its assessment gets stretched out to six (6) years from the date the return is filed or deemed filed, whichever is later.
There is no statute of limitation at all where a taxpayer has committed fraud, attempted to evade tax; or failed to file a return. Unlike the cases where tax returns are filed (even with errors), these are cases in which a taxpayer is willfully or intentionally not filing taxes or is filing fraudulent return(s). Not only will there be no time limit on IRS action against such taxpayers, but heightened interest fees and penalties will apply.
So without getting too wonky or hung up in the weeds on statistical probabilities, the best methodology to employ (Bayesian or Frequentist) or optimum variables to include or exclude, suffice it to say that if you earn enough annual income so that you own a yacht or are considering donating one, then the probabilities are about 50 / 50 (or greater) you will be audited by the IRS anyway over a 3 to 6 year period (and maybe even 12 years if the IRS thinks there could be some type of fraud or attempted tax evasion involved) – regardless - no matter what else you do or don’t do ceteris paribus and as long as you continue to earn that income.
Sure there are things you can do to increase those odds of being audited in any one year - like not file or tax fraud for example. But the facts are that if you enjoy a certain income, you are probably going to be audited sooner or later and they will audit multiple years at a time - regardless of whether you make the large charitable donations you are entitled to or not - so prepare accordingly.
HERE IS THE POINT: Since you are likely to be audited anyway, take all the deductions you are entitled to – including large charitable deductions, and just be prepared to be audited. If you can afford to own a yacht, you are probably going to be audited sooner or later anyway. The larger your income and more sophisticated your economic activities, the greater the likelihood of an audit.
If you own a yacht, you need to prepare and expect an IRS audit. Consequently, conduct all your tax affairs correctly and comply fully with your understanding of the code.
If you are not doing things properly, stop playing audit roulette because you will get caught. If you have a yacht, there is no excuse for failure to comply with all appropriate tax rules and regulations.
If you can afford to own a yacht, you can surely afford to hire competent tax advisors to assure your compliance.
If you can't afford to own a yacht without risky (and possibly illegal) tax shenanigans, there are many alternatives to the costly conventional means of actually owning a yacht that still provide the benefits of the yachting lifestyle but much more economically. Net worth neutral yacht ownership is just one such strategy.
Now here is what very few CPAs, tax attorneys and other tax professionals will ever tell their clients, even when their clients are considering large charitable donations such as yachts,
“Based solely upon your income alone - the top 1,2,3%, regardless of any other potentially exacerbating factors, the odds of you being audited by the IRS over the next few years are at least 50 / 50 (and probably greater if you own a yacht). And when you are audited, it will probably be for multiple years at a time. This is regardless of any large charitable donations or however you may ultimately dispose of the yacht - either selling it or donating it.
Therefore if you are not 100% confident in me, my abilities, your current tax plan, or your other preparers, advisors, and counsel, then perhaps you should find some others in which you are more confident or at least supplement the existing team with some specific expertise. Because you are probably going to need them sooner or later."
But now, you don't need a CPA to tell you, you already know it.
Oh and by the way, take all of your legal and legitimate deductions, reap all the benefits and rewards you are entitled, comply with the code, and especially make large charitable donations (including yachts) - that is the intent of Congress!