IRS Attacks Tax Shelters with a Carrot
January 2002
After the Tax Reform Act of 1986, some practitioners thought tax shelters were dead, having been "killed off" by the passive loss rules. However, the practical elimination of individual tax shelters only encouraged tax shelter promoters to seek new customers in corporate America. For the past decade, many corporations, both large and small, have used tax shelters to reduce their tax liability.
The Internal Revenue Service and the U.S. Congress have responded to these tax shelters the way they usually do, by brandishing bigger sticks. The penalties for tax shelters were increased, and the definition of a tax shelter was broadened to cover any transaction with "a significant purpose" of tax avoidance1 (instead of "the principal purpose" of tax avoidance). In addition, tax shelter promoters were required to register confidential tax shelters.2 For corporate tax shelters, the IRS issued complex rules requiring the disclosure of the tax shelters on the corporation’s tax return3 and also requiring the promoter to maintain a list of their shelters and the corporations to which it was sold.4
In addition, the IRS attempted to mold taxpayers’ behavior by identifying transactions that the IRS believes are not appropriate. The IRS has issued numerous notices describing abusive tax shelters, only to watch new shelters arise and old ones morph into transactions not described by the existing guidance. Moreover, it is far from certain that the IRS will prevail in court when it challenges some of these "listed" transactions.
The IRS has also fought the tax shelters in court. The IRS won some of the early cases against corporate tax shelters,5 but it has recently lost several other cases.6 In one notable decision,7 the U.S. Tax Court held that a transaction should be treated as a corporate tax shelter that should be treated as a sham and the taxpayer should be penalized, but the decision was reversed on appeal because there was a substantial business purpose for the transaction. Moreover, as the appeal of some corporate tax shelters has begun to wane, tax shelter promoters (who are always looking for a juicy fee) began to sell tax shelters to individuals so as to avoid the existing disclosure, registration and list-maintenance rules.
The IRS recently adopted a new tactic. Instead of trying to punish taxpayers who engage in tax shelter transactions (i.e., trying to limit demand), the IRS is aiming to track tax shelter promoters so supply can be reduced. To do this, the IRS has offered a "carrot." The IRS has agreed to waive certain penalties that could be imposed on taxpayers who have entered into tax shelters and other transactions for which the imposition of a penalty may be appropriate. Moreover, the taxpayer does not have to admit any liability with respect to the taxation of the underlying transaction; the taxpayer merely needs to timely disclose what has occurred. The disclosure must include, however, the identity of the promoter and the tax practitioners who advised the promoter. This disclosure will allow the IRS to determine whether or not the promoter is selling abusive tax shelters and, if so, take the steps necessary to put the promoter out of business.
Specifically, in Announcement 2002-2, the IRS announced a disclosure initiative to encourage taxpayers to disclose their tax treatment of tax shelter and other items for which the imposition of the accuracy related penalty may be appropriate if there is an underpayment of tax. If a taxpayer properly discloses certain items before April 23, 2002, the IRS will waive the accuracy related penalty under Section 6662(b) for any underpayment of tax attributable to that item. Specifically, the penalty will be waived for the portion of the underpayment attributable to the disclosed item and due to negligence or disregard of rules or regulations; any substantial understatement of income; any substantial or gross valuation misstatement, except for any portion of an underpayment attributable to a net Section 482 transfer price adjustment (unless the standards of Section 6662(e)(3)(B) regarding documentation are met); and any substantial overstatement of pension liabilities.
The waiver of these penalties does not affect other penalties. Thus, any other appropriate civil penalty could be imposed by the IRS. Likewise, criminal penalties will not be waived, and the IRS reserves the right to recommend prosecution for any violation of a criminal statute.
Disclosure must be made before April 23, 2002, although a disclosure will not be effective with respect to an item that is an issue raised during an examination before the disclosure was made.8 To disclose an item, the taxpayer must provide a statement describing the material facts of the item, a statement describing the taxpayer’s tax treatment of the item and the taxpayer years affected. If the taxpayer is a Coordinated Industry Case (CIC) taxpayer, the taxpayer must provide a statement that the taxpayer will agree to address the disclosed item under the Accelerated Issue Resolution process described in Rev. Proc. 94-679 if requested to do so by the IRS. In addition, taxpayers must furnish the names and addresses of any parties who promoted, solicited or recommended the taxpayer’s participation in the transaction underlying the item and who had a financial interest, including the receipt of fees in the taxpayer’s decision to participate, and if known to the taxpayer, any parties who advised the promoter, solicitor or recommender with respect to that transaction. Finally, a taxpayer must supply a statement agreeing to provide, if requested, copies of all of the following: transactional documents, internal documents or memoranda used by the taxpayer in the decision-making process and opinions and memoranda that provide a legal analysis of the item, whether prepared by the taxpayer or a tax professional. A statement must also be signed under penalties of perjury that the disclosure is true, correct and complete.
The disclosure, which is submitted to the Office of Tax Shelter Analysis, must be signed and dated by an individual taxpayer or a corporate officer and not the taxpayer’s representative.
The disclosure initiative covers all items except items resulting from a transaction that did not in fact occur, in whole or in part, but for which the taxpayer claimed a tax benefit on its return; involved the taxpayer’s fraudulent concealment of the amount or source of any item of gross income; involved the taxpayer’s concealment of its interest in, or signature or other authority over, a financial account in a foreign country; involved the taxpayer’s concealment of a distribution from, a transfer of assets to, or that the taxpayer was a grantor of a foreign trust; or involved the treatment of personal, household or living expenses as deductible trade or business expense.
There are several interesting aspects to the approach taken by the IRS in Announcement 2002-2. First, the IRS has apparently recognized that tax shelters will most successfully be combated by identifying the promoters of such transactions instead of the taxpayers who invest in them. The IRS apparently assumes that if it attacks the promoters, tax shelters will be reduced; this appears to be a reasonable assumption.
More importantly, by not requiring a taxpayer to concede any liability for the underlying tax, the IRS is giving corporate taxpayers an opportunity that many will find irresistible. If the corporation expects to be audited in any event, it is likely that the tax shelters on its returns will be identified and investigated. This initiative permits a corporation to obtain an advance penalty waiver while retaining the right to defend its tax position. Moreover, the additional "cost" to the corporation will frequently be nothing more than identifying the promoter, who the corporation probably believes received excessive fees in any event. Thus, corporate taxpayers that are audited will have an incentive to disclose transactions and little reason not to do so.
The question is a little closer for individual taxpayers but not by much. Many individual taxpayers that have purchased tax shelters from promoters may think that their returns will not be examined due to the "audit lottery." However, if even one taxpayer who entered into the same or a similar transaction with the promoter makes a disclosure, every other taxpayer who invested in the same transaction will likely be audited. As a result, most individual taxpayers may be better off if they disclose a transaction before it is disclosed by someone else.
The IRS should be commended for this new initiative. By not requiring taxpayers to concede the underlying tax liability in order to obtain a waiver of penalties, the IRS will encourage taxpayers to promptly identify tax shelters in which they have invested and, more importantly, the promoters who are selling these shelters. Armed with this information, the IRS may be able to attack those shelters that are abusive and address other transactions through changes in the applicable law or regulations.
1 Section 6662. All statutory references are to the Internal Revenue Code of 1986, as amended (Code).
2 Section 6111.
3 Section 6011.
4 Section 6112.
5 ACM Partnership v. Commissioner, 157 F.3d 231 (3d. Cir. 1998), ASA Investerings Partnership v. Commissioner, 340 U.S. App. D.C. 55 (D.C. Cir. 2000).
6 IES Industries, Inc. v. United States, 253 F.3d 350 (8th Cir. 2001), Boca Investerings Partnership v. United States, 167 F. Supp. 2d 298 (D.C. Cir. 2001), Compaq Computer Corporation v. Commissioner, 2001 U.S. App. (5th Cir. 2001).
7 United Parcel Service v. Commissioner, 254 F.3d 1014 (11th Cir. 2001).
8 An item is an issue raised during an examination if the person examining the return communicates to the taxpayer knowledge about the specific item or, on or before December 21, 2001, the examiner has made a request to the taxpayer for information, and the taxpayer could not make a complete response to that request without giving the examiner knowledge of the specific item.
9 1994-2 CB 800.
