On March 21, 2002, the U.S. Department of the Treasury (Treasury) announced several new administrative and legislative proposals to combat tax shelters. Underlying the proposals are two goals: to increase transparency through broader disclosure rules and to discourage participation in tax shelters by lowering the odds of winning the audit lottery. (Tax Shelters and Inversions, Hearing Before the Senate Finance Comm., 107th Cong. (2002) (statement of B. John Williams, Chief Counsel, Internal Revenue Service).)
The Treasury’s proposals signify the failure of an earlier effort to increase the disclosure of tax motivated transactions. In February 2000, the Treasury issued a series of temporary regulations under Internal Revenue Code (Code) §§ 6011, 6111 and 6112 in an effort to encourage disclosure by taxpayers, registration with the Internal Revenue Service and list maintenance by promoters of tax shelters. The purpose of the regulations was to provide the IRS with a wide variety of sources of information so it could understand and shut down tax shelters. However, the temporary regulations fostered confusion about which transactions were covered as reportable. As a result, the Treasury and IRS believe that most transactions were not disclosed, registered or listed.
The Treasury proposals follow several other IRS initiatives designed to increase disclosures by taxpayers. On December 21, 2001, the IRS issued Announcement 2002-2, which provides that if a taxpayer complies with the disclosure requirements of the announcement by April 23, 2002, then the IRS will generally waive the accuracy-related penalty for any underpayment of tax attributable to the disclosed item. This proposal has resulted in a significant number of tax shelter disclosures. On the same date, Larry Langdon, commissioner of the Large and Mid-Size Business Division (LMSB) issued a memorandum regarding the application of the accuracy-related penalty. According to the memorandum, IRS examiners must consider the accuracy-related penalty under Code § 6662 for underpayments attributable to a taxpayer’s participation in a listed transaction. On January 29, 2002, Langdon issued a memorandum in which he announced that the LMSB Tax Shelter Committee approved a standard information document request (IDR) to be used in all LMSB examinations as of April 24, 2002. The purpose of the IDR is to determine whether a taxpayer entered into a transaction that is the same or substantially similar to a listed transaction.
Single, Expanded Definition of "Reportable Transaction"
To increase transparency, the Treasury proposes a single definition of a reportable transaction. The government proposes that the disclosure, registration and list maintenance regulations under Code § 6011, 6111 and 6112 be amended to define a reportable transaction as a transaction that fits into any one of the following categories, with no exceptions:
Listed transactions: These are transactions designated by the IRS. The definition of a transaction "similar to" a listed transaction would be clarified to include any transaction designed to produce the same or similar type of tax result using the same, or similar, strategy.
Loss transactions: A loss transaction is a transaction resulting in a loss under Code section 165 of at least $10 million in any single year or $20 million in any combination of years for corporate taxpayers; at least $10 million in any combination of years for partnership and S corporations; $2 million in any single year or $4 million in any combination of years, whether or not the losses flow through to one or more beneficiaries, for trusts; and for individual taxpayers, at least $2 million in any single year or $4 million in any combination of years.
Transaction with brief asset holding period: Any transaction resulting in a tax credit (including the foreign tax credit) if the underlying asset giving rise to the credit was held by the taxpayer for less than 45 days, and the transactions result in credits exceeding $250,000.
Transactions that are marketed under conditions of confidentiality and provide minimum tax benefits: With respect to corporate taxpayers that constitutes the reduction of taxable income of at least $500,000 and for individual, trust, partnership and S corporation taxpayers, the reduction of taxable income of at least $250,000.
Significant book-tax differences: A transaction that results in the difference of at least $10 million, subject to certain exceptions that are not indicative of tax avoidance, including depreciation, depletion, amortization, bad debt reserves, state and local taxes and employee compensation.
Strict Liability for Accuracy-Related Penalty for Reportable Transactions that Are Not Disclosed
To make reportable transactions less attractive, the government seeks to increase the penalties for taxpayers and promoters. The Treasury proposes an amendment to the regulations under Code § 6662 and 6664 to impose strict liability for reportable transactions that are not disclosed. This would effectively prevent taxpayers from relying on opinion letters as a defense to the accuracy-related penalty for nondisclosed transactions. Strict liability would also be imposed for accuracy-related penalties for transactions based on the invalidity of a regulation that are not disclosed.
Expand Persons Subject to Disclosure and Registration Rules
Currently, Treasury regulation § 1.6011-4T requires corporations to disclose reportable transactions. The Treasury proposes amending the regulations to require partnerships, S corporations, trusts and individuals to disclose reportable transactions. All taxpayer disclosures will be sent to the IRS’ Office of Tax Shelter Analysis. The Treasury contends that the current disclosure regime does not capture all reportable transactions, as an increasing number of non-corporate taxpayers are using tax shelters. The Treasury further seeks to broaden the definition of those who must register reportable transactions and maintain lists of investments. In addition, Circular 230 would be amended to increase standards for opinions that are used to support tax avoidance transactions.
The Treasury seeks to impose several new strict liability penalties for failure to disclose. The penalties they seek to impose are: a penalty on corporate taxpayers for each failure to disclose a listed transaction equal to the sum of $200,000 and 5 percent of any underpayment resulting from the listed transaction; a penalty of $50,000 on corporate taxpayers for each failure to disclose a reportable transaction (other than a listed transaction); a penalty of $200,000 on partnerships, S corporations and trusts for each failure to disclose a listed transaction and $50,000 for each failure to disclose other reportable transactions; a penalty on individual taxpayers for each failure to disclose a listed transaction equal to the sum of $100,000 and 5 percent of any underpayment resulting from the listed transaction; and a penalty of $10,000 on individual taxpayers for each failure to disclose a reportable transaction (other than a listed transaction).
The portion of the proposed penalty that is dependent on the amount of any underpayment would be incorporated as an increase to the existing accuracy-related penalty under Code § 6662. The disclosure penalty for listed transactions would not be waivable. Further, corporations would be required to publicly disclose in the U.S. Securities and Exchange Commission filings the imposition of penalties for the failure to disclose listed and unlisted transactions.
As part of its legislative proposal, the Treasury will seek to codify its single definition of reportable transaction for disclosure, registration and list-maintenance requirements. The Treasury will also seek legislation to expand and increase the penalties related to a promoter’s failure to register a reportable transaction and to timely produce investor lists. Further, the Treasury will seek legislation to amend Code § 7408 to allow the government to permanently enjoin promoters who repeatedly disregard the registration and list maintenance requirements.
The Treasury believes that its proposals will strengthen the IRS’ efforts to crack down on abusive tax shelters. Moreover, the Treasury says the new disclosure rules will even the playing field, such that all taxpayers entering into reportable transactions will be subject to IRS scrutiny.
These proposals raise a number of issues. The proposed definition of a reportable transaction is extremely broad, and this is likely to substantially increase reportable transactions. It is unclear how the IRS would effectively handle such a voluminous number of disclosures. In addition, the book-tax difference rule will be impossible to apply except for disclosure purposes, because transactions must be registered or listed when they occur, which is before the book consequences can be determined.
It is also possible that the proposed penalties will increase litigation. Taxpayers who fail to disclose listed transactions will not have an incentive to settle because the new penalties are not waivable. Lastly, a strict liability penalty could unfairly penalize taxpayers that inadvertently fail to disclose a transaction.
Senators Max Bacus (D - MT) and Charles Grassley (R - IA) announced that they will introduce legislation in April or May 2002 that will address tax shelters. Their previous draft proposal would increase the accuracy-related penalty for tax shelters to 40 percent. But the penalty would not apply if there was substantial authority for the tax treatment of the shelter, the taxpayer adequately discloses the relevant facts regarding the shelter on his/her return or the taxpayer reasonably believes that it will more likely than not prevail on the merits regarding its tax treatment if challenged by the IRS.