Tax Planning and the Tax Shelter Penalty Rules
Companies may have a harder time avoiding the accuracy-related penalties for substantial understatements of income tax that relate to relatively routine corporate tax planning initiativestougher standards may apply to understatements attributed to tax shelters.

The Taxpayer Relief Act of 1997 broadened the definition of tax shelter to include any entity, investment, plan or arrangement with a significant purpose of avoiding (or evading) federal income tax. Prior to the 1997 act, tax shelter rules were triggered only if there was a principal purpose of avoiding taxes.

The revised definition was intended to complement a new provision in the law that requires registration of some tax reduction schemes that are marketed on a confidential basis. It exposes companies to increased penalty risk and transaction costseven in the absence of confidential corporate tax shelters.

What has changed?
The penalty (20% of the underpayment related to the tax shelter) applies to an understatement of income tax that is substantial because it exceeds 10% of the tax that should have been shown on the return or $5,000 ($10,000 for a C corporation), whichever is greater. Companies can exclude amounts that relate to non-tax-shelter positions for which the taxpayer had substantial authority or that were adequately disclosed to the Internal Revenue Service (assuming a reasonable basis for the companys position existed).

However, a company cannot exclude a tax shelter item (for penalty purposes) unless it acted with reasonable cause and in good faith. The minimum requirements are substantial authority for the position and the taxpayers reasonable belief (independently formed or based on the advice of others) that the tax treatment was proper. The taxpayer may not be considered to have acted in good faith if there were negative factors, such as the lack of a significant business purpose, unreasonable benefits (relative to the investment) or the taxpayers agreement to protect the confidentiality of the shelters tax structure.

Observation: The new definition of a tax shelter is so broad that it may encompass routine or even incidental corporate tax planning. Structuring a transaction in a tax-efficient mannerlong an accepted practicecould trigger the tax shelter penalty rules if tax reduction was a significant purpose. Companies and their tax advisers should be aware that Congress has raised the bar on the documentation and professional advice that should underpin any entity, investment, plan or arrangement that is structured with an eye on tax planning.

Tracy Hollingsworth, Esq., staff director of tax councils at Manufacturers Alliance, Arlington, Virginia.


New Capital Netting Rules
The Internal Revenue Service announced (Internal Revenue Bulletin notice 97-59) it will apply new capital gains rules when a technical corrections act is passedretroactivelyfor tax years ending after May 6, 1997.

The Taxpayer Relief Act of 1997 amended Internal Revenue Code section 1(h) to provide for new capital gains rates for individual taxpayers. However, the act did not clarify how Congress wanted capital gains and losses netted or what holding periods would apply to different transactions. With the help of key members of Congress, the IRS has summarized the technical corrections and described how the new section 1(h) rules will be administered.

For example, if an individual taxpayer has a net capital gain, the long-term capital gains and losses would be separated into three tax rate groups: 28%, 25% and 20% (10% for gains that otherwise would be taxed at 15%). Gains and losses within each group would be netted to arrive at a net gain or net loss for each group. The following additional netting and ordering rules also would apply:

  • Short-term capital losses (including short-term capital loss carryovers) would offset short-term capital gains. Any remaining net short-term capital loss would then be applied to reduce any net long-term capital gain from each of the tax rate groups, starting with the 28% group.
  • For long-term gains and losses, a net loss from the 28% group (including long-term capital loss carryover) would offset any gains from the 25% group and, then, any from the 20% group. A net loss from the 20% group would offset any gains in the 28% group and, then, any in the 25% group. Any remaining capital gains would be taxed at that groups marginal rate.

The IRS amended schedule D and its instructions for 1997 to reflect these new rules, including an elaborate 36-line section (part IV) that assures readers that no gains are taxed at a rate higher than the groups marginal rate.

Observation: In a related announcement (97-109), the IRS warned tax preparers it will not update certain information returns and related instructions for 1997 even though the new rules would change the reporting requirements for these forms. CPAs should read the detailed instructions in this announcement for changes in the following forms: 1997 Form 1099-DIV, Dividends and Distributions ; 1997 Form 1099-B, Broker and Barter Exchange Transactions ; 1996 Form 2439, Notice to Shareholder of Undistributed Long-Term Capital Gains , for 1996-97 fiscal years ending after May 6, 1997; and 1996 schedules K and K-1 for partnerships, S corporations and estates with 1996-97 fiscal years ending after May 6, 1997.

Michael Lynch, CPA, Esq., associate professor of accounting at Bryant College, Smithfield, Rhode Island.

Line Items

  • Homework for CPAs
    In Notice 97-60 (1997-46, IRB 1), the Internal Revenue Service explains the new, higher education tax incentives and answers a series of questions relating to other education-related tax relief, such as the Hope scholarship credit, the lifetime learning credit, interest deductions for student loans, the avoidance of the 10% tax on early individual retirement account withdrawals to pay for higher education expenses, the education IRA, employer-provided education assistance plans and qualified state tuition programs. 
  • Measuring Gains
    The IRS issued guidance on capital gains dividends for tax years ending after May 6, 1997, for regulated investment companies, mutual funds, real estate investment trusts and their shareholders. Notice 97-64 includes examples of how dividends are designated as 20% gain distributions, unrecaptured Internal Revenue Code section 1250 gain distributions (taxed in the 25% group) or 28% gain distributions.
  • Settling With the IRS
    A wife transferred stock, real estate and her principal residence to her former husband in accordance with a property settlement agreement. In exchange, he agreed to pay her $300,000 down and another $625,000 at 10% per year for 10 years. The husband sought to deduct his interest payments. The IRS denied the deduction as personal interest; however, the Tax Court upheld the deduction. According to the Tax Court, interest on indebtedness incurred incident to a divorce is not required under Internal Revenue Code section 1041 to be characterized as nondeductible personal interest. Therefore, interest paid can be deducted if it is investment interest, passive activity interest or qualified residence interest ( Seymour v. Commissioner , 109 TC no. 14, 1997).
  • Denied Credit
    An office products wholesaler was denied a research tax credit under IRC section 41 for the costs incurred in developing seven computer software programs for internal use. According to the district court, the company failed to venture into an uncertain field or provide the technology to utilize computers in a manner that was never before available. This was the first case to examine credit eligibility for internal-use software ( United Stationers Inc. v. United States , no. 92 C 6065, 1997).
  • Drive-In Resolutions
    The IRS is testing a new administrative process for resolving tax disputes in bankruptcy cases. The tests are being conducted in Arizona, Indiana, Massachusetts and Houston, Texas. The process allows debtors or their estates to resolve their tax disputes with the IRS as soon as bankruptcy proceedings begin. Most disputes now take at least 15 to 30 days to be resolved (announcement 97-111, IR-97-43).

  • Middleman Obligations
    Relying on revenue ruling 93-70 (1993-2 CB 294), the IRS ruled that an attorney who made payments from a client trust account to expert witnesses and private investigators was a middleman payer under IRC section 6041. Since he exercised oversight and management functions in connection with the payments, the attorney was required to file informational returns and payee statements (TAM 9744002).

    Michael Lynch, CPA, Esq., associate professor of accounting at Bryant College, Smithfield, Rhode Island.


©1998 AICPA


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