Businesses and individuals may structure their transactions in a tax-efficient manner, but when a transaction's expected tax results eclipse its economic substance, the IRS may deny those benefits. With President Joe Biden's administration wanting to reduce the tax gap — the estimated annual amount of taxes owed but unpaid — of as much as $1 trillion and to provide the IRS with $80 billion in additional funding, partly to do so, taxpayers and their advisers should be aware that the nation may be entering a new tax enforcement era (testimony of IRS Commissioner Charles Rettig to the Senate Finance Committee, April 13, 2021; Treasury, The American Families Plan Tax Compliance Agenda, May 2021, pp. 1 and 16).
At the same time, with the administration and Congress proposing higher taxes for taxpayers with more than $400,000 in income, strategies to shelter income and gains could become more tempting. However, an existing regime of reportable transactions makes such stratagems riskier than they would be otherwise. The following discussion outlines the requirements for reportable transactions and penalties for failing to comply, both for taxpayers and their advisers.
Regs. Sec. 1.6011-4 provides that taxpayers who are required to file a tax return and that participate in a "reportable transaction" for any tax year must disclose information about the transaction to the IRS in a manner and time specified in the regulations. Secs. 6111 and 6112 further require any material adviser with respect to a reportable transaction to disclose information about the transaction to the IRS and to maintain a list of persons he or she has advised with respect to it.
A reportable transaction is any transaction for which the IRS requires information to be included with a return or statement because the Service has determined, pursuant to the regulations under Sec. 6011, that the transaction is of a type that has the potential for tax avoidance or evasion (Sec. 6707A(c)(1)). The term "transaction" includes all the factual elements relevant to the expected tax treatment of any investment, entity, plan, or arrangement and includes any series of steps carried out as part of a plan (Regs. Sec. 1.6011-4(b)(1)).
TYPES OF REPORTABLE TRANSACTIONS
The types of reportable transactions include:
A listed transaction is defined in Regs. Sec. 1.6011-4(b)(2) as a transaction that is the same or similar to one that the IRS has determined to be a tax-avoidance transaction and identified in a notice, regulation, or other publication. Listed transactions include, for example, claiming deductible losses on a disposition of stock by applying rules relating to distributions to shareholders of encumbered property to give the stock an artificially high basis (see Notice 99-59) and similar arrangements in a disposition of partnership interests (Notice 2000-44). These are popularly known, respectively, as boss (bond and option sales strategy) and son-of-boss transactions. Other listed transactions involve such practices as lease stripping (Notice 2003-55) and, highlighted more recently, certain syndicated conservation easements (Notice 2017-10). A taxpayer has participated in a listed transaction if the taxpayer's return reflects, or the taxpayer knows or has reason to know, that the taxpayer's tax benefits are derived directly or indirectly from tax consequences or a tax strategy described in IRS guidance as a listed transaction (Regs. Sec. 1.6011-4(c)(3)(i)(A)).
A confidential transaction is a transaction that is offered to a taxpayer under conditions of confidentiality and for which the taxpayer has paid an adviser (promoter) a minimum fee (Regs. Sec. 1.6011-4(b)(3)).
Transactions with contractual protection
Transactions with contractual protection are transactions for which taxpayers or related parties (Sec. 267(b) or Sec. 707(b)) have contractual protection (including contingent fees) that provide for a full or partial refund (rights to reimbursements) if the intended tax consequences are not achieved.
A loss transaction under Sec. 165 is a reportable transaction if the taxpayer engaging in it claims a loss of at least:
- $10 million in a single tax year or $20 million in any combination of tax years for corporations;
- $10 million in any single tax year or $20 million in any combination of tax years for partnerships that have only corporations as partners, whether or not any losses flow through to one or more partners;
- $2 million in any single tax year or $4 million in any combination of tax years for all other partnerships, whether or not any losses flow through to one or more partners;
- $2 million in any single tax year or $4 million in any combination of tax years for individuals, S corporations, or trusts, whether or not any losses flow through to one or more shareholders or beneficiaries; or
- $50,000 in any single tax year for individuals or trusts if the loss arises in a foreign currency transaction (as defined in Sec. 988(c)(1)) (Regs. Sec. 1.6011-4(b)(5)(i)).
Only losses claimed in the tax year in which the transaction is entered into and the five succeeding tax years are combined to meet the cumulative threshold amounts. Rev. Proc. 2013-11 lists a number of losses that are not taken into account in determining whether a transaction is a loss transaction.
Transactions of interest
Transactions of interest are transactions identified by the IRS in a notice, regulation, or other published guidance as a transaction of interest, such as microcaptive insurance arrangements described in Notice 2016-66. If the listed transaction or transaction of interest involves a tax on generation-skipping transfers, the disclosure must follow the published guidance (Regs. Sec. 26.6011-4). Treasury and the IRS believe that transactions of interest have the potential for abuse but lack sufficient information to determine whether they should be identified as tax-avoidance transactions.
REPORTING THE TRANSACTION
Under Regs. Sec. 1.6011-4(d), a taxpayer discloses a reportable transaction by attaching Form 8886, Reportable Transaction Disclosure Statement, to the tax return. To be considered complete, the information provided on Form 8886 must:
- Describe the expected tax treatment and all potential tax benefits expected to result from the transaction;
- Describe any tax result protection (as defined in Regs. Sec. 301.6111-3(c)(12)) for the transaction; and
- Identify and describe the transaction in sufficient detail for the IRS to be able to understand the tax structure of the reportable transaction and the identity of all parties involved in it.
A copy of the disclosure statement must be sent to the IRS Office of Tax Shelter Analysis (OTSA) at the same time that the taxpayer first files any disclosure statement pertaining to a particular reportable transaction (Regs. Sec. 1.6011-4(e)). Incomplete or incorrect information on Form 8886 can lead to penalties, described below.
The IRS may request tax accrual workpapers for any return that claims a tax benefit from a listed transaction. If the transaction was properly disclosed, the IRS routinely requests only the workpapers pertaining to the listed transaction. If the transaction was not properly disclosed, the IRS routinely will request all tax accrual workpapers, even those that do not pertain to the listed transaction. The IRS generally limits its tax accrual workpaper requests to the workpapers for the years under examination but may also request the workpapers for other years if directly relevant to the years under examination (Chief Counsel Notice 2003-012).
MATERIAL ADVISER RESPONSIBILITIES
Persons who are material advisers must meet the disclosure and list maintenance obligations under Secs. 6111 and 6112. Material advisers who fail to meet the disclosure requirements in Sec. 6111 are subject to penalties under Sec. 6707, and those who fail to maintain required lists as required by Sec. 6112 are subject to penalties under Sec. 6708(a). The OTSA was created to serve as the focal point for efforts to gather and analyze information relating to tax shelter activities and to coordinate appropriate responses.
A material adviser is any person who:
- Provides any material aid, assistance, or advice with respect to organizing, managing, promoting, selling, implementing, insuring, or carrying out any reportable transaction; and
- Directly or indirectly derives gross income for the advice or assistance in excess of a threshold amount.
The threshold amount is $50,000 for reportable transactions where substantially all of the tax benefits are provided to natural persons and $250,000 in any other case (Sec. 6111(b)(1); Regs. Secs. 301.6111-3(b)(1) and (b)(3)).
For reportable transactions (including listed transactions) in which the material adviser provides material aid, assistance, or advice, the adviser must file an information return that includes the same information required on Form 8886, except that instead of providing the identity of all parties to the transaction, the material adviser must provide the identity of any material adviser(s) who the material adviser knows or has reason to know acted as a material adviser with respect to the transaction. This disclosure is made on Form 8918, Material Advisor Disclosure Statement, on or before the last day of the month following the end of the calendar quarter in which the person first became a material adviser with respect to the transaction (Regs. Secs. 301.6111-3(d) and (e)).
The list of reportable transactions the material adviser maintains and provides to the IRS must include an itemized statement of information relating to each reportable transaction, a detailed description of the transaction that includes both the transaction's tax structure and its purported tax treatment, a copy of any designation agreement (a written agreement among multiple material advisers for the transaction designating that one of the advisers will maintain all or a portion of the list) to which the material adviser is a party, and copies of certain documents that relate to an understanding of the purported tax treatment or tax structure of the transaction (Regs. Sec. 301.6112-1(b)(3)).
Material advisers who fail to maintain the required list of advisees and who fail to properly maintain the list, maintain an incomplete list, or refuse to those make the list available to the IRS when requested to do so may be subject to a penalty (Sec. 6708(a)). Material advisers who fail to file a correct and complete Form 8918 by the due date also may be subject to a penalty (Sec. 6707; Regs. Sec. 301.6707-1).
Other ethical requirements may also come into play for tax practitioners, including Treasury Circular 230, Regulations Governing Practice Before the Internal Revenue Service (31 C.F.R. Part 10), and, for AICPA members, the Statements on Standards for Tax Services (SSTSs).
B and J are an ultrawealthy couple who have nearly $50 million in capital gains and ordinary income each year. They are contacted by a tax strategy promoter who offers a loss-generating tax strategy to offset their gains and income. Before they are allowed to hear the specifics of the strategy, they must sign a confidentiality and nondisclosure agreement. The promoter then explains that this is a loss-generating trading strategy involving equities and foreign currency in a flowthrough entity (S corporation) supported by a more-likely-than-not tax opinion from a reputable law firm. The gains go to the traders, while the losses are left to flow through to the taxpayers on Schedule E, Supplemental Income and Loss, of their Form 1040, U.S. Individual Income Tax Return, where most of their income is shown. The losses generated will be 10 times the level of their investment, and their investment is contractually protected along with the agreed-upon losses. The promoter's fee is 3% of the amount of capital loss generated and 5% of the amount of ordinary loss generated. Their CPA conditions his approval and signature on their tax return on disclosing the strategy and provides the following reasons:
- Unless the applicable taxing authority imposes a higher standard, AICPA members must have a good-faith belief that the position taken on a tax return has at least a realistic possibility of being sustained on its merits (SSTS No. 1, Tax Return Positions, Statement 5.a). Otherwise, members may recommend a tax position or sign a return reflecting it if the position has a "reasonable basis" and is appropriately disclosed (SSTS No. 1, Statement 5.b).
- In determining whether the reporting and disclosure standards are met, the member should consider whether a listed or reportable transaction is involved (SSTS Interpretation No. 1-1, Reporting and Disclosure Standards, General Interpretation 11.6).
- The reason or reasons why this transaction must be disclosed: listed, confidential, contractual protection, loss, and/or transaction of interest (Form 8886, line 2, "Identify the Type of Reportable Transaction").
- A failure to disclose may be subject to a penalty of 75% of the decrease in the tax shown on the return (Sec. 6707A(b)(1)).
PLAYING IT SAFE WITH A RULING REQUEST
A taxpayer may submit a request to the IRS for a ruling whether a transaction is subject to these reporting/disclosure requirements. The request should be submitted on or before the date that disclosure would otherwise be required. However, the potential obligation to report/disclose is not suspended during the period that the request is pending. The IRS determines whether the ruling request itself satisfies the disclosure requirement (Regs. Sec. 1.6011-4(f)(1)). A taxpayer may make a protective disclosure by following the requirements of this rule. To qualify, the disclosure statement should indicate that the taxpayer is uncertain whether the transaction is required to be reported/disclosed and that the statement is being filed on a protective basis (Regs. Sec. 1.6011-4(f)(2)).
In addition, a taxpayer may request a ruling on the merits of a transaction. If this is done on or before the date that disclosure/reporting would otherwise be required and the taxpayer receives a favorable ruling as to the transaction, the disclosure rules are deemed to have been satisfied by the taxpayer with regard to that transaction, so long as the request fully discloses all relevant facts relating to the transaction that would otherwise be required to be disclosed (Regs. Sec. 1.6011-4(f)(1)).
The privilege of confidentiality under Sec. 7525(a)(1)applicable to communications between tax practitioners and taxpayers does not apply to written communications regarding tax shelters (Sec. 7525(b)). Thus, given the reportable transaction regime, tax shelter participants cannot have a reasonable expectation that their identities or their participation in tax shelters will be confidential.
The IRS and state tax officials have established a nationwide partnership to combat abusive tax avoidance — the Abusive Tax Avoidance Transactions Program. Under agreements with individual states, the IRS and states share information on abusive tax-avoidance transactions and their participants.
Taxpayers who fail to disclose may be subject to civil penalties. A separate penalty applies to taxpayers who fail to include on any return or statement any information with respect to a reportable transaction that is required to be included under Sec. 6011 (Sec. 6707A(a)). The penalty is equal to 75% of the decrease in tax shown on the return as a result of the transaction or that would have resulted if the transaction were respected for federal tax purposes (Sec. 6707A(b)(1); Regs. Sec. 301.6707A-1(a)). The minimum penalty is $10,000, or $5,000 for natural persons (Sec. 6707A(b)(3)). The maximum amounts for listed transactions are $200,000, or $100,000 for natural persons, and for all other reportable transactions, $50,000, or $10,000 for natural persons. The IRS can assess a Sec. 6707A penalty for failure to file Form 8886 or for filing one that fails to include all required information and attachments or that contains incorrect information.
The penalty on material advisers is imposed if the material adviser fails to file the required return on or before the date it is due or files a false or incomplete information return (Sec. 6707). The penalty may be assessed against each material adviser required to file Form 8918. Thus, if more than one material adviser is responsible for filing a return for the same reportable transaction, a separate penalty may be assessed against each material adviser who fails to file the return timely or files the return with false or incomplete information (Regs. Sec. 301.6707-1(c)(2)).
The penalty for failure to maintain and make a list of advisees with respect to a reportable transaction available to the IRS is $10,000 per day of each failure after the 20th business day after the date of the request (Sec. 6708(a)). The penalty for the failure to maintain lists of advisees is a divisible penalty for establishing refund suit jurisdiction. Thus, a taxpayer assessed with the penalty need only pay the divisible amount of the penalty attributable to a single day, or $10,000, before instituting a tax refund suit under Sec. 7422 (Chief Counsel Advice 200646016).
Promoting abusive tax shelters
A person who organizes, assists in organizing, or participates in the sale of any interest in a partnership or other entity, or any plan or arrangement (i.e., an abusive tax shelter), is subject to a penalty if he or she makes, furnishes, or causes another person to make or furnish:
- A statement concerning the allowability of any tax benefit obtained through participation in the tax shelter that the person knows or has reason to know is materially false or fraudulent; or
- A gross valuation overstatement concerning any matter material to the tax shelter (Sec. 6700(a)(2)).
The penalty is $1,000 or, if the person can establish that it is less, 100% (50% for allowability statements) of the gross income derived by the person from the activity related to the entity, plan, or arrangement (Sec. 6700(a)(2)). Persons subject to the penalty include not only the promoter of a tax shelter but also any other person who organizes (or assists in the organization of) or sells (directly or indirectly) a plan or arrangement and makes (or causes someone else to make) a material misrepresentation of the tax benefits to be derived from participation in the plan or arrangement or makes a gross valuation overstatement as to any matter. The gross valuation overstatement can be made knowingly or unknowingly (see Humphrey, No. 1:11-cv-1647 (D. Ga. 3/5/13)). The penalty can be applied even if the purchaser of the tax shelter does not rely on it or does not underreport income tax. The penalty may be imposed on the tax shelter entity, with the result that the penalty can become the obligation of the participating members of passthrough entities.
ABLE TO WITHSTAND SCRUTINY
There is nothing wrong with aggressive tax planning. However, when a transaction must be cloaked in secrecy to avoid an IRS challenge, taxpayers must know something is wrong. Tax transactions that are "too good to be true" may be reportable, and disclosure protocols must be followed to avoid the associated penalties. Knowing the rules in this area may avoid pitfalls. e it to the IRS, and material advisers with respect to these transactions must maintain a list of advisees.
About the authors
Ray A. Knight, CPA/PFS, CGMA, J.D., is a professor of accounting at Elon University in Elon, N.C., and Lee G. Knight, Ph.D., is a professor of accounting emerita at Wake Forest University in Winston-Salem, N.C. To comment on this article or to suggest an idea for another article, contact Paul Bonner, a JofA senior editor, at Paul.Bonner@aicpa-cima.com or 919-402-4434.
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