AJCA penalties for noncompliance with reportable transaction regs.

On Oct. 22, 2004, President Bush signed into law the American Jobs Creation Act of 2004 (AJCA), a $138 billion tax package with a wide-ranging effect on foreign and domestic tax planning. Besides the AJCA's numerous tax planning opportunities, it alerts taxpayers to their obligation to disclose certain transactions the IRS deems reportable transactions. Prior to the AJCA, Regs. Sec. 1.6011-4, which required all taxpayers to disclose certain transactions that fell into one of six broad categories, prescribed no penalties for failing to disclose a "reportable transaction"

The AJCA added and modified numerous provisions to the reportable transaction roles. First, it imposed significant penalties for failing to disclose reportable transactions, regardless of a tax underpayment. There are strict-liability penalties in the case of listed transactions (i.e., transactions specifically identified by the Service as falling into one of the six categories). For other reportable transactions, the penalty can be rescinded only by IRS authority (which cannot be reviewed by a court).

Also, the AJCA extended the statute of limitations (SOL) on assessment for undisclosed listed transactions, until the taxpayer provides the required information to the IRS or responds to a list-maintenance request. In addition, it increased accuracy-related penalties for certain undisclosed reportable transactions and imposed new limits on avoiding such penalties via reasonable cause (e.g., relying on disqualified opinions and disqualified advisors).

Reportable Transactions

The IRS issued the reportable transaction final regulations in February 2003; they apply to transactions entered into on or after Feb. 28, 2003 (although the regulations may apply to transactions entered into on or after Jan. 1, 2003, at the taxpayer's election). The final regulations set forth six categories of reportable transactions; see the exhibit on p. 233. (For a discussion of the final regulations, see Mendelson and Emilian, "Tax Shelter Final Regs." TTA, June 2003, p. 338.)

Exhibit: Categories of reportable transactions (Regs. Sec. 1.6011-4(b))

* Listed transactions

* Transactions offered under conditions of confidentiality

* Transactions with contractual protection

* Transactions generating certain losses under Sec. 165

* Transactions resulting in a book/tax difference in excess of $10 million for any tax year

* Transactions generating a tax credit exceeding $250,000 if the underlying asset giving rise to the credit is held by the taxpayer for 45 days or less (i.e., "brief asset holding period" transactions)

Penalty for Failing to Disclose Reportable Transactions

Pre-AJCA: Prior to the AJCA, taxpayers were required to disclose on their returns certain information about "reportable transactions" (including listed transactions) in which they participated. They were not, however, subject to a specific penalty for failing to do so. Rather, the failure to disclose jeopardized the taxpayer's ability to claim that an income tax understatement resulting from the undisclosed transaction was due to reasonable cause, and that the taxpayer acted in good faith.

AJCA: AJCA Section 811 created a new penalty under Sec. 6707A for failing to include with a return or statement any required information on a reportable transaction with a significant tax avoidance purpose (as determined under Regs. Sec. 1.6011). Reportable transactions are disclosed on Form 8886, Reportable Transaction Disclosure Statement, and, in accordance with Rev. Proc. 2004-45, Schedule M-3, Net Income (Loss) Reconciliation of Corporations With Total Assets of $10 Million or More. The penalty, which applies regardless of whether the transaction ultimately results in a tax understatement and in addition to any accuracy-related penalty, is $10,000 for a natural person and $50,000 for all others. For a listed transaction, the penalty is $100,000 for a natural person and $200,000 for all others.

The IRS may rescind any portion of the penalty if (1) the violation does not involve a listed transaction; and (2) rescinding the penalty would promote compliance and effective tax administration. In deciding whether to exercise that authority, however, the Committee Report directs the Service to consider (1) the taxpayer's history of compliance, (2) whether the violation is due to an unintentional factual mistake and (3) whether imposing the penalty would be against equity and good conscience. The AJCA provides that, notwithstanding any other provision of law, an IRS determination on rescinding the penalty may not be reviewed in any judicial proceeding. Thus, this is a strict-liability penalty.

Notice 2005-11: On Jan. 19, 2005, the IRS issued Notice 2005-11, which provides interim guidance on the imposition and rescission of penalties under Sec. 6707A. These rules apply until further guidance is issued. In the notice, the Service stated its intention to issue regulations.

Under the notice, a taxpayer will be subject to a Sec. 6707A penalty for failing to (1) attach Form 8886 to an original or amended return or (2) provide a copy of the disclosure statement to the Office of Tax Shelter Analysis (OTSA), if required. A single penalty will apply to a taxpayer that fails to (1) attach Form 8886 to an original or amended return and (2) provide a copy of Form 8886 to the OTSA. This penalty, which is tied to a taxpayer's failure to disclose, applies regardless of whether the IRS successfully challenges the transaction.

The interim guidance further provides that the penalty applies to each failure to provide a disclosure statement required to be attached to an original or amended return filed after Oct. 22, 2004 (with a copy sent to the OTSA, if required), regardless of whether the original return was due on or before Oct. 22, 2004. Under Regs. Sec. 1.6011-4(e)(1), a reportable transaction disclosure statement is due when filing a return or an amended return that reflects participation in a reportable transaction. Accordingly, a Sec. 6707A penalty will not be imposed until a taxpayer fails to provide (1) the required disclosure statement with an original or amended return or (2) a copy to the OTSA (if applicable), even if the return is filed after the due date. A Sec. 6707A penalty will not be imposed if the disclosure statement is attached to a return filed after the due date for filing the return, unless the taxpayer fails to provide a copy of the disclosure statement to the OTSA (if required); for examples, see Tax Trends, "IRS Guidance on Reportable Transaction Disclosure Penalties" p. 241, this issue.

Under the interim guidance, if a return with a due date prior to Oct. 22, 2004 is filed after the Sec. 6707A enactment date and does not contain a disclosure for a reportable transaction, the penalty will apply. However, a cogent argument can be made that the interim guidance is flawed, because it links the imposition of the Sec. 6707A penalty to the return's filing date, rather than the due date, as provided by AJCA Section 811.

SEC Reporting

Taxpayers that are Securities and Exchange Commission (SEC) registrants have added concerns after the AJCA. Those required to make periodic reports under Securities Exchange Act of 1934, Section 13 or 15(d), are now required to disclose in those reports the payment of (1) a penalty imposed for failing to disclose a listed transaction; (2) an understatement penalty resulting from a failure to disclose a listed or reportable transaction; and (3) a gross valuation misstatement penalty under Sec. 6662(h), resulting from a failure to disclose a listed or reportable transaction.

Disclosure does not depend on the penalty's materiality to the report and would occur only after (1) the taxpayer has exhausted administrative and judicial remedies, or (2) payment (if earlier). A failure to disclose the penalty in the report is treated as a failure to disclose a listed transaction, which carries a $200,000 penalty.

Modified Accuracy-Related Penalty for Listed Transactions and Other Reportable Transactions

Prior to the AJCA, noncorporate taxpayers could avoid imposition of the accuracy-related penalty for under statements resulting from their participation in tax shelters if (1) the treatment of the item was supported by substantial authority and (2) they reasonably believed that the treatment claimed was more likely than not the proper treatment. The exception was not available to corporate taxpayers.

Under AJCA Section 812, the tax shelter accuracy-related penalty was replaced with a new penalty under Sec. 6662A that applies to listed and reportable transactions with a significant tax avoidance purpose (reportable avoidance transactions). The penalty rate and defenses available to avoid the penalty vary depending on whether the transaction was adequately disclosed.

If disclosure was adequate, a 20% accuracy-related penalty applies to an understatement resulting from a listed transaction or reportable avoidance transaction.

Exception: The only exception to the penalty is if the taxpayer satisfies a more stringent reasonable cause and good-faith exception set forth in new Sec. 6664(d).The strengthened reasonable cause exception would apply only if (1) the taxpayer adequately disclosed the relevant facts affecting the tax treatment; (2) there is or was substantial authority for the claimed tax treatment; and (3) the taxpayer reasonably believed that the claimed tax treatment was more likely than not proper. A belief is reasonable only if it (1) was based on the facts and law in existence when the return that included the item was filed and (2) related solely to the taxpayer's chances of success on the merits. A taxpayer cannot rely on a tax advisor's opinion to establish reasonable belief if the opinion is (1) provided by a "disqualified tax advisor" or (2) considered a "disqualified opinion."

Taxpayers who do not adequately disclose the transaction are not eligible for the more stringent reasonable cause exception and will be subject to a strict-liability penalty of 30% of the understatement.

Computing the understatement: The penalty applies to the understatement attributable to the listed or reportable avoidance transaction, without regard to other items on the return (e.g., net operating loss carryovers). Under the provision, the understatement equals the sum of (1) the product of the highest corporate or individual tax rate (as appropriate) and the increase in taxable income resulting from the difference between the taxpayer's treatment of the item and the proper treatment (without regard to other items on the return); and (2) the decrease in the aggregate credits that results from a difference between the taxpayer's treatment of an item and the proper tax treatment.

Coordination with other penalties: The portion of an understatement subject to the Sec. 6662A penalty is not subject to the accuracy-related penalty under Sec. 6662. In addition, any portion of an understatement subject to the Sec. 6663 fraud penalty is not subject to the new penalty. However, the amount of the understatement subject to the Sec. 6662A penalty will be included in determining whether the threshold for the substantial understatement penalty under Sec. 6662(d)(1) is satisfied.

Notice 2005-12

The Service issued Notice 2005-12 to provide guidance on new Sec. 6662A and on the AJCA amendments to Secs. 6662 and 6664. The notice states that adequate disclosure, for Secs. 6662A and 6664(d)(2)(A) purposes, involves filing a disclosure statement as prescribed in Kegs. Sec. 1.6011-4(d) (i.e., filing Form 8886) or Rev. Proc. 2004-45. It also clarifies the meaning of "material advisor" for purposes of determining whether such advisor is a "disqualified advisor." It specifically states that a tax advisor, including a material advisor, will not be treated as participating in the organization, management, promotion or sale of a transaction if the tax advisor's only involvement is rendering an opinion on a transaction's tax consequences. The advisor may suggest modifications to the transaction (but not material modifications) that assist the taxpayer in obtaining anticipated tax benefits. For disqualified compensation arrangements, a tax advisor who receives a referral fee or has a fee-sharing arrangement with a disqualified advisor also be treated as a disqualified advisor.

SOL for Unreported Listed Transactions

Sec. 6501 requires taxes to be assessed within three years after the date a return is filed. However, that period is extended to six years for substantial omissions of items of gross income that total more than 25% of the gross income on a return. Tax can be assessed or collected only within the required time periods. If a taxpayer files a false or fraudulent return with the intent to evade tax or does not file a return, tax may be assessed at any time.

AJCA Section 814 extends the SOL for a listed transaction when a taxpayer fails to include information about the transaction with a return or statement for a tax year. The SOL for a listed transaction Hill not expire before the date that is one year after the earlier of the date (1) on which the taxpayer provides the Service with the required information or (2) a material advisor satisfies the list-maintenance requirement, prompted by an IRS request. If the IRS lists a transaction after the SOL closed for the year of the transaction, this provision does not re-open the SOL. However, if the transaction's purported tax benefits are recognized over multiple years, the provision's extension of the SOL applies to tax benefits in any subsequent tax year when the SOL had not closed prior to the date the transaction became listed.

Conclusion

The lack of redress and other unprecedented characteristics of these penalties have seriously muddied the landscape of an already-complicated area of tax compliance. Under the final regulations, taxpayers must now diligently uncover and disclose every transaction that may fit within the six categories of reportable transactions, or face the consequences. If, at a later examination, the Service finds a reportable, but undisclosed, transaction and imposes penalties, there will be little recourse.

FROM NANCY CHASSMAN, SENIOR MANAGER, AND JAMES E. BRENNAN, SENIOR MANAGER., TAX CONTROVERSY & RISK MANAGEMENT SERVICES, ERNST & YOUNG LLP, NEW YORK, NY