Ann. 2002-2: the carrot and the stick?

On Dec. 20, 2001, the IRS issued Ann. 2002-2, outlining a new initiative to encourage taxpayers to disclose their involvement in tax shelters in exchange for a waiver of accuracy-related penalties under Sec. 6662. At the same time, Commissioner Langdon issued a memorandum to Large and Mid-Size Business Division personnel on applying Sec. 6662 penalties in examinations involving listed transactions and other potentially abusive tax shelters. The clear implication of Ann. 2002-2 and the memorandum is that the Service will pursue penalties vigorously if taxpayers fail to disclose their tax shelter transactions.

Historically, conventional wisdom provided that if a taxpayer's tax shelter transaction were examined, the taxpayer would have little exposure to Sec. 6662 penalties, for two primary reasons. First, in most transactions, the taxpayer relied on a"more likely than not" opinion that the tax treatment would be sustained if challenged on the merits. Under Regs. Sec. 1.6664-4(e), a more-likely-than-not opinion may be taken into account in establishing reasonable cause to avoid Sec. 6662 penalties. Second, even if the IRS questioned a taxpayer's good-faith reliance on a more-likely-than-not opinion, from a practical standpoint, it has routinely waived penalties to encourage settlement and avoid time-consuming, costly litigation. Accordingly, most taxpayers believe that they are better off playing the audit lottery and avoiding an examination of a transaction's merits altogether. In contrast, disclosure would almost certainly mean examination (and possibly litigation) of the transaction's merits.

Ann. 2002-2 places certain significant limits on the penalty waiver, which can be interpreted as a demarcation line that the Service believes separates aggressive tax shelter transactions from potential criminal conduct. Specifically, Ann. 2002-2 excludes transactions that (1) did not,in fact, occur, in whole or in part, but for which the taxpayer claimed a tax benefit on his returns; (2) involved the taxpayer's fraudulent concealment of the amount or source of any item of gross income; (3) involved the taxpayer's concealment of its interest in (or signature or other authority over) a financial account in a foreign country; (4) 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 (5) involved the treatment of personal, household or living expenses as deductible trade or business expenses. Indeed, Ann. 2002-2 specifically provides that this initiative neither affects whether the IRS will impose any civil penalties other than Sec. 6662 penalties, nor whether it will investigate any associated criminal conduct or recommend prosecution for violation of any criminal statute.

The Service waives Sec. 6662 penalties if a taxpayer discloses the tax shelter before the earlier of (1) the date the shelter is an issue raised during an examination or (2) April 23, 2002. In determining whether disclosure is timely, a tax shelter is considered raised during an examination if (1) the person examining the return communicated to the taxpayer knowledge about the specific shelter no later than Dec. 21, 2001, (2) the examiner made a request to the taxpayer for information and (3) the taxpayer could not make a complete response to that request without giving the examiner knowledge of the tax shelter.

To qualify for a penalty waiver, taxpayers must provide the IRS with certain information:

* A statement describing the material facts of the shelter;

* A statement describing the taxpayer's tax treatment of the shelter;

* The tax years affected by the shelter;

* For a Coordinated Industry Case taxpayer, a statement that the taxpayer will agree to address the disclosed item under the Accelerated Issue Resolution process described in Rev. Proc. 94-67, if requested to do so by the Service.

* The names and addresses of (1) any parties who promoted, solicited or recommended the taxpayer's participation in the shelter transaction and who had a financial interest (including the receipt of fees) in the taxpayer's decision to participate and (2) if known to the taxpayer, any parties who advised the promoter, solicitor or recommender with respect to the shelter;

* A statement agreeing to provide, if requested, copies of all of the following:

--All transactional documents, including agreements, contracts, instruments and schedules and, if the taxpayer's participation in the transaction was promoted, solicited or recommended by any other party, all material received from that other party or that party's adviser(s); --All internal documents or memoranda used by the taxpayer in the decisionmaking process, including information presented to the taxpayer's board of directors; and --All opinions and memoranda that provide a legal analysis of the item, whether prepared by the taxpayer or its tax professional.

* A penalty-of-perjury statement that the person signing the disclosure has examined the disclosure and that to the best of his knowledge and belief, the information provided as part of the disclosure contains all relevant facts and is true, correct and complete. For an individual taxpayer, the declaration must be signed and dated by the taxpayer, and not his representative. In the case of a corporate taxpayer, the declaration must be signed and dated by a corporate officer with personal knowledge of the facts. If the corporate taxpayer is a member of an affiliated group filing consolidated returns, a penalty-of-perjury statement must also be signed, dated and submitted by an officer of the group's common parent. The person signing for a trust, a state law partnership or a limited liability company must be, respectively, a trustee, general partner or member-manager with personal knowledge of the facts. A stamped signature is not permitted.

Many practitioners have expressed concern that their clients will make a blanket waiver of privilege by disclosing all opinions or memoranda that provide a legal analysis of the tax shelter transaction. Several senior IRS officials have publicly stated that the Service is not seeking a blanket waiver of privilege. Instead, it seeks disclosure of the opinion or legal analysis that serves as the basis of the taxpayer's good faith-belief that a transaction's tax treatment more likely than not would be sustained on the merits if challenged. To address the waiver issue, the IRS has indicated that it is willing to discuss negotiating written agreements on the scope of any privilege or waiver.

As recently stated by Deputy Assistant Treasury Secretary for Tax Policy, Pamela Olsen, the IRS believes that "disclosure really matters" and that "penalties can apply if the taxpayer does not act in good faith in its dealings with the IRS, and the failure to disclose the transaction shows a lack of good faith."

FROM M. TODD WELTY, J.D., CPA, MEADOWS, OWENS, COLLIER, REED, COUSINS & BLAU, L.L.P., DALLAS, TX