Death of the corporate tax shelter?

The Taxpayer Relief Act of 1997 (TRA '97) contains two important provisions regarding tax shelters. The new provisions are designed to discourage corporate tax-payers from investing in the modern-day tax shelters that have been revived in the 1990s. One provision expands the requirements for registration of certain corporate tax shelters with the IRS by including plans and transactions subject to confIdentiality agreements, and also toughens the penalties that may be assessed for failure to comply with the revised registration and investor disclosure provisions.

The other provision expands the definition of a tax shelter for purposes of the Sec. 6662 substantial understatement penalty. Under the TRA '97, any arrangement with a "significant" tax-avoidance purpose will now be considered a tax shelter. In addition, the TRA '97 provides that the reasonable basis exception to the penalty will not be available to a corporate taxpayer when multiple-party financing transactions are involved and the taxpayer's treatment of the transaction does not clearly reflect income.

Tax Shelter Registration

Previously, Sec. 6111 required organizers or promoters of tax shelters to register them with the Service. Such registration primarily included information identifying the shelter and its promoter, and a description of the shelter's tax benefits as represented to the investors. The registration process resulted in an identification number being assigned by the IRS to the shelter; investors subsequently were required to include the identification number on their tax returns whenever deductions, credits or other tax benefits from the shelter any were claimed on their returns (Sec. 6707(b)(2)). As a means of enforcing compliance with the registration process, the Service could assess penalties for failing to (1) register, (2) provide investors with registration numbers and (3) report the assigned registration number on an investing taxpayer's tax return (Secs. 6707 and 6708).

This registration process was enacted in response to the tax shelters of the 1970s and early 1980s. Typically, the shelters marketed in these years involved rental real estate, oil investments, mining or other ventures designed to provide taxpayers (primarily individuals) with substantial deductions or tax credits with minimal investment on the taxpayer's part. Over the years, the registration of these types of tax shelters became primarily a mechanical process that served to notify the IRS of the shelter's existence, its investors and the tax benefits promoted. This notification often led to further investigation, subsequent audits and, in particularly egregious cases, litigation.

In the 1990s, however, a new type of tax shelter emerged. Aimed primarily at sophisticated corporate investors, these modern-day tax shelters are typically promoted by investment bankers, lawyers and accountants, and normally involve an offer to invest in the shelter under conditions of confidentiality. These new tax shelter investments promote substantial tax savings through the use of particularly complex business deals and structures.

The complex nature of the modern-day tax shelter investment has no doubt presented an audit and litigation challenge to the Service. Nowhere was this more evident than in the recent Tax Court case, ACM Partnership, TC Memo 1997-115, which involved one of the more complicated modern-day tax shelter investment vehicles. After an extremely lengthy trial that took nearly four weeks, involved 400 exhibits, 3,000 pages of transcript, dozens of expert witnesses and a virtual army of government litigators, the Tax Court concluded that the transaction involved lacked economic substance and was to be disregarded for tax purposes. The case is significant in the tax shelter area because it clearly demonstrated that the IRS is still willing to incur substantial expenses and time commitments to attack abusive tax shelters. Moreover, it reinforced the notion that modern-day tax shelter investments must, in addition to a legitimate business reason, have some degree of economic substance.

According to the Service, a desire to obtain up-front information about these new corporate tax shelter investments, with the hope that costly audit and litigation battles (such as those in ACM Partnership) could be avoided, were the driving force behind the new tax shelter registration procedures adopted in the TRA '97. It is anticipated that the new registration procedures in forthcoming Treasury guidance will be specifically designed to provide such up-front information to the IRS by requiring tax shelter promoters to register the shelter with the Service no later than the day on which the shelter is first offered to potential users. The registration will require the submission of information describing the shelter and the regulations will likely require the promoter to maintain lists of those potential users who have signed confidentiality agreements and those who have paid fees with respect to the shelter. For those tax shelters subject to the new provisions, the TRA '97 modifies the penalties that may be assessed on the failure of a promoter to register the investment; the IRS may now impose a penalty of the greater of $10,000 or 50% of all fees received from offerings made before the tax shelter is registered (Sec. 6707).

With this up-front registration provision and somewhat draconian penalty measures to ensure compliance, the Service will now be given even more time to unravel the complex business structures normally associated with these modern-day corporate tax shelters. At the same time, the IRS will also be given ample opportunity to determine whether there are valid economic and business purposes behind a particular transaction.

In addition, to ensure that the new law "catches" the tax shelters that are the focus of the Service's attention, the definition of a "tax shelter" in Sec. 6111 has been modified. Under the new law, tax shelters will include any entity, plan, arrangement or transaction, a significant purpose" (prior law required a "principal purpose") of which is the avoidance of Federal income taxes by a corporation, for which the promoters of such entity, plan, arrangement or transaction receive fees in excess of $100,000 in the aggregate and which is offered under conditions of confidentiality. In defining "confidentiality," an offer is deemed made under conditions of confidentiality if an offeree has an understanding or agreement with or for the benefit of a promoter that will limit disclosure of the tax shelter, or any other promoter of the tax shelter claims, knows or has reason to know that the tax shelter is proprietary to any person other than the offeree. Clearly, this new language brings the modern-day corporate tax shelters, with their confidentiality agreements, claims of propriety and fees well in excess of $100,000, squarely within the reach of the new provisions.

Substantial Understatement Penalty

Perhaps even more important, however, is the fact that the TRA '97 has expanded the Sec. 6662 substantial understatement penalty. Under the old language of Sec. 6662(d)(2)(C), a tax shelter was subject to the penalty provisions if it was determined that the principal purpose" of the investment was tax avoidance or evasion. Now, a tax shelter will Be subject to the penalty provisions when it is shown that a "significant purpose" of the investment is tax avoidance or evasion (Sec. 6662(d)(2)). Because the IRS might argue that almost any entity, plan, arrangement or transaction will now meet the "significant purpose" standard, this change places a particularly greater burden on corporations as they can avoid a Sec. 6662 substantial understatement penalty for a tax shelter item only if they meet the "reasonable cause and in good faith " requirements. As a result, a corporation that fails to prevail on a return position resulting from a tax shelter may avoid the substantial understatement penalty only by meeting the reasonable cause/good faith requirement, a facts-and-circumstances test under Regs. Sec. 1.6664-4(b)(1).

In addition, the new provisions provide the Service with the "clear reflection of income" doctrine as an additional weapon to fight abusive tax shelters. Sec. 6662(d)(2) has been amended to now provide that a corporation will not be treated as having a reasonable basis for its tax treatment of an item attributable to a multi-party financing transaction if such treatment does not clearly reflect the corporation's income. With this new tool available to attack tax shelters, and because the determination of what constitutes 11 a significant purpose" and "tax avoidance" or "tax evasion" and "tax minimization" is so subjective, practitioners should prepare themselves for increased controversies between the IRS and taxpayers over whether a penalty applies in a given situation involving a tax shelter.

Although the effective date for the revised tax shelter registration procedures is not until Treasury publishes regulations providing guidance in the area, the registration provisions in the TRA '97 are substantially similar to 1995 legislation that was passed by Congress but ultimately vetoed by the President. Thus, it is not likely to take Treasury very long to promulgate regulations in this area; practitioners should expect to see some guidance soon.

Meanwhile, the changes to the Sec. 6662 penalty provisions were effective on the President's signature. Accordingly, taxpayers (especially corporate taxpayers) should immediately begin to assess the increased risks associated with the broader definition of a tax shelter.

The tax shelter provisions in the TRA '97 will clearly make it easier for the Service to assert that a particular entity, plan, arrangement or transaction is a tax shelter. This fact alone will force many taxpayers to reconsider investing in a modern-day tax shelter. In addition, taxpayers should examine, prior to the investment, what steps need to be taken as a defense to an IRS assertion that the Sec. 6662 substantial understatement penalty applies. Under the new provisions, taxpayers (and in particular, corporate taxpayers) need to consider the fact that when investing in a corporate tax shelter, they may incur substantial costs beyond those of the investment bankers, attorneys and accountants. With the implementation of these new tax shelter provisions, it will be interesting to see the impact they will have on corporate tax shelter investments of the 1990s.

From William W. Ciesar, CPA, J.D., Chicago, Ill.