Reportable transactions - what tax advisers need to know.

After the American Jobs Creation Act of 2004 (AJCA), reportable transactions have new importance to tax advisers and their clients, causing them extra concern. The risks for not disclosing such transactions have become significant. Although it was once felt that disclosure guaranteed an IRS audit, nondisclosure under the new rules creates even more problems.

Most tax advisers recommended disclosure only if they had knowledge that a client participated in a tax shelter. The only nondisclosure penalty was a substantial underpayment penalty. However, under the AJCA, new disclosure requirements for returns and statements due after Oct. 22, 2004 make noncompliance very costly. Tax advisers, as return preparers, could be liable for penalties, because they are viewed as the experts, whether or not they know about a reportable transaction. As such, clients have to be informed of additional requirements for preparing and filing returns, and tax advisers need to be able to identify reportable transactions.

Reportable Transactions

According to Regs. Sec. 1.6011-4(b), there are six categories of reportable transactions (unless otherwise noted, the rules generally apply to transactions entered into after Feb. 27, 2003):

1. Confidential transaction: A transaction in which (1) an adviser places a limit on disclosure by the taxpayer of the transaction's tax treatment or structure, to protect the confidentiality of tax strategies; and (2) the adviser has been paid a minimum fee of $50,000 by noncorporate taxpayers, or $250,000 by corporate taxpayers (effective for transactions entered into after Dec. 28, 2003).

2. Contractual protection: A transaction for which a taxpayer or related party has the right to a refund of all or part of the transaction fees paid, but only if (1) all or part of the intended tax consequences are not sustained under audit or (2) the fees were contingent on realizing tax benefits. The fees had to be paid to a person who made an oral or written statement as to the transaction's potential tax consequences, Rev. Proc. 2004-65 lists exceptions for fees based on the Sec. 51 work opportunity credit, the Sec. 51A welfare-to-work credit, the Sec. 45A(a) Indian employment credit and state tax liabilities.

3. Loss transactions: Any transaction that results in a loss of (1) at least $10 million in a single tax year or $20 million in any combination of tax years for corporations or partnerships with only corporate partners, or $2 million/$4 million, respectively, for individuals, S corporations, masts or all other partnerships; or (2) $50,000 in a single tax year for individuals or masts stemming from a foreign currency transaction under Sec. 988. There are exceptions in Rev. Proc. 2004-66 for assets with qualifying basis, casualty/involuntary conversion losses, certain mark-to-market and hedging losses, factoring transactions under Sec. 1221 and basis determinations under Sec. 338(b), and other types of transactions.

4. Significant book-tax differences: This applies to any transaction in which the amount for tax purposes of any item differs by more than $10 million gross from the amount for book purposes. This applies to Securities and Exchange Commission reporting companies and entities with more than $250 million in gross assets. There are exceptions in Rev. Proc. 2004-67 for any item for which the (1) book loss/expense is reported before or without a tax loss/deduction or (2) tax gain/ income is reported before or without book gain/income. There are also 33 other specific exceptions. If a company required to file Schedule M-3, Net Income (Loss) Reconciliation For Corporations With Total Assets of $10 Million or More, files it with a timely filed original return, it would be deemed under Rev. Proc. 2004-45 to have satisfied the disclosure requirements for book/tax purposes.

5. Brief holding period: A transaction for which a taxpayer claims a tax credit that exceeds $250,000 (including foreign tax credits (FTCs) and credits passed through to the taxpayer), if the taxpayer held the underlying asset giving rise to the credit for less than 46 days. There are exceptions in Rev. Proc. 2004-68 for (1) certain sales in the ordinary course of business involving FTCs; (2) brief holding periods due to certain hedges or guarantees; (3) transactions with debt instruments with terms of 45 days or less, if the holding period equals the term; and (4) transactions with FTCs from withholding taxes on nondividend income or gain not disallowed under Sec. 901(1).

6. Listed transactions: These are specific transactions as shown in the exhibit starting below (as of July 21, 2005). The IRS can modify listed transactions at any time; see www.irs.gov/businesses/corporations/article/0,,id=120633,00.html for updates.

Penalties

Under Sec. 6707A, taxpayers who fail to disclose reportable transactions can be subject to penalties for nonlisted transactions of $10,000 for natural persons and $50,000 for all others (per occurrence), and for listed transactions of $100,000 for natural persons and $200,000 for all others (per occurrence). These penalties are effective whether or not a client is aware of having entered into in a reportable transaction or participated in one.

According to Sec. 6707A(d)(1), the IRS may rescind all or a portion of the penalty if a reportable transaction is not a listed transaction and rescinding the penalty would promote compliance and effective tax administration. There is no authority to rescind penalties for listed transactions. Also, Sec. 6707(d) (2) provides that the penalties cannot be reviewed by any court, although a taxpayer could contest whether a transaction was reportable and, based on that determination, whether a penalty should have been imposed.

Besides the penalties noted above, the AJCA also added a new accuracy-related penalty under Sec. 6662A. A 20% understatement penalty may be levied if a reportable transaction was adequately disclosed, and a 30% understatement penalty if it was not disclosed. However, a reasonable cause exception, under which an understatement penalty will not apply, may be available under Sec. 6664(d) if (1) the transaction was adequately disclosed, (2) substantial authority exists and (3) the taxpayer reasonably believed that the treatment was more likely than not the proper treatment; see Sec. 6664. Under Sec. 6664 (d)(3)(B), the exception does not apply if the taxpayer relied on a "disqualified tax advisor" (an advisor who is a"material advisor" under Sec. 6111 (see below)) for advice.

Under the AJCA, there is an extended statute of limitations for reportable transactions if a taxpayer fails to submit a required disclosure; see Rev. Proc. 2005-26. The time for the assessment of tax on the reportable transaction will not expire before one year after the earlier of the date (1) on which the required information is submitted to the IRS or (2) the material advisor meets the list-maintenance requirements for the undisclosed reportable transaction in response to an IRS request.

Material Advisors

Under Sec. 6111(b)(1), a material advisor is any person who provides any material aid, assistance or advice related to organizing, managing, promoting, selling, implementing, insuring or carrying out any reportable transaction, and who directly or indirectly derives income in excess of $50,000 for such advice or assistance, when substantially all the tax benefits are provided to natural persons ($10,000 in the case of listed transactions), and $250,000 in any other case ($25,000 in the case of listed transactions). Material advisors must prepare and maintain a list of persons to whom they provide such advice or assistance, furnish such list to the IRS on request, and file Form 8264, Application for Registration of a Tax Shelter.

Form 8886

If a transaction has to be disclosed, Form 8886, Reportable Transaction Disclosure Statement, must be completed and attached to an original or amended return. The form must also be filed with the IRS Office of Tax Shelter Analysis. If taxpayers are unsure whether they participated in a reportable transaction, they may want to consider filing Form 8886 to avoid penalties.

Conclusion

Today, the IRS is investigating tax shelters on a regular basis. It continuously adds to the reportable transaction list and has been increasing penalties. There is no indication that it intends to let up soon. As a result, tax advisers will need to work more closely with their clients to determine whether they have reportable transactions.

Exhibit: Summary of listed and delisted transactions (as of July 21, 2005)

Listed transactions:

* Rev. Rul. 90-105 matching contributions: Contributions to a Sec. 401(k) or defined contribution plan are deducted by an employer as matching contributions attributable to the next year's compensation.

* Notice 95-34 (Secs. 419 and 419A plans): An employer makes contributions to welfare benefit plans allegedly falling within the multiemployer exception to the limited funding standards of Secs. 419 and 419A.

* ASA Investerings Partnership: Contingent installment sale of securities, with gain allocated to a tax-exempt party (such as a foreign entity) and loss recognized by the U.S. company; see ASA Investerings Partnership, 201 F3d 505 (DC Cir. 2000), and ACM Partnership, 157 F3d 231 (3rd Cir. 1998).

* Regs. Sec. 1.643(a)-8 (certain distributions from CRTs): Distributions are made by a charitable remainder trust (CRT) set up with highly appreciated property; the trustee borrows money and enters into a forward sale of the assets, which renders the distributions tax free.

* Notice 99-59 BOSS transactions: Arrangements under which a taxpayer acting through a partnership contributes cash to a foreign corporation in exchange for stock. The corporation borrows money from a bank and distributes securities to the partnership (which reduces the value of the remaining stock) and eventually repays the debt with other assets.

* Regs. Sec. 1.7701(1)-3 (fast pay or step-down stock): Dividends are paid on stock and defined as a return of capital rather than as a return on investment (can be structured when the dividend rate is expected to decline, or the stock is issued for an amount that exceeds the amount for which the holder is compelled to sell the stock).

* Rev. Rul. 2000-12 debt straddles: Two securities are purchased when one is going up in value and the other is going down at the same rate, and then the latter is sold.

* Notice 2000-44 "son of BOSS" transactions: Artificial deductible losses are generated when a taxpayer borrows at a premium, a partnership assumes the debt and receives the proceeds, and the taxpayer buys and writes options that create positive basis in the partnership interest by transferring them to the partnership.

* Notice 2000-60 stock compensation: A subsidiary buys parent stock and gives it to certain employees as compensation, and then is liquidated or sold.

* Notice 2000-61 Guam Trust." A trust is used to avoid U.S. and Guam income tax, by claiming that it is not subject to either income tax regime, under Sec. 935.

* Notice 2001-16 intermediary transactions tax shelter: A corporation's assets are sold following the purported sale of the corporation's stock to an intermediary.

* Notice 2001-17 Sec. 351 contingent liability: A taxpayer transfers assets to a corporation; the latter assumes a liability not yet taken into account for income tax purposes by the transferor.

* Notice 2001-45 Sec. 302 basis-shifting transactions: Transactions involving related parties that increase the basis of stock owned by a taxpayer; the taxpayer then sells the stock and claims a loss.

* Notice 2002-21 custom adjustable rate debt (CARD) transactions: CARD transactions involve loan assumptions that enable a taxpayer to claim an inflated basis in assets acquired from another party (not subject to U.S. tax), and the loan is substantially in excess of the assets' fair market value (FMV).

* Notice 2002-35 notional principal contracts: These contracts (swaps) are used to claim current deductions for periodic payments, without currently recognizing future noncontingent income rights.

* Notices 2002-50, 2003-54 and 2002-65 straddle tax shelters: These transactions use tiered passthough entities to claim deductions for noneconomic losses on foreign currency straddles.

* Rev. Rul. 2002-69 lease-in/lease-out (LILO) transactions: A taxpayer deducts expenses (e.g., rent and interest)incurred in connection with a LILO transaction that is properly characterized as a future interest in properly.

* Rev. Rul. 2003-6 abuses associated with S corp. ESOPs: Employee stock option plans (ESOPs) hold employer securities in an S corporation and claim eligibility for the delayed effective date of Sec. 409(p), to avoid current income and excise taxes for disqualified persons.

* Notice 2003-22 offshore deferred compensation arrangements: These arrangements involve companies that lease services to avoid or evade income and employment taxes.

* Notice 2003-24 exception for collectively bargained welfare benefit funds under Sac. 419A(f)(5): Transactions purport to meet the exception under Sec. 419A for collectively bargained agreements.

* Notice 2003-47 compensatory stock options to related persons: A person sells or otherwise disposes of a nonstatutory compensatory stock option (granted in connection with the performance of services, but not an incentive stock option) to a related person for an amount that includes any deferred payment.

* Notice 2003-55 lease strips and other strip transactions: One party claims to realize rental or other income from property, while another party claims the deductions related to that income (e.g., depreciation and rental expenses). This also includes certain assignments or accelerations of future payments as financings.

* Notice 2003-77 contested liability trusts: Contested liability trusts under Sec. 461(f) are used improperly (e.g., retention of certain powers; transfers of debt to provide services or properly in future years; transfers of taxpayer's stock, or stock or note of a related party; transfers for workers' compensation, or tort or other liability, unless payment is made to the claimant or the liability to the claimant is discharged).

* Notice 2003-81 offsetting foreign currency option contracts: A party claims a loss on the assignment of a Sec. 1256 contract (foreign currency contract) to a charity, but fails to recognize gain when the obligation under an off. setting non-See. 1256 contract terminates.

* Notice 2004-8 abusive Roth IRAs: An individual, related persons or a business controlled by the individual or related persons, engages in one or more transactions with a corporation, including contributions of properly when substantially all the shares are owned by one or more Roth IRAs maintained for the benefit of the individual or related persons.

* Rev. Rul. 2004-4 prohibited allocations of securities in an S corp.: Prohibited allocations of securities in an S corporation, when (1) at least 50% of the corporation's outstanding shares are employer securities held by an ESOP; (2) the corporation's profits generated by a specific individual's business activities are accumulated and held in a qualified subchapter S subsidiary (QSub) or limited liability company (LLC) for his or her benefit; (3) the profits are not paid to the individual as compensation within 2 1/2 months of year-end; and (4) the individual has rights to acquire 50% or more of the FMV of the shares held in the QSub or LLC.

* Rev. Rul. 2004-20 insurance policies in Sec. 412(i) plans: A qualified Sec. 412(i) pension plan holds life insurance and annuity contracts for a perticipant's benefit, which provides for benefits at normal retirement age in excess of the participant's benefits at normal retirement age under the plan by more than $100,000.

* Notice 2004-20 FTC: Transactions under a prearranged plan, in which a domestic corporation acquires stock in a foreign target and makes a Sec. 338 election before selling all (or substantially all) of the target's assets subject to foreign income tax.

* Notice 2004-30 shifting S corporation income to exempt organization: S shareholders attempt to transfer the tax on S income by donating S nonvoting stock to an exempt organization, while retaining the economic benefits associated with that stock.

* Notice 2004-31 intercompany financing through partnerships: A corporation claims inappropriate deductions (See. 163(j) excess interest paid to foreign or exempt entities) for payments made through a partnership.

* Notice 2005-13 sale-leaseback (SILO) transactions: Transactions purport a sale-leasebock arrangement with a tax-indifferent person; that person's obligations are released, and the taxpayer's risk of less and opportunity for appreciation in the property are limited.

Transactions delisted:

* Notice 2004-19 FTC: Under Notice 98-5, for transactions in which the expected economic profit is insubstantial in comparison to the value of the expected FTCs.

* Notice 2004-64: Modification of exemption for small property and casualty insurance companies.

* Notice 2004-65 reinsurance arrangements: Under Notice 2002-70, for reinsurance arrangements between a taxpayer and its own reinsurance company that are subject to little or no Federal income tax.

Editor's note: Mr. Holub is the former chair of the AICPA Tax Division's Tax Practice Management Committee. Mr. Muirhead is the Chair of the AICPA Tax Division's Tax Practice Improvement Committee. Ms. Schaefer is a member of that Committee.

Implementation Checklist

Below are a few steps tax advisers can take to avoid the new risks and penalties associated with not disclosing reportable transactions.

[] Create resources on common reportable transactions, including a quick reference guide to the underlying transactions, and situate them in a central location (such as an intranet) for easy accessibility.

[] Assign one person or the tax department to assist in determining whether disclosure is necessary.

[] Identify key areas in which particular clients may be at risk.

[] Educate partners and staff on how to discuss potential reportable transactions with clients.

[] Develop tools to communicate the risks and requirements of reportable transactions to clients, such as through newsletters, specific mailings, meetings and telephone.

[] Prepare a checklist to be used for all tax returns.

[] Establish tax policy and guidelines to protect the firm from liability and bad press.

For more information about this column, contact Mr. Holub at [phone] or [e-mail], or Ms. Schaefer at [phone] or [e-mail].

Co-Editors:

Steven F. Holub, CPA 

Aidman, Piser & Co.

Tampa, FL

T. Chris Muirhead, CPA

Porter, Muirhead, Cornia & Howard

Casper, WY

Author:

Rene C. Schaefer, MST, CPA

Principal

Suby, Von Haden & Associates, S.C.

Brookfield, WI