Tax shelter transactions: to amend or not to amend?

In its ongoing efforts to crack down on promoters and taxpayers participating in tax shelters, the IRS has suggested that taxpayers should file amended returns to eliminate the shelter transaction's tax benefits. Setting aside the question of whether the Service will allow taxpayers who voluntarily amend to participate in a global settlement offered to all taxpayers who entered into a particular transaction, the Service's ambiguous regulations on qualified amended returns and its aggressive interpretation of the interest-suspension rules send mixed messages to taxpayers about whether to amend.

When Is an Amended Return Qualified?

An amended return may reduce or eliminate accuracy-related penalties if it qualifies. Sec. 6662(a) and (b) provide for a 20% penalty on an underpayment resulting from (among other things) negligence or a "substantial understatement of income tax" Under Sec. 6662(h), this penalty can increase to 40% of an underpayment if a taxpayer's adjusted basis is grossly misstated (i.e., overstated by 400% or more). In many tax shelter transactions, an asset's basis can become "enhanced" by more than 400%, and the IRS has been proposing the 40% penalty.

Regs. Sec. 1.6664-2(a) defines "underpayment" as the difference between the correct amount of tax and the "amount shown as the tax by the taxpayer on his return" Under Regs. Sec. 1.6664-2(c)(2) and (3), the latter includes "an amount shown as additional tax on a qualified amended return" except when an original return is fraudulent. Thus, a qualified amended return effectively eliminates accuracy-related penalties, by removing amounts shown on the amended return from the penalty calculation.

A "qualified amended return," according to Regs. Sec. 1.6664-2(c)(3)(i) and (ii), is an amended return, or administrative adjustment request, filed after the return's due date for the tax year (including extensions) and before the taxpayer or "any person described in section 6700(a) (relating to the penalty for promoting abusive tax shelters)" is first contacted by the IRS. Consistent with its promoter strategy, the Service has initiated a significant number of promoter examinations to obtain (among other objectives) tax shelter client lists. However, it is conducting most of the examinations under Secs. 6707 (failure to register penalty) and 6708 (failure to maintain investor list penalty), not under Sec. 6700 (promoting abusive tax shelters).

A number of tax advisers (and at least one senior IRS executive) interpret the regulations as providing that an amended return would be qualified even if the taxpayer filed it after the Service has initiated a Sec. 6707 or 6708 promoter examination, as long as the promoter is not under a Sec. 6700 examination when the taxpayer filed the amended return. The qualified amended return regulations, however, do not appear to contain the temporal element suggested by this interpretation.

Indeed, it appears that the IRS can nullify the penalty reduction or elimination effect of a putative qualified amended return filed after the initiation of a promoter examination under Secs. 6707 and 6708, simply by taking the position that the promoter is a "person described in section 6700," even if the Service neither seeks nor imposes Sec. 6700 penalties against the promoter. Absent further IRS clarification of its position on amended returns filed in such situations, many practitioners are uncomfortable in advising clients that an amended return accomplishes anything, other than possibly reducing the likelihood that the IRS will seek penalties.

How Is Interest Calculated?

Another consideration is the effect an amended return may have on calculating interest. Generally, interest accrues on any tax underpayment from the date tax was originally due. In 1998, Congress enacted Sec. 6404(g), which generally provides that interest stops accruing on an underpayment 18 months after the taxpayer filed the return, unless the Service provided a notice to the taxpayer specifically stating the taxpayer's liability and the basis for it. This rule is supposed to protect a taxpayer from mounting interest when the IRS has not given the taxpayer notice about any return item that may be improper. Interest does not begin to accrue again until the Service provides such notice.

Under Sec. 6404(g)(2)(C), interest is not suspended for any "interest, penalty, addition to tax, or additional amount with respect to any tax liability shown on the return." The legislative history of this exception supports the conclusion that Congress did not want to suspend interest on underpayments self-assessed on an original return. This makes sense, as Congress did not want to give a break on interest to taxpayers who simply failed to pay the tax shown on their return.

The IRS has been interpreting this "self-assessment" exception to interest suspension to apply to amounts shown on amended returns; see Memorandum for Commissioner, Small Business/Self-Employed Division Deputy Commissioner for Modernization/Chief Information Officer (Ref. No. 2002-10-187, September 2002) (available at www.ustreas.gov/ tigta/2002reports/200210187fr.html). This would be true even if a taxpayer filed an original return in good faith, relying on the advice of competent tax advisers, but later filed amended returns after learning that the IRS considers a transaction in which the taxpayer participated to be an "abusive tax shelter." Consequently, under the Service's interpretation of Sec. 6404(g)(2)(C), a taxpayer who files an amended return loses the benefit of interest suspension, while taxpayers who play the audit lottery would get the benefit of interest suspension (whether the IRS examines them at all). Obviously, the Service's current position on interest militates against filing amended returns.

Conclusion

If the IRS sincerely wants taxpayers to file amended returns, it should first clarify its position as to the definition of a qualified amended return, including whether it will (1) consider a promoter a person described in Sec. 6700 if the taxpayer files an amended return when the promoter is under examination under Secs. 6707 and 6708, and not Sec. 6700; or (2) disqualify the amended return because the promoter is a person described in Sec. 6700, even if the IRS never imposes a Sec. 6700 penalty. Second, the Service should modify its current interpretation of Sec. 6404(g)(2)(C), so that interest suspension applies to amended returns, as long as the taxpayer filed the original return in good faith.

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

Mark H. Ely, J.D., CPA

Partner

Washington National Tax

KPMG LLP

Washington, DC