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Modified accuracy-related penalty for listed transactions and other reportable transactions.

Prior to the AJCA, noncorporate taxpayers were able to avoid imposition of the accuracy-related penalty for understatements 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 was more likely than not proper for that item. The exception was not available for corporate taxpayers.

New Law

AJCA Section 812 replaces the present-law Sec. 6662A accuracy-related penalty that applies to tax shelters with a new penalty that applies to listed transactions 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.

Disclosed transactions: In general, a 20% accuracy-related penalty applies to any understatement resulting from an adequately disclosed listed transaction or reportable avoidance transaction.

The only exception to the penalty is if the taxpayer satisfies a more stringent reasonable cause and good faith exception. The strengthened reasonable cause exception applies 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 tax treatment was more likely than not proper. A belief is reasonable only if it is based on the facts and law in existence at the time the tax return including the item is filed and relates solely to the taxpayer% chances of success on the merits.

A taxpayer cannot rely on a tax advisor's opinion to establish reasonable belief if the opinion (1) is provided by a "disqualified tax advisor" or (2) is a "disqualified opinion." Disqualified tax advisor: Under the provision, a disqualified tax advisor is one who:

1. Is a "material advisor" who participates in the "organization, management, promotion or sale of the transaction" or is related (under Sec. 267(b) or 707(b)(1)) to any such person;

2. Is compensated directly or indirectly by a material advisor for the transaction;

3. Has a fee arrangement for the transaction contingent on all or part of the intended tax benefits from the transaction being sustained; or

4. Has a disqualifying financial interest in the transaction, as determined under regulations.

The provision defines a "material advisor" as any person who provides any material aid, assistance or advice on organizing, managing, promoting, selling, implementing or carrying out any reportable transaction, and who derives gross income in excess of $50,000 for a reportable transaction, substantially all of the tax benefits from which are provided to natural persons ($250,000 in any other case). The provision considers a material advisor to be participating in the "organization" of a transaction if the advisor performs acts relating to the transaction's development, such as preparing documents that:

1. Establish a structure used in connection with the transaction (such as a partnership agreement);

2. Describe the transaction (such as an offering memorandum or other statement describing the transaction); or

3. Relate to the registration of the transaction with a Federal, state or local government body.

Under the provision, participation in the "management" of a transaction means involvement in the decision-making process regarding any business activity with respect to the transaction. Participation in the "promotion or sale" of a transaction means involvement in the marketing or soliciting of the transaction to others. For example, an advisor who provides information about the transaction to a potential participant is involved in the promotion or sale of a transaction, as is any advisor who recommends the transaction to a potential participant.

Disqualified opinion: The provision defines a disqualified opinion as an opinion that:

1. Is based on unreasonable factual or legal assumptions (including assumptions as to future events);

2. Unreasonably relies on representations, statements, findings or agreements of the taxpayer or any other person;

3. Does not identify and consider all relevant facts;

4. Fails to meet any other requirement prescribed by the IRS.

Undisclosed transactions: Taxpayers who do not adequately disclose the transactions are not eligible for the strengthened reasonable cause exception and are subject to a strict-liability penalty of 30% of the understatements.

Determination of the understatement amount: The penalty applies to the amount of any understatement attributable to the listed or reportable avoidance transaction, without regard to other items on the return. Under the provision, the amount of 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 of the item (without regard to other items on the return); and (2) the amount of any decrease in the aggregate amount of credits that results from a difference between the taxpayer's treatment of an item and the proper tax treatment of such item.

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

Effective Date

The new penalties are effective for tax years ending after Oct. 22, 2004.


These provisions make it imperative that taxpayers develop internal processes and controls to facilitate compliance with the Sec. 6011 rules. Further, new rules related to "disqualified advisors" and "disqualified opinions" also make it more difficult for taxpayers to meet the "reasonable cause" standard to avoid penalty assertions.

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Article Details
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Author:Manning, Paul
Publication:The Tax Adviser
Date:Jan 1, 2005
Previous Article:Modifications of substantial understatement penalty for nonreportable transactions.
Next Article:Modified penalty for failing to maintain investor lists.

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