Penalty Zone
Strict liability provisions could penalize you!
By Harvey Coustan, CPA
Last September, the Internal Revenue Service published temporary regulations interpreting the “strict liability” provisions of Code Section 6707A, which penalizes the taxpayer’s failure to disclose reportable transactions. The temporary regulation verbiage doubled as the text for the proposed regulations.
To refresh your memory, temporary regulations have the same effect as final regulations. Using them as proposed regulations (which are usually not effective until final regulations are issued) means that the IRS is looking for comments before they’re issued in final form. However, in the interim, they have the same impact as final regulations.
Disclosure of listed and other reportable transactions is required under Regulations Section 1.6011-4 for income tax returns. Other sections require disclosure of certain transactions for estate tax (§20.6011-4), gift tax (§25.6011-4), employment tax (31.6011-4), and certain excise tax purposes.
Taxpayer penalties for failure to disclose are quite severe. Section 6707A has one set of penalties for “listed” transactions and another for reportable transactions that are not listed. This seems logical, because listed transactions are those that the IRS has targeted as “tax avoidance transactions,” and has specifically identified in published guidance. If an individual taxpayer fails to disclose a listed transaction, the penalty is $100,000. A taxpayer that is not an individual, (e.g., a corporation) will pay $200,000. The penalty for an individual taxpayer who fails to disclose a reportable transaction that is not a listed transaction is “only” $10,000, and the penalty for a taxpayer other than an individual is $50,000.
Since a taxpayer can’t claim there was a “reasonable cause” for non-disclosure, the penalty seems especially severe. The IRS does have the ability to rescind the penalty if the failure to disclose doesn’t involve a listed transaction. A significant portion of the temporary regulations is devoted to discussing factors the IRS will consider in making a decision to rescind. Nevertheless, the decision is not subject to judicial review so the IRS’s word is final, which is why I call this penalty a “strict liability” penalty.
First, a quick review of the disclosure requirements of Treasury Regulations §1.6011-4. There are four categories of reportable transactions other than listed transactions.
1. Confidential transactions: Those offered under conditions of confidentiality so that the taxpayer’s disclosure of the structure or tax aspects of the transaction is restricted or limited. This applies even if the restriction or limitation is not legally binding. Also, the taxpayer needs to have paid the advisor a minimum fee of $250,000 for corporate taxpayers and $50,000 for most other taxpayers.
2. Contractually protected transactions: Where the taxpayer has been contractually protected against total or partial loss of tax benefits. Contingent fee arrangements are one example.
3. Losses in excess of certain thresholdamounts deductible under Section 165: Thresholds for corporations are $10 million in a single year and $20 million in any combination of years, with other thresholds for other taxpayers.
4. Transactions of interest: Those for which the IRS does not have sufficient information to classify as “listed” transactions. Listed transactions are those that the IRS has identified specifically in published guidance as tax avoidance transactions, and those that are “substantially similar” to the identified transactions.
The transaction has to be disclosed on the tax return for each year the taxpayer participates in the transaction, with a copy also sent to the IRS Office of Tax Shelter Analysis (OTSA) in the first year of participation. If an amended return is filed, the disclosure statement must be included. A special rule applies if a taxpayer receives a timely K-1 less than 10 days before the taxpayer’s return due date. The current prescribed form is Form 8886. If the transaction becomes a listed transaction or a transaction of interest after the taxpayer’s return is filed, but before the end of the statutory period for additional assessments, then the disclosure statement has to be filed with the OTSA within 90 days after it becomes a listed transaction or a transaction of interest.
The temporary regulations impose a penalty for each failure to file, as well as for an incomplete filing, but only one penalty will be imposed if the taxpayer fails to disclose a transaction and fails to send the required copy to the OTSA.
The temporary regulations generally adopt the same list of factors that the IRS has previously considered when deciding to rescind a penalty (see Revenue Procedure 2007-21), but with one significant addition involving materiality. The factors are:
• The taxpayer, upon becoming aware of its failure to file, files a complete and properly prepared Form 8886 (or successor form). This factor will weigh heavily in favor of rescission if it is filed prior to the IRS’s first contact with the taxpayer concerning an IRS examination of the return for the year in which the taxpayer participated, and other circumstances suggest that the taxpayer did not delay the filing until after the IRS had taken steps to identify the taxpayer’s participation in the reportable transaction.
• Failure to disclose was due to an unintentional mistake of fact despite the taxpayer’s reasonable attempt to ascertain the correct facts with respect to the transaction.
• The taxpayer has an established history of properly disclosing other reportable transactions and complying with other tax laws.
• The taxpayer establishes that the failure to disclose arose from events beyond the taxpayer’s control.
• The taxpayer cooperates with the IRS by providing timely information requested by the IRS while rescission is being considered.
• Assessment of the penalty weighs against equity and good conscience, including the fact that the penalty is disproportionate to the tax benefit received, the taxpayer demonstrates that there was reasonable cause, and that it acted in good faith with respect to the failure to properly disclose the transaction. (This is where materiality is considered and the only place where having a reasonable cause for the failure may be helpful.)
Section 6707A also imposes penalties on SEC registrants that do not disclose penalties assessed under §6707A for failure to disclose listed transactions and certain other penalties. This penalty is not subject to rescission.
Final regulations in this area are yet to come, but my hunch is that there will be few substantive changes. In the meantime, these temporary regulations became applicable to disclosure statements due on September 12 of last year and after.
Harvey Coustan is an Ernst & Young retired partner. He is presently consulting on substantive technical and professional standards issues and has been an expert witness in a number of cases.