Abusive Tax Shelters
Heavy Penalties Under the American Jobs Creation Act of 2004

By James G.S. Yang, Agatha E. Jeffers, and Beixin Lin

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KPMG sold tax shelters to at least 350 people, which brought the firm $124 million in fees and cost the Treasury $1.4 billion in unpaid taxes between 1996 and 2002. On June 16, 2005, KPMG issued a statement acknowledging “full responsibility for unlawful conduct by former partners during that period.” As a consequence, KPMG, LLP, agreed to pay $456 million in fines, restitution, and penalties as part of an agreement to defer prosecution. Subsequently, KPMG reached a $225 million settlement in a class-action suit covering 275 former tax-shelter clients.

Tax shelters have become so widespread and abusive that Congress has taken action. The American Jobs Creation Act (AJCA) of 2004 includes provisions that impose hefty penalties for failure to report tax shelters. In addition, the IRS amended Circular 230 to enhance its ethical standards for attorneys, CPAs, enrolled agents and actuaries, and tax professionals regarding tax-shelter advice.

New Reporting Requirements

New information return. Under the AJCA, each material advisor with respect to any reportable transaction is required to file a new information return that includes information identifying and describing the transaction, information describing any potential tax benefits expected to result from the transaction, and any other information sought by the IRS.

List of advisees. Each material advisor to any reportable transaction must maintain a list that identifies each person advised with respect to the reportable transaction, and that contains any other information that may be required by regulations. The filer must make the list available to the IRS for inspection upon written request, and must retain the information for seven years.

Extended statute of limitations. As a general rule, a three-year statute of limitations applies to most tax returns. Under the AJCA, however, if a taxpayer fails to include any required information in a tax return or statement relating to a listed transaction, the statute of limitations with respect to that transaction will not expire before one year after the earlier of the date on which the information is furnished to the IRS or the date that a material advisor meets the list-maintenance requirements of IRC section 6112. In other words, the statue of limitations for tax shelters may possibly be extended from three to as long as four years.

Listed and reportable transactions. A listed transaction is a reportable transaction that is the same as, or substantially similar to, a transaction specifically identified by the Treasury Department as a tax avoidance transaction; in other words, a tax shelter determined by the IRS to be abusive and therefore unlawful. A reportable transaction is any transaction for which information is required to be included with a return or statement because the Treasury Department has determined such a transaction has the potential for tax avoidance or evasion. A reportable transaction has a much broader scope than a listed transaction. Therefore, a listed transaction is a reportable transaction, but not vice versa. In this sense, the treatment of a reportable transaction can be very ambiguous and can be contested by a taxpayer.

Example. Andy is engaged in a partnership transaction as a tax shelter that results in tax benefits on his income tax returns filed on April 15 of 2006 and 2007, but he failed to disclose the required tax-shelter information in the return. On May 15, 2009, the IRS disallowed the partnership transaction as an abusive tax shelter. For the 2006 tax return, the statute of limitations expires after three years, on April 15, 2009. Because the IRS’s decision was made on May 15, 2009, after the close of the statute for the 2006 return, the 2006 tax return is not subject to the extended statute of limitations.

For the 2007 tax return, however, the statute of limitations will not expire until after April 15, 2010. Because the IRS’s decision was made well before this date, the 2007 tax return is subject to the extended statute of limitations as a listed transaction. The IRS has the right to audit Andy’s 2007 return until April 15, 2011.

New Penalty for Failure to Disclose Tax Shelters

Amount of penalty. The AJCA imposes a new, separate penalty on any person who fails to include on his tax return any required information or statement with respect to a tax shelter. The penalty depends upon whether it is a reportable transaction or a listed transaction. It further depends upon whether the transaction is committed by a natural person or by a business entity. The penalty amounts are:

This penalty is in addition to any other penalty, such as an accuracy-related penalty, that may be imposed on the taxpayer.

Rescission of penalty. The IRS may abate or rescind a penalty in whole or in part, but only if the transaction at issue is not a listed transaction and the rescission would promote effective tax administration and compliance with the tax laws. In the case of a reportable transaction, however, the IRS can waive the penalty. Further, the IRS’s decision regarding the rescission of a penalty is not subject to judicial review. Although the Tax Court has no authority to review the IRS’s rescission determination, the court can review whether the transaction at issue is reportable.

Example. Bob, an individual taxpayer, failed to report a reportable transaction that resulted in a $10,000 penalty. He also failed to report a listed transaction that entailed a $100,000 penalty. The IRS decided to reduce the penalty on the reportable transaction from $10,000 to $8,000, but not to reduce the $100,000 penalty on the listed transaction.

If Bob were to file a petition claiming rescission for all penalties on both transactions, the court cannot do anything, because it is the IRS’s sole authority to decide by how much the penalty on the reportable transaction can be reduced, and whether the penalty on the listed transaction can be rescinded at all.

After receiving a refusal of hearing by the court, Bob can file another petition to the court contending that both the reportable transaction and the listed transactions were not reportable in the first place. In this case, the court can hold a hearing to decide whether both transactions are reportable and thus subject to penalties. The issue of whether a transaction is reportable is not the same as the rescission determination of a penalty.

Increased Penalty on Tax-Shelter Promoters

The IRC imposes a civil penalty on promoters of abusive tax shelters. Before the AJCA, the penalty for making a false or fraudulent statement was the lesser of $1,000 or 100% of the gross income derived, or to be derived, from the tax-shelter activity by the person. For purposes of computing this penalty, the organization of an entity, plan, or arrangement and the sale of each interest in an entity, plan, or arrangement are separate activities subject to penalty. In other words, the penalty for each activity is counted separately, and those amounts are then added together to derive the total amount of the penalty.

Under the AJCA, for a person who knowingly makes, or causes another to make, a false or fraudulent tax benefit statement of a material matter pertaining to a tax-shelter plan, the penalty is increased to 50% of the gross income derived, or to be derived, from the abusive plan. Nevertheless, for purposes of computing this penalty, all activities are added together first, and the 50% penalty is then applied to the aggregate income.

Example. In 2004, Charles was engaged in establishing a cattle-breeding tax-shelter arrangement for his clients. This tax shelter was determined to be abusive and thus unlawful. Charles made a false representation to his clients claiming benefits of an income tax deduction. He received $900 in fees from the first client and an additional $3,000 in fees from each of the next 10 clients. What is the amount of penalty for promoting the abusive tax shelter after the 2004 Act? What would have the penalty been before the AJCA?

Before the AJCA, the penalty was computed for each client separately. The penalty for the first client would have been the lesser of $1,000 or 100% of $900, resulting in a penalty of $900. For each of the next 10 clients, the penalty would have been the lesser of $1,000 or 100% of $3,000, resulting in a penalty of $1,000 for each client. Therefore, the total penalties for all 11 of Charles’ clients would have been $10,900 [$900 + ($1,000 x 10)].

Under the AJCA, the penalty is computed on the basis of gross income in the aggregate amount for all 11 clients as a whole. Because the gross income is $30,900 [$900 + ($3,000 x 10)], the 50% penalty would be $15,450 ($30,900 x 50%).

Charles’ penalties have increased by $4,550 ($15,450 – $10,900) as a result of the AJCA. These larger penalties are aimed at deterring tax-shelter abuses.

This increased penalty does not apply to gross valuation overstatements. Any person who makes, or causes another to make, a gross valuation overstatement continues to be subject to a penalty equal to the lesser of $1,000 or 100% of the gross income derived, or to be derived, from such activity. This penalty may be waived if a reasonable basis for the valuation is shown and the statement was made in good faith.

Increased Penalty for Failure to Furnish Information on Reportable Transactions

An organizer of a tax shelter is required to register the tax shelter with the IRS on Form 8264, Application for Registration of a Tax Shelter, on the first day the tax shelter is offered for sale. The registration must provide information identifying and describing the tax shelter, the tax benefits expected by investors in the tax shelter, and other required information. If the tax shelter is registered but the organizer provides false or incomplete information, an additional penalty is imposed.

To encourage compliance with the disclosure requirements of a reportable transaction, the penalty for failure to furnish required information with respect to a reportable transaction has been increased to $50,000 under the AJCA. More important, in the case of a listed transaction, the penalty is the greater of $200,000 or 50% of the gross income derived by the individual. This 50% limit is raised to 75% if an intentional failure or action is involved.

Modified Penalty for Failure to Maintain Investor Lists

Any person who organizes and sells potentially abusive tax shelters is required to maintain a list identifying each person who purchases an interest in any such tax shelter, along with any additional information required by the IRS. Upon receipt of a written request from the IRS, an individual must make those lists available within 20 business days, or be subject to a $10,000 penalty per day thereafter. Prior to the AJCA, the penalty for maintaining an incomplete investor list was $50 per name omitted, with a maximum penalty of $100,000 per year.

New Accuracy-Related Penalty for Listed and Reportable Transactions

Any tax underpayment arising from negligence or disregard of the regulations is subject to an accuracy-related penalty. This includes tax-shelter transactions. Any taxpayer who participates in a tax-shelter transaction must file Form 8886, Reportable Transaction Disclosure Statement. Prior to the AJCA, the penalty was equal to 20% of the amount of underpayment.

Under the AJCA’s provisions, a new accuracy-related penalty is provided for understatement resulting from any listed transaction and reportable transactions designed with a significant tax-avoidance purpose. The penalty is generally 20% of the understatement if the taxpayer disclosed the transaction and 30% if the transaction was not disclosed. The penalty applies only to the amount of the understatement that is attributable to the listed or reportable transaction.

The accuracy-related penalty on abusive tax shelters is always 35% for individuals or corporations, regardless of a taxpayer’s marginal tax bracket.

Example. David is an individual taxpayer in the 15% bracket. He invested in an oil-drilling partnership intended to be a tax shelter, but never participated in its management. He did not register by filing Form 8886. In 2004, the business incurred a loss, and David’s share was $40,000. The partnership also claimed a business energy tax credit, and David’s share was $1,000. He filed his 2004 tax return by claiming the $40,000 loss as a deduction from compensation income, alongside the $1,000 tax credit. The IRS ruled the business an abusive tax shelter. What is the amount of tax understatement? What is David’s accuracy-related penalty? What is his final tax liability?

The tax understatement for the $40,000 disallowed loss deduction is $14,000 ($40,000 x 35%). Together with the $1,000 disallowed tax credit, the total tax understatement is $15,000. Because David failed to register the tax shelter, the penalty is 30% of the $15,000 total tax understatement, or $4,500. Therefore, David’s total tax liability is $19,500 ($15,000 + $4,500). Although David’s tax bracket is only 15%, his $40,000 excess-loss deduction is taxed at the highest individual tax rate of 35%. It results in an additional tax understatement of $8,000 [$40,000 x (35% – 15%)], of which the additional penalty is $2,400 ($8,000 x 30%). In total, the additional tax liability is $10,400 ($8,000 + $2,400).

Had David registered the tax shelter with the IRS by filing Form 8886, the accuracy-related penalty rate would have been only 20%, meaning his penalty would have been only $1,600, rather than $2,400.

Had David “materially participated” in the management of the partnership business and also registered with the IRS by filing Form 8886, the $40,000 loss would have been deductible, the $1,000 tax credit would have been allowed, and the 30% penalty on the tax understatement would have been eliminated. The entire additional $19,500 tax liability could have been avoided. The penalty for nonregistration can be hefty indeed.

Because this business is most likely a “listed transaction,” the IRS, under the AJCA, could probably impose an additional, highly punitive, $100,000 penalty for failure to register the shelter.

Penalty coordination. In sum, the listed and reportable transactions penalty is coordinated with three other penalties:

• Accuracy-related penalties: The understatement attributable to listed and reportable transactions is included in the amount of the taxpayer’s total understatement for purposes of determining whether the taxpayer has a substantial understatement of tax. However, the understatement attributable to a listed or reportable transaction is not included in the taxpayer’s total understatement for purposes of calculating the accuracy-related penalty.
• Fraud penalties: An understatement for purposes of the fraud penalty includes understatements attributable to listed and reportable transactions.
• Valuation misstatement penalties: These valuation misstatement penalties do not apply to any portion of an understatement on which the listed and reportable avoidance transaction penalty was imposed.

Denial of Interest Deduction

Before the AJCA, interest paid or accrued on delinquent federal or state taxes and on debt used to pay such taxes was nondeductible for individuals, but it was deductible for corporations as an ordinary and necessary business expense. The AJCA made the interest related to the underpayment of tax in connection with an undisclosed tax shelter also nondeductible for corporations.

Expanded Authority to Enjoin Material Advisors

The government may seek an injunction against any person—a material advisor—who knowingly aids and abets in the understatement of the tax liability of another person by failing to file an information return with respect to a reportable tax-shelter transaction as required by regulations and subject to penalty, or by failing to maintain, or to timely furnish upon written request by the IRS, a list of investors with respect to each reportable tax-shelter transaction as required by regulations.

Enhanced Ethical Standards: Amended Circular 230

The Treasury Department upgraded Circular 230 to enhance ethical
standards through the following best practices:

• Communicating clearly with the client regarding the terms of the engagement.
• Establishing the relevant facts, evaluating the reasonableness of assumptions, relating the applicable law to the relevant facts, and arriving at a conclusion.
• Advising the client regarding the importance of the conclusions reached and the reliance that can be placed on the advice.
• Acting with integrity in practice before the IRS.

It is hoped that these measures will curb many of the abuses of the past.

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