Increased Scrutiny of Reportable Transactions
Final Disclosure Requirements and New Nondisclosure Penalties

By John K. Cook, Jr.

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Background

IRC section 6011(a) imposes a general requirement on taxpayers to “make a return or statement according to the forms and regulations prescribed by the [Treasury] Secretary.” On February 28, 2000, the IRS issued temporary regulations under section 6011 requiring taxpayers to disclose various transactions that, in the IRS’s view, were potentially abusive. [While Treasury Regulations section 1.6011-4(a), discussed here, relates to federal income tax, similar rules exist with respect to other taxes, such as the estate tax (section 20.6011-4) and the gift tax (section 25.6011-4).]

These transactions are referred to in the regulations, and in subsequently enacted legislation, as “reportable transactions.” The temporary regulations were modified and reissued several times before being finalized in early 2003. In general, the final regulations are both broader in scope and stricter than the temporary regulations. In the final regulations, disclosure of broad classes of transactions is required and disclosure is required regardless of whether the taxpayer’s intent when entering into the transaction is improper tax avoidance.

In terms of enforcement, the IRS quickly realized that many taxpayers were choosing not to report arguably reportable transactions. This lack of compliance resulted, to a great extent, from the lack of any specific penalty for a failure to comply with the regulations. As a consequence, Congress, in the American Jobs Creation Act of 2004 (AJCA), enacted several new penalties, and enhanced already-existing penalties, for failures to report reportable transactions as required under the final section 1.6011-4 regulations.

The general rule embodied in the final Treasury Regulations section 1.6011-4 is that every taxpayer who has participated in a reportable transaction must disclose that transaction on their return. This rule represents a fundamental change in approach from the prior temporary regulations. Whereas the temporary regulations had generally allowed taxpayers to consider a number of factors in determining whether a transaction was reportable, the final regulations require disclosure of broad classes of potentially abusive transactions, and there are no exceptions from disclosure, except through published guidance or private letter ruling. The taxpayer’s intent (e.g., potential tax avoidance) is irrelevant to the disclosure requirement. (But see below for the section 6662A penalty, which does consider if the transaction had a significant tax avoidance or evasion purpose.)

Key Terms and Concepts

Transaction. A transaction, according to Treasury Regulations section 1.6011-4(b)(1), “includes all of the factual elements relevant to the expected tax treatment of any investment, entity, plan, or arrangement, and includes any series of steps carried out as part of a plan.” This broad definition is generally intended to cast as wide a net as possible.

Participation. Somewhat confusingly, Treasury Regulations section 1.6011-4(c)(3)(i) contains a different definition of “participation” for each reportable transaction. Generally, however, a taxpayer has “participated” in a reportable transaction if the taxpayer’s federal income tax return reflects a benefit from such transaction.

Reportable transactions. There are six categories of reportable transactions [Treasury Regulations section 1.6011-4(b)]:

• Listed transactions
• Confidential transactions
• Transactions with contractual protection
• Loss transactions
• Transactions with a significant book-tax difference
• Transactions involving a brief asset-holding period.

While none of these transactions—other than, arguably, listed transactions—are inherently abusive, all are perceived by the IRS as potentially abusive transactions and therefore are required to be disclosed. Each type of reportable transaction is briefly described below.

Listed transactions. A listed transaction is a transaction that is the same as or substantially similar to a type of transaction identified by the IRS through guidance (e.g., a notice or regulation) as a tax avoidance transaction [Treasury Regulations section 1.6011-4(b)(2)]. A transaction is “substantially similar” to a listed transaction when it is “expected to obtain the same or similar types of tax consequences” and is either factually similar to a listed transaction or is based on the same or similar tax strategy. According to Treasury Regulations section 1.6011-4(c)(4), the term “substantially similar” is intended to be broadly construed in favor of disclosure.

Confidential transactions. A confidential transaction is one offered to a taxpayer under “conditions of confidentiality” and for which the taxpayer has paid an advisor a “minimum fee” [see Treasury Regulations section 1.6011-4(b)(3)(i) through (iv)]. Conditions of confidentiality exist if an advisor with respect to the transaction limits disclosure of the transaction’s tax structure or tax treatment and when such limitation on disclosure protects the confidentiality of the advisor’s tax strategies. A minimum fee for these purposes is defined as $250,000 if the taxpayer is a corporation (including trusts whose beneficiaries are all corporations, and partnerships whose partners are all corporations) and $50,000 for all other taxpayers.

In determining whether an advisor has been paid a minimum fee, all fees paid for a tax strategy or for advice (whether or not tax advice) or for the implementation of a transaction are included. These fees include consideration in whatever form paid, whether in cash or in kind, for services to analyze the transaction (whether related to tax consequences or not), for services to implement the transaction, for services to document the transaction, and for services to prepare tax returns to the extent that the fees exceed the fees customary for return preparation. For these purposes, a taxpayer also is considered to be paying fees to an advisor if the taxpayer knows or should know that the amount paid to a third party will be paid indirectly to the advisor, such as through a referral fee or a fee-sharing arrangement.

Transactions with contractual protection. Transactions with contractual protection are those where a taxpayer has a right to a full or partial refund of fees if all or part of the intended tax consequences are not realized, or where the fees are contingent upon realization of tax benefits [Treasury Regulations section 1.6011-4(b)(4)(i)].

One notable exception is that this general rule applies only to fees paid to a person who makes or provides a statement to the taxpayer regarding the “potential tax consequences” of a transaction. If no such statement is made, the transaction (at least with respect to that advisor) is not a transaction with contractual protection. Additionally, the contractual protection must relate to federal income tax treatment of the transaction. Thus, contractual protection with respect to fees that are contingent upon something other than the tax treatment of a transaction (e.g., a break-up fee in a merger transaction) would not cause the transaction to be reportable. Moreover, the mere right to terminate a transaction (e.g., upon receipt of an unfavorable ruling) does not constitute contractual protection. Finally, the rule specifically does not encompass fees paid with respect to transactions previously reported on the taxpayer’s federal income tax return. Thus, contingent fees paid with respect to a claim for refund would not cause a transaction to be reportable.

Loss transactions. A loss transaction is any transaction resulting in a gross loss under IRC section 165 that exceeds certain dollar thresholds [see Treasury Regulations section 1.6011-4(b)(5)]. For corporations, including partnerships with only corporate partners, the threshold is $10 million in a single year or $20 million over a six-year period beginning with the year the loss transaction is first entered into. For individual taxpayers and other partnerships, the threshold is $2 million in a single year or $4 million over a six-year period beginning with the year the loss transaction is first entered into. With respect to individuals or trusts, any loss transaction in excess of $50,000 (singly or cumulatively) realized in an IRC section 988 transaction (i.e., certain foreign currency transactions) is a “reportable transaction.”

Recognizing that this definition of a loss transaction necessarily encompasses a number of routine, non–tax avoidance transactions, the IRS has excepted many such transactions from the reporting requirements. For example, Revenue Procedure 2004-66 (2004-50 IRB 966) has excepted from the reporting requirements assets having a “qualifying basis” as well as certain transactions commonly referred to as “angel transactions.”

Under Revenue Procedure 2004-66, an asset with a “qualifying basis” is generally an asset the basis of which is determined by cash purchase (including purchase money debt) or determined in a carryover basis transaction. Transactions that have been excepted from the reporting requirements as angel transactions include, most notably, casualty or theft losses, hedging losses, and abandonment losses.

Transactions with a significant book-tax difference. Transactions with a significant book-tax difference are those transactions where the tax treatment of any item of income, gain, expense, or loss differs by more than $10 million on a gross basis from the book treatment (i.e., U.S. GAAP) of such item in any taxable year [Treasury Regulations section 1.6011-4(b)(6)(i)]. This type of reportable transaction applies only to publicly traded companies or very large private companies.

As was the case with loss transactions, the IRS initially issued guidance in Revenue Procedure 2004-67, 2004-50 IRB 967, excepting many ordinary business transactions from disclosure as significant book-tax difference transactions. The most frequently encountered examples included the following:

• Depreciation or amortization
• Bad debts
• Federal, state, local, and foreign taxes
• Corporate reorganizations
• Like-kind exchanges
• Gains or losses from F/X
• Sale or lease for book versus financing for tax
• Inventory differences, including LIFO.

Subsequently, the IRS announced in Notice 2006-6 that the significant book-tax difference category of reportable transaction would no longer be reportable. This position has been confirmed in proposed Treasury regulations section 1.6011-4, issued on November 1, 2006, wherein the IRS completely removed this category of reportable transaction. This change was made in recognition by the IRS that new Schedule M-3 (Form 1120) “provides the IRS a more complete disclosure of book-tax differences for corporations.” Thus, transactions with significant book-tax differences entered into after January 5, 2006, need not be disclosed, unless otherwise disclosable under another provision of section 1.6011-4.

Transactions involving a brief asset-holding period. A transaction involving a brief asset-holding period is any transaction that results in the taxpayer’s claiming a tax credit exceeding $250,000 if the underlying asset is held by the taxpayer for 45 days or less [Treasury Regulations section 1.6011-4(b)(7)]. In response to the enactment of sections 901(l) and 901(k) of the AJCA, which disallow foreign tax credits for withholding and certain other foreign taxes imposed on dividends or other income or gain with respect to property if the taxpayer does not meet a minimum holding period, the proposed Treasury Regulations section 1.6011-4, issued November 1, 2006, excludes from this category transactions resulting in a claimed foreign tax credit.

Transactions of interest. The proposed Treasury Regulations section 1.6011-4, issued November 1, 2006, would add a new, seventh, category of reportable transaction, the “transaction of interest.” A transaction of interest is a transaction which is the same as or substantially similar to one of the types of transactions that the IRS has identified by notice, regulation, or other form of published guidance as a transaction of interest. This is a sort of “listed transaction lite” category, encompassing “transactions for which the IRS and Treasury Department lack enough information to determine whether the transaction should be identified specifically as a tax avoidance transaction” (i.e., a listed transaction). The IRS has announced that this category will be reportable with respect to transactions entered into after November 1, 2006.

Administrative Issues

Required disclosure. According to the regulations, any taxpayer who has participated in one of the foregoing reportable transactions is required to disclose it on IRS Form 8886. The information required to be disclosed is fairly extensive. Taxpayers must furnish details regarding the type of reportable transaction being reported (i.e., one of the six types of transactions discussed above), the entity used (if any) to engage in such transaction, the name and address of any promoters and advisors with respect to the transaction, and a qualitative and quantitative estimate of the tax benefits the taxpayer expects to derive from the transaction.

Special rules. The regulations prescribe a number of special disclosure rules. For example, with respect to listed transactions, if a transaction becomes a listed transaction after it is entered into but before the statute of limitations expires, the required disclosure must be made in the taxpayer’s next return, even if the taxpayer has not participated in such a transaction in that year. With respect to transactions engaged in by a controlled foreign corporation (CFC), such transactions, to the extent they are reportable transactions, must be reported by the U.S. shareholder of the CFC. In addition, Form 8886 must be filed even if the transaction is otherwise already disclosed (e.g., on Form 8275).

Timing. Form 8886 must be filed every year in which the taxpayer participates in the reportable transaction; that is, whenever the return reflects a tax benefit derived from such transaction. In addition, the first-year filing must also be sent to the IRS Office of Tax Shelter Analysis.

Legislative Response: AJCA

As mentioned above, the reporting requirements embodied in the final regulations were commonly perceived as ineffective, primarily because of the lack of penalties for a failure to comply. Congress attempted to remedy this situation in the AJCA of 2004 by enacting or modifying several provisions designed to penalize taxpayers for failing to comply with the reportable transaction regulations. Generally, these provisions include a new nondisclosure penalty, a modified accuracy-related penalty for nondisclosed reportable transactions, a more stringent reasonable-cause and good-faith standard for nondisclosed reportable transactions, and new penalties on material advisors with respect to nondisclosed reportable transactions. In addition, Congress enacted new statute of limitations rules with respect to nondisclosed listed transactions and provided for mandatory financial statement disclosure of penalties related to certain nondisclosed transactions. These new statutory rules are discussed in greater detail below.

Taxpayer Nondisclosure Penalty

New IRC section 6707A imposes a penalty for a taxpayer’s failure to disclose a reportable transaction. This is effectively a strict-liability penalty, as the ultimate resolution of the merits of the taxpayer’s treatment of the transaction is irrelevant in determining the applicability of the penalty. The penalty applies if the transaction was reportable under the regulations, regardless of the propriety of the taxpayer’s treatment thereof and regardless of the existence of, or the absence of, any intent on the part of the taxpayer to evade federal income tax.

Amount of penalty. The amount of the IRC section 6707A penalty depends on both the type of taxpayer and the type of nondisclosed reportable transaction. With respect to natural persons, the penalty is $100,000 for nondisclosed listed transactions and $10,000 for other nondisclosed reportable transactions [IRC sections 6707A(b)(2)(A) and (b)(1)(A), respectively]. With respect to all other taxpayers, the penalty is $200,000 for nondisclosed listed transactions and $50,000 for other nondisclosed reportable transactions [IRC sections 6707A(b)(2)(B) and (b)(1)(B), respectively]. The section 6707A penalty is imposed in addition to any other penalties related to the nondisclosed reportable transaction (e.g., the penalty imposed by IRC section 6662A).

Potential rescission. The IRC section 6707A penalty can be rescinded by the IRS Commissioner, but only if the transaction is not a listed transaction and the Commissioner determines that rescinding the penalty would “promote compliance … and effective tax administration” [see IRC sections 6707A(d)(1) through (3)]. Moreover, the Commissioner’s reasons for rescinding the penalty are statutorily required to be articulated in an opinion maintained in the Commissioner’s files. Curiously, the statute states that the Commissioner’s decision to rescind (or, more likely, not to rescind) any 6707A penalty “may not be reviewed in any judicial proceeding.” Nonetheless, the issue of whether the suspect transaction was in fact reportable under the regulations should be subject to judicial review, and it is likely that taxpayers will challenge this provision on due-process grounds.

SEC disclosure. Finally, taxpayers and their advisors should be aware that any taxpayer that is an SEC registrant and that is required to pay a penalty with respect to a nondisclosure of a reportable transaction under section 6707A, a nondisclosed listed/other reportable transaction under section 6662A, or a gross valuation misstatement under section 6662(h), must disclose the requirement to pay such penalty in SEC filings. Any failure to do so is itself treated as a failure to disclose a listed transaction under section 6707A and is subject to further penalty.

Effective date. The section 6707A penalty is imposed with respect to returns which are due after November 22, 2004.

Accuracy-Related Penalty: Section 6662A

New IRC section 6662A imposes a penalty on any understatement of tax attributable to a “reportable transaction understatement.” A reportable transaction understatement is one that is attributable to either a listed transaction or a reportable transaction (other than a listed transaction), if such reportable transaction had a significant tax avoidance or evasion purpose [IRC section 6662A(b)(2)].

Amount of penalty. The penalty is equal to 20% of the understatement of tax if the transaction was disclosed and 30% of the understatement if the transaction was not disclosed [IRC sections 6662A(a) and (c), respectively.]

Potential reasonable-cause/good-faith exception. The newly revised IRC section 6664(d)(1) provides that the familiar reasonable-cause/good-faith exception to certain section 6662 penalties also potentially applies to any section 6662A penalty. Thus, if the taxpayer can demonstrate that there was reasonable cause with respect to any IRC section 6662A understatement and that the taxpayer acted in good faith, no section 6662A penalty will apply to such understatement. Congress has, however, raised the bar for taxpayers trying to avail themselves of the reasonable-cause/good-faith exception for any reportable transaction understatement. Specifically, in order to avail themselves of the IRC section 6664 reasonable-cause/good-faith exception with respect to any reportable transaction, taxpayers must demonstrate that the reportable transaction was disclosed pursuant to section 6011, that there was substantial authority for the taxpayer’s treatment of the reportable transaction, and that the taxpayer had a reasonable belief that her treatment of the reportable transaction was more likely than not proper [section 6664(d)(2)].

Reliance on an advisor’s opinion. The taxpayer’s reasonable belief may be based on an advisor’s opinion so long as that advisor or the advisor’s opinion is not “disqualified” [see IRC section 6664(d)(3)(B)(i) to (iii)]. An advisor is “disqualified” for these purposes if he is: 1) a “material advisor” [as defined in IRC section 6111(b)(1)] with respect to the transaction and participate in the organization, management, promotion, or sale of the transaction or is related [within the meaning of IRC section 267(b) or 707(b)(1)] to any person who so participates; 2) is compensated directly or indirectly by a material advisor with respect to the transaction; 3) has a fee arrangement with respect to the transaction that is contingent on all or part of the intended tax benefits from the transaction being sustained; or 4) has a disqualifying financial interest with respect to the transaction.

An opinion is disqualified for these purposes if it: 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; or 4) fails to meet any other requirement the Treasury Secretary may prescribe.

Effective date. The section 6662A penalty applies to tax years ending after November 22, 2004.

Extended Statute of Limitations: Section 6501(c)(10)

The general statute of limitations under IRC section 6501(a) for federal income tax returns is three years. The statute with respect to a taxable year generally begins to run upon the filing of the return for that year. That is, the government is generally prohibited from assessing any additional income tax for a taxable year after three years from the date the taxpayer filed for that year. Under the new IRC section 6501(c)(10), however, the time for assessing tax related to any undisclosed listed transaction will not expire before one year after the earlier of the date the taxpayer provides the relevant information pertaining to the undisclosed listed transaction, or the date a material advisor provides such information upon a request by the IRS.

Increased Compliance Requirements and Liability Risk

The implications of the final disclosure requirements and new nondisclosure penalties for taxpayers seem fairly clear. To be prudent, taxpayers and their advisors should establish procedures to identify potential reportable transactions for past, current, and future tax returns. Such transactions should then be disclosed as appropriate. Additionally, taxpayers and their advisors should review, and revise if necessary, record-retention policies to ensure that information with respect to transactions will be available should such transactions become reportable in future tax years.

As discussed above, the reportable transaction regulations impose a significant compliance burden on taxpayers. Moreover, with the enactment of new or increased penalties for failures to comply with the reporting requirements, the risks and potential costs for taxpayers resulting from noncompliance are now significant as well. This is especially true in light of the fact that some of the penalties apply notwithstanding a lack of tax-avoidance intent on the part of the taxpayer or notwithstanding the ultimate merits of the taxpayer’s per-return treatment of the transaction. Moreover, given the definitions of certain reportable transactions, a taxpayer may have a disclosure obligation several years after having engaged in the transaction. Potential liability for penalties related to such “legacy” transactions is likely to provide ample cause for many sleepless nights.