Forms 8275 and 8275-R: How Much Information Is Enough?

Sec. 6694 was amended in 2007 to extend application of the income tax return preparer penalties to all tax return preparers. The new law also raised the preparer standards of conduct and increased the applicable penalties. However, the penalty will not apply if (1) the preparer has a reasonable belief that the position would more likely than not be sustained on its merits or (2) there is a reasonable basis for the position and the position is adequately disclosed. Except in the case of tax shelters, taxpayers can avoid the Sec. 6662 accuracy-related penalty if the position has substantial authority or the taxpayer adequately discloses an item or position that has a reasonable basis.

For these purposes, disclosure generally is made on Form 8275, Disclosure Statement, or Form 8275-R, Regulation Disclosure Statement. Although seemingly straightforward, completing the forms can be difficult because there is little guidance on when a disclosure will be treated as “adequate.” The regulations and instructions contain little in the way of specific examples or standards. Disclosures that are made but that are not treated as adequate will attract IRS attention but will not provide penalty protection. Thus, the challenge is to disclose the appropriate amount of information to satisfy the IRS that disclosure is adequate.

Defining Adequacy

The instructions to both disclosure forms are similar with respect to the information required in Parts I and II, except that Form 8275-R contains more specific instructions and requires an explanation of the regulation’s invalidity. Both forms require:

• A citation of the rule for which a contrary position is taken;
• The name of the item; and
• A complete description of the item being disclosed.

One example in the instructions to both forms provides that if entertainment expenses are reported, then a description such as “theater tickets, catering expenses, and banquet hall rentals” should be listed.

For Part II of the forms, little guidance is provided other than a warning similar to that set forth in the Internal Revenue Manual (IRM) that the disclosure must provide sufficient information to apprise the IRS of the controversy (see below). An example in Part II of the instructions to both forms shows that disclosure is not adequate if Form 8275 or Form 8275-R is not attached, even if an underlying document at the source of the controversy is attached to the return. Regs. Sec. 1.6662-4(f) provides some helpful guidance with respect to recurring items, carrybacks and carryovers, and passthrough entities but refers only to “properly completed” Forms 8275 and 8275-R.

The IRM relies on case law in stating that taxpayers must disclose sufficient information so that the IRS can identify the potential controversy that may be involved (Schirmer,89 TC 277 (1987), acq. 1989-2 CB 1) and that the disclosure must provide the IRS with more than simply a clue (Horwich, TC Memo 1991-465). Similarly, the IRM lists some of the essential items for an adequate disclosure, including a reference to “the facts affecting the tax treatment of the item sufficient to apprise the Ser-vice of the nature of the potential controversy” (IRM Section 20.1.5.8.1.2). However, the IRM also states that if the disclosure statement is too general to “reasonably apprise” the IRS of the nature and amount of the potential controversy, the disclosure exception to Secs. 6662 and 6694 will not apply.

Completing the Form

The purpose of the disclosure forms is to put the IRS on notice of a potential controversy. These forms are not intended to be, and should not be treated as, a rebuttal to an IRS challenge. The taxpayer risks foreclosing additional arguments if, before the IRS even determines that the issue is worthy of challenge, the taxpayer relies on particular arguments to support the position or item in the disclosure form. In addition, attempts to draft legal arguments in anticipation of an IRS challenge could create an audit issue where one otherwise might not exist.

Thus, the detailed explanation in Part II generally should not include contrary authorities or arguments supporting the position taken on the return. However, there are situations in which citing contrary authority may be helpful in avoiding examination of the issue (e.g., citing a case in which the court did not follow a revenue ruling). Likewise, it is not necessary to state the level of confidence with respect to the position (e.g., that the position has a reasonable basis). Rather, the detailed explanation should identify the item or position, the amount of the item, the statute, ruling, notice, or other guidance that is the source of the controversy, and a description of the nature of the controversy.

When to Use Form 8275-R

The IRS uses Form 8275-R as a means to identify taxpayer claims that a regulation is invalid. Courts sometimes may agree that a regulation is invalid, but only in exceptional cases (e.g., Rite Aid Corp., 255 F3d 1357 (Fed. Cir. 2001)). Thus, Form 8275-R should be used only when the taxpayer is challenging the validity of an IRS regulation. When making this kind of challenge, the taxpayer is arguing that the government issued the regulation contrary to its statutory authority.

Taxpayer positions that involve interpretations of a regulation, or determinations that a particular regulation does not apply, should not be treated as a challenge to the validity of a regulation. In these cases, Form 8275, rather than Form 8275-R, should be used. Use of Form 8275-R almost certainly will result in an IRS challenge to the taxpayer’s position. Therefore, it is prudent to use this form only when required.

Conclusion

Adequate disclosure can protect the preparer and taxpayer from penalties in certain cases. However, preparing a disclosure that is adequate to apprise the IRS of the controversy without prejudicing the taxpayer is not a simple task. Care should be taken to provide only the appropriate information. Save the detailed analysis and arguments to respond to an actual government challenge and use the disclosure form to notify, rather than to advocate.

From Rochelle L. Hodes, J.D., LL.M., and Lewis J. Fernandez, MBA, J.D., Washington, DC

As the IRS intensifies its scrutiny of worker classification, businesses may want to take a fresh look at how their policies, procedures, and documentation around engaging independent contractors might withstand IRS review.

IRS Initiatives

While the worker classification issue never seems to go away, for most businesses it has been on the back burner for more than a decade. In 1996, the IRS—recognizing that changes in the way businesses were operating would affect the relevance of the common law factors traditionally used to classify workers, and after seeking input from the public—revised the training for its revenue agents (IRS, “Independent Contractor or Employee?” Training 3320-102 (10-96) TPDS 84238I). Examiners were encouraged to consider the entire relationship between a business and a service provider and to understand that as long as the rules were followed, businesses legitimately could use independent contractors.

During the same period, the IRS launched its Classification Settlement Program (CSP), which provides a standard settlement agreement for use if examiners determine that workers are misclassified. The settlement program, which is still in place, can be quite useful to taxpayers. In most cases, if a business agrees to begin treating the workers in question as employees prospectively, a tax assessment is made for only one year, rather than for all years of the examination. Moreover, the tax rate used for this assessment, assuming the misclassification was not a matter of intentional disregard, is less than the usual federal income tax withholding and FICA rates.

These initiatives likely helped the IRS clear its backlog of highly contentious worker classification cases. However, given recent developments, it is clear that the worker classification issue will again be a high priority for the IRS. Worker classification started receiving increased attention when the GAO reported in May 2007 that underreporting of income by self-employed individuals makes up 43% of the tax gap—the difference between the tax that is owed and the actual revenue collected. The report also stated that 15% of employers misclassify workers, resulting in an estimated annual revenue loss of $4.7 billion.

Further, in July 2007, the Senate Appropriations Committee urged the IRS to increase enforcement in the area of worker classification. As a result, the IRS chief of employment tax indicated that worker classification cases will be a major IRS focus in 2008. Most recently, the IRS issued new Form 8919, Uncollected Social Security and Medicare Taxes on Wages, to be filed by individuals who believe they are employees but who were improperly treated as independent contractors.

Classification Factors

Identifying the correct status of a service provider as an employee or independent contractor for federal tax purposes depends on application of common law standards, which can be unclear and often seemingly contradictory as applied to the facts and circumstances of particular businesses. The key question is whether the service recipient has the right to direct and control the service provider.

The employment tax regulations provide that an employer-employee relationship exists when the business for which the services are performed has the right to direct and control the worker who performs the services. This control refers not only to the result to be accomplished by the work, but also to the means and details by which that result is accomplished. Thus, the very nature of determining whether a worker is an employee or an independent contractor is both subjective and fact intensive.

As a practical matter, independent contractors are subject to some constraints, while employees enjoy some autonomy. Control, therefore, is a matter of degree. All relevant facts are weighed to determine whether an employer-employee relationship exists. Before the release of its training materials in the mid-1990s, examiners relied on Rev. Rul. 87-41, which described what are usually referred to as the “20 common law factors.” While not abandoning the 20-factor test, the training materials offered a new approach to the evaluation. Examiners were trained to look to certain categories of evidence to better understand the relationship.

Behavioral control:“Facts which illustrate whether there is a right to direct or control how the worker performs the specific task for which he or she is engaged” (IRS Training 3320-102, p. 2-7). Indicators of behavioral control include instructions and training.

Financial control: “Facts which illustrate whether there is a right to direct or control the business aspects of how the worker’s activities are conducted” (id.). Indicators of financial control include significant investment, unreimbursed expenses, services available to the relevant market, method of payment, and opportunity for profit or loss.

Relationship of the parties:  “Facts which illustrate how the parties perceive their relationship” (id.). Indicators of the parties’ relationship include intent of the parties (often embodied in written contracts), employee benefits, discharge/termination, and regular business activity.

Relief Provisions

Even if a common law analysis would indicate that a service provider is an employee, the business may be able to rely on relief provisions of Section 530 of the Revenue Act of 1978 and continue to treat the worker and those working under similar fact patterns as independent contractors. The IRS has instructed examiners that eligibility for relief under Section 530 must be actively considered at the beginning of an examination (id. at i). The business must meet the consistency and reasonable-basis requirements before the Section 530 relief provision applies. Under the consistency tests, the business must have filed required Forms 1099 (reporting consistency) and must have treated all workers in similar positions the same (substantive consistency). Also, in making the determination to treat the service provider as an independent contractor, the business must have reasonably relied on one of the following: the prior audit safe haven, the judicial precedent safe haven, the industry practice safe haven, or some other reasonable basis. Meeting the consistency and reasonable-basis tests may give the business relief from federal employment taxes, both retroactively and prospectively, with respect to the workers whose status is in question.

From Kathy Mort, CPA, Pittsburgh, PA

When the last day prescribed by federal tax law for per-     forming an act falls on a Saturday, Sunday, or legal holiday, Sec. 7503 treats performance as timely if the act is performed on the next succeeding day that is not a Saturday, Sunday, or legal holiday.

Example 1: If the due date of a corporate taxpayer’s federal income tax return is March 15, 2008, and March 15 is a Saturday, under Sec. 7503 a return filed on Monday, March 17, 2008, will be considered timely. That “extension” applies, however, only if the taxpayer files the return on March 17. If the taxpayer does not, the normal March 15 due date applies for purposes of computing penalties, etc.

In two revenue rulings issued almost 40 years apart, the IRS explored the effect of the Saturday-Sunday-holiday rule on the limitation periods applicable to refund claims.

Limitation Periods

Sec. 6511 provides two limitation periods. The first determines whether a claim for refund is timely; the second determines how much money, if any, can be refunded to the taxpayer, assuming its claim is meritorious. Both limitation periods must be satisfied, because a timely refund claim would be pointless if the taxpayer could not obtain the requested refund.

Sec. 6511(a) provides that in order for a refund claim to be timely it must be filed within three years from the time the relevant return was filed, or two years from the date the tax was paid, whichever is later. As shown in the following example, the interplay between this rule and Sec. 7503 is fairly straightforward.

Example 2: If a taxpayer’s original 2004 return was filed on March 15, 2005, and March 15, 2008, is a Saturday, a refund claim filed on Monday, March 17, 2008, would be considered timely.

Sec. 6511(b) limits the amount that may be refunded. If a taxpayer files a refund claim within three years from the date its return was filed, Sec. 6511(b)(2)(A) provides that the amount of the refund shall not exceed the amount of tax paid during a lookback period that begins on the date the refund claim is filed. The lookback period is three years, plus the period of any extension of time obtained by the taxpayer for filing the relevant return. The interplay between this rule and Sec. 7503 can be complicated.

In Example 2, a refund claim filed on Monday, March 17, 2008, would be timely with respect to an original return that was filed on March 15, 2005. However, applying the lookback rule of Sec. 6511(b)(2)(A) to that situation appears to present a problem for the taxpayer. Tracing back three years from March 17, 2008, only gets to March 17, 2005, and under Sec. 6513(b) the taxpayer’s estimated tax payments for 2004 (as well as any withholding and prior year’s overpayment applied to 2004 estimated tax) are deemed to have been paid on March 15, 2005, which is outside the lookback period.

Rev. Rul. 66-118

The IRS took a pragmatic approach to the situation presented in Example 2 in Rev. Rul. 66-118. While acknowledging that nothing in Sec. 7503 affects the time when tax is paid or deemed paid, the IRS held that imposing the limitation of Sec. 6511(b)(2)(A) “would obviously nullify the full effectiveness” of Sec. 7503. Accordingly, the IRS ruled that Sec. 7503 not only makes the refund claim filed on the Monday at issue timely, but for purposes of the lookback rule of Sec. 6511(b) the filing of the claim is considered to have occurred on the preceding Saturday (i.e., on the actual due date). As a result, the date on which the taxpayer’s withholding credits are deemed paid falls within the lookback period.

Rev. Rul. 2003-41

Rev. Rul. 2003-41 provides guidance on three other factual situations involving refund claims and Sec. 7503.

First, if the due date of a return falls on a Saturday, Sunday, or legal holiday but the taxpayer files its return before the due date (and is not relying on the “timely mailing equals timely filing” rule under Sec. 7502), Sec. 7503 does not apply. Instead, under Sec. 6513(a), the return will be deemed to be filed on the actual due date. Accordingly, in order to be timely, a refund claim must be filed within three years of the actual due date.

Second, if the due date of a return falls on a Saturday, Sunday, or legal holiday and the taxpayer files a valid extension for the return but fails to file its return by the extended due date, for purposes of the “three year plus extensions” lookback period of Sec. 6511(b)(2)(A), Sec. 7503 is not treated as having extended the return’s due date.

For example, assume the facts are the same as in Example 1, except the taxpayer does not file the return until March 31, 2008. Because Sec. 6513(b) treats withholding and estimated tax payments as having been paid as of the actual unextended due date of the return (Saturday, March 15, 2008), in order to obtain a refund the taxpayer must file its claim by March 15, 2011.

A refund claim filed on March 17, 2011, creates something of a paradox. The claim would be timely (since it would be filed within three years of March 31, 2008, the date on which the taxpayer actually filed its 2007 return), but a refund attributable to excess withholding or estimated tax payments would be barred by Sec. 6511(b)(2)(A) because tracing back three years from the March 17, 2011, claim date only gets to March 17, 2008. Since the taxpayer did not file its return on Monday, March 17, 2008, Sec. 7503 is not treated as providing the two-day extension necessary to bring the deemed payment date of March 15, 2008, within the lookback period of Sec. 6511(b)(2)(A).

Third, if the due date of a return falls on a Saturday, Sunday, or legal holiday and the taxpayer files its return on the next succeeding day that is not a Saturday, Sunday, or legal holiday, Sec. 7503 applies and is treated as having extended the due date of the return to that next succeeding day. For example, assume again the facts from Example 1. In this situation, Sec. 7503 is treated as having extended the due date from Saturday, March 15, 2008, to Monday, March 17, 2008. As a result, a refund claim filed on March 17, 2011, would be both timely and effective to obtain a refund. The claim would be timely because it would be filed exactly three years after the return was filed. The taxpayer’s estimated and/or withholding tax payments would be refundable because the date on which they were deemed paid—March 15, 2008—falls within the lookback period of Sec. 6511(b)(2)(A). As in the second situation addressed by Rev. Rul. 2003-41, tracing back three years from the March 17, 2011, claim date only gets to March 17, 2008, but here the taxpayer did file its return on that date. Therefore, Sec. 7503 is treated as providing the two-day extension necessary to bring the deemed payment date of March 15, 2008, within the lookback period of Sec. 6511(b)(2)(A).

From Michael A. Urban, J.D., MLT, Washington, DC

In some situations, taxpayers have only 90 days from the date a listed transaction or transaction of interest is identified to disclose it to the IRS. In other cases, taxpayers are not required to disclose participation in a newly identified listed transaction or transaction of interest until they file their next return. Failure to timely disclose a listed transaction or a transaction of interest could result in significant penalties—up to $200,000—even if there is no tax due. Because these rules can be confusing and mistakes are costly, knowing whether the 90-day time limit applies to a transaction is essential.

Background

There currently are five categories of reportable transactions that must be disclosed, including listed transactions and transactions of interest—the newest category added by final regulations (TD 9350) issued on August 3, 2007 (revised final regulations). Under the general disclosure rules, a taxpayer must attach a statement (generally Form 8886, Reportable Transaction Disclosure Statement) to its federal income tax return for each year in which the taxpayer participated in the reportable transaction. In addition, for the first year that the taxpayer participates in a reportable transaction, it must send a copy of the disclosure statement to the Office of Tax Shelter Analysis (OTSA).

Before the revised final regulations were issued, there was an exception to the general disclosure rule for a transaction identified as a listed transaction after the taxpayer filed a return reporting participation in the transaction, but before the limitation period expired for the last return that reflected participation in the transaction (subsequently listed transaction). Under this exception, a taxpayer was required to disclose past participation in the listed transaction by attaching a disclosure statement to the first tax return filed after the transaction was identified (regardless of whether the taxpayer participated in the transaction in that year) and to send a copy of the disclosure statement to OTSA.

Revised Final Regs. Alter Timing of Disclosure

The revised final regulations shorten the time for disclosure of a subsequently listed transaction from the next filed return to within 90 calendar days after the date the listed transaction is identified as such by the IRS in published guidance (90-day rule) (Regs. Sec. 1.6011-4(e)(2)). The regulations apply this shortened disclosure period for subsequently identified transactions of interest, i.e., those identified as transactions of interest following the filing of a tax return reflecting the transaction. These 90-day disclosures are sent to OTSA only. The 90-day rule applies regardless of whether the taxpayer participated in the transaction in the year the transaction became a listed transaction or a transaction of interest.

Notwithstanding this 90-day disclosure rule, if the taxpayer participated in the transaction during the tax year in which the transaction is first identified as a listed transaction or transaction of interest, then the taxpayer must disclose such participation with its regularly filed income tax return under the general rule.

Although Regs. Sec. 1.6011-4(e)(2) appears to require disclosure to OTSA within 90 days after the transaction is identified as either a transaction of interest or a listed transaction, that is not always the case. As explained below, the 90-day rule applies only if:

1. The taxpayer already has reported the tax consequences or tax structure of the listed transaction or transaction of interest on a previously filed return, and

2. The taxpayer has entered into the listed transaction or the transaction of interest on or after the effective date of the 90-day rule (August 3, 2007, for listed transactions; November 2, 2006, for transactions of interest).

From a practical perspective, this later effective date for listed transactions means that many taxpayers may not be subject immediately to the 90-day rule for subsequently listed transactions.

Subsequently Listed Transactions

The revised final regulations require taxpayers to disclose subsequently listed transactions within 90 days of the notice date only if (1) the listed transaction is identified as such after the taxpayer files its first tax return reflecting participation in the listed transaction, and (2) the limitation period remains open for any year in which the taxpayer participated in the listed transaction. However, as noted, the 90-day rule applies only to subsequently listed transactions entered into on or after August 3, 2007. Thus, even if the transaction was reported on a previously filed return, a transaction entered into before August 3, 2007, will not be subject to the 90-day rule if such transaction is subsequently listed. Instead, the prior rule, which requires disclosure on the next filed tax return, will continue to apply to such transactions.

The examples below illustrate the impact of the disclosure timing rules in the revised final regulations. For purposes of these examples, the listed transaction is the distressed asset trust (DAT) transaction identified as a listed transaction in Notice 2008-34 on February 27, 2008.

Example 1: The taxpayer entered into the DAT transaction before August 3, 2007. The 90-day disclosure obligation does not apply, and the taxpayer must disclose its participation in the transaction on its next filed tax return.

Example 2: The taxpayer entered into the transaction on August 15, 2007, but did not file its tax return before February 27, 2008, the day the transaction was identified as a listed transaction. The 90-day disclosure obligation does not apply, and the taxpayer must disclose its participation in the transaction on its next filed tax return.

Example 3: The taxpayer entered into the transaction on August 15, 2007, but filed its tax return reflecting participation in the transaction before February 27, 2008, the day the transaction was identified as a listed transaction. The 90-day disclosure obligation applies, and the taxpayer must disclose the transaction to OTSA on or before May 27, 2008.

As these examples illustrate, to determine whether the 90-day disclosure rule applies, taxpayers should consider the date on which the transaction is entered into and whether a tax return reflecting participation in the transaction has already been filed.

Conclusion

In certain situations, the revised final regulations impose a 90-day disclosure obligation on taxpayers that participate in subsequently identified transactions of interest and listed transactions. However, this early disclosure obligation may not apply immediately to many taxpayers. Understanding the timing of disclosure obligations allows taxpayers to adopt appropriate internal controls to identify potentially reportable transactions of interest and listed transactions and to avoid significant penalties by timely complying with their disclosure obligations.

From Corina Trainer, J.D., and Rochelle Hodes, J.D., Washington, DC