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AJCA Creates Nondisclosure Penalties for Reportable Transactions Pre-Filing Agreement Program Reduces Time to Resolution Editor: Editors note: Mr. Ely is the former chair of the AICPA Tax Divisions IRS Practice and Procedures Committee. Mr. Brennan is the Vice Chair of that Committee.
AJCA Penalties for Noncompliance with Reportable Transaction Regs. On Oct. 22, 2004, President Bush signed into law the American Jobs Creation Act of 2004 (AJCA), a $138 billion tax package with a wide-ranging effect on foreign and domestic tax planning. Besides the AJCAs numerous tax planning opportunities, it alerts taxpayers to their obligation to disclose certain transactions the IRS deems reportable transactions. Prior to the AJCA, Regs. Sec. 1.6011-4, which required all taxpayers to disclose certain transactions that fell into one of six broad categories, prescribed no penalties for failing to disclose a reportable transaction. The AJCA added and modified numerous provisions to the reportable transaction rules. First, it imposed significant penalties for failing to disclose reportable transactions, regardless of a tax underpayment. There are strict-liability penalties in the case of listed transactions (i.e., transactions specifically identified by the Service as falling into one of the six categories). For other reportable transactions, the penalty can be rescinded only by IRS authority (which cannot be reviewed by a court). Also, the AJCA extended the statute of limitations (SOL) on assessment for undisclosed listed transactions, until the taxpayer provides the required information to the IRS or responds to a list-maintenance request. In addition, it increased accuracy-related penalties for certain undisclosed reportable transactions and imposed new limits on avoiding such penalties via reasonable cause (e.g., relying on disqualified opinions and disqualified advisors).
Reportable Transactions The IRS issued the reportable transaction final regulations in February 2003; they apply to transactions entered into on or after Feb. 28, 2003 (although the regulations may apply to transactions entered into on or after Jan. 1, 2003, at the taxpayers election). The final regulations set forth six categories of reportable transactions; see the exhibit. (For a discussion of the final regulations, see Mendelson and Emilian, Tax Shelter Final Regs., TTA, June 2003.)
Penalty for Failing to Disclose Reportable Transactions Pre-AJCA: Prior to the AJCA, taxpayers were required to disclose on their returns certain information about reportable transactions (including listed transactions) in which they participated. They were not, however, subject to a specific penalty for failing to do so. Rather, the failure to disclose jeopardized the taxpayers ability to claim that an income tax understatement resulting from the undisclosed transaction was due to reasonable cause, and that the taxpayer acted in good faith. AJCA: AJCA Section 811 created a new penalty under Sec. 6707A for failing to include with a return or statement any required information on a reportable transaction with a significant tax avoidance purpose (as determined under Regs. Sec. 1.6011). Reportable transactions are disclosed on Form 8886, Reportable Transaction Disclosure Statement, and, in accordance with Rev. Proc. 2004-45, Schedule M-3, Net Income (Loss) Reconciliation of Corporations With Total Assets of $10 Million or More. The penalty, which applies regardless of whether the transaction ultimately results in a tax understatement and in addition to any accuracy-related penalty, is $10,000 for a natural person and $50,000 for all others. For a listed transaction, the penalty is $100,000 for a natural person and $200,000 for all others. The IRS may rescind any portion of the penalty if (1) the violation does not involve a listed transaction; and (2) rescinding the penalty would promote compliance and effective tax administration. In deciding whether to exercise that authority, however, the Committee Report directs the Service to consider (1) the taxpayers history of compliance, (2) whether the violation is due to an unintentional factual mistake and (3) whether imposing the penalty would be against equity and good conscience. The AJCA provides that, notwithstanding any other provision of law, an IRS determination on rescinding the penalty may not be reviewed in any judicial proceeding. Thus, this is a strict-liability penalty. Notice 2005-11: On Jan. 19, 2005, the IRS issued Notice 2005-11, which provides interim guidance on the imposition and rescission of penalties under Sec. 6707A. These rules apply until further guidance is issued. In the notice, the Service stated its intention to issue regulations. Under the notice, a taxpayer will be subject to a Sec. 6707A penalty for failing to (1) attach Form 8886 to an original or amended return or (2) provide a copy of the disclosure statement to the Office of Tax Shelter Analysis (OTSA), if required. A single penalty will apply to a taxpayer that fails to (1) attach Form 8886 to an original or amended return and (2) provide a copy of Form 8886 to the OTSA. This penalty, which is tied to a taxpayers failure to disclose, applies regardless of whether the IRS successfully challenges the transaction. The interim guidance further provides that the penalty applies to each failure to provide a disclosure statement required to be attached to an original or amended return filed after Oct. 22, 2004 (with a copy sent to the OTSA, if required), regardless of whether the original return was due on or before Oct. 22, 2004. Under Regs. Sec. 1.6011-4(e)(1), a reportable transaction disclosure statement is due when filing a return or an amended return that reflects participation in a reportable transaction. Accordingly, a Sec. 6707A penalty will not be imposed until a taxpayer fails to provide (1) the required disclosure statement with an original or amended return or (2) a copy to the OTSA (if applicable), even if the return is filed after the due date. A Sec. 6707A penalty will not be imposed if the disclosure statement is attached to a return filed after the due date for filing the return, unless the taxpayer fails to provide a copy of the disclosure statement to the OTSA (if required); for examples, see Tax Trends, IRS Guidance on Reportable Transaction Disclosure Penalties, this issue. Under the interim guidance, if a return with a due date prior to Oct. 22, 2004 is filed after the Sec. 6707A enactment date and does not contain a disclosure for a reportable transaction, the penalty will apply. However, a cogent argument can be made that the interim guidance is flawed, because it links the imposition of the Sec. 6707A penalty to the returns filing date, rather than the due date, as provided by AJCA Section 811.
SEC Reporting Taxpayers that are Securities and Exchange Commission (SEC) registrants have added concerns after the AJCA. Those required to make periodic reports under Securities Exchange Act of 1934, Section 13 or 15(d), are now required to disclose in those reports the payment of (1) a penalty imposed for failing to disclose a listed transaction; (2) an understatement penalty resulting from a failure to disclose a listed or reportable transaction; and (3) a gross valuation misstatement penalty under Sec. 6662(h), resulting from a failure to disclose a listed or reportable transaction. Disclosure does not depend on the penaltys materiality to the report and would occur only after (1) the taxpayer has exhausted administrative and judicial remedies, or (2) payment (if earlier). A failure to disclose the penalty in the report is treated as a failure to disclose a listed transaction, which carries a $200,000 penalty.
Modified Accuracy-Related Penalty for Listed Transactions and Other Reportable Transactions Prior to the AJCA, noncorporate taxpayers could 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 claimed was more likely than not the proper treatment. The exception was not available to corporate taxpayers. Under AJCA Section 812, the tax shelter accuracy-related penalty was replaced with a new penalty under Sec. 6662A that applies to listed 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. If disclosure was adequate, a 20% accuracy-related penalty applies to an understatement resulting from a listed transaction or reportable avoidance transaction. Exception: The only exception to the penalty is if the taxpayer satisfies a more stringent reasonable cause and good-faith exception set forth in new Sec. 6664(d). The strengthened reasonable cause exception would apply 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 claimed tax treatment was more likely than not proper. A belief is reasonable only if it (1) was based on the facts and law in existence when the return that included the item was filed and (2) related solely to the taxpayers chances of success on the merits. A taxpayer cannot rely on a tax advisors opinion to establish reasonable belief if the opinion is (1) provided by a disqualified tax advisor or (2) considered a disqualified opinion. Taxpayers who do not adequately disclose the transaction are not eligible for the more stringent reasonable cause exception and will be subject to a strict-liability penalty of 30% of the understatement. Computing the understatement: The penalty applies to the understatement attributable to the listed or reportable avoidance transaction, without regard to other items on the return (e.g., net operating loss carryovers). Under the provision, 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 taxpayers treatment of the item and the proper treatment (without regard to other items on the return); and (2) the decrease in the aggregate credits that results from a difference between the taxpayers treatment of an item and the proper tax treatment. Coordination with other penalties: The portion of an understatement subject to the Sec. 6662A penalty is not subject to the accuracy-related penalty under Sec. 6662. In addition, any 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 Sec. 6662A penalty will be included in determining whether the threshold for the substantial understatement penalty under Sec. 6662(d)(1) is satisfied.
Notice 2005-12 The Service issued Notice 2005-12 to provide guidance on new Sec. 6662A and on the AJCA amendments to Secs. 6662 and 6664. The notice states that adequate disclosure, for Secs. 6662A and 6664(d)(2)(A) purposes, involves filing a disclosure statement as prescribed in Regs. Sec. 1.6011-4(d) (i.e., filing Form 8886) or Rev. Proc. 2004-45. It also clarifies the meaning of material advisor for purposes of determining whether such advisor is a disqualified advisor. It specifically states that a tax advisor, including a material advisor, will not be treated as participating in the organization, management, promotion or sale of a transaction if the tax advisors only involvement is rendering an opinion on a transactions tax consequences. The advisor may suggest modifications to the transaction (but not material modifications) that assist the taxpayer in obtaining anticipated tax benefits. For disqualified compensation arrangements, a tax advisor who receives a referral fee or has a fee-sharing arrangement with a disqualified advisor will also be treated as a disqualified advisor.
SOL for Unreported Listed Transactions Sec. 6501 requires taxes to be assessed within three years after the date a return is filed. However, that period is extended to six years for substantial omissions of items of gross income that total more than 25% of the gross income on a return. Tax can be assessed or collected only within the required time periods. If a taxpayer files a false or fraudulent return with the intent to evade tax or does not file a return, tax may be assessed at any time. AJCA Section 814 extends the SOL for a listed transaction when a taxpayer fails to include information about the transaction with a return or statement for a tax year. The SOL for a listed transaction will not expire before the date that is one year after the earlier of the date (1) on which the taxpayer provides the Service with the required information or (2) a material advisor satisfies the list-maintenance requirement, prompted by an IRS request. If the IRS lists a transaction after the SOL closed for the year of the transaction, this provision does not re-open the SOL. However, if the transactions purported tax benefits are recognized over multiple years, the provisions extension of the SOL applies to tax benefits in any subsequent tax year when the SOL had not closed prior to the date the transaction became listed.
Conclusion The lack of redress and other unprecedented characteristics of these penalties have seriously muddied the landscape of an already-complicated area of tax compliance. Under the final regulations, taxpayers must now diligently uncover and disclose every transaction that may fit within the six categories of reportable transactions, or face the consequences. If, at a later examination, the Service finds a reportable, but undisclosed, transaction and imposes penalties, there will be little recourse. From Nancy Chassman, Senior Manager, and James E. Brennan, Senior Manager, Tax Controversy & Risk Management Services, Ernst & Young LLP, New York, NY
PFA ProgramAn Increasingly Useful Tool for Taxpayers One of the strategic priorities of the IRSs Large and Mid-Size Business Division (LMSB) is issue management, which it defines as developing a strategy to resolve disputes with taxpayers sooner or to eliminate controversy earlier in the process. The Pre-Filing Agreement (PFA) Program was developed to assist LMSB in this purpose. It allows LMSB taxpayers to request an examination of specific return issues, which could be subject to post-filing disputes, to determine the proper tax treatment prior to filing the return. PFAs are finalized with a closing agreement under Sec. 7121. This provides the taxpayer with certainty as to return positions specified in the agreement. This item discusses the evolution of the PFA program and highlights some of its goals and key revisions announced in Rev. Proc. 2005-12.
Overview Through the use of the PFA program, the IRSs goal is to reduce the taxpayers and the IRSs costs and burdens, by providing certainty on issues earlier than the traditional post-filing examination process. Because the examination is performed prior to return filing, the taxpayer and IRS have timelier access to both the relevant tax records and personnel. The Service, on an annual basis, releases a report on the program that discusses the types of issues resolved, taxpayer satisfaction and time saved. Exhibit 1 is an IRS chart showing the time saved in pursuing a PFA, as opposed to resolving an issue during the post-filing examination process.
Although the program has been expanded and has proven to be efficient, it is underused, having received only 42 applications during calendar-year 2003. Exhibit 2 compares the number of applications received per year since the programs inception.
Pilot Program Evolution In February 2000, the Service announced the pilot PFA program in Notice 2000-12. At that time, the program was available only for Coordinated Issue Cases with an examination team on site at the time a PFA request was made. Of the 19 applications received during the pilot program, seven closing agreements were executed, in an average of 166.1 days. This was significantly shorter than the time needed to examine an issue during the post-filing audit process, which could take a number of years. Since its inception, the PFA program has evolved; it has become an increasingly useful tool for taxpayers. Rev. Proc. 2001-22 made the pilot permanent and expanded the program by making PFAs available to all taxpayers under the jurisdiction of the LMSB, including those not currently under audit. It increased the number of international issues eligible for the program. In addition, it added a user fee, ranging from $1,000 for taxpayers with assets from $5 million to $50 million; $5,000 for taxpayers with assets from $50 million to $250 million; and $10,000 for taxpayers with assets of $250 million or more. As additional issues were accepted into the program, the IRS noted an increase in resolution timefrom 166.1 days to 299.4 days for calendar-year 2003. However, despite this increase in time from the pilot, the program is still significantly faster than the traditional process.
Program Revisions In December 2004, Rev. Proc. 2005-12 expanded the PFA program by (1) allowing taxpayers to resolve issues for multiple future tax years and (2) broadening the eligible, acceptable international issues. Under guidelines outlined in Rev. Proc. 2001-22, eligible tax years had been limited to the current tax year or any prior tax year for which a return was not yet due and not yet filed. The IRS acknowledged that this limit prevented taxpayers and the Service from resolving (1) issues for future tax years or (2) methods that would affect future tax years. Thus, it expanded the program to enable taxpayers to request a PFA for the current tax year, any prior tax year for which an original return is not yet due and filed, and up to four future tax years. Scope: In general, the Service will consider entering into a PFA (1) on any issue that requires either a factual determination or an application of well-established legal principles; (2) regarding a method used by a taxpayer to determine the appropriate amount of an item of income, allowance, deduction or credit; (3) for an issue under an IRS operating division other than LMSB, but only with the other divisions concurrence. The revised guidelines expand the issues eligible for the program, by stating that any domestic or international issue that requires either a factual determination or application of well-established legal principles and is not excluded by the revenue procedure, is likely suitable for the PFA program. The nonexclusive list of eligible domestic issues and the exclusive list of eligible international issues provided in Rev. Proc 2001-22 have been removed. Rev. Proc. 2005-12 also provides clear guidance that a PFA cannot be obtained for a transaction that has not yet occurred, but rather only for completed transactions and events. According to the IRS, there had been some confusion on this issue. In the new revenue procedure, the IRS encourages taxpayers pursuing a PFA on international issues to seek competent authority consideration under the mutual agreement procedures of any applicable U.S. income tax convention. A PFA may also be requested for an international issue that has been previously submitted for competent authority assistance. Under previous guidance, the acceptance of a taxpayers PFA request was at the discretion of the LMSB Industry Director with subject-matter jurisdiction over the taxpayer. The Industry Director had final decisionmaking authority as to whether a taxpayers request was suitable for the PFA program. Now, prior to making any decisions to proceed with a taxpayers request, the Industry Director must first coordinate and consult with the Associate Chief Counsel having subject-matter jurisdiction over issues proposed for the PFA program. As part of that coordination effort, the Associate Chief Counsel may decide whether the issue would be better suited for the letter ruling process. In general, an issue concerning the interpretation of rules of law that are not well settled is more appropriately handled by that process.
Summary Rev. Proc. 2005-12 describes the application, review and acceptance process for the PFA program. The program has been highly successful, consistently receiving high ratings from taxpayers. It has been an effective tool for reducing costs and providing certainty on examined issues earlier than resolution sought during the traditional post-filing examination process. From Jim Dougherty, Director, and Sharlene Sylvia, Manager, Tax Controversy Services, Deloitte Tax LLP, Washington, DC |
