Inconsistent Treatment of Protective Disclosures • Government Ends Long-Distance Phone Excise Tax Dispute • IRS Compliance Studies Aim For Fairness
 

Editor:
John L. Miller, CPA
Faculty Instructor
Metropolitan Community College
Omaha, NE

Editors note: Mr. Miller is a member of the AICPA Tax Divisions Practice & Procedures Committee. Ms. Stiff and Mr. Keenan are members of that Committee. For further information about this column, contact Mr. Miller at jmiller@mccneb.edu.

IRS Treats Protective Disclosures Inconsistently

In shaping the reportable transaction disclosure rules, Treasury provided a way for taxpayers who are uncertain about whether to report a particular transaction to file a protective disclosure. In this way (or so it seems), taxpayers can lodge their uncertainty on Form 8886, Reportable Transaction Disclosure Statement. Regs. Sec. 1.6011-4(f)(2) expressly provides:

Protective disclosures. If a taxpayer is uncertain whether a transaction must be disclosed under this section, the taxpayer may disclose the transaction in accordance with the requirements of this section, and indicate on the disclosure statement that the taxpayer is uncertain whether the transaction is required to be disclosed under this section and that the disclosure statement is being filed on a protective basis.

Until December 2005, taxpayers used to indicate in writing at the top of Form 8886 that they were filing a protective disclosure. Now they check a box that was added to the form. As a matter of tax administration, the new procedure assists the IRS in easily identifying protective disclosures, particularly if the underlying tax return is e-filed. Yet, even when a taxpayer identifies a disclosure as protective, what is the practical effect of a protective filing? Are these disclosures treated any differently from nonprotective disclosures?

Revised Form 8886

In December 2005, the IRS revised Form 8886 and its instructions. It now asks taxpayers for more detailed information than it had apparently been receiving with prior versions of the form. Perhaps the most significant change is a prohibition banning taxpayers from stating on Form 8886 that further information will be available upon request. Rather, taxpayers must now provide all required information with the original form. The instructions to the new form expressly specify that stating available upon request will subject taxpayers to penalties for failing to disclose (taxpayers must also now answer all questions on the face of the form, and only use additional sheets of paper as continuation sheets).

For protective disclosures, taxpayers must give as much detailed information as they would for nonprotective disclosures. Indeed, the only difference between a protective filing and a nonprotective filing is the checkbox. Yet, a protective disclosure covers those scenarios which the taxpayer is uncertain about whether to disclose a transaction altogether. By definition, a protective disclosure filing requires uncertainty either about whether the (1) transactions facts meet one of the reportable transaction categories or (2) regulations even require reporting the transaction at all. In the case of a protective disclosure, however, taxpayers must effectively provide the IRS with as much information about the transaction as they would for a nonprotective filing (and, indeed, taxpayers also have to file such protective disclosure forms with the Office of Tax Shelter Analysis). As a result, taxpayers are left wondering what the IRS is doing with the information filed on protective disclosures.

Tax Accrual Workpapers and Other Bountiful Requests

The Internal Revenue Manual (IRM) (July 12, 2004) sets forth the IRSs tax accrual workpaper request policy. Unless taxpayers participated in a listed transaction, the IRS generally should ask for workpapers only in unusual circumstances, which may exist when, for example, it requires additional facts; see IRM Section 4.10.20.3.1. If a taxpayer has participated in listed transactions, however, the policy is expanded. For one disclosed listed transaction, the IRS will request workpapers pertaining to the transaction, and for one undisclosed listed transaction or multiple listed transactions (disclosed or undisclosed), it will generally ask for all workpapers pertaining to the tax year.

If a taxpayer has undisclosed listed transactions or nonprotective disclosed listed transactions, the policy is clearthe taxpayer might receive a request for all tax accrual workpapers pertaining to one transaction or to a given tax year. When a protective disclosure serves as the basis for applying the workpaper policy, however, it had been unclear (until recently) how the IRS would treat the protective designation.

A series of frequently asked questions (FAQs) released in July 2005 have added clarity to how the IRS will treat protective designations; see www.irs.gov/businesses/corporations/article/0,,id=146242,00.html. The FAQs address a situation in which a taxpayer has preserve[d] the taxpayers opportunity to assert that the transaction is not a listed transaction or substantially similar to a listed transaction by filing a protective disclosure. The FAQs direct examiners to determine whether the transaction is in fact the same as, or substantially similar to, a listed transaction. FAQ No. 2 provides what appears to be the IRSs first written guidance giving taxpayers a chance to explain why the transaction is not the same as, or substantially similar to, a listed transaction. While the FAQ does not exclude protective disclosures from the workpaper policy, it does give taxpayers an occasion to assert why the transaction should not be considered listed. This new guidance seems to be the IRSs first formal procedure affording taxpayers the chance to explain why a transaction described in a protective disclosure is not reportable.

Protective Material Advisor Forms

Advisors who are required under Sec. 6111 to file information returns reporting their role as a material advisor must do so on Form 8264, Application for Registration of a Tax Shelter; see Notice 2004-80. The confidential corporate tax shelter regulations under former Sec. 6111 provide for filing a protective Form 8264 when the taxpayer is uncertain whether the transaction is required to be registered as a confidential corporate tax shelter; see Regs. Sec. 301.6111-2(b)(5). While the regulations have not been amended to reflect the changes made to Sec. 6111 by the American Jobs Creation Act of 2004, material advisors continue to file protective Forms 8264. The IRS, however, does not appear to treat such protective filings differently from nonprotective filings in the case of material advisor forms.

Consider, for example, a material advisor who files a protective Form 8264 for a transaction that might have reportable-transaction characteristics. Because of the uncertainty, however, the advisor files the form on a protective basis. Once the IRS receives a Form 8264whether protective or nonprotectivethe IRS computer system may, in some instances, send the advisor a request for an investor list under Sec. 6112. The IRSs system does not appear to discriminate between protective filings or nonprotective filings when it comes to investor list requests. When a list request letter is sent, it is often based merely on receiving Form 8264.

There is no written guidance directing the IRS to afford material advisors an opportunity to assert a transaction described in a protective Form 8264 is not, in fact, reportableeither prior or subsequent to the mailing of a list request. The IRS may be taking the position that a list request in these cases is merely an automatic function of its computer system responding to the filing of Form 8264.

Material advisor information returns even present issues unique to disclosures made by taxpayers on Form 8886. While a taxpayers disclosure can trigger an examination based on its content, a material advisors reporting can trigger a list request under Sec. 6112. An examiner may consider the protective nature of a disclosure or a change in circumstances after a taxpayers disclosure is filed. In the case of material advisor disclosures, however, the IRS has no written guidance and may in fact be unwilling to recognize a protective designation or a change in IRS guidance. There may be instances, however, in which a transaction that might have been reported on Form 8264 protectivelyor not protectivelyhas become delisted or otherwise excepted from disclosure by, for example, a revised revenue procedure (e.g., so-called angel lists) or other IRS notice. If there is an outstanding list request or the IRS has already received information required under Sec. 6112, there is no written guidance as to whether the IRS should either withdraw the list request or return the information to the advisor. It is likely that in these cases, the IRS would simply stand behind the initial request. The IRSs stance may result in unjust consequences to an advisor, particularly if any IRS guidance is retroactive in effect; see Notice 2006-16. This might occur, for example, when a material advisor files a protective Form 8264 to report the advisors role in a transaction that later becomes expressly excepted from disclosure and reporting under Notice 2002-35. The IRS has no policies in force to effectively defuse the already-filed protective Form 8264.

Conclusion

Taxpayers and advisors filing disclosures on a protective basis do so because of the uncertainty as to whether the transaction is reportable under Sec. 6011. While the IRSs treatment of such protective filings is unclear in most cases, the IRS has taken a position in applying its tax accrual workpaper policy that respects disclosures filed and designated as protective. For material advisors, however, the IRS has not adopted formal guidance allowing advisors to assert a transaction reported on a protective basis is, in fact, not reportable. These divergent policies are examples of the continued uncertainty that surrounds the IRSs treatment of protective disclosures.

From Todd Simmens, CPA, J.D., LL.M., Ernst & Young LLP, Washington, DC and Metropark, NJ

Government Ends Long-Distance Phone Excise Tax Dispute

On May 26, 2006, Treasury announced its concession in the legal dispute over the Federal excise tax on long-distance telephone service. The IRS also announced its decision to stop collecting the tax and to issue refunds of tax paid on long-distance service over the past three years. These announcements came after the U.S. recently lost, in rapid succession, three more appeals in cases involving the validity of the tax. On March 30, 2006, the Sixth Circuit denied the governments motion for an en banc rehearing in OfficeMax, Inc., 428 F3d 583 (6th Cir. 2005). The government filed its motion after the Sixth Circuit affirmed a district court decision and held that the taxpayers long-distance telephone service charges must vary by both time and distance to be taxable under Sec. 4252(b)(1).

On April 27, 2006, the government suffered defeat in the Second Circuit; the judges devoted only two paragraphs to their opinion in Fortis, Inc., No. 05-2518 (2d Cir. 2006). Less than two weeks later, on May 9, 2006, the Third Circuit handed down its decision in Reese Brothers Inc., No. 05-2135 (3d Cir. 2006), discussing fully, and rejecting, all of the governments arguments. In total, the government lost five appellate decisions on this issue, which fueled speculation, for some time, that it would abandon further litigation.

Statutory Overview

Sec. 4251 imposes a 3% excise tax on certain communications services. The tax is paid by the person paying for the services (Sec. 4251(a)(2)) and is collected by the person receiving payment for them (Sec. 4291). Communications services subject to the tax are local telephone service, toll telephone service or teletypewriter exchange service; see Sec. 4251.

Local telephone service is defined as access to a local telephone system and the privilege of telephonic-quality communication with substantially all persons having telephone or radio telephone stations in that system, as well as any service or facility provided in connection with local telephone service; see Sec. 4252(a). However, local telephone service does not include a service that can be categorized as toll telephone service or private communications service; see Sec. 4252(a).

There are two types of services that fall within the definition of toll telephone service. The first is a telephonic-quality communication for which there is a toll charge, which varies in amount with the distance and elapsed transmission time of each individual communication, and the charge is paid within the U.S.; see Sec. 4252(b)(1). The second type of toll telephone service is a wide area telephone service (WATS-type service) that entitles the subscriber, on payment of a periodic charge (determined as a flat amount or on the basis of total elapsed transmission time), to the privilege of an unlimited number of telephonic communications to or from all (or a substantial portion of) the persons with telephone or radio telephone stations in a specified area outside the local telephone system area in which the station provided with this service is located; see Sec. 4252(b)(2).

Teletypewriter exchange service is defined as access from a teletypewriter or such data station and the privilege of intercommunication with substantially all persons having teletypewriter or other such data stations; see Sec. 4252(c).

The Dispute

Under Sec. 4251, the 3% telephone excise tax is imposed on amounts paid for toll telephone service and local telephone service. Sec. 4252(b)(1) defines taxable toll telephone service (long distance) to include service for which there is a toll charge that varies in amount with the distance and elapsed transmission time of each individual communication.

Historically, the charge for long-distance telephone service was based on both time and distance. Under that system, a call from New Jersey to Pennsylvania was cheaper than a call from New Jersey to California, assuming the calls were of equal duration. As the telecommunications industry and supporting infrastructure became more sophisticated, billing practices evolved. Today, the common industry billing practice for long-distance communication does not charge based on distance. A call from New Jersey to California now costs the same as a call from New Jersey to Pennsylvania, if the calls are of equal duration.

The dispute was whether excise tax applies to modern long-distance telephone services, most of which no longer charge based on each calls distance.

Position of the Parties

The government had argued that and meant or in the phrase distance and elapsed transmission time in Sec. 4252(b)(1), and that the excise tax applied to long-distance telephone services even when the charges were not based on both the distance and duration of the call. It also had contended that the statute was ambiguous and should have been set aside in favor of an interpretation that Congress intended to tax all communication services, whether or not within the statutes scope.

Taxpayers argued that the statute is clear in its meaning and the distance element in Sec. 4252(b)(1) is not optional, but required, to be subject to the excise tax.

Five Strikes

The Second, Third, Sixth, Eleventh and DC Circuits all issued opinions rejecting the governments position that the word and means or in the phrase distance and elapsed transmission time; see Fortis, Inc.; Reese Brothers Inc.; OfficeMax, Inc.; American Bankers Ins. Group, 408 F3d 1328 (11th Cir. 2005); and National Railroad Passenger Corp., 431 F3d 374 (DC Cir. 2005).

All but the DC Circuit also rejected the governments arguments that long-distance telephone service falls under either (1) Sec. 4252(b)(2), as a periodic-charge service if the toll charge varies by elapsed transmission time alone or (2) Sec. 4252(a), as local telephone service. The government supported the latter argument by reasoning that all long-distance services require access to local telephone systems to originate or terminate the transmissions.

Government to Issue Refunds

In Notice 2006-50, the IRS said that long-distance telephone service and certain bundled services are nontaxable. The notice outlines the procedures for taxpayers to request refunds of Federal excise tax paid on such service. Interest will be paid on refunds.

According to a Treasury press release (IR-2006-82), refunds will not include tax paid on local telephone service; such service was not involved in the litigation.

Taxpayers may request a refund on nontaxable service billed after Feb. 28, 2003, and before Aug. 1, 2006, only on their 2006 Federal income tax returns. Individual taxpayers will be permitted to request either a refund of (1) a safe-harbor amount or (2) the actual amount of tax paid. Taxpayers requesting the actual amount paid will be required to maintain documentation (such as bills for each month during the refund period), and receipts, cancelled checks or other evidence that the amount requested was actually paid. Taxpayers other than individuals may only request the actual amount of tax paid; no safe harbor will be provided.

Notice 2005-79, in which the IRS stated it would continue to collect the tax under Sec. 4251 on all taxable communications services, has been revoked.

From John R. Keenan, J.D., Director, Elizabeth Magin, J.D., LL.M., Manager, and Sharlene M. Sylvia, CPA, Manager, Deloitte Tax LLP, Washington, DC

This article does not constitute tax, legal or other advice from Deloitte Tax LLP, which assumes no responsibility with respect to assessing or advising the reader as to tax, legal or other consequences arising from the readers particular situation.

IRS Compliance StudiesEnsuring Fairness for All

The IRS has a deep appreciation for the critical role small business men and women play in the U.S. economy. Small businesses represent more than 99% of all employers. They employ half of all private-sector workers and create two-thirds of the net new jobs in the economy. The IRS does not want to do anything to deter the entrepreneurial spirit that drives individuals to start up small businesses and to grow them.

The IRS has an important role in ensuring all small businesses play by the same rules. Small businesses face enough difficult challenges without having to deal with competitors that are willfully not paying their fair share of taxes. It has an obligation to compliant small businesses to ensure that competitors are also onboard. This is not only a matter of fairness, but also a way of supporting compliant small businesses in their effort to remain in good standing.

NRP

The most recent individual income tax gap estimates are based on a National Research Program (NRP) study of individual 2001 returns. It is the first such comprehensive study done since 1988. The tax gap is the difference between the amount of tax imposed on taxpayers for a given year and the amount that is paid voluntarily and timely. The tax gap represents, in dollar terms, the annual amount of noncompliance with current tax laws.

The NRP study estimates the overall tax gap for all types of tax to be approximately $345 billion; underreporting constitutes nearly 83% of the gross tax gap. The NRP study also states that compliance rates are higher on returns that include income (e.g., wages and salaries) subject to both third-party reporting and withholding, and is thus the most visible. As expected, amounts not subject to withholding or third-party information reporting (e.g., sole proprietor income and the other income line on Form 1040) are the least visible and thus are most likely to be misreported; the misreporting estimate for other income is 64%.

The newest NRP study will focus on S corporations and is part of a strategy to conduct reporting compliance studies each year. The IRS decided to study S corporations for a number of reasons. Since 1985, S corporation filings have increased dramatically. In that year, there were over 720,000 Form 1120S returns filed by companies with less than $10 million in assets. By 2002, that number had grown by four times, to over 3.1 million. Over that same period, other corporate return filings actually declined by approximately 450,000. In fact, by 1997, S corporations became the most common corporate entity. In 2003, nearly 3.4 million S corporations filed tax returns, accounting for over 58% of all corporate returns filed that year. The last time the IRS conducted an S corporation study was 1984. Since then it does not have reliable reporting compliance data for S corporations.

In FY 2004, the IRS examined 6,402 S corporation returnsless than one-fifth of 1% of all S corporation returns filed. (That coverage rate is one of the lowest for any type of tax return examined by the IRS.) In comparison, the IRS examined 17,097 C corporation returns and 6,226 partnership returns in FY 2004, producing coverage rates of 0.71% and 0.26%, respectively.

The current NRP reporting compliance study involves approximately 5,000 Form 1120S returns from a nationwide random sample. The IRS used asset size of the S corporation in the return selection process. Even with the increased focus from the NRP study, the overall audit rate for S corporation returns remains below that of C corporations.

In designing the S corporation NRP study, the primary consideration was to balance the need for reliable estimates for reporting compliance against the burden of collecting compliance data. The IRS wants to learn as much as possible about the extent of S corporation noncompliance and its causes so that it can devise cost-effective ways to increase compliance with current tax laws. The Service will use the NRP results to more effectively manage compliance programs and design pre-filing activities that help taxpayers comply with the law. Perhaps the greatest value of the NRP study is that it should give the IRS the ability to identify returns that merit further examination and to avoid examining compliant taxpayers.

Conclusion

Closing the tax gap will require continued diligence, not only by the IRS, but by the tax professional community. The American tax system can be administered fairly through a combination of burden reductionto assist those who are willing to complyand an enlightened, focused approach to enforcementto address those who are not. Tax professionals have helped the IRS by identifying obstacles to compliance and pointing out areas of potential abuse. This cooperative effort continues to strengthen the tax system, as well as help the IRS to be more responsive to the needs of the American people.

From Linda Stiff, Division Commissioner, Small Business/Self-Employed Division, IRS, Washington, DC