Exempt Organizations

New Tax-Shelter Excise Tax on Exempt Entities

Sec. 4965, added by Section 516(a)(1) of the Tax Increase Prevention and Reconciliation Act of 2005 (TIPRA), imposes a new excise tax on tax-exempt entities. (Managers of these entities may also be liable for tax.) The taxes are intended to discourage exempt entities from facilitating tax shelters by becoming a party to any prohibited-tax-shelter transaction (PTST) or a transaction that may subsequently become a listed transaction. 

Scope

Sec. 4965 is broad, covering both “nonplan” and “plan” exempt entities. Under Notice 2006-65, nonplan entities are:

• Entities described in Sec. 501(c);

• Religious or apostolic associations or corporations described in Sec. 501(d);

• Entities described in Sec. 170(c), including states, U.S. possessions, the District of Columbia and political subdivisions of states and U.S. possessions (but not including the U.S.); and

• Indian tribal governments, within the meaning of Sec. 7701(a)(40).

Plan entities are:

• Qualified pension, profit-sharing and stock bonus plans described in Sec. 401(a);

• Annuity plans described in Sec. 403(a);

• Annuity contracts described in Sec. 403(b);

• Qualified tuition programs described in Sec. 529;

• Retirement plans described in Sec. 457(b) maintained by a governmental employer;

• Individual retirement accounts, within the meaning of Sec. 408(a);

• Archer Medical Savings Accounts, within the meaning of Sec. 220(d);

• Individual retirement annuities, within the meaning of Sec. 408(b);

• Coverdell education savings accounts described in Sec. 530; and

• Health savings accounts, within the meaning of Sec. 223(d).

PTSTs and SLTs 

PTSTs: A PTST is a listed transaction as defined in Sec. 6707A or a prohibited reportable transaction (PRT).

For Sec. 6707A purposes, a listed transaction is a reportable transaction that is the same as, or substantially similar to, a transaction specifically identified by the IRS as a tax-avoidance transaction under Sec. 6011; see Sec. 6707A(c)(2). Currently, there are 31 listed transactions; see Notices 2004-67 and 2005-13.

Sec. 4965(e)(1)(C) defines a PRT as any confidential transaction or any trans-
action with contractual protection (as defined by regulations) that is a reportable transaction as defined by Sec. 6707A. A reportable transaction for Sec. 6707A purposes is any transaction for which information is required to be included with a return or statement because, as determined under the Sec. 6011 regulations, the transaction is of a type that Treasury has determined to have a potential for tax avoidance or evasion; see Sec. 6707A(c)(1). For now, the Service has given the terms “confidential transaction” and “transaction with contractual protection,” as used in Sec. 4695, the meanings ascribed to them in Regs. Secs. 1.6011-4(b)(3) and (4), respectively; see Notice 2006-65.

SLTs: A subsequently listed transaction (SLT) is any transaction to which an exempt entity is a party that the IRS determines to be a listed transaction at any time after the entity became a party to the transaction. An SLT excludes a transaction that was a PTST when the entity became a party to it; see Sec. 4965(e)(2).

Entity-Level Tax 

PTSTs: A nonplan entity that be-
comes a party to a PTST is liable for a tax on the greater of (1) its net income (after taking into account any other tax imposed by subtitle A with respect to the transaction) attributable to the PTST for the tax year or (2) 75% of the proceeds received by the entity for the tax year attributable to the PTST; see Sec. 4965(b)(1)(A). The tax is computed using the highest marginal rate imposed by Sec. 11 (currently, 35%). The tax is increased, however, if the entity knew, or had reason to know, that the transaction was a PTST when it became a party; see Sec. 4965(b)(1)(B). Specifically, the tax is the greater of 100% of the net income of the entity attributable to the PTST (after taking into account any other tax imposed by subtitle A with respect to the transaction) for the tax year or 75% of the proceeds received by the entity attributable to the PTST for the tax year.

Generally, according to the TIPRA Conference Report, Congress intended that, for an entity or an entity manager (in the case of the manager-level tax) to have reason to know that a transaction is a PTST, the entity or entity manager must have knowledge of sufficient facts that would lead a reasonable person to conclude that the transaction is a PTST; see Conf. Rep’t No. 109-455, 109th Cong, 2d Sess. 113 (2006). An entity or entity manager will not have reason to know that a transaction is a PTST if the entity or manager (1) justifiably relies on a reasoned written opinion of legal counsel (including in-house counsel) or of an independent accountant with expertise in tax matters (after making full disclosure of relevant facts about the transaction to the lawyer or the accountant) that the transaction is not a PTST; and (2) does not otherwise have knowledge of facts not considered in the reasoned written opinion that would lead a reasonable person to conclude that the transaction is a PTST. The absence of a written opinion is not fatal, per se. But if a transaction (1) is extraordinary for the entity; (2) promises a return for the organization that is exceptional, considering the amount invested by, the participation of, or the absence of risk to, the organization; or (3) is of significant size, either in an absolute sense or relative to the entity’s receipts, the presence of such factors generally may indicate that the entity or entity manager has a responsibility to inquire further about whether a transaction is a PTST, or, absent such inquiry, that the reason-to-know standard is satisfied.

Regardless of whether the lower or higher tax rate applies, the entity-level tax is payable for the year that the entity became a party and for each subsequent year.

SLTs: If a nonplan entity becomes a party to a transaction that is not a PTST but subsequently becomes a listed transaction, the entity’s income and proceeds attributable to the transaction are allocated between the periods before and after the listing; see Sec. 4965(b)(1)(A). The tax for each tax year is the highest marginal rate imposed by Sec. 11, multiplied by the greater of (1) the entity’s net income with respect to the subsequently listed transaction for the tax year allocable to the period beginning on the later of the date such transaction is listed or the first day of the tax year; or (2) 75% of the proceeds received by the entity for the tax year attributable to such transaction and allocable to the period beginning on the later of the date such transaction is listed or the first day of the tax year.  

Manager-Level Tax 

The manager-level tax applies to both nonplan and plan entities. In the case of a nonplan entity, Sec. 4965(d)(1) defines an entity manager as the person with authority or responsibility similar to that exercised by an officer, director or trustee and, with respect to any act, the person having authority or responsibility with respect to such act. In the case of a plan entity, Sec. 4965(d)(2) defines the entity manager as a person who approves or otherwise causes the entity to be a party to the PTST. The manager-level tax applies to any entity manager who approves the entity as a party (or otherwise causes the entity to be a party) to a PTST and knows or has reason to know that the transaction is a PTST; see Sec. 4965(a)(2). (With respect to the “has reason to know” standard, see the previous discussion.) The tax is $20,000 per approval or act that causes the entity to be a party; see Sec. 4965(b)(2). The manager- and entity-level taxes can apply simultaneously.  

Effective Dates 

Sec. 4965 is effective for tax years ending after May 17, 2006, with respect to transactions occurring before, on or after that date. However, the entity-level tax does not apply to income or proceeds properly allocable to any period ending on or before the date that is 90 days after May 17, 2006. Moreover, the increased entity-level tax on knows-or-has-reason-to-know transactions does not apply to any PTST to which an exempt entity became a party before May 18, 2006; see Sec. 4965(b)(1)(B), flush language.

Disclosures 

TIPRA Section 516(b) amended Sec. 6033 to require any exempt entity that is a party to a PTST to disclose that fact to the IRS, as well as the identity of any other party to the transaction known to the entity; see Sec. 6033(a)(2).

TIPRA Section 516(c) also amended Sec. 6652(c) to impose a penalty for each failure by an exempt entity to make the required Sec. 6033(a)(2) disclosure. Under Sec. 6652(c)(3)(A), the penalty (imposed on the entity in the case of nonplan entities and on the entity manager in the case of plan entities) is $100 for each day the failure continues, not to exceed $50,000 for any one disclosure. (The penalty does not apply, however, if the failure is due to reasonable cause; see Sec. 6652(c)(4).)

Treasury is also authorized to make a written demand on any entity or manager subject to the Sec. 6652(c) penalty that specifies a reasonable future date by which the disclosure must be made; see Sec. 6652(c)(3)(B). Failure to comply is subject to an additional $100 penalty for each day that it continues, not to exceed $10,000 as to any one disclosure; see Sec. 6652(c)(3)(B)(ii). Again, however, the penalty does not apply if the failure is due to reasonable cause.

Both the disclosure and penalty rules described above are effective for disclosures, the due date for which is after May 17, 2006, according to TIPRA Section 516(d)(2). 

Concerns

The terms “net income” and “proceeds” are not defined by Sec. 4965, and are not explained in the legislative history. “Net income” implies the allowance of some expenses (in addition to Federal income taxes, which are expressly allowed). “Proceeds” has a broader connotation. Still, it is uncertain how Treasury will define these terms in forthcoming regulations and, thus, how expansive the tax base will actually be. Sec. 4965(f) grants Treasury the authority to promulgate regulations on the allocation of net income or proceeds of an exempt entity attributable to a transaction to various periods, including before and after the listing of the transaction or the date that is 90 days after Sec. 4965’s enactment date. Again, it is uncertain which approach Treasury will take on this tax base issue.

The term “party” is similarly undefined in the statute. Providing clarity to this concept is critical, because taxation depends on an exempt entity’s becoming or being a party to a PTST or an SLT. The TIPRA Conference Report states: 

In general, the conferees intend that in determining whether a tax-exempt entity is a “party” to a prohibited tax shelter transaction all the facts and circumstances should be taken into account. Absence of a written agreement is not determinative. Certain indirect involvement in a prohibited tax shelter transaction would not result in an entity being considered a party to the transaction. For example, investment by a tax-exempt entity in a mutual fund that in turn invests in or participates in a prohibited tax shelter transaction does not, in general, make the tax-exempt entity a party to such transaction, absent facts or circumstances that indicate that the purpose of the tax exempt entity’s investment in the mutual fund was specifically to participate in such a transaction. However, whether a tax-exempt entity is a party to such a transaction will be informed by whether the entity or entity manager knew or had reason to know that an investment of the entity would be used in a prohibited tax shelter transaction. Presence of such knowledge or reason to know may indicate that the purpose of the investment was to participate in the prohibited tax shelter transaction and that the tax-exempt entity is a party to such transaction. 

It is clear from the foregoing that Congress generally did not intend for an exempt entity to run aground of Sec. 4965 solely by reason of innocent, indirect involvement in a PTST. However, in light of the injection of a reason-to-know standard, there is still much uncertainty for exempt entities and their managers. A regulatory safe harbor in this area would undoubtedly be welcome.

Another unknown is whether Treasury believes it has the regulatory authority to waive Sec. 4965 taxes. It is interesting that, as originally proposed in the Senate, the statute contained a reasonable-cause exception with respect to PTSTs; however, this was eliminated in conference. Similarly unclear and awaiting regulatory clarification is whether (and how) an exempt entity that is a party to a PTST or an SLT may extricate itself from the transaction to avoid further Sec. 4965 taxation.

Conclusion

The new tax-shelter excise tax on exempt entities may prove very expensive for the inattentive. Exempt entities and their managers must become thoroughly familiar with Sec. 4965 and the related disclosure and penalty rules. Contemplated transactions in which an exempt entity is to be a direct party must be scrutinized to ensure that the transactions do not constitute confidential or contractual-protection transactions within the meaning of Regs. Sec. 1.6011-4 (unless and until Treasury decides on different regulatory meanings for Sec. 4965 purposes), and are not listed transactions or substantially similar to listed transactions. Further, with respect to passive investment by an exempt entity, particularly in the absence of Treasury guidance on indirect involvement in PTSTs, it may be prudent for the entity manager to seek assurance from the party offering the investment vehicle that invested funds will not be used in PTSTs.

From Ronald A. Stein, LL.M., CPA, and Robert Brazzil, CPA, Chicago, IL