The definition of a corporate tax shelter under sections 6662 and 6111 of the Internal Revenue Code

Tax Executive, The, Nov, 1998

November 24, 1998

On November 24, 1998, Tax Executives Institute submitted the following comments on the new definition of "tax shelter" for purposes of the substantial understatement penalty to the Internal Revenue Service. The Institute's comments were prepared under the joint aegis of TEI's Federal Tax Committee, whose chair is Philip G. Cohen of Unilever United States Inc., and IRS Administrative Affairs Committee, whose chair is Stephen W. Boocock of Allegheny Teledyne, Inc. A number of TEI members contributed to the development of the submission through their postings on TEI On-Line.

The Taxpayer Relief Act of 1997 amended section 6662(d)(2)(C)(iii) of the Internal Revenue Code to provide a new definition of "tax shelter" for purposes of the substantial understatement penalty. Under this definition, a tax shelter includes any entity, investment, plan, or arrangement with a significant purpose of avoiding or evading federal income tax. Under prior law, a plan was a tax shelter only if tax avoidance or evasion was a principal purpose. The change is effective in respect of transactions entered into after August 5, 1997. The definition also affects the scope of section 6111(d)(1)'s registration requirements for confidential corporate tax shelters, which was also addressed by the 1997 legislation. (The registration provision becomes effective after promulgation of final Treasury regulations.) These comments set forth the Institute's concerns and recommendations in respect of impending regulations relating to the amended definition of tax shelter under sections 6662 and 6111 of the Code.

Background

Tax Executives Institute is the principal association of corporate tax executives in North America. Our approximately 5,000 members represent 2,800 of the leading corporations in the United States and Canada. TEI represents a cross-section of the business community, and is dedicated to the development and effective implementation of sound tax policy, to promoting the uniform and equitable enforcement of the tax laws, and to reducing the cost and burden of administration and compliance to the benefit of taxpayers and government alike. As a professional association, TEI is firmly committed to maintaining a tax system that works -- one that is administrable and, because it provides certainty, that taxpayers can comply with in a cost-efficient manner.

Members of TEI are responsible for managing the tax affairs of their companies and must contend daily with the provisions of the tax law relating to the operation of business enterprises. We believe that the diversity and professional training of our members enable us to bring an important, balanced, and practical perspective to the issues raised by the definition of corporate tax shelter under section 6662 of the Internal Revenue Code, relating to the substantial understatement penalty, and section 6111, relating to the registration requirements for confidential tax shelters.

The Definition of Corporate Tax Shelter

A. In General. Section 6662 of the Internal Revenue Code imposes a 20-percent penalty for "substantial" understatements of tax required to be shown on a return. For corporations, "substantial" is defined as an understatement that exceeds the greater of (i) 10 percent of the tax required to be shown on the return for the taxable year, or (ii) $10,000. Exceptions to the penalty apply if there is substantial authority for the position or if the position is disclosed on the taxpayer's return and there is a reasonable basis for the position. These exceptions do not apply, however -- and, hence, the existence of substantial authority or a taxpayer's disclosure has no effect -- in respect of any item attributable to a corporate "tax shelter." Thus, if a corporation has a substantial understatement attributable to a tax shelter item, the penalty applies with respect to that understatement, unless the reasonable cause exception of section 6664(c)(1) is satisfied.

The Taxpayer Relief Act of 1997, Pub. L. No. 105-34, [sections] 1028, amended section 6662(d)(2)(C)(iii) of the Code to provide a new definition of "tax shelter" for purposes of the substantial understatement penalty. Under this definition, a tax shelter includes (i) a partnership or other entity, (ii) any investment plan or arrangement, or (iii) any other plan or arrangement "if a significant purpose of such partnership, entity, plan, or arrangement is the avoidance or evasion of Federal income tax." (Emphasis added.) Prior to this amendment, the definition of "tax shelter" was defined as a plan or arrangement having as its principal purpose the avoidance or evasion of tax. The new definition thus potentially subjects more transactions to the tax shelter penalty. The change is effective for items with respect to transactions entered into after August 5, 1997.

TEI appreciates Congress's desire to discourage abusive tax-motivated transactions. Whether amending the section 6662 penalty and extending the section 6111 registration provisions were the most efficacious way of accomplishing this goal is open to debate. (Too many penalties combined with vague substantive standards seem in our view a recipe not for enhanced compliance but for uncertainty and frustration by both taxpayers and IRS personnel.) What should not be open to debate, however, is whether Congress intended to capture within the definition of "tax shelter" routine business transactions that incorporate tax reduction planning ideas. It did not. Hence, TEI strongly urges the IRS and Treasury Department to confirm that transactions entered into for legitimate, nontax reasons will not be subject to section 6662(d)(2)(C) simply because the federal tax ramifications were evaluated when analyzing a transaction. Mere consideration of tax consequences should not subject a transaction to the substantial understatement penalty. Moreover, care must taken that the definition does not automatically taint any transactions where an outside adviser is used under a cloak of confidentiality.