The new penalty regime finally arrives: proceed with caution!

Tax Executive, The, Nov-Dec, 2004 by Herbert N. Beller

We all knew it had to happen sooner or later. After several false starts, Congress recently passed a robust package of anti-tax shelter measures as part of the American Jobs Creation Act of 2004 (the "Jobs Act"). (1) The centerpiece of the tax shelter provisions is a quiver of stiff new statutory penalties tied to the nondisclosure of "reportable transactions" and aimed not only at offending taxpayers but their outside advisers as well.

Overview

New section 6707A of the Internal Revenue Code (2) prescribes a fixed dollar penalty for each failure to adequately disclose any type of "reportable transaction" (RT), as identified in the Treasury regulations under section 6011, regardless of whether such transaction is successfully challenged by Internal Revenue Service on the merits (Nondisclosure Penalty). For corporate taxpayers, the penalty is $200,000 for so-called listed transactions (LTs), including transactions "substantially similar" to a listed transaction; and $50,000 for all other RT categories. For LTs, the Nondisclosure Penalty is absolute--there is no process for obtaining a waiver, rescission, or abatement based on a "reasonable cause" or other subjective standard. For undisclosed RTs other than LTs, only the Commissioner can waive or rescind the Nondisclosure Penalty and then only in very limited circumstances.

New section 6662A provides a more stringent set of accuracy-related penalty rules for RTs--increasing the ante from 20 percent to 30 percent for undisclosed LTs and "reportable avoidance transactions" (RATs); and more expansively calculating the "understatement" against which the penalty is applied. The accuracy penalty can now be avoided in the case of an RT only if it is disclosed and qualifies for dispensation under the "strengthened reasonable cause exception" described in new section 6664(d). What's more, in the case of LTs and RATs, the circumstances in which taxpayers can avoid the accuracy penalty via reliance on an outside tax opinion have been narrowed considerably.

Public companies must report to the SEC their required payment of any Nondisclosure Penalty with respect to a LT. SEC reporting also is required for increased accuracy penalties imposed with respect to undisclosed LTs or RATs.

Additional new penalties apply to "material advisors" (MAs), who are now required to file special information returns with respect to any RT advised upon. Failure to file a required information return triggers a $50,000 penalty in the case of RTs other than LTs; and a $200,000 or possibly greater penalty in the case of an LT. Another new penalty--$10,000 per day--will be imposed on MAs who fail to furnish required RT "list maintenance" information requested by the IRS. On November 16, 2004, in Notice 2004-80, the IRS issued interim guidance relating to certain aspects of the new MA provisions.

The new rules are generally effective for transactions reportable in returns due after the date of enactment (October 22, 2004). Taken together, they put real teeth into the RT disclosure regulations, place added pressure upon companies to implement effective internal procedures for identifying and reporting RTs, and potentially affect the nature and scope of relationships between companies and outside professionals. They also increase the importance of upfront communication between taxpayers and their advisers on whether the transaction is a RT or the adviser is a MA--and, if so, what disclosure responsibilities and potential penalties flow from such status.

The Nondisclosure Penalty

The Nondisclosure Penalty is imposed upon taxpayers who fail to disclose any type of RT. Tied solely to nondisclosure, it has nothing to do with whether the IRS challenges (successfully or unsuccessfully) the taxpayer's reported tax treatment of the underlying transaction. The amount of the penalty varies depending on whether the transaction is a LT or another type of RT, and also depending on the type of taxpayer involved (but not, as under the Senate bill, upon the size or wealth of the taxpayer). The penalty is effective with respect to RTs (LTs or otherwise) for which disclosure is required in returns or statements due after October 22, 2004. (3)

Listed Transactions

For undisclosed LTs, the penalty is $100,000 in the case of any natural person, and $200,000 for corporations and all other non-individual taxpayers. It cannot be waived, rescinded, or abated under any circumstances; in other words, it is a "strict liability" penalty. (4)

There currently are 30 LTs that Treasury and the IRS have identified as abusive tax shelters in notices or other published guidance. (5) Disclosure is also required for transactions which are "substantially similar" to a LT. These include transactions that are based on a "similar tax strategy," even if the transactional structure or fact pattern is dissimilar from that of the LT. The regulations warn that the "substantially similar" concept will be broadly construed. (6)

Given especially the strict liability nature of the Nondisclosure Penalty for LTs, taxpayers may opt to deal with potential uncertainty about "substantially similar" status by filing a protective disclosure pursuant to a procedure specifically permitted under the RT regulations. (7) Some taxpayers may be reluctant to acknowledge that a transaction might be viewed as having LT overtones. Particularly for public companies, however, a protective disclosure will normally be advisable; for imposition of a Nondisclosure Penalty with respect to a LT must be reported to the SEC, and a failure to do that will trigger a separate, additional Nondisclosure Penalty. (8)