The carrot and the stick: IRS’s new disclosure initiative and guidelines for imposing the section 6662 accuracy-related penalty
Mark H. Ely
The federal tax system in the United States is a system of voluntary compliance and, as such, the Internal Revenue Service relies to a large extent on taxpayers’ willingness to self-report their tax liabilities in order to administer the tax system. Congress has recognized that some taxpayers need additional encouragement to accurately report their tax liabilities and has enacted penalty provisions to deter noncompliance. (1) In some situations, the IRS has waived certain penalties in an effort to give taxpayers an opportunity (and incentive) to comply with new requirements of the Internal Revenue Code or Treasury Regulations. (2)
In late December 2001, the IRS announced a new, two-step program to encourage taxpayer compliance regarding tax shelters and other transactions. Under one step of this program, the “disclosure initiative” announced on December 21, 2001, the IRS generally will waive certain components of the section 6662(b) accuracy-related penalty for taxpayers that disclose their participation in transactions within a window of 120 days, ending on April 23, 2002. Announcement 2002-2, 2002-2 I.R.B. 304 (Jan. 14, 2002).
The other step of the program is a set of new IRS internal penalty guidelines setting forth new policy and procedures for considering and developing penalty issues. In a memorandum dated December 20, 2001, from Larry R. Langdon, Commissioner of the IRS’s Large and Mid-Size Business Division (LMSB), to all LMSB examination personnel, LMSB announced new requirements to be followed in all LMSB examinations regarding the consideration of the section 6662 accuracy-related penalty in cases where taxpayers participated in “listed” and “other potentially abusive tax shelters” (defined later). Revisions will soon be made to the Internal Revenue Manual to incorporate the new guidelines.
Together, the two steps of the program function as a carrot and a stick (the IRS terms it a “compliance incentive”) to encourage taxpayer disclosure of the transactions in which they participate. The disclosure initiative is the “carrot,” in that it offers taxpayers a limited window of opportunity to get the accuracy-related penalty waived if they disclose transactions in which they participated. The penalty guidelines are the “stick,” in that they spell out the consequences that taxpayers may face if they do not take advantage of the window of opportunity offered by the disclosure initiative.
The IRS has been making a concerted effort to deal with what it considers to be abusive tax shelters since early in 2000. In February 2000, the IRS created the Office of Tax Shelter Analysis (OTSA), which is a part of the Pre-Filing and Technical Guidance (PFTG) function in LMSB. OTSA describes itself as being responsible for planning, coordinating, and providing assistance to examiners working abusive tax shelter issues, and serving as a clearinghouse for information that comes to the attention of the IRS relating to potentially improper tax shelter activity by corporate and noncorporate taxpayers. (3) OTSA’s primary focus has been to identify what it considers to be abusive transactions and to expeditiously develop a published IRS position on such transactions.
On February 28, 2000, the IRS published three sets of temporary regulations: Temp. Reg. [section] 1.6011-4T, which requires taxpayers to disclose their participation in “listed” and “other reportable transactions;” Temp. Reg. [section] 301.6111-2T, which requires promoters to register “confidential corporate tax shelters;” and Temp. Reg. [section] 301.6112-1T, which requires tax shelter promoters to maintain a list of each tax shelter participant that must be provided to the IRS within 10 days of the date it is requested.
Although there is no penalty, per se, for failing to disclose under Temp. Reg. [section] 1.6011-4T, a taxpayer’s failure to disclose a “listed” or “other reportable transaction” could affect the taxpayer’s ability to satisfy the reasonable cause and good faith exception to the accuracy-related penalty, if otherwise applicable. The preamble to Temp. Reg. [section] 1.6011-4T states:
If a taxpayer has an underpayment attributable to a reportable transaction
that has not been properly disclosed on its return, the nondisclosure could
indicate that the taxpayer has not acted in “good faith” with respect to
the underpayment, even if the taxpayer’s return position has sufficient
legal justification to meet the minimum requirements of section 6664(c)(1).
In such a case, the determination of whether a taxpayer has acted in “good
faith” will depend on all of the facts and circumstances, including the
reason or reasons why the taxpayer failed to make the required disclosure.
Section 6662(b) generally imposes a 20-percent penalty on any portion of an underpayment of tax required to be shown on a return that is attributable to one or more of the following: (1) negligence or disregard of rules or regulations; (2) any substantial understatement of income tax; (3) any substantial valuation misstatement under chapter 1; (4) any substantial overstatement of pension liabilities; and (5) any substantial estate or gift tax valuation understatement.
With regard to the substantial understatement component of the accuracy-related penalty, section 6662(d)(2)(B)(ii) ordinarily provides relief from the penalty to the extent that the taxpayer had a reasonable basis for the treatment of the item and disclosed the tax treatment of the item in a statement attached to the return. In the case of a “tax shelter” item, however, which for these purposes is defined very broadly as a partnership or other entity, any investment plan or arrangement, or 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,” (5) there is no disclosure exception to the substantial understatement component. (6) Thus, although taxpayers are required under the temporary regulations to disclose their participation in “listed” and “other reportable” transactions, such disclosure will not limit taxpayers’ exposure to the accuracy-related penalty under section 6662. Therefore, even though penalties are imposed for the purpose of encouraging taxpayer compliance, section 6662 provides no incentive for a taxpayer to disclose its participation in a transaction if the transaction could fall under the broad definition of “tax shelter.”
The IRS believes that its new disclosure initiative and accuracy-related penalty guidelines will provide some incentive for taxpayers to disclose their participation in transactions and strengthen its ability to deal with what it perceives as a proliferation of abusive tax shelters. (7) The guideline memorandum states that “[d]isclosure is critical to the IRS’s ability to efficiently and judiciously use its resources to administer the tax laws.” The IRS hopes that disclosures will assist it in evaluating transactions, (8) identifying tax shelter promoters who have not registered the transactions, and finding other taxpayers who have participated in transactions that the IRS finds questionable.
Under Announcement 2002-2, the IRS will waive certain components of the accuracy-related penalty under section 6662(b) on underpayments attributable to disclosed transactions. The Announcement explicitly states that disclosure creates no inference that the tax treatment of the item was improper or that the accuracy-related penalty would apply if there were an underpayment of tax.
Nuts and Bolts of the Disclosure Initiative
1. Waivable Components of the Accuracy-Related Penalty
The waivable components of the accuracy-related penalty under Announcement 2002-2 are: (1) negligence or disregard of rules and regulations under section 6662(b)(1); (2) a substantial understatement of income tax under section 6662(b)(2); (3) a substantial or gross valuation misstatement (except for any portion of an underpayment attributable to a net section 482 transfer price adjustment, unless the documentation rules are satisfied) under section 6662(b)(3); and (4) a substantial overstatement of pension liabilities under section 6662(b)(4). (9)
2. When Waiver Is Not Available
The Announcement provides that taxpayers will not be entitled to a waiver of the accuracy-related penalty for items resulting from transactions that:
(1) did not occur, in whole or part, but for which a tax benefit was claimed; (2) involved the taxpayer’s fraudulent concealment of the amount or source of any item of gross income; (3) involved the taxpayer’s concealment of its interest in, or signature authority over, a financial account in a foreign country; (4) involved the taxpayer’s concealment of a distribution from, a transfer of assets to, or that the taxpayer was a grantor of a foreign trust; and (5) involved the treatment of personal, household, or living expenses as deductible business expenses.
The Announcement also states that disclosure under the initiative “does not affect whether the IRS will impose, as appropriate, any other civil penalty that may be applicable under the Code or will investigate any associated criminal conduct or recommend prosecution for violation of any criminal statute.”
3. When to Disclose
The disclosure initiative provides that, in order for the accuracy-related penalty components to be waived, the taxpayer must make the required disclosure before the earlier of (1) the date the item or another item arising from the same transaction is “raised during an examination” or (2) April 23, 2002. The Announcement provides that, for these purposes, an item is an issue “raised during an examination” if (1) the person examining the return communicates to the taxpayer knowledge about the specific item, or (2) on or before December 21, 2001, the examiner has made a request to the taxpayer for information, and the taxpayer “could not make a complete response to that request without giving the examiner knowledge of the specific item.”
4. Indications of Culpability
Announcement 2002-2 expressly provides that “a taxpayer’s disclosure of an item creates no inference that the taxpayer’s treatment of the item was improper or that the accuracy-related penalty would apply if there were an underpayment of tax.” Indeed, the disclosure initiative provides that taxpayers making disclosures will have the same opportunity to challenge any proposed adjustments to their tax liabilities relating to the disclosed transaction as they would if they had not disclosed their participation in the transaction. Thus, all administrative rights, including IRS Appeals’ consideration, will generally be available to the taxpayer. The Announcement also notes that taxpayers that do not disclose their transactions under the initiative will not be prevented from demonstrating that they satisfy the reasonable cause and good faith exception (10) to the accuracy-related penalty with respect to any portion of an underpayment.
5. Information Required to Be Disclosed
To disclose under the initiative, the Announcement requires that the taxpayer provide the IRS with the following:
* A statement describing the material facts of the item;
* A statement describing the taxpayer’s tax treatment of the item;
* The taxable years affected by the item;
* If the taxpayer is a Coordinated Industry Case (CIC) taxpayer, (11) a statement that the taxpayer will agree to address the disclosed item under the Accelerated Issue Resolution process described in Rev. Proc. 9467, 1994-2 C.B. 800, if requested to do so by the IRS;
* The names and addresses of (a) any parties who promoted, solicited, or recommended the taxpayer’s participation in the transaction underlying the item and who had a financial interest, including the receipt of fees, in the taxpayer’s decision to participate, and (b) if known to the taxpayer, any parties who advised the promoter, solicitor or recommender with respect to that transaction;
* A statement agreeing to provide (if requested) copies of all of the following:
** All transactional documents and, if the taxpayer’s participation was promoted, solicited or recommended by another party, all material received from that other party or its advisor(s);
** All internal documents used by the taxpayer in its decision-making, including, if applicable, information presented to the taxpayer’s board of directors; and
** All opinions and legal analyses of the item, whether prepared by the taxpayer or a tax professional on the taxpayer’s behalf; and
** A penalty of perjury statement that the person signing the disclosure has examined the disclosure and that to the best of that person’s knowledge and belief, the information provided as part of the disclosure contains all relevant facts and is true, correct, and complete.
** In the case of an individual taxpayer, the declaration must be signed by the taxpayer, and not the taxpayer’s representative.
** In the case of a corporate taxpayer, the declaration must be signed and dated by an officer of the corporate taxpayer that has personal knowledge of the facts.
** If the corporate taxpayer is a member of an affiliated group filing consolidated returns, a penalty of perjury statement also must be signed, dated, and submitted by an officer of the common parent of the group.
** In the case of a trust, a state law partnership, or a limited liability company, the declaration must be signed by a person who has personal knowledge of the facts and is a trustee, general partner, or member-manager, respectively.
** A stamped signature is not permitted.
6. Where to File Disclosure
CIC taxpayers are to submit the disclosure information to the assigned team manager, with a copy to OTSA. Non-CIC taxpayers under examination as of December 21, 2001, are to submit this information to the examiner, with a copy to OTSA. Non-CIC taxpayers not under examination as of December 21, 2001, are to submit the information directly to OTSA. OTSA’s address is:
Office of Tax Shelter Analysis
Internal Revenue Service
1111 Constitution Avenue, NW,
Washington, D.C. 20224
The day before the IRS issued the disclosure initiative, LMSB Commissioner Langdon issued new guidelines for considering and developing the accuracy-related penalty in cases dealing with what the guidelines refer to as “listed and other potentially abusive tax shelters.” The new guidelines are the other step that the IRS has taken to address transactions that it views as questionable. Mr. Langdon stated that the guidelines were issued in an effort “to ensure that penalties are considered and applied consistently, impartially, and fairly among all taxpayers.”
During the period of the disclosure initiative, the penalty guidelines will only be used in those cases where the taxpayer does not qualify for a waiver of the accuracy-related penalty. After April 23, 2002, however, the penalty guidelines will be used in all cases where the taxpayer did not disclose under the Announcement and participated in a “listed” transaction under Temp. Reg. [section] 1.6011-4T or “other potentially abusive tax shelter.” The guidelines differ for “listed” transactions and “other potentially abusive tax shelters.” The guidelines also provide factors to be considered in determining whether the taxpayer meets the reasonable cause and good faith exception to the accuracy-related penalty? (12)
The IRS has identified certain “listed” (and substantially similar) transactions as tax avoidance transactions. (13) Corporate taxpayers are required to disclose their participation in these transactions on their returns under Temp. Reg. [section] 1.6011-4T(b)(2). In the case of “listed” (and substantially similar) transactions, the guidelines provide that examiners must consider the accuracy-related penalty for underpayments attributable to a taxpayer’s participation in the transaction. The guidelines instruct examiners to consider and develop the penalty issue and prepare a written report supporting the recommendation to impose or not to impose the penalty. Examiners must also give the taxpayers an opportunity to demonstrate that the penalty should not apply.
The guidelines require that examiners make a thorough assessment of whether the taxpayer has shown that the transaction was not a tax shelter and thus not subject to the provisions in sections 6662 and 6664 that apply to a substantial understatement attributable to a tax shelter. In addition, the guidelines require that examiners assess a number of factors, including whether the taxpayer: (1) was not negligent; (2) if a noncorporate taxpayer with a substantial understatement attributable to a tax shelter, satisfied the requirements of sections 6662(d)(2)(B) and (C) (regarding disclosure of the item giving rise to the understatement); and (3) satisfied the requirements of the reasonable cause and good faith exception under section 6664(c).
The guidelines correctly acknowledge that, for a taxpayer to be subject to the accuracy-related penalty, there must be an underpayment of tax. The guidelines also recognize that a taxpayer’s participation in a “listed” (or substantially similar) transaction may not necessarily result in an underpayment of tax. In every case in which the taxpayer’s participation in a “listed” (or substantially similar) transaction is at issue, however, the guidelines require that, after the penalty issue is fully developed, a recommendation to impose or not to impose the accuracy-related penalty be submitted to the Director of Field Operations (DFO) for approval.
“Other Potentially Abusive Tax Shelters”
With respect to “other potentially abusive tax shelters,” the guidelines concede that the broad definition of “tax shelter” in section 6662 does not provide much guidance whether a transaction is an abusive tax shelter. Thus, the guidelines refer examiners to the five factors listed in Temp. Reg. [section] 1.6011-4T as an aid for evaluating a transaction. (14) The guidelines are careful to point out that, although the factors listed in Temp. Reg. [section] 1.6011-4T may be indicative of “tax shelter activity,” a transaction in which two or more of these characteristics are present “is not necessarily a tax shelter and may not be one for which an adjustment to the taxpayer’s return is warranted.” The guidelines direct examiners to scrutinize those transactions giving rise to an underpayment where the transaction lacks a business purpose, or where tax avoidance was a significant purpose of the taxpayer’s participation in the transaction and the tax benefits claimed by the taxpayer are unusual or not of a kind clearly contemplated under the Code.
After examiners have identified and evaluated the facts regarding a “potentially abusive tax shelter,” the guidelines require that the examiners contact LMSB field counsel and OTSA, which will assist in determining whether the transaction qualifies as a “tax shelter.” In the case of “potentially abusive tax shelters,” if the examiner determines that the section 6662 accuracy-related penalty should be imposed, the Director of Field Operations must approve that decision. If the examiner determines that the penalty should not be imposed, however, no DFO approval is necessary.
Reasonable Cause and Good Faith Exception to the Accuracy-Related Penalty
The new penalty guidelines explain that sections 6662 and 6664 impose higher standards on taxpayers for a substantial understatement attributable to a “tax shelter.” For corporate taxpayers, the only relief from the substantial understatement penalty attributable to a tax shelter is found in section 6664(c)(1), which provides that no penalty will be imposed with respect to any portion of an underpayment if the taxpayer can show that there was reasonable cause and good faith with respect to such portion. Because all taxpayers that participate in a transaction (whether “listed” or otherwise) for which the accuracy-related penalty is being considered have an opportunity to show that there was reasonable cause and good faith, the guidelines provide examiners with insight as to factors that should be considered in making such a determination.
The guidelines instruct examiners that the determination of whether a corporation acted with reasonable cause and in good faith regarding its treatment of a tax shelter is based on all of the pertinent facts and circumstances. Legal justification is listed as one factor to be considered in establishing whether a corporation acted reasonably and in good faith. The guidelines duplicate the concepts found in Treas. Reg. [section] 1.6664-4(e), regarding indications of a taxpayer’s legal justification for a transaction and reasonable cause and good faith regarding the transaction. (15)
In addition to legal justification, the guidelines parrot the preamble to Temp. Reg. [section] 1.6011-4T by stating that whether a corporation disclosed a transaction that was required to be disclosed is relevant to a determination of whether the taxpayer acted reasonably and in good faith. A corporation’s compliance with the reporting requirement of Temp. Reg. [section] 1.6011-4T may indicate that the taxpayer acted reasonably and in good faith with respect to an underpayment attributable to the disclosed transaction. Conversely, a taxpayer’s noncompliance with the reporting requirement of Temp. Reg. [section] 1.6011-4T may indicate that the taxpayer did not act reasonably and in good faith.
The guidelines are also careful to point out that a corporation that did not disclose a “reportable transaction” may still establish that it acted reasonably and in good faith if, for example, the corporation shows that it reasonably believed it satisfied one of the exceptions in Temp. Reg. [section] 1.6011-4T(b)(3)(ii). (16) The guidelines direct examiners to consult with LMSB field counsel for assistance in determining whether a taxpayer acted with reasonable cause and in good faith.
Strategic Considerations/Factors to Consider
Taxpayers making disclosures under the initiative are required to identify the promoters, solicitors, or persons who recommended or had financial interests in the transaction. In turn, if the transaction constitutes a “potentially abusive tax shelter” as defined in section 6112 and the applicable regulations, the promoters, organizers, or sellers of the transaction must provide the IRS with a list of all investors in the transaction within 10 calendar days of the IRS’s request for such information. (17) Thus, the IRS hopes that the disclosure initiative will assist it in identifying promoters as well as other investors who participated in the transaction. Taxpayers that have participated in transactions will, therefore, have to decide strategically whether disclosure would be in their best interests, taking into account the facts and circumstances of their particular situations.
Some of the reasons for a taxpayer to take advantage of the initiative are: (1) to avoid the imposition of the accuracy-related penalty; (2) to avoid the expenses and resources associated with contesting the imposition of the penalty; and (3) to put the taxpayer in a better settlement or litigation position concerning the underlying tax issue. Thus, of significant import will be the taxpayer’s assessment of its likelihood of prevailing on the underlying merits of the transaction and the chances that the IRS may assert a penalty in the event the anticipated tax benefits are disallowed. The taxpayer’s determination whether the reasonable cause and good faith exception would be satisfied if a penalty were asserted will also be significant. For example, if the taxpayer has reasonably relied in good faith on an opinion letter meeting the requirements set forth in the section 6664 regulations, (18) the taxpayer may not be subject to the accuracy-related penalty. (19) In coming to a decision regarding the initiative, many factors should be considered, including those highlighted below:
Transactions Previously Disclosed Under Temp. Reg. [section] 1.6011-4T
Taxpayers that have already disclosed their participation in a “listed” or “other reportable transaction” under Temp. Reg. [section] 1.6011-4T may have already alerted the IRS to the transaction. The IRS may scrutinize the transaction based on the taxpayer’s Temp. Reg. [section] 1.6011-4T disclosure. If the transaction is a “listed” transaction, it is very likely that the IRS will inquire about the transaction and will consider penalties pursuant to the new guidelines. Any information required under the disclosure initiative will be submitted to OTSA, which is the same office that receives and analyzes the Temp. Reg. [section] 1.6011-4T disclosure statements. Thus, although the information to be submitted will likely be different–more expansive information is required under the initiative–the level of scrutiny will likely be very similar. (20)
Transactions Not Previously Disclosed Under Temp. Reg. [section] 1.6011-4T
Taxpayers that have not previously disclosed their participation in a “listed” or “other reportable transaction” under Temp. Reg. [section] 1.6011-4T may take into account, in determining whether to disclose under the new initiative, the possibility that the transaction otherwise would be subject to IRS scrutiny. One important factor to consider is whether one or more participants in the same or similar transaction will disclose the transaction to the IRS, which could result in the IRS being able to identify all the participants. Disclosure does not imply that the tax treatment of a transaction was improper, nor does it inhibit the taxpayer’s ability to argue the merits of the transaction, but it does preclude the imposition of the accuracy-related penalty under section 6662(b). Remember that the disclosure opportunity expires on April 23, 2002. If the IRS learns of the transaction from another source and raises it first in an examination of a taxpayer’s return, the taxpayer will be precluded from taking advantage of the initiative.
A CIC taxpayer has a coordinated examination team on site that constantly reviews that taxpayer’s returns. Thus, it is much more likely that a CIC taxpayer’s participation in a transaction will be discovered by the IRS, especially if it is an unusually large item or is something that is al ways reviewed by the coordinated exam team (e.g., Schedule M-1, “Reconciliation of Income (Loss) per Books With Income per Return”). (21) Depending on the likelihood of prevailing on the underlying merits, if challenged, and the taxpayer’s satisfaction of the reasonable cause and good faith standards, CIC taxpayers must analyze the chances of an underpayment and of penalty imposition.
Level of Scrutiny
The level of scrutiny that disclosed transactions will receive by the IRS is also an important factor that all taxpayers contemplating disclosure should consider. Taxpayers seeking a waiver of the accuracy-related penalty under the disclosure initiative must provide information on the transaction to OTSA. The IRS has acknowledged that it plans to scrutinize carefully every disclosed transaction in order to determine if it considers the transaction to be “listed” or an “other potentially abusive tax shelter.” OTSA has indicated that it will coordinate its review of disclosed transactions with IRS national office attorneys. If the taxpayer determines that there is a strong likelihood of prevailing on the merits, if challenged, whether or not OTSA scrutinizes the transaction may not be as important to the taxpayer. If the taxpayer is unsure, however, whether the treatment of the item on the return will be accepted by the IRS, the taxpayer may decide that it is not in its best interest to disclose its participation in the transaction.
Information Required to Be Disclosed
In making the decision whether or not to disclose participation in a transaction, taxpayers should consider the information that will be required to be disclosed. First, the disclosure initiative requires that the taxpayer agree to provide a comprehensive list of information and documentation regarding the transaction. The information required is much broader than the information required on the section 6011 disclosure. (22) Second, although most of the information required may be discoverable by the IRS in an examination of the taxpayer’s return for the year in question, some information that may have to be disclosed under the initiative, such as legal opinions or various legal risk analysis memoranda, may not ordinarily be discoverable by the IRS. Thus, in deciding whether to make a disclosure under the initiative, taxpayers must consider whether the information required is available to the IRS, otherwise discoverable, or otherwise ordinarily privileged.
Taxpayers considering making a disclosure under the initiative need to be cautioned about the possible implications of the requirement that the taxpayer include:
A statement agreeing to provide, if requested, copies of all of the following:
(a) All transactional documents, including agreements, contracts, instruments, schedules, and, if the taxpayer’s participation in the transaction was promoted, solicited or recommended by any other party, all material received from that other party or that party’s adviser(s);
(b) All internal documents or memoranda used by the taxpayer in its decision-making process, including, if applicable, information presented to the taxpayer’s board of directors; and
(c) All opinions and legal analyses of the item, whether prepared by the taxpayer or a tax professional on behalf of the taxpayer.
This disclosure requirement is extremely broad and could encompass communications that would ordinarily be subject to attorney-client privilege, the work product doctrine, or the section 7525 confidentiality privilege. (23) Given this broad language, it is not clear whether the IRS expects taxpayers that want to avail themselves of the initiative to turn over otherwise confidential communications. For example, under the work product doctrine the IRS would not ordinarily be entitled to memoranda prepared by the taxpayer, or on behalf of the taxpayer, in anticipation of litigation.
The IRS is currently considering this issue, but has informally stated that it wants taxpayers to disclose opinion letters regarding the transaction — whether subject to any privilege or not — ordinarily used by a taxpayer for purposes of establishing that the taxpayer had reasonable cause and good faith. The IRS’s rationale for wanting such documents is that, because the IRS is waiving the penalty, the IRS should be entitled to that which was ordinarily used to get the penalty waived under the reasonable cause and good faith exception to the accuracy-related penalty (i.e., reliance on the advice of a practitioner). The IRS has also said informally that it may require production of documents or communications obtained by the taxpayer after the transaction has been reported on the return. But, the IRS continued, turning over certain documents was not intended to make taxpayers effect a waiver of any privilege that otherwise would apply to communications with a similar subject matter. (24)
The area of privilege is a gray one, and there is no clear indication how far the IRS will push the issue under the initiative. The IRS could determine that, because the relief from penalties under the initiative is a matter of administrative grace, it will only allow such relief if privileged documents are disclosed. One would hope that the IRS will reasonably administer the initiative such that it will not expect taxpayers to provide information to which it would not otherwise be entitled, but unless the IRS releases further guidance on this particular disclosure requirement, the uncertainty will remain. This lack of certainty may affect a taxpayer’s decision regarding whether to disclose a transaction. Indeed, once a taxpayer discloses a transaction, if a disagreement subsequently arises regarding the documents that need to be turned over to the IRS, there may be no way for the taxpayer to “back-out” of making the disclosure.
Interaction of Disclosure Initiative and Penalty Guidelines
Given that the stated purpose of penalties is to encourage compliant conduct, the IRS is to be commended for attempting an initiative having a goal of encouraging taxpayer disclosure. Although there are issues with the information required to be submitted by taxpayers to avail themselves of the initiative and although the disclosure initiative is being offered for just a limited time, it is a step in the right direction. It may, depending on a taxpayer’s facts and circumstances, encourage taxpayers to disclose their participation in transactions. While the disclosure initiative may help both taxpayers and the IRS in resolving issues regarding various types of transactions, the penalty guidelines make it clear that the IRS will scrutinize transactions (specifically “listed” and “other potentially abusive tax shelters”) from now on, and that it will fully consider the application of the accuracy-related penalty. The window of time offered by the disclosure initiative provides taxpayers with an opportunity, which would not ordinarily be available to them, to have certain components of the accuracy-related penalty waived. Taxpayers are on notice that, once that window is closed, the IRS will fully consider the application of the accuracy-related penalty and will impose it, if appropriate.
One hopes that the IRS will administer the disclosure initiative in a reasonable manner and in the spirit in which it was offered. Taxpayers that qualify and make disclosures in accordance with the initiative should be given blanket relief from the waivable components of the accuracy-related penalty. Optimistically, taxpayers will not be denied relief after disclosing because, for example, the examiner claims that, given the information provided before the disclosure, the taxpayer’s participation in the transaction could have been discovered, or that the taxpayer did not provide the examiner with privileged materials to which the examiner would not otherwise ordinarily be entitled.
As far as the penalty guidelines are concerned, they afford taxpayers the opportunity to be fairly and consistently treated. The consideration of the accuracy-related penalty will no longer be considered on an ad hoc basis. Rather, examiners are required to fully develop the issue and obtain approval from the DFO before the penalty can be imposed.
Taxpayers must fully understand the consequences and weigh the pros and cons of disclosure in order to make informed decisions regarding their particular situations. Depending on one’s facts, taxpayers may regard the disclosure initiative and the penalty guidelines as a unique opportunity to resolve unsettled issues. Because this is an important matter with significant ramifications, taxpayers should consult their tax professionals in making this decision.
(1) See, e.g., Notice 99-4, 1999-1 C.B. 318, citing H.R. Rep. No. 386, 101st Cong., 1st Sess. 661 (1989) (“Penalties encourage voluntary compliance by: (1) helping taxpayers understand that compliant conduct is appropriate and that noncompliant conduct is not; (2) deterring noncompliance by imposing costs on [noncompliance]; and (3) establishing the fairness of the tax system by justly penalizing the noncompliant taxpayer.”). Even though other results, such as revenue raising, punishment, or reimbursement of the costs of enforcement, may also arise when penalties are asserted, the IRS is to design, administer, and evaluate penalty programs solely on the basis of whether they do the best possible job of encouraging compliant conduct. See Penalty Policy Statement P-1-18, I.R.M. Penalty Handbook 120.1, Exhibit 1-1 (Aug. 20, 1998).
(2) The IRS has waived penalties where taxpayers were required to use a new filing method or a means of filing that would require the purchase of electronic equipment or special software. See, e.g., Notice 97-43, 1997-2 C.B. 294, where the IRS temporarily waived the failure to deposit penalty of section 6656 for taxpayers that were first required to submit payroll tax deposits using the Electronic Federal Tax Payment System (EFTPS) on or after July 1, 1997, and submitted their payroll tax deposits timely but failed to use EFTPS.
(3) IRS Office of Tax Shelter Analysis Report to Treasury, 2001 TNT 250-11 (Dec. 18, 2001).
(4) T.D 8877, 65 Fed. Reg. 11205, 11206.
(5) I.R.C. [section] 6662(d)(2)(C)(iii).
(6) I.R.C. [subsection] 6662(d)(2)(C)(iii), (d)(2)(C)(i)(I), (d)(2)(C)(ii), and Treas. Reg. [section] 1.6662-4(g)(1)(iii).
(7) In remarks before the Federal Bar Association on February 28, 2000, then-Treasury Secretary Lawrence H. Summers stated that since 1990, the gap between book income and taxable income had more than doubled, in real terms, to more than $90 billion. See “Tackling the Growth of Corporate Tax Shelters,” Treasury Press Release No. LS-421 (Feb. 29, 2000).
(8) OTSA has indicated that, in the first 11 months of 2001, 272 voluntary disclosures were made by 95 taxpayers. Of those disclosures, 72 were listed transactions. OTSA contends that the listed transactions, alone, resulted in $4.4 billion in tax savings for the 2000 tax year. The total tax savings from all of the transactions disclosed equaled $14.7 billion. OTSA Report to Treasury, 2001 TNT 250-11 (Dec. 18, 2001).
(9) The only component of the accuracy-related penalty that is not waivable under the initiative is that which is attributable to a substantial or gross estate or gift tax valuation understatement under I.R.C. [section] 6662(b)(5).
(10) I.R.C. [section] 6664(c) and Treas. Reg. [section] 1.6664-4(e).
(11) The IRS previously referred to CIC taxpayers as CEP or “Coordinated Examination Program” taxpayers. CIC taxpayers are approximately the top 1,300 to 1,600 large business taxpayers, have a coordinated IRS examination team on site, and are generally continually under audit.
(12) I.R.C. [section] 6664(c) and Treas. Reg. [section] 1.6664-4(e).
(13) The latest list of “listed” transactions is set forth in Notice 2001-51, 2001-34 I.R.B. 190.
(14) Temp. Reg. [section] 1.6011-4T lists the following five factors, the presence of any two of which indicate that a transaction is “reportable” (assuming the tax savings are sufficiently large and no exception applies): (1) the taxpayer participated in the transaction under conditions of confidentiality; (2) the taxpayer received contractual protection against the possibility that all or part of the intended tax benefits would not be sustained; (3) the taxpayer’s participation in the transaction was promoted, solicited, or recommended by one or more persons who are expected to receive, in the aggregate, more than $100,000 in fees or other consideration, and such amounts were contingent on the taxpayer’s participation in the transaction; (4) the expected tax treatment of the transaction for federal income tax purposes in any taxable year differs or is expected to differ by more than $5 million from the treatment of the transaction for purposes of determining book income as taken into account on Schedule M-1 (or comparable schedule) on the taxpayer’s federal corporate income tax return for the same period; or (5) the transaction involves the participation of a person that the taxpayer knows or has reason to know is in a different federal income tax position from that of the taxpayer (e.g., a tax-exempt entity or foreign person) and the taxpayer knows or has reason to know that such difference in tax position has permitted the transaction to be structured on terms that are intended to provide the taxpayer with more favorable federal income tax treatment than it could have obtained without the participation of such person.
(15) Treas. Reg. [section] 1.6664-4(e)(2)(i) provides that to rely on legal justification, a corporation must demonstrate, at a minimum, that (1) “there is substantial authority for the tax treatment of the item,” and (2)”based on all of the facts and circumstances, the corporation reasonably believed, at the time the return was filed, that the tax treatment of the item was more likely than not the proper treatment.” Treas. Reg. [section] 1.6664-4(e)(4) provides that other facts and circumstances may be considered, as appropriate, in determining whether a corporation acted with reasonable cause and in good faith with respect to a tax shelter item, regardless of whether it satisfied the minimum requirements for legal justification. In addition, Treas. Reg. [section] 1.6664-4(e)(3) provides that, depending on the circumstances, satisfaction of the minimum requirements for legal justification may not be dispositive if the taxpayer’s participation in the tax shelter lacked a significant business purpose, if the taxpayer claimed tax benefits that are unreasonable in comparison to the taxpayer’s investment in the tax shelter, or if the taxpayer agreed with the organizer or promoter of the tax shelter that the taxpayer would protect the confidentiality of the tax aspects of the structure of the tax shelter.
(16) Some exceptions are the taxpayer participated in the transaction in the ordinary course of business in a form consistent with customary commercial practice and would have participated in the transaction irrespective of the expected federal income tax benefits; the taxpayer participated in the transaction in the ordinary course of its business and the taxpayer reasonably determines that there is a generally accepted understanding that the expected federal income tax benefits from the transaction are allowable under the Code; or the taxpayer reasonably determines that there is no reasonable basis under federal tax law for denial of any significant portion of the expected federal income tax benefits from the transaction.
(17) I.R.C. [section] 6112(c); Temp. Reg. [section] 301.6112-1T, Q&A 21.
(18) The requirements of Treas. Reg. [section] 1.6664-4(c) must be satisfied in order for the taxpayer to have reasonably relied on a tax opinion or advice. Those requirements are: (1) the advice must be based on all pertinent facts and circumstances and the law as it relates to those facts and circumstances; and (2) the advice must not be based on unreasonable factual or legal assumptions (including assumptions about future events) and must not unreasonably rely on the representations, statements, findings, or agreements of the taxpayer or any other person.
(19) Treas. Reg. [section] 1.6664-4(e)(3) provides that a corporate taxpayer’s reliance on an opinion may not be dispositive. For example, if the taxpayer’s participation in the transaction lacked significant business purpose, if the taxpayer claimed tax benefits that are unreasonable in comparison to the taxpayer’s investment in the transaction, or if the taxpayer agreed with the organizer or promoter of the transaction that the taxpayer would protect the confidentiality of the tax aspects of the structure of the tax shelter, then the taxpayer may not have acted with reasonable cause and in good faith.
(20) It is not clear from Announcement 2002-2 that a taxpayer that had made a proper disclosure prior to December 21, 2001, would be entitled to relief under the initiative by making a second disclosure, including any additional information that the initiative may require. The IRS has informally confirmed, however, that taxpayers that disclosed on their returns in accordance with the section 6011 regulations will also be entitled to take advantage of the disclosure initiative. Disclosure under the initiative gives the IRS more information than it would receive from a typical Temp. Reg. [section] 1.6011-4T disclosure. More fundamentally, if taxpayers that previously voluntarily complied with the requirements of Temp. Reg. [section] 1.6011-4T were punished for such compliance by not being entitled to the penalty waiver, the disclosure initiative would not be furthering its purpose of encouraging voluntary compliance. Indeed, it could actually discourage compliant taxpayers from complying with regulatory requirements in the future.
(21) Temp. Reg. [section] 1.6011-4T(b)(3)(D) provides that one of the factors potentially indicative of tax shelter activity is that the expected treatment of the transaction for federal income tax purposes in any taxable year differs or is expected to differ by more than $5 million from the treatment of the transaction for purposes of determining book income as taken into account on the Schedule M-1 (or comparable schedule) on the taxpayer’s federal corporate income tax return for the same period.
(22) For example, under Temp. Reg. [section] 1.6011-4T, a taxpayer is required to: (1) identify the transaction; (2) provide a statement regarding whether the transaction has been registered under section 6111; (3) provide a description of the transaction; (4) describe the principal tax benefits of the transaction; (5) estimate the expected reduction of federal income tax liability for affected taxable years; and (6) provide the names and addresses of any promoters. In contrast, under the disclosure initiative, in addition to the items listed above, the taxpayer must agree to provide the IRS with copies of all transactional documents, promotional materials received, memoranda prepared in determining whether to enter into the transaction, and opinions and memoranda providing a legal analysis of the item.
(23) In very general terms, the attorney-client privilege protects confidential communications between attorneys and their clients in connection with rendering legal advice given by the attorney. It is intended to encourage “full and frank communication between attorneys and their clients and thereby promote broader public interests in the observance of law and the administration of justice.” Upjohn Co. v. United States, 449 U.S. 383 (1981). It also may protect communications disclosed to agents of the attorney who are assisting the attorney in providing legal advice to the client. Agents of the attorney include accountants or other tax professionals retained by, and functioning under the direction and control of, the attorney. United States v. Kovel, 296 F.2d 918 (2d Cir. 1961). The work product doctrine is codified by Rule 26(b)(3) of the Federal Rules of Civil Procedure, and it protects against disclosure of mental impressions, conclusions, opinions, or legal theories of an attorney or other representative of a party in anticipation of litigation. The section 7525 confidentiality privilege was enacted as part of the IRS Restructuring and Reform Act of 1998, and it generally extends attorney-client privilege to tax advice furnished to a client-taxpayer (or potential client-taxpayer) by any individual who is authorized under Federal law to practice before the IRS if such practice is subject to regulation under 31 U.S.C. [section] 330. The section 7525 privilege does not apply to written communications between a federally authorized tax practitioner and a corporation in connection with the promotion of the direct or indirect participation in any “tax shelter,” as defined in section 6662(d)(2)(C)(iii).
(24) IRM 22.214.171.124.4 provides: “Once a party has begun to disclose any confidential communication for a purpose outside the scope of the attorney-client privilege, the privilege is lost for all communications relating to the same matter. A party cannot choose to disclose only so much of allegedly privileged material as is helpful to his case.” Karme v. Commissioner, 73 T.C. 1163, 1184-85 (1980), aff’d on other grounds, 673 F.2d 1062 (9th Cir. 1982); Teachers Insurance & Annuity Association of America v. Shamrock Broadcasting Co., 521 F. Supp. 638, 641 (S.D.N.Y. 1981).”
* Mr. Ely expresses his appreciation to the following members of KPMG’s Washington National Tax group: Bridget Finkenaur, Harve Lewis, Norlyn Miller, and Nancy Galib.
MARK H. ELY is National Partner-In-Charge of Tax Controversy Technical Services in the Washington National Tax Practice of KPMG LLP. He previously served as acting Branch Chief/Assistant Branch Chief in the IRS’s Office of the Assistant Chief Counsel (Income Tax and Accounting). Mr. Ely received a B.S. degree in Accounting and Business and Management and a J.D. degree from the University of Maryland. Mr. Ely is a former chair of the AICPA’s Practice and Procedure Committee and is on the AICPA’s Tax Executive Committee. He is a frequent speaker at TEI’s educational programs.
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