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Tax shelters: Traps for the unwary
By C.J. Rhoades
Stout, Causey & Horning, P.A.
What is a tax shelter? It is possible you are participating in one and don't even know it.
A tax shelter is a transaction in which a significant purpose is to avoid or evade federal income tax. There are significant penalties in place for failure to comply with reporting rules related to such transactions, and the Internal Revenue Service has recently issued final regulations governing the disclosure and reporting requirements related to them.
The regulations identify transactions that might be considered tax shelters and the disclosure requirements for them. The transactions are broken down into six categories of "reportable transactions." If a transaction falls into one of these categories, it must be reported on IRS Form 8886, Reportable Transaction Disclosure Statement, unless it meets one of the exceptions provided in the regulations.
The six categories are as follows:
Listed transactions
The IRS has published guidance on certain transactions that have been determined to be tax avoidance transactions. A listed transaction is any transaction that is substantially similar to one of these transactions. "Substantially similar" is defined as any transaction that expected to achieve similar tax consequences and is either factually similar or based on similar tax strategies. Currently, there are more than 20 of these transactions. Notice 2001-51 summarizes 16 of them.
Confidential transactions
If a taxpayer's disclosure of the tax treatment or tax structure of the transaction is limited in any way, whether it be express or implied, the transaction is considered a confidential transaction. However, when conditions of confidentiality are due to disclosure restrictions reasonably necessary to comply with federal and state securities law or in relation to certain mergers and acquisitions, the transaction does not fall into this category. Additionally, facts and circumstances (including the prior conduct of the parties involved) are considered in all cases when determining confidentiality.
Transactions with contractual protection
A transaction with contractual protection is one in which all or part of the fees may be refunded if all or part of the intended tax consequences are not achieved. Transactions also are considered to have contractual protection if the fees are contingent on the amount of benefit the taxpayer receives from the transaction. Similar to confidential transactions, all facts and circumstances are considered when determining if the transaction has contractual protection.
Loss transactions
A loss transaction results in claiming a Section 165 loss of at least:
- $10 million in any one taxable year or $20 million in any combination of tax years for corporations (other than S corporations) or any partnerships that have only corporate owners (other than S corporations);
- $2 million in any tax year or $4 million in any combination of tax years for all other individuals, partnerships, S corporations or trusts;
- $50,000 in any single tax year for individuals or trusts, whether or not the loss flows through from a pass-through entity, if the loss arises from a section 988 transaction (relating to foreign currency transactions).
Revenue Procedure 2003-24 offers additional guidance on loss transactions that might be considered reportable transactions.
Transactions with a significant book / tax difference
Transactions are considered to have a significant book / tax difference if the amount for tax purposes differs from the amount for book purposes by more than $10 million. This applies to any item of income, gain, expense or loss that is a result of the transaction.
This category applies to companies under the Securities and Exchange Act of 1934 (and their related business entities) and business entities that have $250 million or more in gross assets for book purposes at the end of the period that ends within the tax year the transaction occurs.
Revenue Procedure 2003-25 offers additional guidance on certain exceptions to this category.
Transactions involving a brief asset holding period
This category includes transactions in which an asset is held for 45 days or fewer and generates a tax credit greater than $250,000.
Exceptions
In addition to the exceptions for each of the six categories, the IRS included general exceptions to the reporting requirements in the final regulations. These exceptions are for regulated investment companies or investment vehicles that are 95 percent or more owned by regulated investment companies.
If it is unclear to the taxpayer whether or not the transaction falls under one of the six categories or whether it qualifies under one of the many exceptions, the taxpayer may submit a request to the IRS for a ruling on whether the transaction is subject to the disclosure requirements.
The final regulations are generally effective for transactions entered into on or after Feb. 28, 2003. Transitional rules apply to transactions occurring prior to this date.
Penalties
It is essential that participants and potential participants in these types of transactions are made aware of all of the pertinent issues. Failure to disclose one of the above transactions to the IRS could result in significant penalties, including an accuracy-related penalty of 20 percent of the resulting underpayment of taxes. The following example illustrates this point.
Taxpayer A has a tax liability in the amount of $300,000 on his tax return. If not for the benefits of an undisclosed tax shelter, the tax liability would have been $600,000. Taxpayer A could be penalized $60,000 for the $300,000 underpayment of tax.
In addition to the penalties imposed on participants in tax shelters, promoters of tax shelters are subject to fines of up to $10,000 for not properly registering confidential corporate tax shelters. Intentional failure to supply information on tax shelters could result in criminal penalties.
Furthermore, a recent press conference was held at the Department of the Treasury to announce that the IRS and state officials would be using an enhanced system of information-sharing to combat abusive tax shelter arrangements. Because of the scrutiny and potential penalties involved in these types of transactions, it is critical to get competent legal and tax advice when entering into a transaction that could be considered a tax shelter.
C.J. Rhoades is a manager in the Tax Department at Stout, Causey & Horning, P.A.
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