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Tax
Advisors vs. Taxpayers
By
However, the government has been relentlessly extending the varied tax penalty provisions applicable to tax preparers and advisors to the point where the advisors and preparers are caught in a dilemma. Overly aggressive representation of clients can easily put a preparer or advisor into a position where they can be subject to varied penalties, which might even result in the loss of their license to practice law or accounting in addition to some significant financial penalties as described in this report.
The IRS has issued regulations that govern the conduct of tax advisors and tax preparers. These regulations are combined in a document called Circular 230 – Regulations Governing Practice Before the Internal Revenue Service. The tax law specifically permits attorneys, CPAs, enrolled agents and enrolled actuaries to represent taxpayers in disputes with the IRS. Circular 230 requires tax return preparers to sign a return prepared for compensation, to provide a copy of the return to the taxpayer, to keep a copy of the return, to avoid misleading advertising and some other ministerial duties. Modest penalties are imposed for violations of these rules. More substantial penalties are imposed if a return preparer understates a taxpayer’s tax liability due to taking unrealistic positions or to recklessly disregard of the rules and regulations or aiding and abetting a taxpayer in the understatement of a federal tax liability. The circular also sets forth the requirements for disclosure of certain tax shelter transactions by tax professionals who assist in the promotion of any tax shelters. In addition, the circular includes an explanation of revised regulations relating to the issuance of a tax opinion -- which is discussed later in this report. Please note that this is a very brief summary of an 84 page document. (A link to the complete document is included in the Appendix.)The American Jobs Creation Act of
2004 (Jobs Act) explicitly authorizes the revised regulations
governing
return preparers and regulations governing those who are involved in
the
promotion of tax shelters. [1]
The new Jobs Act strengthens
our hand in
the
fight against abusive shelters, said IRS Commissioner Mark W. Everson. Under the new
law, attorneys, accountants and other tax advisers who
fail
to comply with these disclosure requirements will face significant
monetary penalties
In addition, the
Jobs Act
modifies the reporting requirements for material advisors involved in
providing
aid, assistance or advice regarding organizing, managing, promoting,
selling,
implementing, insuring or carrying out any reportable transaction – AND
– who
receive (directly or indirectly) compensation of at least $50,000 in
the case
of an individual investor or $250,000 for other investors.
The reporting
requirement
includes providing information to the IRS identifying and describing
the
transaction, the potential tax benefits expected from the transaction
and any
other information required by the IRS.
On the surface,
it might
appear that these changes only apply to those taxpayers (and their tax
advisors) who are involved in large tax shelter transactions or
transactions
involving large corporations. But, revised regulations also impose new
obligations on tax professionals and taxpayers engaged in any kind of
tax
avoidance transaction. While it might
not be the clear intent of the Congress or even of the IRS to extend
that
authority to include transactions that are sanctioned by the Internal
Revenue
Code, there is enough ambiguity in the new regulations to cause may tax
advisors
and preparers to disclose transactions that are in doubt.
The primary
benefit of
getting a written opinion letter from a tax professional is that it
represents
a form of insurance against civil fraud penalties for reckless
disregard of
the tax code and related regulations.
Tax code section 6662 imposes a penalty of 20% of an
underpayment of tax
for a transaction that is found to be (1) a substantial understatement
of tax,
(2) a tax shelter and (3) substantial valuation understatements. Code
section
6663 imposes a civil fraud penalty of 75% of an underpayment that is
found to
be attributable to fraud – which is a willful intent to evade a tax.
Tax code
section 6664(c) provides for an exception to these penalties for a
reasonable
cause where the taxpayer acted in good faith.
In practice,
reasonable cause and good faith can be demonstrated
by
showing that the taxpayer sought advice from a qualified tax
professional, that
the taxpayer did in fact follow that advice and that the position was
disclosed.
Recent IRS final
regulations
(TD 9109) modify the rules as to when reliance on an opinion letter
will
relieve the taxpayer of penalties. One of the changes is that
In addition,
this new
regulation stipulates that
…reliance
(on a tax advisor) may not be
reasonable
or in good faith if the taxpayer knew, or reasonably should have known,
that
the advisor lacked knowledge in the relevant aspects of Federal Tax Law.
The days of
gambling on
whether the details of a tax return might not be examined (the so
called audit
lottery) are over. Many tax preparers and advisors will hereafter take
the
position that any contemplated tax avoidance transaction should be
disclosed in
order to minimize potential penalties. (More aggressive advisors may
disagree.)
And, it is possible that the IRS will not use the new regulations to
encompass
transactions that are clearly sanctioned and even encouraged by the
Congress -- such as tax exempt bond interest, exempt gains on the sale
of a
personal residence, claiming section 179 expense deductions for
equipment and other transactions that are clearly intended to provide
tax benefits by the Internal Revenue Code.
New Disclosure Rules in
the Jobs Act
of 2004
The Jobs Act
added a new
concept of reportable transactions in tax code sections 6707 and
6707A that
impose new penalties for a failure to disclose certain reportable
transactions in the return of a taxpayer. Reportable transactions
include ….
A
reportable transaction is
any transaction with respect to which information
is required to be included with a return or statement because (under
Section
6011) such transaction is of a type which the Secretary determines as
having a
potential for tax avoidance or evasion. [IRC 6707A(c)(1)]
A
listed transaction is one
that is
a reportable transaction which
is the same as, or substantially
similar to, a transaction
specifically identified by the Secretary (of the
IRS) as a tax avoidance transaction for purposes of Section 6011.
(Emphasis
added.) [IRC 6707A(c)(2)]
Tax code section
6011
provides very broad authority to the IRS to require taxpayers to submit
returns
and information prescribed by the Secretary.
Substantially
similar to
is not defined in the Jobs Act but is defined by the IRS in
regulations. (The
regulations have already been issued [1.6011-4(c)(4)] and the Jobs Act
effectively authorizes the regulations after-the-fact.) The regulations
describe the phrase as …any
transaction that is expected to produce
the same
or similar types of tax consequences and that is either factually
similar or
based on the same or a similar tax strategy.
(Comments
about the problems that may arise in
determining what constitutes a substantially similar transaction are
discussed
later.)
Listed
transactions are set
forth in IRS regulations 1.6011-4. A non-technical description of these
transactions can be found at the IRS web site at
http://www.irs.gov/businesses/corporations/article/0,,id=120633,00.html and
http://www.irs.gov/individuals/content/0,,id=97749,00.html
Confidential
transactions are those
where a paid tax advisor or promoter (who
receives a minimum fee) requires the taxpayer and any independent tax
professionals to sign a non-disclosure agreement in order to receive
the
details of the proposed transaction. A minimum fee is one where the
advisor or
promoter receives at least $250,000 if the taxpayer is a corporation or
$50,000
for other taxpayers. (Further details
about the definition of confidential transactions have been provided in
TD
9108.)
Contractual
protection is an
arrangement where the taxpayer or a related
party receives a full or partial refund of fees if all or part of the
proposed
tax benefits are not sustained in a dispute with the IRS. It does not
appear
that there is any dollar threshold for transactions with contractual
protection.
Loss
transactions are defined
as
…
transactions that are not included in
the angel
list of acceptable transactions (Rev. Proc. 2003-24) and that result
in a deductible
loss exceeding (1) $10 million in any single taxable year or $20
million in any
combination of years for a corporation or partnership; (2) $2 million
in any
single taxable year or $4 million in any combination of taxable years
for
individuals, S corporations or trusts and (3) $50,000 in any single
taxable
year … if the loss arises with respect to a section 988 transaction
related to
foreign currency transactions.
The reference to
section 165
is to the tax code section that sets forth the rules for most types of
loss
deductions. A section 988 transaction involves forward contracts,
futures
contracts or options on foreign currencies.
Specific
exceptions to the
requirement to report loss transactions are described in IRS Revenue
Procedure
2004-66 (http://www.irs.treas.gov/pub/irs-drop/rp-04-66.pdf ).
Generally, the exceptions include casualty losses, involuntary
conversions, certain mark-to-market losses, losses determined by
reference to
cash payments and various other losses as described in Rev. Proc.
2004-66. Taxpayers
who incur losses in excess of the amounts described above should expect
to pay
their tax preparer to spend the time to become familiar with this
Revenue
Procedure or will need to find a preparer who has already taken the
time to do
so. If a taxpayer is not certain if a transaction is a reportable
transaction
they can file the Form 8886 (discussed below) by writing Protective
Disclosure at the top of the form.
Transactions
with a significant book-tax difference include transactions where the tax
treatment of an
item differs from the accounting treatment of the item by more than $10
million
for a taxable year. However, this
reporting requirement only applies to companies that are subject to
disclosure
under the Securities and Exchange Act of 1934 or business entities with
$250
million or more in gross assets. IRS Revenue Procedure 2003-25
describes 30
items that are excluded from this reporting requirement. (http://www.unclefed.com/Tax-Bulls/2003/rp03-25.pdf
)
The Required Disclosure
Statement
Filing the form
does not
mean that the claimed tax benefits will be disallowed or that the
taxpayer will
automatically be audited. If the information in the disclosure form and
any
attachments is not sufficient to explain the merits of the transaction
to the
IRS, the first response by the IRS may only be a request for more
information.
A separate form
must be
submitted for each reportable transaction unless separate transactions
involve
the same issues of law. If an amended return is caused by a reportable
transaction, the Form 8886 must be attached to the amended return.
Penalties for
Non-Disclosure of a
Reportable Transaction
The instructions
to Form
8886 do not identify the penalties that apply for a failure to file the
form.
However, various penalties are prescribed by the Jobs Act.
New tax code
section 6707A
provides for a $10,000 penalty for a mere failure to disclose a
reportable transaction (other than a listed transaction) for an
individual and
a penalty of $50,000 for all other taxpayers. Where the transaction is
a listed
transaction, the penalty is $100,000 for an individual and $200,000 for
all
other taxpayers. These penalties are in addition to any other penalties
that
may be imposed as a result of the applicable transaction. The
penalty is not
waivable by the IRS and is not subject to judicial review.
In addition to
the explicit
penalties, the statute of limitations on the audit of tax returns by
the IRS is
extended to one year after the date that the taxpayer discloses a
listed
transaction or the date it is disclosed by a material advisor if that
date is
earlier.
New Disclosure
Requirements for
Material Advisors
The Jobs Act
also revised
tax code section 6111 which dealt with the Registration of Tax
Shelters.
Among other changes, the revised code section provides a
definition of a
material advisor and requires such advisors to make a return
pursuant
to regulations to report client information on annual returns
to the
IRS. (The regulations are not yet
written.)
This rule,
unless it should
be over-ruled by the courts, would put lawyers, CPAs and other material
advisors in the position of having to inform the IRS about those
clients who
engaged in reportable transactions. At this time, it is not clear if
the
reporting would be required without regard to whether the clients had
filed the
required disclosure form.
A material
advisor is now
defined as a person or entity that provides material aid, assistance or
advice
with respect to organizing, managing, promoting, selling, implementing,
insuring or carrying out any reportable transaction. However, this
definition
does not apply to an advisor if
the fee
received is less than $50,000 for transactions applicable to
individuals and
$250,000 for transactions applicable to corporation.
Advisors who
fail to comply
with the reporting requirements will be subject to the penalties set
forth in
tax code section 6707.
Some Observations
It does not
appear that the
varied types of reportable transactions must all meet the same
financial
threshold as to the amount of money involved or as to any fees that are
received by an advisor. A listed transaction is simply one that is
listed by
the IRS in a public document. Most of these are listed at http://www.irs.gov/businesses/corporations/article/0,,id=120633,00.html Some examples of transactions that are listed
and must be reported, include;
In addition to
the listed
transactions, IRS Form 8886 stipulates that a reportable transaction
includes
certain transactions involving U.S. shareholders of a foreign personal
holding
company, a controlled foreign corporation or a shareholder of a passive
foreign
investment company that has elected to be treated as a qualified
electing fund
(QEF) as specified in IRS Regulation 1.6011-4( c)(3)(i)(G).
The IRS can
add any
transaction to their list at any time
without any judicial or legislative consent or support. If they deem a
transaction to be abusive they can include it in their list.
Thereafter, any
transaction that is substantially similar (as described above) would
also be a
transaction that must be reported.
The concept of substantially similar is going to
cause a lot of uncertainty on the
part of
tax professionals.
For example, one
of the
listed transactions involves a welfare benefit fund under code section
419 or
419A. Some of these plans are clearly abusive in that they rely on
strained
interpretations of the tax code and regulations. But, this type of
arrangement
is utilized by many large corporations in a non-abusive manner. Are all
of
those to be reported? Does substantially similar mean any tax
deductible
employee benefit plan even if it is not based on section 419? The IRS
has
already exempted qualified retirement savings plans from the reporting
requirements. Will they also exempt other kinds of employee benefit
plans?
Another listed
transaction
involves Roth IRAs that invest in the stock of entities that generate
business
income. The business income is usually the result of diverting profits
from the
taxpayer’s regular business to the entity owned by the Roth IRA. Are
all Roth
IRA accounts substantially similar or just the ones that own a business
enterprise? What about the Roth IRAs that own stock in privately owned
companies that are not related in any way to the owner of the Roth IRA?
Would
the reporting requirement extend to traditional self directed IRAs that
invest
in non-publicly listed corporations?
A third type of
listed
transaction is a deferred compensation arrangement with an offshore
employee
leasing company. These arrangements usually involve
For every item
that is a
listed transaction, there are similar transactions from which the
abusive
transaction evolved. Is it the concept of an abusive interpretation of
the tax
law that must be reported, or is it any transaction that is similar in
some
manner? Taxpayers and tax professionals may have to wait for court
cases to
generate some clarity in this otherwise ambiguous area.
It appears that
a person who
is only involved in helping a taxpayer to prepare a return that
includes a
reportable transaction is not a material advisor if the preparation
of a
return is their only involvement.
However, the law
is
sufficiently vague as to cause many tax preparers to be very wary of
any return
involving any transaction that might be deemed by the IRS to be
substantially
similar to a reportable transaction. When in doubt, they are likely to
prepare
the disclosure form. If the client refuses to submit the disclosure
form with
his tax return, there are likely to be a number of tax preparers who
will simply
refuse to prepare the return.
It will become
much more
difficult for taxpayers to find tax professionals who will be willing
to
express an opinion regarding a reportable transaction that is at odds
with the
position of the IRS on the transaction.
Informed tax
preparers will
be likely to require their clients to complete a checklist or
questionnaire
regarding their involvement in any reportable transactions before
preparing any
returns for the client.
Many tax
preparers and
advisors are very likely to require clients to sign waivers of
confidentiality
with respect to any disclosure required by the IRS with respect to any
reportable transactions. Some advisors
may require clients to sign an indemnification agreement to reimburse
the
advisor/preparer for any penalties the preparer might incur as a result
of a
failure of the client to inform the advisor of a reportable
transaction.
Revised Regulations of
Tax
Practitioners
Circular 230 is
a
compilation of the various IRS regulations that govern the practice of
attorneys, CPAs, enrolled agents, enrolled actuaries and appraisers who
practice before the IRS. A printed copy in PDF format is 84 pages long.
(http://www.irs.gov/pub/irs-pdf/pcir230.pdf ) The
regulations are based in part on various sections of the tax law that
authorize
the IRS to impose the regulations.
For example, tax
code
section 6694(a) imposes a $250 penalty on a tax preparer who helps a
taxpayer
to understate his tax obligation on the basis of a reckless or
intentional
disregard of rules or regulations – unless the position was disclosed
on the
return or was based on reasonable cause or good faith. Preparers are
also subject
to penalties of $1,000 for aiding or abetting a taxpayer in an
understatement
of a federal tax liability.
Some of the tax
code
sections or regulations relate to the conduct of a tax advisor
representing a
taxpayer in a dispute with the IRS or in the US Tax Court.
Other sections
of the law
and/or regulations relate to tax advisors – which may or may not
include tax
preparers. Specifically, there are a variety of rules for those
involved in the
organization, promotion or marketing of any tax shelter or other
listed
transaction.
Circular 230 is
essentially
a compilation of various tax code sections, regulations, revenue
rulings and
court decisions relating to the conduct of return preparers and
advisors.
The
part with the most impact on many tax
preparers, advisors and taxpayers are those that relate to tax shelter
opinions.
The definition
of a tax
shelter is not changed from that presently included in tax code section
6662,
which states that tax shelters are
(1) any
partnership or other entity, or
(2) any
investment or arrangement, or
(3) any
other plan or arrangement
if a
significant purpose of such
partnership, entity,
plan or arrangement is the avoidance or evasion of any tax.
Read that
again a few
times and ask yourself if
there are
very many tax reduction transactions that would not meet that
definition. Any
investment in a new business venture (by a material participant) is
likely to
generate deductions or credits in excess of the income from the
investment for
a number of years. Is the purchase of some business equipment that is
fully
deductible in the year of the purchase an investment? If so, such
investments
rarely generate any income. At best, they may reduce some expenses or
may just
conserve some time. There is an
exclusion from this definition with respect to written advice to a
client with
respect to the qualification of a qualified retirement plan. (But
recall that
certain Roth IRA transactions are listed transactions.)
A
tax shelter opinion is
defined by the revised Circular 230 as
written
advice by a
practitioner concerning
the Federal tax aspects of any Federal tax issue relating to a tax
shelter item
or items.
Despite the
sweeping scope
of this definition, it does not appear that it is the intent of the
Congress or
the IRS to require a tax advisor to provide a written opinion to all
clients
with respect to every contemplated transaction that could meet the
definition
of a tax shelter (above) and with the rigorous process of identifying
all
salient tax code sections, regulations, rulings, court cases and long
standing
court doctrines pertinent to that contemplated transaction.
Where a
transaction is not a
listed transaction but might meet the definition of a tax shelter, if a
client
wants a written opinion, the tax advisor might choose to issue an
opinion that
is limited in scope. Such opinions must provide disclosures at the
beginning of
the opinion that it is limited in scope. The practitioner must disclose
The proposed
changes include
prescribed rules for the issuance of a tax shelter opinion. General
practitioners and preparers who do not devote a major part of their
time to the
study of tax shelters may find it very difficult to satisfy many of the
requirements to issue an opinion on a tax shelter transaction. Even so,
it
would behoove all tax professionals (preparers and advisor) to secure a
copy of
the new Circular 230 and to study the sections that detail the
requirements for
the issuance of a tax shelter opinion.
As to return
preparers, a
practitioner can’t sign a return or advise a client regarding a
transaction if
the return will contain a position that does not have a realistic
possibility
of being sustained on its merits, unless the position is not frivolous
and is
adequately disclosed on the return. The realistic possibility standard
requires
that a person knowledgeable in the tax law, following a reasonable,
well-informed analysis, concludes that the position has a one-in-three
or
greater chance of being sustained on its merits in a dispute with the
IRS. What is frivolous? At the least it
would
include those arguments that the various courts have held to be
frivolous. Some
sources of information regarding frivolous tax positions include http://www.irs.gov/newsroom/article/0,,id=120802,00.html and http://www.quatloos.com/taxscams/frivolous_tax_penalties.htm
The tax preparer
must make
reasonable inquiries if the information appears to be incorrect,
inconsistent
or incomplete. This does not require that the preparer must audit the
supporting transactions, but it would prohibit the preparer from
ignoring any
inconsistent information based on the totality of the knowledge the
preparer
has of the financial affairs of the taxpayer. Many preparers are likely
to
devote more time to a face-to-face interview of clients who have a
tendency to
gloss over some details and leave it to their preparer to fill in the
blanks.
It will also be
necessary
for tax practitioners to study the various sanctions and penalties that
will be
prescribed for a claimed failure to satisfy the requirements of the
various tax
code sections and regulations that are used as the basis for the
Circular 230.
Until then,
practitioners
who are aware of these changes are likely to be overly cautious
about
any aggressive transactions on which clients are seeking advice or
which are to
be reported on a tax return.
One commentator
at a recent
tax law conference suggested that these changes might very well result
in a
major exodus from the practice of tax law by many current tax
professionals.
Those that remain will likely fit into two groups. One will be the tax
professionals who have studied these new rules and have adopted changes
in
their engagement letters and relationships with client. The other group
will be
blissfully ignorant of these new rules until the IRS puts them out of
business.
May 18, 2005 Revisions to Circular 230
Due to numerous
complaints from tax lawyers and accountants regarding the ambiguity of
many of the new rules in Circular 230, the IRS issued
clarifications of the required standards for covered opinions on May
18, 2005 in TD 9201.
The IRS has
expanded the definition of "Excluded advice" to include
In the original
regulations, excluded advise included
The revised
regulations modify the requirements of "prominently disclosed" so that
the disclaimer does not have to be at the very top of the document or
in a type face as large as any other type face in the document. The
modified regulations require that the disclaimer must be set forth in a
separate section in a typeface of the same size (or larger) then used
in any discussion of the facts or law in the written advice and that
the disclaimer may not be included in a footnote.
The
revised regulations modify the definition of "principal purpose" (of
tax avoidance or evasion) if that arrangement (or transaction) has as
its purpose the claiming of tax benefits in a manner consistent with
the statute and Congressional purpose. Thus, tax reduction
transactions that are clearly sanctioned by the tax law (Internal
Revenue Code) are not subject to the covered opinion rules so long as
the transaction is not a listed transaction.
Copyright, 2005,
All rights reserved.
Acknowledgments:
This
article was prompted by a presentation on A
Potential Tax Shelter in Every Transaction by R. Brent Clifton,
J.D., CPA with the firm of
Locke Liddell & Sapp LLP
in
About the Author.
Vernon Jacobs is
a CPA who
works as an international tax consultant and an author/publisher of
various tax
reports and articles. Information about his work experience is
available at http://www.offshorepress.com/vkjcpa/vkjcpa.htm
Internet Information
Resources
Recent Tax
Shelter and
Circular 230 Developments (2004) http://www.cadwalader.com/assets/article/Swartz_063004_Recent_Tax.pdf
Sources of information regarding frivolous tax positions include http://www.irs.gov/newsroom/article/0,,id=120802,00.html and http://www.quatloos.com/taxscams/frivolous_tax_penalties.htm
[1] Act Section
822(a) and (b) which amend 31 U.S.C. 330(b) and (d)