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Tax Advisors vs. Taxpayers
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. Act section 822(a)(1)(B) provides in part that
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)]
listed transaction is one
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
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 )Transactions involving a brief asset holding period include transactions owned or held by the taxpayer for 45 days or less and from which the taxpayer is claiming a tax credit (including a foreign tax credit) exceeding $250,000.
The Required Disclosure StatementReportable transactions are to be reported by the taxpayer on Form 8886 – Reportable Transaction Disclosure Statement Copies of the form and related instructions are available on the IRS web site at http://www.irs.gov/pub/irs-pdf/i8886.pdf
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.
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
transaction is a deferred compensation arrangement with an offshore
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
section 6694(a) imposes a $250 penalty on a tax preparer who helps a
to understate his tax obligation on the basis of a reckless or
disregard of rules or regulations – unless the position was disclosed
return or was based on reasonable cause or good faith. Preparers are
to penalties of $1,000 for aiding or abetting a taxpayer in an
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.This will put many tax advisors and preparers in conflict with their clients regarding whether to disclose various ambiguous transactions that might meet the overly fuzzy definition of a tax shelter or of a transaction that is substantially similar to a listed transaction. Many clients will conclude that their tax advisor has been conscripted into working as a de facto extension of the IRS.
at a recent
tax law conference suggested that these changes might very well result
major exodus from the practice of tax law by many current tax
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
their engagement letters and relationships with client. The other group
blissfully ignorant of these new rules until the IRS puts them out of
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
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.
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.
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
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 ResourcesOffshore Press Portal to Articles and News about Circular 230
Announcement 2004-4: Reporting Foreign Disregarded Entities http://www.treas.gov/press/releases/reports/js10667.pdf
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