United States: Anti-Tax Shelter Provisions of American Jobs Creation Act of 2004 Expand Reporting Rules for Taxpayers and Advisors, Substantially Increase Penalties for Non-Compliance and Provide IRS with Additional Sanction Authority

The American Jobs Creation Act of 2004 (the "Act") was signed into law by President Bush on October 22, 2004. Among many significant changes to the Internal Revenue Code (the "Code"), the Act adopts expanded anti-tax shelter reporting rules, and imposes substantially increased penalties for non-compliance, which will affect both taxpayers and their advisors.

The major changes made by the Act do the following:

• Impose substantial new penalties on taxpayers who fail to report required information on their income tax returns with respect to "reportable transactions" in which they participate, or who have tax understatements attributable to reportable transactions.

• Require taxpayers that are SEC reporting companies (and their affiliates) to include disclosure in their SEC reports of certain tax shelter penalties imposed on them regardless of the materiality of the penalties.

• Expand the tax shelter exception to confidentiality of communication between taxpayers and federally authorized tax practitioners to apply to all types of taxpayers, not just corporations.

• Extend the statute of limitations with respect to "listed transactions" that are not properly reported by taxpayers.

• Impose a return filing requirement upon "material advisors" with respect to "reportable transactions" and impose substantial penalties for failure to file required returns.

• Significantly increase penalties applicable to failures by material advisors to maintain lists of persons they advised with respect to reportable transactions.

• Increase the penalty applicable to promoters of abusive tax shelters and expand the rules for enjoining tax shelter-related activities.

• Authorize the IRS to impose a monetary penalty for failure to comply with IRS practice standards.

• Impose a penalty on failure to report interests in foreign financial accounts.

• Taxpayers: Because of substantial new penalties that apply both to failures to disclose reportable transactions and to tax understatements resulting from reportable transactions, plus the extended statute of limitations for undisclosed listed transactions, taxpayers will need to enhance their systems for identifying and disclosing listed and other reportable transactions, and will need to carefully evaluate potential exposure to the new reportable transaction understatement penalty.

• Material Advisors: Because of the new return filing requirements applicable to "material advisors," as newly defined in the Act, and the substantial penalties relating to failures to file these returns and to maintain and disclose advisee lists, legal and accounting firms, financial advisors and insurers of reportable transactions, will have to implement systems for identifying reportable transactions, evaluating their status as material advisors with respect to those transactions, filing timely returns, maintain advisee lists and responding promptly to IRS requests for these lists. Clarification of several aspects of the new rules will require the issuance of guidance by the IRS. The IRS has indicated informally its intent to provide such guidance promptly.

Prior law. In 2003, the IRS adopted regulations under Code Section 6011 requiring taxpayers that participate in "listed transactions" and other "reportable transactions" to include information regarding those transactions in their tax returns. [See prior legal updates from 02/28/03 "IRS Finalizes Anti-Tax Shelter Regulations," and from 02/04/04 "IRS Amends Anti-Tax Shelter Regulations; Narrows Definition of Confidential Transactions"]. Prior to adoption of the Act, there was no explicit penalty for failure to comply with these reporting rules. However, the Code Section 6011 regulations as in effect prior to the Act provided that failure to report a reportable transaction could potentially adversely affect qualification for the Code Section 6664(c) good faith/reasonable cause exception to the imposition of accuracy-related penalties (negligence, substantial understatement, and valuation misstatements).

New penalty. The Act adds new Code Section 6707A, which imposes a penalty on any person who fails to include on any return or statement any information with respect to a reportable transaction which is required to be so included under Code Section 6011. The penalty for each failure for an individual is $100,000 for each listed transaction and $10,000 for each other reportable transaction. In all other cases, the penalty for each failure is $200,000 for each listed transaction and $50,000 for each other reportable transaction. Listed transactions and reportable transactions are defined in the same manner as under the regulations under Code Section 6011. The new penalty imposed by Code Section 6707A is in addition to any other penalty imposed by the Code.

Rescission or abatement of penalty. In the case of reportable transactions other than listed transactions, the IRS is given the authority to rescind the penalty in appropriate cases, but any such determination is not subject to judicial review. The Conference Report indicates that, in determining whether to rescind or abate the penalty, Congress intends that the IRS take into account whether: (1) the person on whom the penalty is imposed has a history of complying with the tax laws; (2) the violation is due to an unintentional mistake of fact; and (3) imposing the penalty would be against equity and good conscience.

Effective date. The new penalty applies to returns and statements the due date for which is after the date of the enactment of the Act.

General. New Code Section 6662A imposes a new accuracy-related penalty on any "reportable transaction understatement." In general, a reportable transaction understatement is an understatement of tax resulting from (i) any listed transaction, or (ii) any reportable transaction other than a listed transaction if a significant purpose of such transaction is the avoidance or evasion of federal income tax. For this purpose, reportable transactions and listed transactions are defined in the same manner as in the existing regulations under Code Section 6011.

Calculation of understatement. The amount of a reportable transaction understatement is determined by (i) multiplying the highest corporate or non-corporate tax rate, as applicable, times the increase in taxable income (generally treating a reduction in losses as an increase in taxable income) resulting from correcting the taxpayer’s tax return treatment of items attributable to the reportable transaction, and (ii) adding the decrease in tax credits resulting from correcting the taxpayer’s tax return treatment of such items. Thus, the calculation of the understatement amount does not take into account other items on the return or the actual change in tax liability that results from the correction of the items attributable to the reportable transaction. This differs from the calculation of other understatement penalties where the understatement is based on the actual difference between the tax on the original return and the tax owing after audit adjustments. In computing the reportable transaction understatement, unless regulations provide otherwise, any tax treatment included with an amendment or supplement to a return is not taken into account if the amendment or supplement is filed after the earlier of the date the taxpayer is first contacted by the IRS regarding the examination of the return or such other date as is specified by the IRS.

Amount of penalty. If a taxpayer has a reportable transaction understatement for any taxable year, the penalty is generally 20 percent of the understatement. However, a 30 percent penalty applies if the relevant facts affecting the tax treatment of the items are not adequately disclosed in accordance with the regulations prescribed under Code Section 6011.

• Substantial understatement penalty. In applying the regular 20 percent substantial understatement penalty of Code Section 6662(d), the understatement amount as otherwise computed for purposes of that section is increased by the aggregate amount of reportable transaction understatements for purposes of determining whether the understatement is a substantial understatement; however, in calculating the actual amount of the substantial understatement penalty, the reportable transaction understatements are excluded.

• Valuation misstatement penalties. The 20 percent substantial valuation misstatement penalty under Code Section 6662(e) does not apply to any portion of an understatement on which a reportable transaction understatement penalty is imposed under Code Section 6662A. Code Section 6662A does not apply to any portion of an understatement on which a 40 percent gross valuation misstatement penalty is imposed under Code Section 6662(h).

• Fraud penalty. The reportable transaction understatement penalty of Code Section 6662A does not apply to any portion of an understatement on which a fraud penalty is imposed under Code Section 6663.

Strengthened reasonable cause exception for reportable transaction understatement penalty. A new, more stringent, reasonable cause exception is added in a new subsection (d) of Code Section 6664 which must be satisfied in order to excuse application of the new reportable transaction understatement penalty. In general, the taxpayer must show that there was a reasonable cause that the taxpayer acted in good faith with respect to the understatement. However, the statute includes three overall requirements that must be satisfied in order to make this showing.

• the relevant facts affecting the tax treatment of the items producing the understatement must be adequately disclosed in accordance with the regulations prescribed under Code Section 6011,

• there is or was substantial authority for such treatment, and

• the taxpayer reasonably believed that such treatment was more likely than not the proper treatment.

The statute provides further specific requirements for establishing that the taxpayer reasonably believed that its treatment of the relevant items was more likely than not the proper treatment:

• such belief must be based on the facts and law that exist at the time the return of tax which includes such tax treatment is filed,

• such belief must relate solely to the taxpayer's chances of success on the merits of such treatment and must not take into account the possibility that a return will not be audited, such treatment will not be raised on audit, or such treatment will be resolved through settlement if it is raised, and

• an opinion of a tax advisor may not be relied upon to establish the reasonable belief of a taxpayer if the advisor is a disqualified tax advisor or the opinion is a disqualified opinion.

A disqualified tax advisor includes a tax advisor who:

1. is material advisor (as defined below in connection with the requirement that material advisors disclose reportable transactions) that participates in the organization, management, promotion, or sale of the transaction or is related (within the meaning of Code Sections 267(b) or 707(b)(1)) to any person who so participates,
2. is compensated directly or indirectly by a material advisor with respect to the transaction,
3. has a fee arrangement with respect to the transaction which is contingent on all or part of the intended tax benefits from the transaction being sustained, or
4. as determined under regulations prescribed by the IRS, has a disqualifying financial interest with respect to the transaction.

The legislative history indicates that a material advisor is considered as participating in the "organization" of a transaction if the advisor performs acts relating to the development of the transaction, which may include, for example, preparing documents: (1) establishing a structure used in connection with the transaction (such as a partnership agreement), (2) describing the transaction (such as an offering memorandum or other statement describing the transaction), or (3) relating to the registration of the transaction with any federal, state or local government body. According to the legislative history, participation in the "management" of a transaction means involvement in the decision-making process regarding any business activity with respect to the transaction, and participation in the "promotion or sale" of a transaction means involvement in the marketing or solicitation of the transaction to others, which can include an advisor who provides information about the transaction to a potential participant or who recommends the transaction to a potential participant.

An opinion is a disqualified opinion if:

1. is based on unreasonable factual or legal assumptions (including assumptions as to future events),
2. unreasonably relies on representations, statements, findings, or agreements of the taxpayer or any other person,
3. does not identify and consider all relevant facts, or
4. fails to meet any other requirement as the IRS may prescribe.

The combined effect of the definitions of disqualified tax advisor and disqualified opinion is likely to impose significant costs and significant constraints on the ability to qualify for the reasonable cause exception. In order not to be disqualified, the advisor probably has to be, in effect, a special tax counsel not involved in documenting the transaction; yet to prevent the opinion from being disqualified, the advisor will need to be fully informed of all aspects of the transaction.

Effective date. These provisions apply to taxable years ending after the date of enactment of the Act.

Code Section 6662(d), governing the regular substantial understatement penalty, is amended to make clear that, in the case of a tax shelter, for non-corporate as well as corporate taxpayers, satisfaction of the reasonable cause exception of Code Section 6664(c) is the only method of avoiding the penalty. For this purpose, tax shelter is defined 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.

Effective date. These provisions apply to taxable years ending after the date of enactment of the Act.

New SEC reporting requirement. New Code Section 6707A(e) provides that a taxpayer required to file periodic reports under Section 13 or 15(d) of the Securities Exchange Act of 1934 (or required to be consolidated with another person for purposes of such reports) must disclose in its SEC reports if it is required to pay certain tax shelter penalties.

Penalties that must be disclosed. The penalties which must be disclosed include: (i) the new penalty for a taxpayer’s failure to disclose a listed transaction imposed under Code Section 6707A, (ii) the new reportable transaction understatement penalty under Code Section 6662A, if imposed at the 30 percent rate, and (iii) the 40 percent valuation misstatement penalty of Code Section 6662(h).

Specific disclosure rules. The Conference Report indicates that the requirement to disclose these tax penalties in SEC reports applies without regard to whether the taxpayer determines the amount of the penalty to be material to the reports. A taxpayer must disclose a penalty in SEC reports once the taxpayer has exhausted its administrative and judicial remedies with respect to the penalty (or, if earlier, when paid). The statute provides that the disclosure must be made in such SEC reports as the IRS specifies. However, the Conference Report indicates that the taxpayer is only required to report the penalty one time.

Penalty for failure to make SEC disclosure. Failure to make a required disclosure in SEC reports is subject to penalty in the same manner as a failure to disclose a listed transaction on a taxpayer’s income tax return, as described above. This penalty is in addition to any other penalty impose by the Code.

Effective date. The new disclosure requirement applies to statements the due date for which is after the date of the enactment of the Act.

Background. Prior to the enactment of the Act, Code Section 7525 provided that, with respect to tax advice, the same common law protections of confidentiality that apply to a communication between a taxpayer and an attorney also apply to a communication between a taxpayer and a federally authorized tax practitioner. However, this rule was inapplicable to communications regarding corporate tax shelters.

General. The Act modifies the rule relating to tax shelters by making it applicable to all tax shelters, whether entered into by corporations, individuals, partnerships, tax-exempt entities, or any other entity. Note that case law had already substantially weakened this privilege.

Effective date. This change applies to communications made on or after the date of the enactment of the Act.

General. The Act amends Code Section 6501(c) to provide that, if a taxpayer fails to include on any return or statement for any taxable year any information with respect to a listed transaction which is required under Code Section 6011, the statute of limitations with respect to such a transaction will not expire before the date which is one year after the earlier of: (1) the date on which the taxpayer furnishes the required information, or (2) the date on which a material advisor satisfies an IRS request to disclose the investor list with respect to the transaction. The extension can apply if a transaction becomes a listed transaction in a year later than the original return was filed and the taxpayer fails to disclose the transaction in the manner required by regulations.

Effective date. The new rule applies to taxable years with respect to which the period for assessing a deficiency did not expire before the date of the enactment of the Act.

Required disclosure of reportable transactions by material advisors

General. The Act repeals the prior tax shelter registration requirements of former Code Section 6111 and replaces them with a new Code Section 6111 that requires each "material advisor" (very broadly defined) with respect to any reportable transaction to make a return setting forth: (1) information identifying and describing the transaction, (2) information describing any potential tax benefits expected to result from the transaction, and (3) such other information as the IRS prescribes. Both the form of the return and its due date are to be prescribed and specified by the IRS. The legislative history indicates the expectation that the IRS may seek from the material advisor the same type of information that the IRS may request from a taxpayer under Code Section 6011 in connection with a reportable transaction.

Definition of key terms. "Reportable transactions," which include "listed transactions," are defined in the same manner as in the existing taxpayer reporting regulations under Code Section 6011. Unfortunately, the Act provides its own definition of "material advisor," rather than conforming to the definition of that term in the existing regulations under Code Section 6112. Under the new statute, the term "material advisor" means any person: (i) who provides any material aid, assistance, or advice with respect to organizing, managing, promoting, selling, implementing, insuring, or carrying out any reportable transaction, and (ii) who directly or indirectly derives gross income in excess of the threshold amount (or such other amount as may be prescribed by the IRS) for such advice or assistance. The threshold amount is: (i) $50,000 in the case of a reportable transaction substantially all of the tax benefits from which are provided to natural persons, and (ii) $250,000 in any other case. Two aspects of the material advisor definition contained in the Act are particularly worth noting. Existing Code Section 6112 regulations have an additional requirement for material advisor status: the person must make a tax statement regarding a tax aspect of the transaction that causes it to be a reportable transaction. The new statutory definition does not require that any tax advice have been provided in order to be a material advisor, a change that has the potential to vastly expand the number of persons considered to be material advisors. Second, the insurer of a transaction may also apparently be a material advisor.

Regulatory authority. The new statute provides that the IRS may prescribe regulations which provide: (1) that only 1 person shall be required to file a return in cases in which 2 or more persons would otherwise be required to do so, (2) exemptions from the return filing requirements, and (3) such rules as may be necessary or appropriate to carry out the purposes of the section.

Effective date. The new return filing requirements apply to transactions with respect to which material aid, assistance, or advice is provided after the date of enactment of the Act.

Critical need for IRS guidance. The regulatory authority described above to limit the number of persons required to file returns or to provide exemptions from the requirement may prove to be very significant in light of the breadth of the definition of material advisor provided in the statute. Further, until guidance is provided by the IRS, the precise contents and the due dates of the required returns will be unclear. The IRS has indicated informally its intent to act quickly in providing guidance.

General. The Act amends Code Section 6707 to repeal the present-law penalty for failure to register tax shelters and failure to furnish identification numbers for registered tax shelters. Instead a penalty is imposed on any "material advisor" (defined in the same manner as for the material advisor’s disclosure requirement discussed above) who fails to file an information return, or who files a false or incomplete information return, with respect to a reportable transaction, including a listed transaction, as those terms are defined in the regulations under Code Section 6011.

Amount of penalty. The base amount of the penalty for reportable transactions other than listed transactions is $50,000. For a listed transaction, the amount of the penalty is increased to the greater of (1) $200,000, or (2) 50 percent of the gross income of such person with respect to aid, assistance, or advice which is provided with respect to the transaction before the date the information return that includes the transaction is filed. Intentional disregard by a material advisor of the requirement to disclose a listed transaction increases the penalty to 75 percent of the gross income.

Waiver. The penalty cannot be waived with respect to a listed transaction. As to reportable transactions, all or part of the penalty may be rescinded only if it would promote compliance with the tax laws and effective tax administration. The decision to rescind a penalty must be accompanied by a record describing the facts and reasons for the action and the amount rescinded. There will be no right to judicially appeal a refusal to rescind a penalty.

Effective date. The new penalty rules apply to returns the due date for which is after the date of the enactment of the Act.

Critical need for IRS guidance. As noted above, until guidance is provided by the IRS, the required contents and the due dates of the returns will be unclear so that it will be unclear what steps are necessary to avoid the penalty. The IRS has indicated informally its intent to act quickly in providing guidance.

Background. Under Code Section 6112, as in effect prior to the Act, any organizer or seller of a potentially abusive tax shelter (which included tax shelters required to be registered under the Code Section 6111 and other transactions identified by the IRS as having a potential for tax avoidance or evasion) was required to maintain a list identifying each person who was sold an interest in any such tax shelter. Regulations under Code Section 6112 issued in 2003 generally applied the list maintenance rules to any "material advisor" with respect to transactions required to be registered under Code Section 6111, "listed transactions" and other "reportable transactions" (as defined in the regulations under Code Section 6011).

Amended Code Section 6112. The Act amends Code Section 6112 to provide that each "material advisor" (defined in the same manner as for the disclosure requirement discussed above) with respect to a reportable transaction (including a listed transaction) is required to maintain a list that: (1) identifies each person with respect to whom the advisor acted as a material advisor with respect to the reportable transaction, and (2) contains other information as may be required by the IRS. In addition, the provision authorizes (but does not require) the IRS to prescribe regulations which provide that, in cases in which two or more persons are required to maintain the same list, only one person would be required to maintain the list.

Effective date. These amendments apply to transactions with respect to which material aid, assistance, or advice is provided after the date of the enactment of the Act.

Critical need for IRS guidance. As noted above in the discussion regarding the material advisor disclosure requirement, the breadth of the definition of material advisor may make the IRS’ regulatory authority to limit the number of persons required to maintain lists very important. Further, until guidance is provided by the IRS, the required contents of the lists will be unclear. The IRS has indicated informally its intent to act quickly in providing guidance.

Amount of penalty. The Act modifies the former penalty for failure to maintain required investor lists imposed by Code Section 6708. The penalty is now imposed for failing to maintain lists of persons advised by the material advisor and the penalty is now time-sensitive. A material advisor who is required to maintain a list of advisees and who fails to make the list available upon written request by the IRS within 20 business days after the request will be subject to a $10,000 per day penalty. The penalty applies to a person who fails to maintain a list, maintains an incomplete list, or has in fact maintained a list but does not make the list available to the IRS.

Waiver. The penalty can be waived if the failure to make the list available is due to reasonable cause.

Effective date. These changes apply to requests made by the IRS after the date of the enactment of the Act.

Critical need for IRS Guidance. As noted above, until guidance is provided by the IRS, the required contents of the lists necessary to avoid penalties will be unclear. The IRS has indicated informally its intent to act quickly in providing guidance.

Background. Prior to the Act, Code Section 6700 imposed a penalty on any person who organizes, assists in the organization of, or participates in the sale of any interest in, a partnership or other entity, any investment plan or arrangement, or any other plan or arrangement, if in connection with such activity the person makes or furnishes a qualifying false or fraudulent statement or a gross valuation overstatement. The amount of the penalty was $1,000 (or, if the person establishes that it is less, 100 percent of the gross income derived or to be derived by the person from such activity).

Increased penalty. The Act increases the penalty applicable to a qualifying false or fraudulent statement to an amount equal to 50 percent of the gross income derived (or to be derived) from such activity by the person on which the penalty is imposed.

Effective date. This change applies to activities after the date of the enactment of the Act.

Background. Prior to the Act, Code Section 7408 authorized civil actions to enjoin any person from promoting abusive tax shelters or aiding or abetting the understatement of tax liability.

Expansion of authority to seek injunctions. The Act expands the prior rule so that injunctions may also be sought against a material advisor to enjoin the advisor from (1) failing to file an information return with respect to a reportable transaction, or (2) failing to maintain, or to timely furnish upon written request by the Secretary, a list of investors with respect to each reportable transaction. In addition, injunctions may also be sought regarding violations of any of the rules under Circular 230, which regulates the practice of representatives of persons before the IRS.

Effective date. These amendments take effect on the day after the date of the enactment of the Act.

Background. The IRS is authorized by Section 330(b) of Title 31 of the United States Code to regulate the practice before it of authorized representatives of taxpayers, and to suspend or disbar from practice before the IRS a representative who is incompetent, disreputable, violates the rules regulating practice, or who (with intent to defraud) willfully and knowingly misleads or threatens the person being represented. The rules issued under this authority are referred to as Circular 230.

Authorization of censure and monetary penalty. The Act amends Section 330(b) of Title 31 to permit censure as a sanction for violating the practice rules, and to permit imposition of a monetary penalty on a representative, or on an employer, firm, or entity on whose behalf the representative was acting, if it knew, or reasonably should have known, of such conduct. The maximum penalty equals the gross income derived (or to be derived) from the conduct giving rise to the penalty and may be in addition to, or in lieu of, any suspension, disbarment, or censure of the representative.

Effective date. These amendments apply to actions taken after the date of the enactment of the Act.

Confirmation of authority to regulate opinions. The Act adds a new subsection (d) to Section 330 of Title 31 confirming the authority of the IRS to impose standards applicable to the rendering of written advice with respect to any entity, transaction plan or arrangement, or other plan or arrangement, which is of a type which the IRS determines as having a potential for tax avoidance or evasion.

Critical need for IRS guidance. In view of the enhanced authority to penalize attorneys, proposed revisions to Circular 230 take on more importance than ever.

General. The Act expands the penalties applicable to failures to report interests in foreign financial accounts as required by Section 5321 of Title 31 of the United States Code, which requires answering of yes or no questions on the taxpayer’s tax return and separately reporting yes answers on Treasury Department Form TD F 90-22.1. The Act increases the civil penalty for willfully violating the reporting requirement from a maximum of $100,000, to an amount equal to the greater of $100,000 or 50 percent of the amount of the transaction or account. The Act also imposes a new penalty of up to $10,000 for non-willful violations. The new penalty does not apply if the violation was due to reasonable cause, and the amount of the transaction or the balance in the account at the time of the transaction was properly reported.

Effective Date. These amendments apply to violations occurring after the date of the enactment of the Act.

Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

© Morrison & Foerster LLP. All rights reserved