Times change. Many practitioners who considered themselves on the cutting edge several years ago when they found and implemented aggressive tax-planning strategies are now concerned that someone at the Internal Revenue Service, or even the Securities and Exchange Commission, may second-guess the propriety of their past activities.
Measured against the new standards of the day, many tax plans that, only a few years ago, circulated as creative tax strategies are now considered too hot to handle.
While many practitioners, today, would not recommend certain tax-sheltered arrangements because of the scrutiny that they would attract, the fact remains that many practitioners have recommended rather aggressive strategies in the past. So, how should the practitioner handle such skeletons in the closet?
To help us put together some advice, David Harris, Manager of the IRS Office of Tax Shelter Analysis, kindly consented to an interview. Here are the results. (Note: David Harris’s views, which are his own and not necessarily those of the IRS, are only those clearly indicated as such in this column).
Criminal fraud is rarely an issue in a tax shelter case. In imposing criminal or civil fraud penalties, the courts, in any case, consider fraudulent intent formed after the return to be irrelevant. Nevertheless, attempts to conceal evidence and a failure to cooperate with IRS agents have been used as "badges" of fraud in proving intent at the time that the return was filed.
On the other hand, taxpayers who realize only after filing a return that they may have made an improper deduction are not required to file an amended return to disprove fraud at the time of signing.
The Tax Court has ruled that the failure by a taxpayer to file an amended return after discovering an understatement of tax does not constitute evidence of fraud. (A mistake in interpreting the law, of course, cannot excuse one from paying the underlying tax liability; i.e., "ignorance of the law is no defense.")
Harris confirmed that the statute of limitations on a deficiency generated by any deduction (whether or not it is generated by a tax-shelter) is generally limited to three years from the date that the return is filed, unless criminal fraud is involved. In addition, failure to disclose under the tax shelter regulations does not stop the ordinary three-year statute of limitations.
As a result, the IRS generally will not reach back more than three years into the past of any taxpayer with a tax shelter deduction to call into account deductions and other claimed tax benefits. Since the latest government assault on tax shelters first began to form in earnest during late 1998 and early 1999, that means that taxpayers soon will no longer be able to claim that they were taken unawares by a newly aggressive IRS position against tax shelters.
Rules of practice
Harris warned that while he could not recall a case, yet, in which his office has recommended criminal tax penalties, the IRS is not adverse to applying criminal sanctions in cases in which fraud occurs in circumstances such as backdating documents and misrepresenting transactions or presenting ones that actually never occurred.
He also promised aggressive referrals of potential violations of Circular 230 (Rules of Practice Before the IRS) to the director of practice for enforcement action, especially in the case of tax shelter promoters.
A practitioner may be in the uncomfortable situation of having recommended a tax shelter in the past that he now recommends be disclosed. Other practitioners may find it awkward to suggest that a client’s past tax shelter positions be re-examined if the client is unwilling to file an amended return if a problem is found.
Still others have expressed concerned over being turned into a discovery agent by the IRS though its disclosure rules and penalty enforcement. The much-awaited Circular 230 Rules of Practice as they deal with tax shelters is promised to be released soon. Hopefully, these rules will clarify a practitioner’s obligation under many of these circumstances.
This past June, the IRS clarified and expanded its tax shelter disclosure rules. It also took the opportunity to remind taxpayers that additional and substantial changes to the tax shelter rules to improve lagging compliance are on the horizon. Harris confirmed that these changes are coming soon.
The IRS had complained that promoters and taxpayers were circumventing the previous disclosure requirements by reading the rules either too broadly or narrowly to suit a particular transaction. The June revisions took two significant steps to challenge this "gamesmanship:"
1. More broadly defining "substantially similar transactions." The original regs defined reportable transactions as substantially similar to listed ones. Under the revised regs, taxpayers have less ability to finesse their transactions. A transaction is substantially similar to a listed transaction if it is expected to obtain the same or similar type of tax benefit and is either factually similar or based on the same or similar tax strategy to the listed transaction. The IRS cautioned that "substantially similar" would be used broadly to favor disclosure.
2. Timing of disclosure. Generally, taxpayers must disclose their participation in a reportable transaction in the tax year affected by the transaction. Harris confirmed that the new regs require that if the transaction becomes reportable after the taxpayer has filed its return, the taxpayer must disclose its participation in its next timely filed return - even if the transaction does not affect the taxpayer’s liability for the subsequent year.
3. More "inclusive." The June regulations expanded the reach of disclosure requirements to include individuals and partnerships, as well as corporations, primarily to cover the million-dollar shelter arrangements that were recently developed to serve them.
Harris suggests that a practitioner or taxpayer who is unsure of whether a particular transaction may be considered an abusive tax shelter, might consider taking advantage of the disclosure provisions as a safe-harbor method of eliminating or reducing exposure to the 20 percent accuracy-related penalty.
However, he admits that further guidance may be needed to prevent some taxpayers from unnecessarily incurring the expense of disclosure in certain business situations. For example, most leverage leasing arrangements are not tax shelters, but because their marketing is often confidential - albeit for financial reasons - many taxpayers are unnecessarily disclosing these leasing arrangements on their returns.
There is no statutory penalty for a failure to disclose a tax shelter. Rather, Harris observes that the teeth to the disclosure rules come from the IRS being able apply the 20 percent accuracy-related penalty if a deficiency results.
If disclosure is made, Harris said that the IRS would accept the disclosure as a good-faith indicator of original motive. As long as the taxpayer can then point to some reasonable basis under the law for having taken that position, the 20 percent penalty will be avoided.
Harris reports that the IRS is not planning any additional 120-day penalty-waiver period, which ended on April 23, 2002. He observed, however, that, even without a formal waiver program, disclosure paired with a "reasonable basis" position generally is adequate to eliminate the 20 percent penalty, in any event.
Harris stresses that a principal goal of the Office of Tax Shelter Analysis is to add more transparency to the tax system. Through disclose and promoter reporting, the IRS must be made aware whenever there is a tax-shelter transaction behind any tax benefit claimed on a return. The taxpayer, observed Harris, must, in turn, see transparency in what the IRS expects in terms of disclosure requirements and remedies. Progress has been made on both fronts, according to Harris. With transparency, fewer mistakes and misinterpretations will be made both by taxpayers and the IRS - thereby, eventually avoiding entirely the problem of whether or not to surface past transactions.
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