2.   Tax Shelters and Other Reportable Transactions

Introduction

Investments that yield tax benefits are sometimes called “tax shelters.” In some cases, Congress has concluded that the loss of revenue is an acceptable side effect of special tax provisions designed to encourage taxpayers to make certain types of investments. In many cases, however, losses from tax shelters produce little or no benefit to society, or the tax benefits are exaggerated beyond those intended. Those cases are called “abusive tax shelters.” An investment that is considered a tax shelter is subject to restrictions, including the requirement that it be disclosed, as discussed later.

Useful Items - You may want to see:

Publication

  • 538 Accounting Periods and Methods

  • 556 Examination of Returns, Appeal Rights, and Claims for Refund

  • 561 Determining the Value of Donated Property

  • 925 Passive Activity and At-Risk Rules

Form (and Instructions)

  • 8275 Disclosure Statement

  • 8275-R Regulation Disclosure Statement

  • 8283 Noncash Charitable Contributions

  • 8886 Reportable Transaction Disclosure Statement

See chapter 5, How To Get Tax Help , for information about getting these publications and forms.

Abusive Tax Shelters

Abusive tax shelters are marketing schemes involving artificial transactions with little or no economic reality. They often make use of unrealistic allocations, inflated appraisals, losses in connection with nonrecourse loans, mismatching of income and deductions, financing techniques that do not conform to standard commercial business practices, or mischaracterization of the substance of the transaction. Despite appearances to the contrary, the taxpayer generally risks little.

Abusive tax shelters commonly involve package deals designed from the start to generate losses, deductions, or credits that will be far more than present or future investment. Or, they may promise investors from the start that future inflated appraisals will enable them, for example, to reap charitable contribution deductions based on those appraisals. (But see the appraisal requirements discussed under Rules To Curb Abusive Tax Shelters , later.) They are commonly marketed in terms of the ratio of tax deductions allegedly available to each dollar invested. This ratio (or “write-off”) is frequently said to be several times greater than one-to-one.

Because there are many abusive tax shelters, it is not possible to list all the factors you should consider in determining whether an offering is an abusive tax shelter. However, you should ask the following questions, which might provide a clue to the abusive nature of the plan.

  • Do the tax benefits far outweigh the economic benefits?

  • Is this a transaction you would seriously consider, apart from the tax benefits, if you hoped to make a profit?

  • Do shelter assets really exist and, if so, are they insured for less than their purchase price?

  • Is there a nontax justification for the way profits and losses are allocated to partners?

  • Do the facts and supporting documents make economic sense? In that connection, are there sales and resales of the tax shelter property at ever increasing prices?

  • Does the investment plan involve a gimmick, device, or sham to hide the economic reality of the transaction?

  • Does the promoter offer to backdate documents after the close of the year? Are you instructed to backdate checks covering your investment?

  • Is your debt a real debt or are you assured by the promoter that you will never have to pay it?

  • Does this transaction involve laundering United States source income through foreign corporations incorporated in a tax haven and owned by United States shareholders?

Rules To Curb Abusive Tax Shelters

Congress has enacted a series of income tax laws designed to halt the growth of abusive tax shelters. These provisions include the following.

Disclosure of reportable transactions.   You must disclose information for each reportable transaction in which you participate. See Reportable Transaction Disclosure Statement , later.

  Material advisors with respect to any reportable transaction must disclose information about the transaction on Form 8918, Material Advisor Disclosure Statement. To determine whether you are a material advisor to a transaction, see the Instructions for Form 8918.

  Material advisors will receive a reportable transaction number for the disclosed reportable transaction. They must provide this number to all persons to whom they acted as a material advisor. They must provide the number at the time the transaction is entered into. If they do not have the number at that time, they must provide it within 60 days from the date the number is mailed to them. For information on penalties for failure to disclose and failure to maintain lists, see Internal Revenue Code sections 6707, 6707A, and 6708.

Requirement to maintain list.   Material advisors must maintain a list of persons to whom they provide material aid, assistance, or advice on any reportable transaction. The list must be available for inspection by the IRS, and the information required to be included on the list generally must be kept for 7 years. See Regulations section 301.6112-1 for more information (including what information is required to be included on the list).

Confidentiality privilege.   The confidentiality privilege between you and a federally authorized tax practitioner does not apply to written communications made after October 21, 2004, regarding the promotion of your direct or indirect participation in any tax shelter.

Appraisal requirement for donated property.   If you claim a deduction of more than $5,000 for an item or group of similar items of donated property, you generally must get a qualified appraisal from a qualified appraiser and complete and attach section B of Form 8283 to your return. If you claim a deduction of more than $500,000 for the donated property, you generally must attach the qualified appraisal to your return. If you file electronically, see Form 8453, U.S. Individual Income Tax Transmittal for an IRS e-file Return, and its instructions. For more information about appraisals, including exceptions, see Publication 561.

Passive activity loss and credit limits.   The passive activity loss and credit rules limit the amount of losses and credits that can be claimed from passive activities and limit the amount that can offset nonpassive income, such as certain portfolio income from investments. For more detailed information about determining and reporting income, losses, and credits from passive activities, see Publication 925.

Interest on penalties.   If you are assessed an accuracy-related or civil fraud penalty (as discussed under Penalties , later), interest will be imposed on the amount of the penalty from the due date of the return (including any extensions) to the date you pay the penalty.

Accounting method restriction.   Tax shelters generally cannot use the cash method of accounting.

Uniform capitalization rules.   The uniform capitalization rules generally apply to producing property or acquiring it for resale. Under those rules, the direct cost and part of the indirect cost of the property must be capitalized or included in inventory. For more information, see Publication 538.

Denial of deduction for interest on an underpayment due to a reportable transaction.   You cannot deduct any interest you paid or accrued on any part of an underpayment of tax due to an understatement arising from a reportable transaction (discussed later) if the relevant facts affecting the tax treatment of the item are not adequately disclosed. This rule applies to reportable transactions entered into in tax years beginning after October 22, 2004.

Authority for Disallowance of Tax Benefits

The IRS has published guidance concluding that the claimed tax benefits of various abusive tax shelters should be disallowed. The guidance is the conclusion of the IRS on how the law is applied to a particular set of facts. Guidance is published in the Internal Revenue Bulletin for taxpayers' information and also for use by IRS officials. So, if your return is examined and an abusive tax shelter is identified and challenged, published guidance dealing with that type of shelter, which disallows certain claimed tax shelter benefits, could serve as the basis for the examining official's challenge of the tax benefits you claimed. In such a case, the examiner will not compromise even if you or your representative believes you have authority for the positions taken on your tax return.

The courts have generally been unsympathetic to taxpayers involved in abusive tax shelter schemes and have ruled in favor of the IRS in the majority of the cases in which these shelters have been challenged.

Investor Reporting

You may be required to file a reportable transaction disclosure statement.

Reportable Transaction Disclosure Statement

Use Form 8886 to disclose information for each reportable transaction (discussed later) in which you participated. Generally, you must attach Form 8886 to your return for each tax year in which you participated in the transaction. Under certain circumstances, a transaction must be disclosed within 90 days of the transaction being identified as a listed transaction or a transaction of interest (discussed later). In addition, for the first year Form 8886 is attached to your return, you must send a copy of the form to:

Internal Revenue Service 
OTSA Mail Stop 4915 
1973 North Rulon White Blvd. 
Ogden, UT 84404

If you file your return electronically, the copy sent to OTSA must show exactly the same information, word for word, provided with the electronically filed return and it must be provided on the official IRS Form 8886 or an exact copy of the form. If you use a computer-generated or substitute Form 8886, it must be an exact copy of the official IRS form.

If you fail to file Form 8886 as required or fail to include any required information on the form, you may have to pay a penalty. See Penalty for failure to disclose a reportable transaction , later under Penalties.

The following discussion briefly describes reportable transactions. For more details, see the Instructions for Form 8886.

Reportable transaction.   A reportable transaction is any of the following.
  • A listed transaction.

  • A confidential transaction.

  • A transaction with contractual protection.

  • A loss transaction.

  • A transaction of interest entered into after November 1, 2006.

Note.

Transactions with a brief asset holding period were removed from the definition of reportable transaction for transactions entered into after August 2, 2007.

Listed transaction.   A listed transaction is the same as, or substantially similar to, one of the types of transactions the IRS has determined to be a tax-avoidance transaction. These transactions have been identified in notices, regulations, and other published guidance issued by the IRS. For a list of existing guidance, see Notice 2009-59 in Internal Revenue Bulletin 2009-31, available at www.irs.gov/irb/2009-31_IRB/ar07.html.

Confidential transaction.   A confidential transaction is offered to you under conditions of confidentiality and for which you have paid an advisor a minimum fee. A transaction is offered under conditions of confidentiality if the advisor who is paid the fee places a limit on your disclosure of the tax treatment or tax structure of the transaction and the limit protects the confidentiality of the advisor's tax strategies. The transaction is treated as confidential even if the conditions of confidentiality are not legally binding on you.

Transaction with contractual protection.   Generally, a transaction with contractual protection is one in which you or a related party has the right to a full or partial refund of fees if all or part of the intended tax consequences of the transaction are not sustained, or a transaction for which the fees are contingent on your realizing the tax benefits from the transaction. For information on exceptions, see Revenue Procedure 2007-20 in Internal Revenue Bulletin 2007-7, available at www.irs.gov/irb/2007-07_IRB/ar15.html.

Loss transaction.   For individuals, a loss transaction is one that results in a deductible loss if the gross amount of the loss is at least $2 million in a single tax year or $4 million in any combination of tax years. A loss from a foreign currency transaction under Internal Revenue Code section 988 is a loss transaction if the gross amount of the loss is at least $50,000 in a single tax year, whether or not the loss flows through from an S corporation or partnership.

  Certain losses (such as losses from casualties, thefts, and condemnations) are excepted from this category and do not have to be reported on Form 8886. For information on other exceptions, see Revenue Procedure 2004-66 in Internal Revenue Bulletin 2004-50, as modified and superseded by Revenue Procedure 2013-11, (or future published guidance) available at www.irs.gov/irb/2004-50_IRB/ar11.html.

Transaction of interest.   A transaction of interest is a transaction entered into after November 1, 2006, that is the same as, or substantially similar to, one of the types of transactions that the IRS has identified by notice, regulation, or other form of published guidance as a transaction of interest. The IRS has identified the following transactions of interest.
  • Toggling” grantor trusts as described in Notice 2007-73, 2007-36 I.R.B. 545, available at www.irs.gov/irb/2007-36_IRB/ar20.html.

  • Certain transactions involving contributions of a successor member interest in a limited liability company as described in Notice 2007-72, 2007-36 I.R.B. 544, available at www.irs.gov/irb/2007-36_IRB/ar19.html.

  • Certain transactions involving the sale or other disposition of all interests in a charitable remainder trust and claiming little or no taxable gain as described in Notice 2008-99, 2008-47 I.R.B. 1194, available at www.irs.gov/irb/2008-47_IRB/ar11.html.

  • Certain transactions involving a U.S. taxpayer owning controlled foreign corporations (CFCs) that hold stock of a lower-tier CFC through a domestic partnership to avoid reporting income as described in Notice 2009-7, 2009-3 I.R.B. 312, available at www.irs.gov/irb/2009-03_IRB/ar10.html.

  For updates to this list, go to www.irs.gov/Businesses/Corporations/Abusive-Tax-Shelters-and-Transactions.

Penalties

Investing in an abusive tax shelter may lead to substantial expenses. First, the promoter generally charges a substantial fee. If your return is examined by the IRS and a tax deficiency is determined, you will be faced with payment of more tax, interest on the underpayment, possibly a 20%, 30%, or even 40% accuracy-related penalty, or a 75% civil fraud penalty. You may also be subject to the penalty for failure to pay tax. These penalties are explained in the following paragraphs.

Accuracy-related penalties.   An accuracy-related penalty of 20% can be imposed for underpayments of tax due to:
  • Negligence or disregard of rules or regulations,

  • Substantial understatement of tax,

  • Substantial valuation misstatement (increased to 40% for gross valuation misstatement),

  • Transaction lacking economic substance (increased to 40% for undisclosed transaction lacking economic substance), or

  • Undisclosed foreign financial asset understatement (40% in all cases).

Except for a transaction lacking economic substance, this penalty will not be imposed if you can show you had reasonable cause for any understatement of tax and that you acted in good faith. Your failure to disclose a reportable transaction is a strong indication that you failed to act in good faith.

  If you are charged an accuracy-related penalty, interest will be imposed on the amount of the penalty from the due date of the return (including extensions) to the date you pay the penalty.

  The 20% penalties do not apply to any underpayment attributable to a reportable transaction understatement subject to an accuracy-related penalty (discussed later).

Negligence or disregard of rules or regulations.   The penalty for negligence or disregard of rules or regulations is imposed only on the part of the underpayment due to negligence or disregard of rules or regulations. The penalty will not be charged if you can show you had reasonable cause for understating your tax and that you acted in good faith.

   Negligence includes any failure to make a reasonable attempt to comply with the provisions of the Internal Revenue Code. It also includes any failure to keep adequate books and records. A return position that has a reasonable basis is not negligence.

  Disregard includes any careless, reckless, or intentional disregard of rules or regulations.

  The penalty for disregard of rules and regulations can be avoided if all the following are true.
  • You keep adequate books and records.

  • You have a reasonable basis for your position on the tax issue.

  • You make an adequate disclosure of your position.

Use Form 8275 to make your disclosure and attach it to your return. To disclose a position contrary to a regulation, use Form 8275-R. Use Form 8886 to disclose a reportable transaction (discussed earlier).

Substantial understatement of tax.   An understatement is considered to be substantial if it is more than the greater of:
  • 10% of the tax required to be shown on the return, or

  • $5,000.

An “understatement” is the amount of tax required to be shown on your return for a tax year minus the amount of tax shown on the return, reduced by any rebates. The term “rebate” generally means a decrease in the tax shown on your original return as the result of your filing an amended return or claim for refund.

  For items other than tax shelters, you can file Form 8275 or Form 8275-R to disclose items that could cause a substantial understatement of income tax. In that way, you can avoid the substantial understatement penalty if you have a reasonable basis for your position on the tax issue. Disclosure of the tax shelter item on a tax return does not reduce the amount of the understatement.

  Also, the understatement penalty will not be imposed if you can show there was reasonable cause for the underpayment caused by the understatement and that you acted in good faith. An important factor in establishing reasonable cause and good faith will be the extent of your effort to determine your proper tax liability under the law.

Substantial valuation misstatement.   In general, you are liable for a 20% penalty for a substantial valuation misstatement if all the following are true.
  • The value or adjusted basis of any property claimed on the return is 150% or more of the correct amount.

  • You underpaid your tax by more than $5,000 because of the misstatement.

  • You cannot establish that you had reasonable cause for the underpayment and that you acted in good faith.

  You may be assessed a penalty of 40% for a gross valuation misstatement. If you misstate the value or the adjusted basis of property by 200% or more of the amount determined to be correct, you will be assessed a penalty of 40%, instead of 20%, of the amount you underpaid because of the gross valuation misstatement. The penalty rate is also 40% if the property's correct value or adjusted basis is zero.

Transaction lacking economic substance.   The economic substance doctrine only applies to an individual that entered into a transaction in connection with a trade or business or an activity engaged in for the production of income. For transactions entered into after March 30, 2010, a transaction has economic substance for you as an individual taxpayer only if:
  • The transaction changes your economic position in a meaningful way (apart from federal income tax effects), or

  • You have a substantial purpose (apart from federal income tax effects) for entering into the transaction.

  For purposes of determining whether economic substance exists, a transaction's profit potential will only be taken into account if the present value of the reasonably expected pre-tax profit from the transaction is substantial compared to the present value of the expected net tax benefits that would be allowed if the transaction were respected.

  If any part of your underpayment is due to any disallowance of claimed tax benefits by reason of a transaction lacking economic substance or failing to meet the requirements of any similar rule of law, that part of your underpayment will be subject to the 20% accuracy-related penalty even if you had a reasonable cause and acted in good faith concerning that part.

  Additionally, the penalty increases to 40% if you do not adequately disclose on your return or in a statement attached to your return the relevant facts affecting the tax treatment of a transaction that lacks economic substance. Relevant facts include any facts affecting the tax treatment of the transaction.

  
Any excessive amount of an erroneous claim for an income tax refund or credit (other than a refund or credit related to the earned income credit) that results from a transaction found to be lacking economic substance will not be treated as having a reasonable basis and could be subject to a 20% penalty.

Undisclosed foreign financial asset understatement.   For tax years beginning after March 18, 2010, you may be liable for a 40% penalty for an understatement of your tax liability due to an undisclosed foreign financial asset. An undisclosed foreign financial asset is any asset for which an information return, required to be provided under Internal Revenue Code section 6038, 6038B, 6038D, 6046A, or 6048 for any taxable year, is not provided. The penalty applies to any part of an underpayment related to the following undisclosed foreign financial assets.
  • Any foreign business you control, reportable on Form 5471, Information Return of U.S. Persons With Respect To Certain Foreign Corporations, or Form 8865, Return of U.S. Persons With Respect to Certain Foreign Partnerships.

  • Certain transfers of property to a foreign corporation or partnership, reportable on Form 926, Return by a U.S. Transferor of Property to a Foreign Corporation, or certain distributions to a foreign person, reportable on Form 8865.

  • Your ownership interest in certain foreign financial assets, temporarily reportable on Form 8275 or 8275-R.

  
Instead of, or in addition to, Form 8275 or 8275-R, you may have to file Form 8938, Statement of Specified Foreign Financial Assets, with your tax return. See the Instructions for Form 8938 for details.

  
  • Your acquisition, disposition, or substantial change in ownership interest in a foreign partnership, reportable on Form 8865.

  • Creation or transfer of money or property to certain foreign trusts, reportable on Form 3520, Annual Return To Report Transactions With Foreign Trusts and Receipt of Certain Foreign Gifts.

Penalty for incorrect appraisals.   The person who prepares an appraisal of the value of property may have to pay a penalty if:
  • He or she knows, or reasonably should have known, that the appraisal would be used in connection with a return or claim for refund; and

  • The claimed value of the property on a return or claim for refund based on that appraisal results in a substantial valuation misstatement or a gross valuation misstatement as discussed earlier.

For details on the penalty amount and exceptions, see Publication 561.

Penalty for failure to disclose a reportable transaction.   If you fail to include any required information regarding a reportable transaction (discussed earlier) on a return or statement, you may have to pay a penalty of 75% of the decrease in tax shown on your return as a result of such transaction (or that would have resulted if the transaction were respected for federal tax purposes). For an individual, the minimum penalty is $5,000 and the maximum is $10,000 (or $100,000 for a listed transaction). This penalty is in addition to any other penalty that may be imposed.

  The IRS may rescind or abate the penalty for failing to disclose a reportable transaction under certain limited circumstances but cannot rescind the penalty for failing to disclose a listed transaction. For information on rescission, see Revenue Procedure 2007-21 in Internal Revenue Bulletin 2007-9 available at www.irs.gov/irb/2007-09_IRB/ar12.html.

Accuracy-related penalty for a reportable transaction understatement.   If you have a reportable transaction understatement, you may have to pay a penalty equal to 20% of the amount of that understatement. This applies to any item due to a listed transaction or other reportable transaction with a significant purpose of avoiding or evading federal income tax. The penalty is 30% rather than 20% for the part of any reportable transaction understatement if the transaction was not properly disclosed. You may not have to pay the 20% penalty if you meet the strengthened reasonable cause and good faith exception. The reasonable cause and good faith exception does not apply to any part of a reportable transaction understatement attributable to one or more transactions that lack economic substance.

  This penalty does not apply to the part of an understatement on which the fraud penalty, gross valuation misstatement penalty, or penalty for nondisclosure of noneconomic substance transactions is imposed.

Civil fraud penalty.   If any underpayment of tax on your return is due to fraud, a penalty of 75% of the underpayment will be added to your tax.

Joint return.   The fraud penalty on a joint return applies to a spouse only if some part of the underpayment is due to the fraud of that spouse.

Failure to pay tax.   If a deficiency is assessed and is not paid within 10 days of the demand for payment, an investor can be penalized with up to a 25% addition to tax if the failure to pay continues.

Whether To Invest

In light of the adverse tax consequences and the substantial amount of penalties and interest that will result if the claimed tax benefits are disallowed, you should consider tax shelter investments carefully and seek competent legal and financial advice.


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