Several months ago, we discussed the American Jobs Creation Act of 2004 (AJCA or Act) and its impact on personal and business tax planning. We also mentioned that the AJCA contained a number of revenue raisers to help offset the cost of other tax breaks in the Act, but we held off on a more thorough discussion of the revenue raisers until another time. Well...that time is now.
One of the more significant provisions of AJCA dealt with the disclosure requirements related to abusive tax shelters and transactions, and penalties for failure to follow the disclosure requirements. The new disclosure requirements are tough, but the penalties for failure to follow the requirements are brutal.
First, let's look at the AJCA definition of abusive transactions and shelters. Simply put, abusive transactions and shelters are schemes to assist a taxpayer in avoiding taxes that seem perfectly legal but are, in fact, not legal. For example, one of the more recent schemes is the use of subsidiary entities owned by Roth IRAs to essentially go around the maximum contribution limitations. The steps seem to be legitimate, but when subjected to the "Substance over Form" tests, they simply do not pass the test. You can find a more complete list of such transactions at the IRS web site, but here are some of the more common types:
- Use of a "Roth IRA Corporation" to circumvent contribution limitations and escape taxation on value buildup and dividends.
- Utilization of Employee Stock Ownership Plans to purchase S Corporation stock when the benefit of ownership (income allocation) is retained by top corporate officers.
- Deducting contributions of an employer to an employee's 401(k) account on income that has not yet been earned by the employee.
- Using certain trust arrangements purported to be Collectively Bargained Welfare Benefit Funds to accelerate the deductions available under employee welfare plans.
- Various other schemes. In all, there are 32 listed transactions.
So what's so bad about schemes set up to take advantage of the tax laws on the books? The long and short of it is that these schemes cost the United States Government significant tax dollars and the underlying transactions do not have economic substance or are not entered into for a business purpose. The key here is that the transactions are not entered into with a business objective in mind. You see, tax law is funny. If the sole purpose for a transaction is to simply reduce your tax bill, there is a good chance the transaction will be considered a sham and the benefits of the transaction will be denied to the taxpayer. If, however, you enter into a transaction for other business reasons, there is a good chance that your transaction(s) will withstand scrutiny. One of the single best evidences of business purpose is the intent, at some point, to earn a profit from the transaction. You don't actually have to turn a profit as long as you can prove you intended the transaction to make a profit at some point.
For example, throughout the 1980s, banks were building up hefty net operating loss carryforwards. In the 1990s, the industry began making money, but not nearly enough to offset net operating loss carryforwards that were expiring. Various promoters came up with a scheme that would produce significant income in the first year of a partnership's life (thereby utilizing the net operating loss carryforward) and then produce losses for the next ten years. Ultimately, the effect was to utilize the net operating loss and, at the end of the day, cost the bank nothing except for whatever fees were charged by the advisors and promoters of the transactions. The IRS is now taking a very hard look at these transactions. Since everything from the gain that allowed the bank to use it's NOL carryforward to the losses incurred later were paper transactions, these were really non-existent transactions from a tax code point of view.
Tax shelters, Abusive Transactions and similar strategies sometimes do work, but the IRS has basically said it will not simply allow the tax benefits of a transaction unless they have reviewed it. That is the reason for the disclosure requirements and penalties created by the new tax law. Let's take a look at the new requirements. All of these requirements are applicable to any tax returns due after October 22, 2004:
- Any person or entity that engages in a reportable transaction is required to disclose any participation in the reported transaction. This is done by filing a separate Form 8886 for each listed transaction engaged in by the taxpayer. Reportable transactions include:
- Listed transactions
- Confidential transactions
- Transactions with a significant book-tax difference
- Transactions with contractual protection
- Certain loss transactions
- Transactions with a brief asset holding period
- Failure to adhere to the reporting requirements will cost a natural person $10,000 and any other entity $50,000. If the reportable transaction is also a Listed Transaction, the penalty is increased to $100,000 for natural persons and $200,000 for other entities.
- The accuracy related penalty for understatement of tax for years ending after October 22, 2004 is increased to 20% for an adequately disclosed listed or reportable tax avoidance transaction or 30% for undisclosed transactions.
- After October 22, 2004, communications between taxpayer and federally authorized tax practitioner related to tax shelter transactions are no longer subject to the confidentiality provisions of the Internal Revenue Code.
- The statute of limitations is extended for listed transactions.
- Each "material advisor" involved in a reportable transaction must timely file an information return with the IRS.
- The penalty for each material advisor who fails to file an information return, or files false or incomplete information, is $50,000 with respect to all reportable transactions, except the amount is increased to the greater of $200,000 or 2) 50% of the gross income of the advisor that is related to the aid or assistance given to the taxpayer.
The purpose of this column this month is not to scare any taxpayer, but with all the hype about the good things accomplished for the taxpayer in the AJCA, the down sides needed to be highlighted too. Transactions related to listed transactions and other reportable transactions are generally high dollar and can have a significant effect on your tax liability. For this reason, you need to be extremely careful in preparing your return this year by knowing the types of transactions the IRS considers abusive and reporting the transactions if you engaged in any of those reportable on Form 8886 or if you engaged in transactions that are substantially similar in nature to the listed transactions. You needn't go crazy trying to determine what is and what is not reportable. Instead, give us a call and let's talk. We have the technical ability to provide you with the expert guidance you need.
Have a great February and Happy Valentine¬ís Day!