A $200,000 Penalty for a $25,000 Deduction??!!: the High Price of Failing to Disclose Listed Transactions Under Section 6707A of the Code

A $200,000 Penalty for a $25,000 Deduction??!!: the High Price of Failing to Disclose Listed Transactions Under Section 6707A of the Code

By Charles M. Ruchelman and Leila D. Carney¹

An Intimidating IRS Weapon

In 2004, Congress provided the IRS with powerful tools to regulate the perceived proliferation of abusive tax shelters. One of those tools, section 6707A of the Internal Revenue Code, imposes a significant penalty on taxpayers who fail to disclose a “reportable” transaction to the IRS. Currently, the disclosure must be made on IRS Form 8886. Failure to properly report the transaction can have devastating consequences.

The amount of the section 6707A penalty varies depending on (1) whether the IRS categorized the transaction as a “listed transaction” and (2) whether the taxpayer is a natural person. The penalty range is as follows: a $10,000 penalty applies to an individual’s failure to report a “reportable” transaction other than a “listed” transaction; a $50,000 penalty applies for the same failure by those who are not individuals; a $100,000 penalty applies to an individual’s failure to report a “listed” transaction; and a $200,000 penalty applies for the same failure by those who are not individuals. For example, a corporation that engaged in a “listed” transaction (or a transaction that is “substantially similar”) which gave rise to a deduction of $25,000 over the course of three years and inadvertently failed to report the transaction may be subject to a $200,000 penalty per year, for a total penalty of $600,000. The penalty can apply even if the deduction is allowable. The statute provides no exception or defense to imposition of the penalty for “reasonable cause.” Therefore, even a taxpayer who provided all the relevant reporting information to its accountant but whose accountant failed to file the information return can be saddled with the penalty.

Even IRS officials are publicly recognizing the harshness of the penalty. Don Korb, IRS Chief Counsel, admitted that the penalties for listed transactions may be preventing the IRS from listing more transactions.² At the Federal Bar Association’s 20th Annual Insurance Tax Seminar in Washington, D.C., Henry Schneiderman, IRS special counsel to the associate chief counsel, explained that the IRS is cautious in characterizing transactions as listed transactions, realizing that “more and more weight has been put on the designation of something as a listed transaction.” Instead, the IRS has retreated to categorizing transactions as “transactions of interest,” rather than making them “listed transactions.”³ National Taxpayer Advocate Nina Olson recommends a change to the section 6707A penalties, among others, in order to “bring the sanity back.”⁴ All around, tax practitioners and IRS officials recognize that the section 6707A penalty can result in very harsh consequences for average taxpayers.

A Trap for the Unwary

The Code’s disclosure regime is replete with traps for the unwary and ill-informed. First, taxpayers may not even be aware that the transaction they have participated in is a “reportable” or “listed” transaction. Second, as transactions are subsequently designated as “listed” transactions, it becomes easier for taxpayers to miss filing requirements inadvertently because they may have to file disclosures that pertain to old tax years in which they engaged in transactions that they are only now obligated to report. Third, even if taxpayers properly determine that they are obligated to file, a common foot fault is the failure to properly meet the dual filing requirement. That is, taxpayers must both file a disclosure with their tax return and also separately mail an initial disclosure to the Office of Tax Shelter Analysis.

Despite the significant traps and disproportionate nature of the penalty, the IRS is imposing the penalty on unsuspecting taxpayers. IRS processing procedures clarify that examiners have little discretion as to whether to assert the penalty, instead instructing examiners that “the penalty must be developed wherever it appears legally applicable.”⁵ Although practitioners have observed that the penalty appears to be assessed as a matter of course, the IRS has recently issued internal guidance requiring the penalty to be approved by the examiner’s supervisor, the Territory Manager, and the Area Director.⁶ This step responds to the realistic concern that such harsh penalties should be applied carefully.

IRS Rescission – An Unlikely Remedy

While section 6707A does not provide a reasonable cause defense or exception, it gives the IRS authority to “rescind” the penalty under certain circumstances. The conditions necessary to obtain a “rescission” are difficult to achieve. First, rescission is only possible with respect to a failure to report a transaction other than a “listed” transaction. Thus, there is no flexibility with respect to the highest penalties. Second, the manner in which this authority will be exercised is unclear. Mr. Schneiderman said in May that he was not aware of any requests for rescission thus far. This delay is likely due to the IRS’s position that the request cannot be made until after the penalty has been assessed, as detailed in Revenue Procedure 2007-21. Third, a rescission request can only seek relief from the penalty on the basis of the mitigating factors described in Revenue Procedure 2007-21 and updated in a recently issued temporary regulation,⁷ not on the basis that the violation did not occur. Fourth, Revenue Procedure 2007-21 requires a taxpayer to exhaust his administrative appeal rights prior to a rescission request. Alternatively, the taxpayer can agree to an assessment of the penalty in writing and waive his refund claim in order to request rescission. The request is timely if made within 30 days of the earlier of a notice and demand for payment or payment in full. Fifth, denial of a rescission request is not subject to judicial review, or even review by the Office of IRS Appeals. These conditions leave taxpayers and their representatives in doubt that the penalty will be rescinded even in sympathetic circumstances.⁸

The Role of IRS Appeals

At least until the rescission process is illuminated, practitioners should focus on doing the best for their clients at IRS Appeals. To this end, practitioners may request a pre-assessment appeals conference, the right to which is outlined in section 8.11.1.13 of the Internal Revenue Manual published in August 2008. The request should be made upon receipt of a 30-day letter proposing a section 6707A penalty. The IRS will expect the taxpayer to file a protest of the penalty, and according to IRS processing procedures dated September 5, 2008, the group manager will review the protest, giving further consideration to the assertion of the penalty. The group manager can return the case to the examiner for further development on an expedited basis and “should attempt to discuss the disputed issues with the taxpayer . . . in an attempt to resolve the issues . . . .”⁹

If the case remains unagreed, the appeals office for the taxpayer’s geographic region will assign an officer, preferably trained in mediation, to review the merits. The taxpayer’s protest should fully brief the three issues that are in play. First, the taxpayer should argue that the transaction was not, in fact, a transaction that the taxpayer was obligated to disclose because it was not a reportable transaction or the same or substantially similar to a listed transaction. Second, the taxpayer should argue that if he was obligated to disclose it, he met that obligation (although that will usually be easily verified). Third, the taxpayer may be able to argue that he had no disclosure obligation even though the transaction is a “reportable” or “listed” transaction. Critical to this third issue are certain so-called “effective date” rules. These rules, in part, identify the dates on which certain entities (e.g., corporations versus non-corporations) became obligated to file the disclosures. The disclosure obligation evolved as the disclosure statutes and regulations were modified. The taxpayer’s representative must understand these complex effective date rules in order to determine whether a disclosure obligation existed in the first place. IRS Appeals will not hear arguments that a taxpayer qualifies for rescission or that are otherwise based on the rescission factors, such as reasonable cause.

The Refund Suit

If the taxpayer is unable to resolve the issue at a pre-assessment appeals hearing, the taxpayer may still sue for a refund on the merits in court. That is, the taxpayer can litigate the questions of whether he was obligated to report the transaction, whether he properly reported the transaction, and whether the transaction is a reportable or listed transaction. Again, the taxpayer cannot litigate the question of whether he qualifies for rescission of the penalty.

Untimely Disclosures

Currently, advisors are at a loss at to how to instruct taxpayers who inadvertently failed to disclose transactions, because advising taxpayers to file late may increase the risk that the IRS will assess substantial penalties. The IRS is interested in providing taxpayers with an opportunity to disclose transactions as required even if such disclosure is late. In the preamble to the temporary regulations issued in September, the IRS indicated its desire to take formal action in response to the problem, by requesting comments on a proposal to create a date by which taxpayers can rectify their failure to disclose prior to being contacted by the IRS.¹⁰ The IRS has suggested that it may even publish a rule that treats filings by such a date as timely.¹¹

Representation Before the IRS

While taxpayers await relief of any sort (legislative or otherwise), practitioners need to prepare to defend against imposition of a section 6707A penalty during an IRS examination and with IRS Appeals. Regarding IRS Appeals, a pre-assessment appeals hearing is available. To make the most of this opportunity, taxpayers will need a skilled representative to prepare the protest and represent them. Taxpayers should select a representative who is familiar with the nuances of the entire disclosure regime. In addition, counsel must be a veteran in navigating the appeals process in order to ensure that the IRS affords the taxpayer full and fair treatment in this new appeals program. Finally, counsel must proceed with an eye to the post-appeal options of requesting rescission or litigating a refund suit in order to wage a full defense against the disproportionately high section 6707A penalty.

This article is designed to give general information on the developments covered, not to serve as legal advice related to specific situations or as a legal opinion. Counsel should be consulted for legal advice.

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FOOTNOTES:

1. Mr. Ruchelman and Ms. Carney are members of Caplin & Drysdale’s tax controversy and litigation practice group. Their practice focuses on representing clients during Internal Revenue Service examinations, before the IRS Office of Appeals, in cases before the U.S. Tax Court, U.S. district courts, the U.S. Court of Federal Claims, and the U.S. appellate courts. Copyright 2008 Charles M. Ruchelman and Leila D. Carney. All rights reserved.
2. See Lee A. Sheppard, News Analysis: Penalty Scheme UP for Reappraisal, 2008 Tax Notes Today 93-3 (May 13, 2008).
3. Jeremiah Coder, IRS Sensitive to Effects of Listing New Transactions, Official Says, 2008 Tax Notes Today 102-1 (May 27, 2008).
4. See Diane Freda, Taxpayer Advocate to Publish Research On IRS Penalty Structure; Overhaul Reviewed, Daily Tax Rep. (BNA), May 14, 2008, at G-4.
5. IRS Issues Updated SB/SE Interim Guidance on Reportable Transactions Information Penalty, 2008 Tax Notes Today 209-12 (September 5, 2008) (attachment 1, p. 8).
6. Id.
7. Treas. Reg. § 301.6707A-1T.
8. In September 2008, the IRS issued temporary regulations making a small change to the factors that it will consider in determining whether to rescind a section 6707A penalty. The factors continue to include: (1) whether the taxpayer voluntarily filed, albeit late; (2) whether an unintentional mistake of fact caused the failure despite the taxpayer’s reasonable attempts; (3) the taxpayer’s compliance history regarding such reports and generally; (4) whether events beyond the taxpayer’s control prevented timely filing; (5) whether the taxpayer cooperates; and (6) whether assessment of the penalty weighs against equity and good conscience in light of reasonable cause and good faith. The temporary regulations add that the final factor now specifically calls for consideration of whether the penalty is disproportionate to the tax benefit of the transaction.
9. See IRS Issues Updated SB/SE Interim Guidance on Reportable Transactions Information Penalty, 2008 Tax Notes Today 209-12 (September 5, 2008) (attachment 1, pp. 9-10).
10. 73 Fed. Reg. 52785 (Sept. 11, 2008).
11. Id.