By: Lance Wallach
Currently, the Internal Revenue Service ("IRS") has the discretion to assess hundreds of thousands of dollars in penalties under §6707A of the Internal Revenue Code ("Code") in an attempt to curb tax avoidance shelters. This discretion can be applied regardless of the innocence of the taxpayer and was granted by Congress. It works so that if the IRS determines you have engaged in a listed transaction and failed to properly disclose it, you will be subject to a potentially draconian penalty regardless of any other facts and circumstances concerning the transaction. For some, this penalty has been assessed a million dollars and for many it is the beginning of a long nightmare.
The following is an example: Pursuant to a settlement with the IRS, the 412(i) plan was converted into a traditional defined benefit plan. All of the contributions to the 412(i) plan would have been allowable if they had initially adopted a traditional defined benefit plan. Based on the business owner negotiations with the IRS agent, the audit of the plan resulted in no income and minimal excise taxes due. This is because as a traditional defined benefit plan, the taxpayers could have contributed and deducted the same amount as a 412(i) plan.
Toward the end of the audit the business owner received a notice from the IRS. The IRS assessed the business owner penalties under the §6707A of the Code in the amount of $900,000. This penalty was assessed because the business owner allegedly participated in a listed transaction and allegedly failed to file the form 8886 in a timely manner.
Another example follows: A business owner never received the letter assessing the §6707A penalty and was still in the midst of the 412(i) audit when he heard a knock on his office door. An IRS collections officer showed up at his office to make "payments" on a $200,000 §6707A penalty.
The IRS may call you a material adviser and fine you $200,000. The IRS may fine your client over a million dollars for being in a retirement plan, 419 plan, etc. As you read this article, hundreds of unfortunate people are having their lives ruined by these fines. You may need to take action immediately. The Internal Revenue Service said it will extend until the end of 2009 a grace period granted to small business owners for collection of certain tax-shelter penalties.
But with that deadline approaching, Congress has not yet acted on the tax shelter penalty legislation. IRS Commissioner Doug Shulman said in a Thursday letter to the chairmen and ranking members of tax-writing committees that the IRS will continue to suspend its collection efforts with regard to the penalties until Dec. 31, 2009.
"Clearly, a number of taxpayers have been caught in a penalty regime that the legislation did not intend," wrote Shulman. "I understand that Congress is still considering this issue, and that a bipartisan, bicameral, bill may be in the works."
The issue relates to penalties for so-called listed transactions, the kinds of tax shelters the IRS has designated most egregious. A number of small business owners that bought employee retirement plans so called 419 and 412(i) plans and others, that were listed by the IRS, and who are now facing hundreds and thousands in penalties, contend that the penalty amounts are unfair.
Leaders of tax-writing committees in the House and Senate have said they intend to pass legislation revising the penalty structure.
The IRS has suspended collection efforts in cases where the tax benefit derived from the listed transaction was less than $100,000 for individuals or less than $200,000 for firms.
Sen. Ben Nelson (D-Nebraska) has sponsored legislation (S.765) to curtail the IRS and its nearly unlimited authority and power under Code Section 6707A. The bill seeks to scale back the scope of the Section 6707A reportable/listed transaction nondisclosure penalty to a more reasonable level. The current law provides for penalties that are Draconian by nature and offer no flexibility to the IRS to reduce or abate the imposition of the 6707A penalty. This has served as a weapon of mass destruction for the IRS and has hit many small businesses and their owners with unconscionable results.
Internal Revenue Code 6707A was enacted as part of the American Jobs Creation Act on Oct. 22, 2004. It imposes a strict liability penalty for any person that failed to disclose either a listed transaction or reportable transaction per each occurrence. Reportable transactions usually fall within certain general types of transactions (e.g. confidential transactions, transactions with tax protection, certain loss generating transaction and transactions of interest arbitrarily so designated as by the IRS) that have the potential for tax avoidance. Listed transactions are specified transactions which have been publicly designated by the IRS, including anything that is substantially similar to such a transaction (a phrase which is given very liberal construction by the IRS). There are currently 34 listed transactions, including certain retirement plans under Code section 412(i) and certain employee welfare benefit plans funded in part with life insurance under Code sections 419A(f)(5), 419(f)(6) and 419(e). Many of these plans were implemented by small business seeking to provide retirement income or health benefits to their employees.
Strict liability requires the IRS to impose the 6707A penalty regardless of innocence of a person (i.e. whether the person knew that the transaction needed to be reported or not or whether the person made a good faith effort to report) or the level of the person’s reliance on professional advisers. A Section 6707A penalty is imposed when the transaction becomes a reportable/listed transaction. Therefore, a person has the burden to keep up to date on all transactions requiring disclosure by the IRS into perpetuity for transactions entered into the past.
Additionally, the 6707A penalty strictly penalizes nondisclosure irrespective of taxes owed. Accordingly, the penalty will be assessed even in legitimate tax planning situations when no additional tax is due but an IRS required filing was not properly and timely filed. It is worth noting that a failure to disclose in the view of the IRS encompasses both a failure to file the proper form as well as a failure to include sufficient information as to the nature and facts concerning the transaction. Hence, people may find themselves subject to the 6707A penalty if the IRS determines that a filing did not contain enough information on the transaction. A penalty is also imposed when a person does not file the required duplicate copy with a separate IRS office in addition to filing the required copy with the tax return.
The imposition of a 6707A penalty is not subject to judicial review regardless of whether the penalty is imposed for a listed or reportable transaction. Accordingly, the IRS’s determination is conclusive, binding and final. The next step from the IRS is sending your file to collection, where your assets may be forcibly taken, publicly recorded liens may be placed against your property, and/or garnishment of your wages or business profits may occur, amongst other measures.
The 6707A penalty amount for each listed transaction is generally $200,000 per year per each person that is not an individual and $100,000 per year per individual who failed to properly disclose each listed transaction. The 6707A penalty amount for each reportable transaction is generally $50,000 per year for each person that is not an individual and $10,000 per year per each individual who failed to properly disclose each reportable transaction.
The IRS is obligated to impose the listed transaction penalty by law and cannot remove the penalty by law. The IRS is obligated to impose the reportable transaction penalty by law, as well, but may remove the penalty when the IRS determines that removal of the penalty would promote compliance and support effective tax administration.
The 6707A penalty is particularly harmful in the small business context, where many business owners operate through an S corporation or limited liability company in order to provide liability protection to the owner/operators.
Numerous cases are coming to light where the IRS is imposing a $200,000 penalty at the entity level and them imposing a $100,000 penalty per individual shareholder or member per year.
The individuals are generally left with one of two options: declare bankruptcy or face a $300,000 penalty per year.
Keep in mind, taxes do not need to be due nor does the transaction have to be proven illegal or illegitimate for this penalty to apply. The only proof required by the IRS is that the person did not properly and timely disclose a transaction that the IRS believes the person should have disclosed. It is important to note in this context that for non-disclosed listed transactions, the Statue of Limitations does not begin until a proper disclosure is filed with the IRS.
Many practitioners believe the scope and authority given to the IRS under 6707A, which allows the IRS to act as judge, jury and executioner, is unconstitutional. Numerous real life stories abound illustrating the punitive nature of the 6707A penalty and its application to small businesses and their owners. In one case, the IRS demanded that the business and its owner pay a total of $600,000 for his and his business’ participation in a Code section 412(i) plan. The actual taxes and interest on the transaction, assuming the IRS was correct in its determination that the tax benefits were not allowable, was $60,000. Regardless of the IRS’s ultimate determination as to the legality of the underlying 412(i) transaction, the $600,000 was due as the IRS’s determination was final and absolute with respect to the 6707A penalty.
Another case involved a taxpayer who was a dentist and his wife whom the IRS determined had engaged in a listed transaction with respect to a limited liability company. The IRS determined that the couple owed taxes on the transaction of $6,812, since the tax benefits of the transactions were not allowable. In addition, the IRS determined that the taxpayers owed a $1,200,000 section 6707A penalty for both their individual nondisclosure of the transaction along with the nondisclosure by the limited liability company.
Even the IRS personnel continue to question both the legality and the fairness of the IRS’s imposition of 6707A penalties. An IRS appeals officer in an email to a senior attorney within the IRS wrote that "…I am both an attorney and CPA and in my 29 years with the IRS I have never {before} worked a case or issue that left me questioning whether in good conscience I could uphold the Government’s position even though it is supported by the language of the law." The Taxpayers Advocate, an office within the IRS, even went so far as to publicly assert that the 6707A should be modified as it "raises significant Constitutional concerns, including possible violations of the Eighth Amendment’s prohibition against excessive government fines, and due process protection."
Senate bill 765, the bill sponsored by Sen. Nelson, seeks to alleviate some of above cited concerns. Specifically, the bill makes three major changes to the current version of Code section 6707A. The bill would allow an IRS imposed 6707A penalty for nondisclosure of a listed transaction to be rescinded if a taxpayer’s failure to file was due to reasonable cause and not willful neglect. The bill would make a 6707A penalty proportional to an understatement of any tax due.
Accordingly, non-tax paying entities such as S corporations and limited liability companies would not be subject to a 6707A penalty (individuals, C corporations and certain trusts and estates would remain subject to the 6707A penalty).
There are a number of interesting points to note about this action:
1. In the letter, the IRS acknowledges that, in certain cases, the penalty imposed by section 6707A for failure to report participation in a "listed transaction" is disproportionate to the tax benefits obtained by the transaction.
2. In the letter, the IRS says that it is taking this action because Congress has indicated its intention to amend the Code to modify the penalty provision, so that the penalty for failure to disclose will be more in line with the tax benefits resulting from a listed transaction.
3. The IRS will not suspend audits or collection efforts in appropriate cases. It cannot suspend imposition of the penalty, because, at least with respect to listed transactions, it does not have the discretion to not impose the penalty. It is simply suspending collection efforts in cases where the tax benefits are below the penalty threshold in order to give Congress time to amend the penalty provision, as Congress has indicated to the IRS it intends to do.
It should also be noted that identical bills have been introduced in the Senate and the House to amend Section 6707A. Each bill has been referred to the appropriate committee, where no action has taken place. There are a couple of points about the proposed legislation:
1. The legislation would reduce the penalty for failure to disclose participation in a reportable transaction, other than a listed transaction, to the amount imposed by section 6662A for an understatement of tax. For a listed transaction, the penalty would equal 200% of the penalty imposed for an understatement of tax. The amount of the penalty imposed by section 6662A is 20%.
2. The proposed legislation is different than the position expressed by the IRS. The IRS would like the penalty to equal the tax benefits obtained from the transaction.
3. The legislation does not change the penalty provisions for material advisers.
The information provided herein is not intended as legal, accounting, financial or any other type of advice for any specific individual or other entity. You should contact an appropriate professional for any such advice.
Mr. Wallach, CLU, CHFC, is a leading speaker on accounting and taxation topics and the author of numerous AICPA CPA exam publications. In addition to developing CPE courses, he is also a member of the AICPA faculty of teaching professionals, and has been featured in The Wall Street Journal, The New York Times, Bloomberg Financial News, NBC, National Public Radio’s All Things Considered, and other radio talk shows. Mr. Wallach is listed in Who’s Who in Finance and Business.
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