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?
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
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
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.
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).
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.