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