The IRS has finalized regulations that impose penalties for failing to disclose what the IRS considers to be suspect tax avoidance transactions. Both individuals and entities are required to make disclosures of so-called “reportable transactions”, including “listed transactions”, which essentially are tax shelters. The disclosures are made by filing a Form 8886, Reportable Transaction Disclosure Statement, with the taxpayer’s original or amended return or application for a refund for each year that the affected transaction has an impact on the return. The penalty is due regardless of whether any tax deficiency results from the transaction. Also, corporations must disclose any penalties they are assessed to the Securities and Exchange Commission (SEC), as discussed below.
Reportable, Listed Transactions
Reportable transactions are a broad category of transactions that the IRS believes have the potential for improper tax avoidance. “Listed transactions” are one category of reportable transaction that is the “same as or substantially similar” to transactions the IRS has specifically identified by notice, regulation, or other form of published guidance as a type of tax shelter.
Other types of reportable transactions include:
- Confidential – Transactions that are offered to a taxpayer under conditions of confidentiality and the taxpayer has paid a minimum advisor fee.
- Contractual Protection – Transactions that are offered with the right to full or partial refund of fees if the IRS does not allow the tax benefit of the transaction.
- Loss Transactions – Transactions that generate losses at high levels, with the threshold amounts set by regulations, for example, $2 million in any single taxable year or $4 million in any combination of taxable years for individuals, S corporations, or trusts.
- Transactions of Interest – Transactions the IRS believes to have the potential for tax avoidance or evasion, but the IRS lacks sufficient information to determine whether the transaction should be specifically identified.
Note that even if a transaction is not listed when the taxpayer enters into it, taxpayers must file a disclosure statement 90 calendar days after the date on which the transaction does becomes a listed transaction, for all of the taxpayer’s open tax years.
Penalties Reduced by 2010 Law
The final regulations reflect the reduced penalties for nondisclosure contained in the Small Business Jobs Act of 2010. The penalty previously was a set amount without regard to the tax benefit the suspect transaction generated:
- $10,000 for individual taxpayers
- $50,000 for other kinds of taxpayers; and,
- For listed transactions, $100,000 for individuals and $200,000 for other entities
These rules could result in a taxpayer paying penalties that were disproportionate to the tax benefits derived from a transaction.
New Penalty Structure
Congress changed the penalty structure to base it on a percentage of the tax benefits received, with minimums and maximums.
- 75% of the decrease in tax shown on the return as a result of a reportable transaction, with a minimum penalty of $5,000 for individuals and $10,000 for other taxpayers.
- Maximum penalty amount of $100,000 for individuals and $200,000 for other taxpayers for failure to disclose a listed transaction
- Maximum penalty of $10,000 for individuals or $50,000 for other taxpayers for failure to disclose any other reportable transaction.
As stated above, taxpayers will pay the minimum penalties for nondisclosure even if they receive no tax benefit from the reportable transaction.
How to Compute Penalties
The new rules also explain how to compute the penalties, with examples shown below. The final regulations state that the “decrease in tax” is: (1) the difference between the amount of tax reported on the filed return and a hypothetical return without the reportable transaction; and (2) “any other tax that results from participation in the reportable transaction but was not reported on the taxpayer’s return.”
Example 1: Taxpayer X, an individual, participated in a listed transaction that resulted in a $40,000 decrease in the tax shown on the return reflecting participation in the transaction. X failed to disclose its participation in the transaction and is subject to a penalty. The amount of X’s penalty is $30,000, which amount is 75 percent of the $40,000 decrease in tax.
Example 2: Taxpayer Y, an individual, files a 2019 return reflecting participation in a reportable transaction that is not a listed transaction but fails to disclose the transaction. The decrease in tax as a result of participation in the transaction is $20,000. Y files an amended 2019 return to include a net operating loss carried forward from a prior year and the amended return also reflects participation in the same reportable transaction, which Y does not disclose. The decrease in tax for the amended return also is $20,000. Y will be subject to two separate penalties. Although 75% of the $20,000 decrease in tax is $15,000 for each year, Y will only pay the maximum penalty of $10,000 for each return, for a total penalty of $20,000.
Example 3: Partnership M is required to attach a disclosure statement to its Form 1065, U.S. Return of Partnership Income, for the 2020 taxable year. M fails to do so and is, therefore, subject to a penalty. No tax is required to be shown on M’s Form 1065, but M still is subject to a penalty of $10,000. The partners of Partnership M also would be subject to separate penalties if they fail to comply with the disclosure requirements.
Corporation Must Disclose Penalties to SEC
This same set of penalties is imposed on corporations that fail to disclose reportable transaction penalties in their filings with the SEC. Corporations that must file periodic reports under section 13 or 15(d) of the Securities Exchange Act of 1934 (10-Ks) must disclose whether they are:
- required to pay a penalty for nondisclosure of a listed transaction;
- required to pay an accuracy-related penalty with respect to any reportable transaction; or
- required to pay a penalty for gross valuation misstatements with respect to any reportable transaction.
A failure to disclose this information to the SEC is treated as a separate failure to report a transaction under the reportable transaction regulations.
Example 4: Taxpayer Z, a public corporation filed its 2019 return reflecting tax benefits from a reportable transaction that is not a listed transaction and properly disclosed the transaction to the IRS. In 2023, the IRS imposes a gross valuation misstatement penalty for the 2019 return with respect to the reportable transaction. The decrease in tax is $190,000. Corporation Z did not disclose the penalty in its SEC filings. Z’s failure to disclose the penalty is treated as a failure to disclose a reportable transaction. Seventy-five percent of the $190,000 decrease in tax is $142,500. However, because Z is a corporation and the transaction is not a listed transaction, the amount of the penalty is limited to $50,000. Therefore, Z is subject to a $50,000 penalty for failure to disclose the penalty to the SEC.
Reportable transactions can expose taxpayers to significant burdens, including increased tax, interest and penalties. Thus, tax avoidance transactions should be carefully reviewed by a professional tax advisor before they are entered into by a taxpayer.