Tax shelters and 6694(a)(2)(C)

A "more likely than not" standard applies to tax shelters and reportable transactions for returns prepared for tax years ending after October 3, 2008. Code Sec. 6694(a)(2)(C), as amended by The Emergency Stabilization Act of 2008.

Section 6694(a)(2)(C) provides: If the position is with respect to a tax shelter (as defined in section 6662(d)(2)(C)(ii) or a reportable transaction to which section 6662A applies, the position is described in this paragraph unless it is reasonable to believe that the position would more likely than not be sustained on its merits.

Tax shelters, defined in accordance with Code Sec. 6662(d)(2)(C)(ii), means a partnership or other entity, any investment plan or arrangement, or any other plan or arrangement if a significant purpose of such partnership, entity, plan, or arrangement is the avoidance or evasion of Federal income tax. While The Small Business Tax Act of 2007 ( P.L. 110-28) expanded the scope of the return preparer penalty to apply to all tax return returns, and not just income tax returns, prepared after May 25, 2007, the definition of tax shelters in Code Sec. 6694(a)(2)(C) is made with reference to the avoidance or evasion of Federal income tax.


Reportable transactions are ones to which Code Sec. 6662A applies. This consists of any listed transaction, and any reportable transaction (other than a listed transaction) if a significant purpose of such transaction is the avoidance or evasion of Federal income tax.

Tax shelter definition. For purposes of this provision, a tax shelter is a partnership or other entity (such as a trust), an investment plan or arrangement, or any other plan or arrangement, the purpose of which is to avoid federal income tax. An entity, plan or arrangement will be considered a tax shelter if one of its significant purposes is tax avoidance ( Code Sec. 6662(d)(2)(C)(ii)). For transactions entered into prior to August 6, 1997, an entity, plan or arrangement was considered a tax shelter only if tax avoidance was its primary purpose.

The existence of economic substance does not of itself establish that a transaction is not a tax shelter if the transaction includes other characteristics that indicate that the transaction is a tax shelter. Typical tax shelters are transactions structured with little or no motive for realization of economic gain, such as those that mismatch income and deductions or misrepresent the substance of a transaction.

An item of income, gain, loss, deduction or credit will be treated as a tax shelter item only if the item is directly or indirectly related to the significant/principal purpose of the tax shelter (i.e., to avoid or evade income tax). For instance, where a partnership is established to evade taxes by acquiring and overvaluing the basis of property for the purpose of claiming accelerated depreciation, the depreciation with respect to such property is a tax shelter item. However, deductions claimed by the partnership with respect to other transactions will not necessarily be tax shelter items ( Reg. §1.6662-4(g)(3)).

6662(d)(2)(C) REDUCTION NOT TO APPLY TO TAX SHELTERS. --

6662(d)(2)(C)(i) IN GENERAL. --Subparagraph (B) shall not apply to any item attributable to a tax shelter.

6662(d)(2)(C)(ii) TAX SHELTER. --For purposes of clause (i), the term "tax shelter" means --

6662(d)(2)(C)(ii)(I) a partnership or other entity,

6662(d)(2)(C)(ii)(II) any investment plan or arrangement, or

6662(d)(2)(C)(ii)(III) any other plan or arrangement,

if a significant purpose of such partnership, entity, plan, or arrangement is the avoidance or evasion of Federal income tax.

6662(d)(3) SECRETARIAL LIST. --The Secretary may prescribe a list of positions which the Secretary believes do not meet 1 or more of the standards specified in paragraph (2)(B)(i), section 6664(d)(2), and section 6694(a)(1). Such list (and any revisions thereof) shall be published in the Federal Register or the Internal Revenue Bulletin.

§1.6662-4.,(g) Items relating to tax shelters

(1) In general
(i) Noncorporate taxpayers. --Tax shelter items (as defined in paragraph (g)(3) of this section) of a taxpayer other than a corporation are treated for purposes of this section as if such items were shown properly on the return for a taxable year in computing the amount of tax shown on the return, and thus the tax attributable to such items is not included in the understatement for the year, if --

(A) There is substantial authority (as provided in paragraph (d) of this section) for the tax treatment of that item; and

(B) The taxpayer reasonably believed at the time the return was filed that the tax treatment of that item was more likely than not the proper treatment.

(ii) Corporate taxpayers

(A) In general. --Except as provided in paragraph (g)(1)(ii)(B) of this section, all tax shelter items (as defined in paragraph (g)(3) of this section) of a corporation are taken into account in computing the amount of any understatement.

(B) Special rule for transactions occurring prior to December 9, 1994. --The tax shelter items of a corporation arising in connection with transactions occurring prior to December 9, 1994 are treated for purposes of this section as if such items were shown properly on the return if the requirements of paragraph (g)(1)(i) are satisfied with respect to such items.

(iii) Disclosure irrelevant. --Disclosure made with respect to a tax shelter item of either a corporate or noncorporate taxpayer does not affect the amount of an understatement.

(iv) Cross-reference. --See §1.6664-4(f) for certain rules regarding the availability of the reasonable cause and good faith exception to the substantial understatement penalty with respect to tax shelter items of corporations.

(2) Tax shelter

(i) In general. --For purposes of section 6662(d), the term "tax shelter" means --

(A) A partnership or other entity (such as a corporation or trust),

(B) An investment plan or arrangement, or

(C) Any other plan or arrangement,

if the principal purpose of the entity, plan or arrangement, based on objective evidence, is to avoid or evade Federal income tax. The principal purpose of an entity, plan or arrangement is to avoid or evade Federal income tax if that purpose exceeds any other purpose. Typical of tax shelters are transactions structured with little or no motive for the realization of economic gain, and transactions that utilize the mismatching of income and deductions, overvalued assets or assets with values subject to substantial uncertainty, certain nonrecourse financing, financing techniques that do not conform to standard commercial business practices, or the mischaracterization of the substance of the transaction. The existence of economic substance does not of itself establish that a transaction is not a tax shelter if the transaction includes other characteristics that indicate it is a tax shelter.

(ii) Principal purpose. --The principal purpose of an entity, plan or arrangement is not to avoid or evade Federal income tax if the entity, plan or arrangement has as its purpose the claiming of exclusions from income, accelerated deductions or other tax benefits in a manner consistent with the statute and Congressional purpose. For example, an entity, plan or arrangement does not have as its principal purpose the avoidance or evasion of Federal income tax solely as a result of the following uses of tax benefits provided by the Internal Revenue Code: the purchasing or holding of an obligation bearing interest that is excluded from gross income under section 103; taking an accelerated depreciation allowance under section 168; taking the percentage depletion allowance under section 613 or section 613A; deducting intangible drilling and development costs as expenses under section 263(c); establishing a qualified retirement plan under sections 401-409; claiming the possession tax credit under section 936; or claiming tax benefits available by reason of an election under section 992 to be taxed as a domestic international sales corporation ("DISC"), under section 927(f)(1) to be taxed as a foreign sales corporation ("FSC"), or under section 1362 to be taxed as an S corporation.

(3) Tax shelter item. --An item of income, gain, loss, deduction or credit is a "tax shelter item" if the item is directly or indirectly attributable to the principal purpose of a tax shelter to avoid or evade Federal income tax. Thus, if a partnership is established for the principal purpose of avoiding or evading Federal income tax by acquiring and overstating the basis of property for purposes of claiming accelerated depreciation, the depreciation with respect to the property is a tax shelter item. However, a deduction claimed in connection with a separate transaction carried on by the same partnership is not a tax shelter item if the transaction does not constitute a plan or arrangement the principal purpose of which is to avoid or evade tax.

(4) Reasonable belief
(i) In general. --For purposes of section 6662(d) and paragraph (g)(1)(i)(B) of this section (pertaining to tax shelter items of noncorporate taxpayers), a taxpayer is considered reasonably to believe that the tax treatment of an item is more likely than not the proper tax treatment if (without taking into account the possibility that a return will not be audited, that an issue will not be raised on audit, or that an issue will be settled) --

(A) The taxpayer analyzes the pertinent facts and authorities in the manner described in paragraph (d)(3)(ii) of this section, and in reliance upon that analysis, reasonably concludes in good faith that there is a greater than 50-percent likelihood that the tax treatment of the item will be upheld if challenged by the Internal Revenue Service; or

(B) The taxpayer reasonably relies in good faith on the opinion of a professional tax advisor, if the opinion is based on the tax advisor's analysis of the pertinent facts and authorities in the manner described in paragraph (d)(3)(ii) of this section and unambiguously states that the tax advisor concludes that there is a greater than 50-percent likelihood that the tax treatment of the item will be upheld if challenged by the Internal Revenue Service.

(ii) Facts and circumstances; reliance on professional tax advisor. --All facts and circumstances must be taken into account in determining whether a taxpayer satisfies the requirements of paragraph (g)(4)(i) of this section. However, in no event will a taxpayer be considered to have reasonably relied in good faith on the opinion of a professional tax advisor for purposes of paragraph (g)(4)(i)(B) of this section unless the requirements of §1.6664-4(c)(1) are met. The fact that the requirements of §l.6664-4(c)(1) are satisfied will not necessarily establish that the taxpayer reasonably relied on the opinion in good faith. For example, reliance may not be reasonable or in good faith if the taxpayer knew, or should have known, that the advisor lacked knowledge in the relevant aspects of Federal tax law.

(5) Pass-through entities. --In the case of tax shelter items attributable to a pass-through entity, the actions described in paragraphs (g)(4)(i)(A) and (B) of this section, if taken by the entity, are deemed to have been taken by the taxpayer and are considered in determining whether the taxpayer reasonably believed that the tax treatment of an item was more likely than not the proper tax treatment. [Reg. §1.6662-4.]

COMMENT:

As a "heads up" - anytime you are working with a transaction that appears complex and anytime you do not understand the purpose of a transation or series of transactions, consult a tax attorney or stay away from preparing a tax return. It is more than being concerned about a large 6694(b) penalty, you need to be concerned about committing a felony. The IRS and the DOJ are very aggressive in bringing criminal fraud charges against promoters of tax shelters and those who work with them. You always want to stay away from any allegation that data you put into a tax return can be construed as a "false statement" under section 7204. Even if a transaction does not appear to be complex but it deals with foreign entities, you need to consult with a tax attorney who is experienced in foreign transactions or reorganizations. In these cases, you do not worry about the "more than likely" standard, you need to worry about an allegation by the IRS that you are a part of a plan to attempt or evade tax.

For any questions you may have about any complex transaction, contact ab@irstaxattorney.com