Publication 550 |
2000 Tax Year |
Abusive Tax Shelters
Abusive tax shelters are marketing schemes that involve 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 the mischaracterization of the substance of the
transaction. Despite appearances to the contrary, the taxpayer
generally risks little.
Abusive tax shelters commonly involve package deals that are
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 Curbing Abusive Tax Shelters.) 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.
Since 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?
- Is your debt a real debt or are you assured by the promoter
that you will never have to pay it?
- Does this transaction involve laundering United
States-source income through foreign corporations incorporated in a
tax haven and owned by United States shareholders?
Curbing Abusive
Tax Shelters
Congress has enacted a series of income tax laws designed to halt
the growth of abusive tax shelters. These provisions include the
following.
- Passive activity losses and credits.
The passive activity loss
and credit rules limit the amount of losses and credits that can be
claimed from passive activities and limit the amount that can offset
nonpassive income, such as certain portfolio income from investments.
For more detailed information about determining and reporting income,
losses, and credits from passive activities, see Publication 925.
- Registration of tax shelters. Generally, the
organizers of certain tax shelters must register the shelter with the
IRS. The IRS will then assign the tax shelter a registration number.
If you are an investor in a tax shelter, the seller (or the
transferor) must provide you with the tax shelter registration number
at the time of sale (or transfer) or within 20 days after the seller
or transferor receives the number if that date is later. See
Investor Reporting, later, for more information about
reporting this number when filing your tax return.
- List of tax shelter investors. Organizers and
sellers of any potentially abusive tax shelter must maintain a list
identifying each investor. 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 Transfer of interests in
a tax shelter, later, for more information.
- Appraisals of donated property. Generally, if you
donate property valued at more than $5,000 ($10,000 in the case of
privately traded stock), you must get a written "qualified"
appraisal of the property's fair market value and attach an appraisal
summary to your income tax return. The appraisal must be done by a
"qualified" appraiser who is not the taxpayer, a party to a
transaction in which the taxpayer acquired the property, the donee, or
an employee or related party of any of the preceding persons. (Related
parties are defined under Related Party Transactions in
chapter 4.)
For more information about appraisals, see Publication 561.
- Interest on penalties. If you are assessed an
accuracy-related or civil fraud penalty (as discussed under
Penalties, later), interest will be imposed on the amount
of the penalty from the due date of the return (including any
extensions) to the date you pay the penalty.
- Accounting methods and capitalization rules. Tax
shelters generally cannot use the cash method of accounting. Also,
uniform capitalization rules generally apply to producing property or
acquiring it for resale. Under those rules, the direct cost and part
of the indirect cost of the property must be capitalized or included
in inventory. For more information, see Publication 538.
Projected income investment.
Special rules apply to a projected income investment. To qualify as
a projected income investment, a tax shelter must not be expected to
reduce the cumulative tax liability of any investor during
any year of the first 5 years ending after the date the investment was
offered for sale. In addition, the assets of a projected income
investment must not include or relate to more than an incidental
interest in:
- Master sound recordings,
- Motion picture or television films,
- Videotapes,
- Lithograph plates,
- Copyrights,
- Literary, musical, or artistic compositions, or
- Collectibles (such as works of art, rugs, antiques, metals,
gems, stamps, coins, or alcoholic beverages).
Tax shelters that qualify as projected income investments are not
subject to the registration rules for tax shelters, described earlier.
However, the requirement to maintain a list of investors that is in
effect for tax shelters also applies to any projected income
investment, except for one an investor later transfers. See
Transfer of interests in a tax shelter, later.
A tax shelter that previously qualified as a projected income
investment may later be disqualified if, in one of its first 5 years,
it reduces the cumulative tax liability of any investor. In that case,
the tax shelter becomes subject to the registration rules for tax
shelters, described earlier.
Pre-filing notification letter.
If you are an investor in an abusive tax shelter promotion, the IRS
may send you a "pre-filing notification letter" if it determines
that it is highly likely that there is:
- A gross valuation overstatement, or
- A false or fraudulent statement regarding the tax benefits
to be derived from the tax shelter entity or arrangement.
This letter will advise you that, based upon a review of the
promotion, it is believed that the purported tax benefits are not
allowable. The letter also will advise you of the possible tax
consequences if you claim the benefits on your income tax return.
You also may receive a notification letter after you file your tax
return. If you have already claimed the benefits on your tax return,
you will be advised that you can file an amended return. However, any
penalties that apply still can be asserted.
If you claim the benefits after receiving the pre-filing
notification or if you fail to amend your return, you will be notified
that your tax return is being examined. Normal audit and appeal
procedures will be followed during the examination, and
accuracy-related, civil or criminal fraud, and other penalties will be
considered and, when appropriate, asserted. For information on the
examination of returns, see Publication 556.
Revenue rulings.
The IRS has published numerous revenue rulings concluding that the
claimed tax benefits of various abusive tax shelters should be
disallowed. A revenue ruling is the conclusion of the IRS on how the
law is applied to a particular set of facts. Revenue rulings are
published in the Internal Revenue Bulletin for taxpayers'
guidance and information and also for use by IRS officials. So, if
your return is examined and an abusive tax shelter is identified and
challenged, a published revenue ruling 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 that you claimed. In such a case, the examiner will not
compromise even if you or your representative believe that you have
authority for the positions taken on your tax return.
The courts have generally been unsympathetic to taxpayers involved
in abusive tax shelter schemes and have ruled in favor of the IRS in
the majority of the cases in which these shelters have been
challenged.
Investor Reporting
If you include on your tax return any deduction, loss, credit or
other tax benefit, or any income, from an interest in a tax shelter
required to be registered, you must report the registration number
that the tax shelter provided to you. (See Registration of tax
shelters, earlier.) Complete and attach Form 8271 to
your return to report the number and to provide other information
about the tax shelter and its benefits. You must also attach Form 8271
to any application for tentative refund (Form 1045) and to any amended
return (Form 1040X) on which these benefits are claimed or income is
reported. If you do not include the registration number with your
return, you will be subject to a penalty of $250 for each such
failure, unless the failure is due to reasonable cause.
Transfer of interests in a tax shelter.
If you hold an investment interest in a tax shelter and later
transfer that interest to another person, you must provide the tax
shelter's registration number to each person to whom you transferred
your interest. (However, this does not apply if your interest is in a
projected income investment, described earlier.) You must also provide
a notice substantially in the following form:
| You have acquired an interest in [name and address
of tax shelter] whose taxpayer identification number is [if
any]. The Internal Revenue Service has issued [name of tax
shelter] the following tax shelter registration number:
[number]. You must report this registration number to the
Internal Revenue Service, if you claim any deduction, loss, credit, or
other tax benefit or report any income by reason of your investment in
[name of tax shelter]. You must report the registration
number (as well as the name and taxpayer identification number of
[name of tax shelter]) on Form 8271. Form 8271 must be
attached to the return on which you claim the deduction, loss, credit,
or other tax benefit or report any income. Issuance of a registration
number does not indicate that this investment or the claimed tax
benefits have been reviewed, examined, or approved by the Internal
Revenue Service. |
The following requirements also apply.
- Maintaining a list. You must maintain a list
identifying each person to whom you transferred your interest. Or, you
may require a designated person or seller to maintain the list.
However, see Special rule for projected income investment,
later, for an exception to this requirement. If you choose to
delegate this requirement, you must give the designated person or
seller all of the information that you would otherwise have to
maintain on the list.
- Providing notice. If the tax shelter is not a
projected income investment, described earlier, you must provide a
notice to each person to whom you transferred your interest. This
notice must be substantially in the following form:
| You have acquired an interest in [name and address
of tax shelter]. If you transfer your interest in this tax
shelter to another person, you are required by the Internal Revenue
Service to keep a list containing that person's name, address,
taxpayer identification number, the date on which you transferred the
interest, and the name, address, and tax shelter registration number
of this tax shelter. If you do not want to keep such a list, you must
(1) send the information specified above to [name and address of
designated person], who will keep the list for this tax shelter,
and (2) give a copy of this notice to the person to whom you transfer
your interest. |
If you do not maintain the required list of investors, or do not
delegate a designated person or seller to maintain the list, you will
be subject to a penalty of $50 for each person required to be on the
list. But, you will not have to pay the penalty if you can show that
the failure to comply with this requirement was due to reasonable
cause and not willful neglect. The maximum penalty under this
provision is $100,000 for each tax shelter in each calendar year.
Special rule for projected income investment.
If you are an investor who later transfers an interest in a
projected income investment, described earlier, you are not required
to maintain a list of investors unless the tax shelter was no longer a
projected income investment, or otherwise became subject to the
registration requirements, before the transfer.
Penalties
Investing in an abusive tax shelter may be an expensive proposition
when you consider all of the consequences. 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%
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, or
- Substantial valuation misstatement.
This penalty will not be imposed if you can show that you had
reasonable cause for any understatement of tax and that you acted 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.
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 that is due to negligence
or disregard of rules or regulations. The penalty will not be charged
if you can show that 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.
Disregard includes any careless, reckless, or intentional
disregard. The penalty for disregard of rules and regulations can be
avoided if both of the following are true.
- 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 tax return. To disclose a position contrary to a regulation,
use Form 8275-R.
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
- $5,000.
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.
Two special rules apply in the case of an understatement due to a
tax shelter.
- An understatement of tax does not include any tax due to a
tax shelter item (such as an item of income, gain, loss, deduction, or
credit) if you had substantial authority for the tax treatment of the
item and reasonably believed that the tax treatment chosen was more
likely than not the proper one.
- Disclosure of the tax shelter item on a tax return does not
reduce the amount of the understatement.
For 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.
Also, the understatement penalty will not be imposed if you can
show that 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.
Valuation misstatement.
In general, you are liable for a 20% penalty for a substantial
valuation misstatement if all of the following are true.
- The value or adjusted basis of any property claimed on the
return is 200% 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 400% 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.
Civil fraud penalty.
If there is any underpayment of tax on your return due to fraud, a
penalty of 75% of the underpayment will be added to your tax.
Joint return.
The fraud penalty on a joint return applies to a spouse only if
some part of the underpayment is due to the fraud of that spouse.
Failure to pay tax.
If a deficiency is assessed and is not paid within 10 days of the
demand for payment, an investor can be penalized with up to a 25%
addition to tax if the failure to pay continues.
Whether To Invest
In light of the adverse tax consequences and the substantial amount
of penalties and interest that will result if the claimed tax benefits
are disallowed, you should consider tax shelter investments carefully
and seek competent legal and financial advice.
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