Investor Reporting

You may be required to provide the following information.

1. Tax shelter disclosure statement.
2. Tax shelter registration number.

Tax Shelter Disclosure Statement

For each reportable tax shelter transaction in which you participated directly or indirectly, you must attach a disclosure statement to your return for each year that your tax liability is affected by your participation in the transaction. In addition, for the first year a disclosure statement is attached to your return, you must send a copy to:

Internal Revenue Service
LM:PFTG:OTSA
Large & Mid-Size Business Division
1111 Constitution Avenue, NW
Washington, DC 20224.

Reportable tax shelter transaction.    Disclosure is required for a reportable tax shelter transaction that is a listed transaction. A transaction is a listed transaction if it is the same as or substantially similar to a transaction determined to be a tax avoidance transaction and identified as a listed transaction in a notice, regulation, or other published guidance. Notice 2001-51, in Internal Revenue Bulletin 2001-34, identifies these transactions. There may be subsequent guidance identifying additional listed transactions.

See section 1.6011-4T of the regulations for more details including:

• Definitions of reportable transaction, listed transaction, and substantially similar.
• Form and content of the disclosure statement.
• Filing requirements for the disclosure statement.

Beginning January 1, 2003, certain transactions not previously classified as reportable transactions must also be disclosed. You must use Form 8886, Reportable Transaction Disclosure Statement, to report transactions entered into after 2002. For more information, see the instructions for Form 8886.

Tax Shelter Registration Number

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.

1. 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.
2. 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.

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:

1. Negligence or disregard of rules or regulations,
2. Substantial understatement of tax, or
3. 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:

1. 10% of the tax required to be shown on the return, or
2. $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.

1. 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.
2. 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.

1. The value or adjusted basis of any property claimed on the return is 200% or more of the correct amount.
2. You underpaid your tax by more than $5,000 because of the misstatement.
3. 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.

Investment Expenses

• At-risk rules
• Passive activity
• Portfolio income

Topics

This chapter discusses:

• Limits on deductions,
• Interest expenses,
• Bond premium amortization,
• Expenses of producing income,
• Nondeductible expenses, and
• How to report investment expenses.

Useful Items You may want to see:

Publication

• 535   Business Expenses
• 925   Passive Activity and At-Risk Rules
• 929   Tax Rules for Children and Dependents

Form (and Instructions)

• Schedule A (Form 1040)   Itemized Deductions
• 4952   Investment Interest Expense Deduction

See chapter 5 for information about getting these publications and forms.

Limits on Deductions

Your deductions for investment expenses may be limited by:

• The at-risk rules,
• The passive activity loss limits,
• The limit on investment interest, or
• The 2% limit on certain miscellaneous itemized deductions.

The at-risk rules and passive activity rules are explained briefly in this section. The limit on investment interest is explained later in this chapter under Interest Expenses. The 2% limit is explained later in this chapter under Expenses of Producing Income.

At-risk rules.   Special at-risk rules apply to most income-producing activities. These rules limit the amount of loss you can deduct to the amount you risk losing in the activity. Generally, this is the amount of cash and the adjusted basis of property you contribute to the activity. It also includes money you borrow for use in the activity if you are personally liable for repayment or if you use property not used in the activity as security for the loan. For more information, see Publication 925.

Passive activity losses and credits.   The amount of losses and tax credits you can claim from passive activities is limited. Generally, you are allowed to deduct passive activity losses only up to the amount of your passive activity income. Also, you can use credits from passive activities only against tax on the income from passive activities. There are exceptions for certain activities, such as rental real estate activities.

Passive activity.   A passive activity generally is any activity involving the conduct of any trade or business in which you do not materially participate and any rental activity. However, if you are involved in renting real estate, the activity is not a passive activity if both of the following are true.

1. More than one-half of the personal services you perform during the year in all trades or businesses are performed in real property trades or businesses in which you materially participate.
2. You perform more than 750 hours of services during the year in real property trades or businesses in which you materially participate.

The term trade or business generally means any activity that involves the conduct of a trade or business, is conducted in anticipation of starting a trade or business, or involves certain research or experimental expenditures. However, it does not include rental activities or certain activities treated as incidental to holding property for investment.

You are considered to materially participate in an activity if you are involved on a regular, continuous, and substantial basis in the operations of the activity.

Other income (nonpassive income).   Generally, you can use losses from passive activities only to offset income from passive activities. You generally cannot use passive activity losses to offset your other income, such as your wages or your portfolio income. Portfolio income includes gross income from interest, dividends, annuities, or royalties that is not derived in the ordinary course of a trade or business. It also includes gains or losses (not derived in the ordinary course of a trade or business) from the sale or trade of property (other than an interest in a passive activity) producing portfolio income or held for investment. This includes capital gain distributions from mutual funds and real estate investment trusts.

You cannot use passive activity losses to offset Alaska Permanent Fund dividends.

Expenses.   Do not include in the computation of your passive activity income or loss:

1. Expenses (other than interest) that are clearly and directly allocable to your portfolio income, or
2. Interest expense properly allocable to portfolio income.

However, this interest and other expenses may be subject to other limits. These limits are explained in the rest of this chapter.

Additional information.   For more information about determining and reporting income and losses from passive activities, see Publication 925.

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