Publication 550: Investment Income and Expenses; Chapter 2 - Tax Shelters and Other Reportable Transactions

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Table of Contents

Introduction

Investments that yield tax benefits are sometimes called “tax shelters.” In some cases, Congress has concluded that the loss of revenue is an acceptable side effect of special tax provisions designed to encourage taxpayers to make certain types of investments. In many cases, however, losses from tax shelters produce little or no benefit to society, or the tax benefits are exaggerated beyond those intended. Those cases are called “abusive tax shelters.” An investment that is considered a tax shelter is subject to restrictions, including the requirement that it be registered, as discussed later, unless it is a “projected income investment” (defined later).

Topics - This chapter discusses:

How to recognize an abusive tax shelter,
Rules enacted by Congress to curb tax shelters,
Investors' reporting requirements, and
Penalties that may apply.

Useful Items - You may want to see:

Publication

538 Accounting Periods and Methods
556 Examination of Returns, Appeal Rights, and Claims for Refund
561 Determining the Value of Donated Property
925 Passive Activity and At-Risk Rules

Form (and Instructions)

8271
Investor Reporting of Tax Shelter Registration Number
8275
Disclosure Statement
8275-R
Regulation Disclosure Statement
8886
Reportable Transaction Disclosure Statement

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

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 mis-characterization 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 Rules To Curb Abusive Tax Shelters, later.) 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.

Because 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?

Rules To Curb 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 loss and credit limits. 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 requirements for tax shelters. Generally, before October 23, 2004, the organizers of certain tax shelters were required to register the shelter with the IRS. The IRS then assigned the tax shelter a registration number. If you are an investor in a tax shelter that was required to be registered, 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.
Disclosure of reportable transactions. You must disclose information for each reportable transaction in which you participate. See Reportable Transaction Disclosure Statement later.

Material advisors with respect to any reportable transaction must disclose information about the transaction on Form 8264 according to the interim guidance provided in Notice 2004-80, which is on page 963 of Internal Revenue Bulletin 2004-50 available at www.irs.gov/pub/irs-irbs/irb04-50.pdf. This requirement applies to material advisors who provide material aid, assistance, or advice on any reportable transaction after October 22, 2004.
Requirement to maintain list. Material advisors must maintain a list of persons to whom they provide material aid, assistance, or advice on any reportable transaction after October 22, 2004. Before October 23, 2004, organizers and sellers who acted as material advisors with respect to any potentially abusive tax shelter (including a reportable transaction, discussed later) were required to maintain a list of persons involved in the tax shelter. 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 Regulations section 301.6112-1 for more information.
Confidentiality privilege. The confidentiality privilege between you and a federally authorized tax practitioner does not apply to written communications made after October 21, 2004, regarding the promotion of your direct or indirect participation in any tax shelter.
Appraisal requirement for 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.

Note. The following rule changes apply to property donated after June 3, 2004.
1. The rule in (6) above does not apply to donations of inventory or publicly traded securities.
2. If the value of the property you donated (other than inventory or publicly traded securities) is more than $500,000, you must attach the qualified appraisal to your tax return.
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 method restriction. Tax shelters generally cannot use the cash method of accounting.
Uniform capitalization rules. The 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.
Denial of deduction for interest on an underpayment due to a reportable transaction. You cannot deduct any interest you paid or accrued on any part of an underpayment of tax due to an understatement arising from a reportable transaction (discussed later) if the relevant facts affecting the tax treatment of the item are not adequately disclosed. This rule applies to reportable transactions entered into in tax years beginning after October 22, 2004.

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 requirement for tax shelters, described earlier. However, the requirement to maintain a list that is in effect for tax shelters also applies to any projected income investment. See Requirement to maintain list, earlier.

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.

Authority for Disallowance of Tax Benefits

The IRS has published guidance concluding that the claimed tax benefits of various abusive tax shelters should be disallowed. The guidance is the conclusion of the IRS on how the law is applied to a particular set of facts. Guidance is published in the Internal Revenue Bulletin for taxpayers' information and also for use by IRS officials. So, if your return is examined and an abusive tax shelter is identified and challenged, published guidance 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 believes 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

You may be required to provide the following information.

Reportable transaction disclosure statement.
Tax shelter registration number.

Reportable Transaction Disclosure Statement

Use Form 8886 to disclose information for each reportable transaction in which you participated. Generally, you must attach Form 8886 to your return for each year that your tax liability is affected by your participation in the transaction. In addition, for the first year Form 8886 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

If you fail to file Form 8886 as required or fail to include any required information on the form, you may have to pay a penalty. See Penalty for failure to disclose a reportable transaction later under Penalties.

The following discussion briefly describes reportable transactions. For more details, see the instructions for Form 8886.

Reportable transaction.

A reportable transaction is any of the following.

A listed transaction.
A confidential transaction.
A transaction with contractual protection.
Loss transactions in excess of certain amounts.
Transactions with a significant book-tax difference.
Transactions with a brief asset holding period. This category includes transactions that result in your claiming a tax credit (including a foreign tax credit) of more than $250,000 if the asset giving rise to the credit was held by you for 45 days or less.

Listed transaction. A listed transaction is a transaction that is the same as or substantially similar to one of the types of transactions that the IRS has determined to be a tax-avoidance transaction. These transactions have been identified in notices, regulations, and other published guidance issued by the IRS. For a list of existing guidance, see the instructions for Form 8886.

Confidential transaction. A confidential transaction is one that is offered to you under conditions of confidentiality and for which you have paid an advisor a minimum fee. A transaction is offered under conditions of confidentiality if the advisor who is paid the fee places a limit on the disclosure of the tax treatment or tax structure on you and the limit protects the advisor's tax strategies. The transaction is treated as confidential even if the conditions of confidentiality are not legally binding on you.

Transaction with contractual protection. Generally, a transaction with contractual protection is a transaction in which you or a related party has the right to a full or partial refund of fees if all or part of the intended tax consequences of the transaction are not sustained, or a transaction for which the fees are contingent on your realizing the tax benefits from the transaction.

Loss transactions. For individuals, a loss transaction is any transaction that results in a claimed loss of at least $2 million in a single tax year or $4 million in any combination of tax years. If the loss is from a foreign currency transaction under Internal Revenue Code section 988, the loss must be at least $50,000 in a single tax year, whether or not the loss flows through from an S corporation or partnership.

Certain losses (such as losses from casualties, thefts, and condemnations) are excepted from this category and do not have to be reported on Form 8886. For information on other exceptions, see Revenue Procedure 2003-24 in Internal Revenue Bulletin 2003-11. This Internal Revenue Bulletin is available at www.irs.gov/pub/irs-irbs/irb03-11.pdf.

Transactions with a significant book-tax difference. This category includes transactions that result in book-tax differences of more than $10 million in any tax year. The book-tax difference is the amount by which the amount of any income, gain, expense, or loss item from the transaction for federal income tax purposes differs on a gross basis from the amount of the item for book purposes for any tax year.

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 requirements for 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 statement 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.

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% or 30% 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. 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.

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. 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 of 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 tax return. To disclose a position contrary to a regulation, use Form 8275-R. Also 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
$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.

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. 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 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.

The 20% penalty does not apply to any understatement that is subject to the accuracy-related penalty for a reportable transaction understatement (discussed later).

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.

Penalty for failure to disclose a reportable transaction. For returns or statements due after October 22, 2004, if you fail to include any required information regarding a reportable transaction (discussed earlier) on a return or statement, you may have to pay a penalty. The amount of the penalty is $10,000 if you are an individual, or $50,000 if you are not. In the case of a listed transaction, the amount of the penalty is $100,000 if you are an individual, or $200,000 if you are not. This penalty applies whether or not there is an understatement of tax and is in addition to any other penalty that may be imposed.

The Internal Revenue Service may rescind or abate the penalty for failing to disclose a reportable transaction under certain limited circumstances, but cannot rescind the penalty for failing to disclose a listed transaction.

Accuracy-related penalty for a reportable transaction understatement. For tax years ending after October 22, 2004, if you have a reportable transaction understatement, you may have to pay a penalty equal to 20% of the amount of that understatement. This applies to any item due to a listed transaction or other reportable transaction with a significant purpose of avoiding or evading federal income tax. The penalty is 30% rather than 20% for the part of any reportable transaction understatement if the transaction was not properly disclosed. You may not have to pay the 20% penalty if you meet the strengthened reasonable cause and good faith exception.

This penalty does not apply to the part of an understatement on which the fraud penalty or gross valuation misstatement penalty is imposed.

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.