Ann. 2002-2: the carrot and the stick?

• Author: Ely, Mark H.
• Position: Taxpayer disclosure of involvement in tax shelters - IRS memorandum

On Dec. 20, 2001, the IRS issued Ann. 2002-2, outlining a new initiative to encourage taxpayers to disclose their involvement in tax shelters in exchange for a waiver of accuracy-related penalties under Sec. 6662. At the same time, Commissioner Langdon issued a memorandum to Large and Mid-Size Business Division personnel on applying Sec. 6662 penalties in examinations involving listed transactions and other potentially abusive tax shelters. The clear implication of Ann. 2002-2 and the memorandum is that the Service will pursue penalties vigorously if taxpayers fail to disclose their tax shelter transactions.

Historically, conventional wisdom provided that if a taxpayer's tax shelter transaction were examined, the taxpayer would have little exposure to Sec. 6662 penalties, for two primary reasons. First, in most transactions, the taxpayer relied on a"more likely than not" opinion that the tax treatment would be sustained if challenged on the merits. Under Regs. Sec. 1.6664-4(e), a more-likely-than-not opinion may be taken into account in establishing reasonable cause to avoid Sec. 6662 penalties. Second, even if the IRS questioned a taxpayer's good-faith reliance on a more-likely-than-not opinion, from a practical standpoint, it has routinely waived penalties to encourage settlement and avoid time-consuming, costly litigation. Accordingly, most taxpayers believe that they are better off playing the audit lottery and avoiding an examination of a transaction's merits altogether. In contrast, disclosure would almost certainly mean examination (and possibly litigation) of the transaction's merits.

Ann. 2002-2 places certain significant limits on the penalty waiver, which can be interpreted as a demarcation line that the Service believes separates aggressive tax shelter transactions from potential criminal conduct. Specifically, Ann. 2002-2 excludes transactions that (1) did not,in fact, occur, in whole or in part, but for which the taxpayer claimed a tax benefit on his returns; (2) involved the taxpayer's fraudulent concealment of the amount or source of any item of gross income; (3) involved the taxpayer's concealment of its interest in (or signature or other authority over) a financial account in a foreign country; (4) involved the taxpayer's concealment of a distribution from, a transfer of assets to, or that the taxpayer was a grantor of, a foreign trust; or (5) involved the treatment of personal, household or living expenses as deductible...