The carrot and the stick: IRS's new disclosure initiative and guidelines for imposing the section 6662 accuracy-related penalty.

• Author: Ely, Mark H.

The federal tax system in the United States is a system of voluntary compliance and, as such, the Internal Revenue Service relies to a large extent on taxpayers' willingness to self-report their tax liabilities in order to administer the tax system. Congress has recognized that some taxpayers need additional encouragement to accurately report their tax liabilities and has enacted penalty provisions to deter noncompliance. (1) In some situations, the IRS has waived certain penalties in an effort to give taxpayers an opportunity (and incentive) to comply with new requirements of the Internal Revenue Code or Treasury Regulations. (2)

In late December 2001, the IRS announced a new, two-step program to encourage taxpayer compliance regarding tax shelters and other transactions. Under one step of this program, the "disclosure initiative" announced on December 21, 2001, the IRS generally will waive certain components of the section 6662(b) accuracy-related penalty for taxpayers that disclose their participation in transactions within a window of 120 days, ending on April 23, 2002. Announcement 2002-2, 2002-2 I.R.B. 304 (Jan. 14, 2002).

The other step of the program is a set of new IRS internal penalty guidelines setting forth new policy and procedures for considering and developing penalty issues. In a memorandum dated December 20, 2001, from Larry R. Langdon, Commissioner of the IRS's Large and Mid-Size Business Division (LMSB), to all LMSB examination personnel, LMSB announced new requirements to be followed in all LMSB examinations regarding the consideration of the section 6662 accuracy-related penalty in cases where taxpayers participated in "listed" and "other potentially abusive tax shelters" (defined later). Revisions will soon be made to the Internal Revenue Manual to incorporate the new guidelines.

Together, the two steps of the program function as a carrot and a stick (the IRS terms it a "compliance incentive") to encourage taxpayer disclosure of the transactions in which they participate. The disclosure initiative is the "carrot," in that it offers taxpayers a limited window of opportunity to get the accuracy-related penalty waived if they disclose transactions in which they participated. The penalty guidelines are the "stick," in that they spell out the consequences that taxpayers may face if they do not take advantage of the window of opportunity offered by the disclosure initiative.

Background

The IRS has been making a concerted effort to deal with what it considers to be abusive tax shelters since early in 2000. In February 2000, the IRS created the Office of Tax Shelter Analysis (OTSA), which is a part of the Pre-Filing and Technical Guidance (PFTG) function in LMSB. OTSA describes itself as being responsible for planning, coordinating, and providing assistance to examiners working abusive tax shelter issues, and serving as a clearinghouse for information that comes to the attention of the IRS relating to potentially improper tax shelter activity by corporate and noncorporate taxpayers. (3) OTSA's primary focus has been to identify what it considers to be abusive transactions and to expeditiously develop a published IRS position on such transactions.

On February 28, 2000, the IRS published three sets of temporary regulations: Temp. Reg. [section] 1.6011-4T, which requires taxpayers to disclose their participation in "listed" and "other reportable transactions;" Temp. Reg. [section] 301.6111-2T, which requires promoters to register "confidential corporate tax shelters;" and Temp. Reg. [section] 301.6112-1T, which requires tax shelter promoters to maintain a list of each tax shelter participant that must be provided to the IRS within 10 days of the date it is requested.

Although there is no penalty, per se, for failing to disclose under Temp. Reg. [section] 1.6011-4T, a taxpayer's failure to disclose a "listed" or "other reportable transaction" could affect the taxpayer's ability to satisfy the reasonable cause and good faith exception to the accuracy-related penalty, if otherwise applicable. The preamble to Temp. Reg. [section] 1.6011-4T states:

If a taxpayer has an underpayment attributable to a reportable transaction that has not been properly disclosed on its return, the nondisclosure could indicate that the taxpayer has not acted in "good faith" with respect to the underpayment, even if the taxpayer's return position has sufficient legal justification to meet the minimum requirements of section 6664(c)(1). In such a case, the determination of whether a taxpayer has acted in "good faith" will depend on all of the facts and circumstances, including the reason or reasons why the taxpayer failed to make the required disclosure. (4) Section 6662(b) generally imposes a 20-percent penalty on any portion of an underpayment of tax required to be shown on a return that is attributable to one or more of the following: (1) negligence or disregard of rules or regulations; (2) any substantial understatement of income tax; (3) any substantial valuation misstatement under chapter 1; (4) any substantial overstatement of pension liabilities; and (5) any substantial estate or gift tax valuation understatement.

With regard to the substantial understatement component of the accuracy-related penalty, section 6662(d)(2)(B)(ii) ordinarily provides relief from the penalty to the extent that the taxpayer had a reasonable basis for the treatment of the item and disclosed the tax treatment of the item in a statement attached to the return. In the case of a "tax shelter" item, however, which for these purposes is defined very broadly as 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," (5) there is no disclosure exception to the substantial understatement component. (6) Thus, although taxpayers are required under the temporary regulations to disclose their participation in "listed" and "other reportable" transactions, such disclosure will not limit taxpayers' exposure to the accuracy-related penalty under section 6662. Therefore, even though penalties are imposed for the purpose of encouraging taxpayer compliance, section 6662 provides no incentive for a taxpayer to disclose its participation in a transaction if the transaction could fall under the broad definition of "tax shelter."

The IRS believes that its new disclosure initiative and accuracy-related penalty guidelines will provide some incentive for taxpayers to disclose their participation in transactions and strengthen its ability to deal with what it perceives as a proliferation of abusive tax shelters. (7) The guideline memorandum states that "[d]isclosure is critical to the IRS's ability to efficiently and judiciously use its resources to administer the tax laws." The IRS hopes that disclosures will assist it in evaluating transactions, (8) identifying tax shelter promoters who have not registered the transactions, and finding other taxpayers who have participated in transactions that the IRS finds questionable.

The Carrot

Under Announcement 2002-2, the IRS will waive certain components of the accuracy-related penalty under section 6662(b) on underpayments attributable to disclosed transactions. The Announcement explicitly states that disclosure creates no inference that the tax treatment of the item was improper or that the accuracy-related penalty would apply if there were an underpayment of tax.

Nuts and Bolts of the Disclosure Initiative

1. Waivable Components of the Accuracy-Related Penalty

   The waivable components of the accuracy-related penalty under Announcement 2002-2 are: (1) negligence or disregard of rules and regulations under section 6662(b)(1); (2) a substantial understatement of income tax under section 6662(b)(2); (3) a substantial or gross valuation misstatement (except for any portion of an underpayment attributable to a net section 482 transfer price adjustment, unless the documentation rules are satisfied) under section 6662(b)(3); and (4) a substantial overstatement of pension liabilities under section 6662(b)(4). (9)

2. When Waiver Is Not Available

   The Announcement provides that taxpayers will not be entitled to a waiver of the accuracy-related penalty for items resulting from transactions that:

   (1) did not occur, in whole or part, but for which a tax benefit was claimed; (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 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; and (5) involved the treatment of personal, household, or living expenses as deductible business expenses.

   The Announcement also states that disclosure under the initiative "does not affect whether the IRS will impose, as appropriate, any other civil penalty that may be applicable under the Code or will investigate any associated criminal conduct or recommend prosecution for violation of any criminal statute."

3. When to Disclose

   The disclosure initiative provides that, in order for the accuracy-related penalty components to be waived, the taxpayer must make the required disclosure before the earlier of (1) the date the item or another item arising from the same transaction is "raised during an examination" or (2) April 23, 2002. The Announcement provides that, for these purposes, an item is an issue "raised during an examination" if (1) the person examining the return communicates to the taxpayer knowledge about the specific item, or (2) on or before December 21, 2001, the examiner has made a request to the taxpayer for information, and the taxpayer "could not make a complete response to that request without giving...