Pattern evidence in tax shelter litigation.

• Author: Trainer, Corina

The IRS has been challenging tax shelters for more than 35 years. One weapon it relies on is Sec. 6103(h), which permits the Service to disclose third-party information in judicial proceedings without violating the confidentiality rule for returns and return information.

IRS's Approach

To deal with the increasing volume of tax shelter cases and to underscore the government's contention of many cases involving mass-marketed transactions, the IRS recently redefined how it intends to apply the item and transaction tests of Sec. 6103, to use certain third-party returns and return information in tax proceedings; see Chief Counsel Notice 2006-003. It also released questions and answers to illustrate how it proposes to employ "pattern evidence" in tax shelter proceedings; see Chief Counsel Notice 2006-006.

Authority for disclosing information about other taxpayers' transactions, the Service argues, can be found in Sec. 6103(h)(4)(B) (the so-called "item" exception to the general privacy rules) and Sec. 6103(h)(4)(C) (the so-called "transaction" exception).

As interpreted by the Service and endorsed by some courts (see Northern Trust, 210 FSupp 955 (ND IL 2001) and Shell Petroleum, 47 Fed. Cl. 812 (2000)), the item exception permits disclosing tax information about taxpayers who participated in substantially similar transactions promoted by the same promoter, provided the nonparty taxpayer information relates to the resolution of an issue in the taxpayer's proceeding.

As interpreted by the Service and endorsed by the court in Balanced Financial Management, 662 FSupp 100 (D UT 1987), the transaction exception permits disclosure of third-party tax information if such information directly relates to a transactional relationship between the third party and a person who is a party to the proceeding, provided the information relates to the resolution of an issue in the proceeding.

The IRS first used transaction pattern evidence successfully to challenge individual tax shelters in which different individuals invested in the same shelter. Now it is focusing primarily on corporate tax shelters in which taxpayers have participated in distinct but arguably similar transactions. Thus, the item exception set forth in Sec. 6103(h)(4) is more likely to be relevant.

Effect on Taxpayers

The use of pattern evidence may not only affect taxpayers that choose to contest transactions, but also taxpayers that have elected to settle their tax shelter transactions. A...