Exhibit 4-1

IRS Example of Abusive Tax Shelter Consequence

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 Internal Revenue Service and a tax deficiency is determined, you will be faced with payment of the tax, interest on the underpayment, possibly a 5 percent negligence penalty, and a penalty equal to 50 percent of the interest attributable to negligence or a 50 percent civil fraud penalty. The penalty for overvaluation of property may also be applied. Furthermore, a penalty of 10 percent will be imposed on any substantial understatement of tax (if the understatement exceeds the greater of 10 percent of the correct tax or $5,000). This penalty will not be imposed on any portion of the substantial understatement on which a penalty is imposed for overvaluation of property. Also, the penalty for failure to make the proper estimated tax payments may apply. In addition, if a deficiency is assessed, and is not paid within 10 days of the demand for it, an investor may be penalized with up to a 25 percent addition to tax.

Example:

Assume that a tax shelter promoter offers to sell to individuals tangible personal property that is 5-year recovery property for purposes of the accelerated cost recovery system (ACRS). An individual can purchase the property by making a $10,000 cash down payment and signing a note for the $90,000 balance of the purchase price. The note appears to be a recourse obligation because, for some period of time, the individual is supposedly personally liable for its payment. However, the note is in reality a nonrecourse obligation, under which the individual is never personally liable for payment. The promoter claims that a purchaser will be able to claim an investment tax credit of $10,000, which is 10 percent of the stated purchase price of $100 ,000 The also claims that in the first year a purchaser will be able to claim a depreciation deduction of $14,250 [15 percent of $95,000 ($100,000 minus 50 percent of $10,000)].

Assume that a taxpayer in the 50 percent Federal income tax bracket purchases the property from the promoter and claims the depreciation deduction and the investment tax credit as stated above. The taxpayer supposedly has saved $17,125 in Federal income tax (the $10,000 investment tax credit plus 50 percent of the $14,250 depreciation deduction). However, upon examination of the taxpayer's return by the Internal Revenue Service, it is determined that the actual value of the property is really only $10,000. Thus, the depreciation deduction is recomputed to be only $1,425, and the investment tax credit is recomputed to be only $1,000. The taxpayer, therefore, owes an additional $15,413 of tax: $6,413 from the $12,825 reduction in the depreciation deduction and $9,000 from the reduction of the investment tax credit.

The determination that additional tax results from the adjustments to the return is only the beginning. The taxpayer claimed the deduction and credit with respect to the property based on a value that exceeded 250 percent of the proper value. Therefore, the taxpayer is subject to the penalty for overvaluation of property in the amount of 30 percent of the underpayment of tax attributable to the overvaluation. The penalty is $4,624 (30 percent of $15,413).

The taxpayer also owes interest on the $15,413 of additional tax from the date the taxpayer's income tax return is required to be filed until the date the taxpayer pays the additional tax and penalty. Thus, by the time the return is examined and the taxpayer pays the additional tax, a substantial amount of interest will also be due.

The promoter represented that the investor would save $17,125 in Federal taxes for the first year for a $10,000 cash investment. However, the promotion has actually cost the taxpayer not less than $15,413 in additional taxes resulting from adjustments to items on the return, $4,624 in an overvaluation penalty, and a substantial amount of interest. Thus, for reporting the $10,000 "investment" on his or her tax return as the promoter instructed, the taxpayer acquired more than $20,000 in tax liabilities. In addition, it is likely that the taxpayer will not be able to show that the activity was engaged in for profit. Alternatively, the facts may indicate that the taxpayer never purchased the property. In either case, the taxpayer may be denied all the claimed deductions and owe additional amounts of tax and interest. As noted earlier, various other penalties may also apply.

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© 1986, 1998 to 2002, Jack Warren Wade, Jr.