Step 4-5

IRS's Tax Shelter Program

The Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA) gave the IRS two new tools to combat abusive tax shelters; injunctions to stop promoters from selling abusive shelters, and the imposition of civil penalties against promoters for making false statements about the tax benefits of the plan or for making gross overstatements regarding the value of the property related to the shelter. The Deficit Reduction Act of 1984 gave the IRS additional tools, such as increased penalties, registration procedures, and certain recordkeeping requirements.

In effect, the IRS has declared war on tax shelters. As of September 30, 1986, there were 426,634 tax returns with tax shelter issues in the examination process. In 1986 the IRS closed 171,354 examination cases by recommending an additional $3.7 billion in taxes.

The purpose of IRS's Tax Shelter Program is to identify, examine, and investigate those taxpayers "utilizing improper or extreme interpretations of the law or of the facts to secure for investors substantial tax benefits which are clearly disproportionate to the economic reality of the transaction."

Tax shelter coordinators and committees have been established in every region and in every district in the IRS to gather information on tax shelter promotions and to implement and manage the provisions of the program. All managers in local IRS offices have been instructed to promptly forward all prospectuses, advertisements, and any other pertinent information regarding any potential tax shelter that should be included in the program. All tax examiners are on the alert for indications of fraud while examining tax shelter issue returns. (See Chapter 7 for indications of fraud.)

The IRS has already sent out tens of thousands of pre-filing notification letters to investors in dozens of abusive shelter projects advising them that their returns will be examined if they claim such benefits. In addition, the IRS is withholding portions of refunds that can be attributed to tax shelters.

The objectives of the Tax Shelter Program are:

• To stop the marketing of abusive tax shelters.
• To prevent future promotional activity of abusive tax shelter schemes.
• To deter other promoters.
• To penalize the promoters of abusive tax shelters.
• To encourage investors to file correct tax returns.
• To discourage future investments in abusive tax shelters.

The Front End Approach

Tax shelter schemes use partnership, individual, fiduciary, and other tax return formats, and frequently involve large numbers of related entities throughout the U.S. and other countries. The impact of these schemes has clearly created major administrative problems for the IRS in identifying, controlling, coordinating, and resolving the examination of related returns. The Tax Shelter Program is designed to overcome that.

In the past the IRS has used an "after-the-fact" approach in identifying, selecting, and examining returns involving tax shelters suspected of using improper or implausible interpretations of the law or the facts. Now the Tax Shelter Program has been created to handle the problem with a "front end" approach, in the hope of preventing investors, before filing, from claiming substantial tax benefits which are clearly disproportionate tot he economic reality of their transaction.

The "front end" approach includes these tools:

• Tax Code Section 6700 provides for a civil penalty against persons who promote abusive tax shelters, equal to the greater of $1,000 or 20 percent of the gross income derived from the promotion of the activity. The penalty applies if a person makes a statement concerning a tax benefit he knows was false or fraudulent, or makes a gross valuation overstatement. This is a statement that places the value of property or services, that is directly related to the amount of any income tax deduction or credit, in excess of 200 percent of the property's correct value. This penalty may only be waived if the valuation was made in good faith and with a reasonable basis.
• Code Section 7408 permits the IRS to obtain an injunction to enjoin any person from further engaging in such shelter activity.
• A tax shelter organizer is now required by Code Section 6111 to register the shelter with the IRS. This registration number must appear on any tax return which reports a deduction, loss, credit, or other tax benefit associated with that tax shelter. The registration number must also be conveyed when an interest in a registered tax shelter is sold or transferred. (You should be aware that IRS regulations clearly note that tax shelter registration is in no way an indication that the IRS has reviewed, examined, or approved the tax shelter.)
• Any person who organizes or sells an interest in a potentially abusive shelter is required to maintain a list identifying each person who was sold an interest. This list must be made available to the IRS upon request and must be retained for seven years. A "potentially abusive shelter: is one that is required to be registered, or one that has otherwise been determined by IRS regulations as having a potential for tax avoidance or evasion.
• Pre-filing Notification Letters will be sent to investors stating that the IRS believes the purported tax benefits are not allowable, and what the possible consequences may be if the investor/taxpayer claims such tax benefits on his tax return. If the notification letter is received after the tax return has been filed, the taxpayer may submit an amended tax return.
• Referred to as the "substantial understatement penalty," an additional penalty of 25 percent of the understated tax reported on the return may be assessed by the IRS under the authority of code Section 6661 if the understatement exceeds the greater of 10 percent of the tax required to be shown on the return, or $5,000. This penalty can only be avoided on tax shelter matters if there was substantial authority for the position taken on the return, and the taxpayer reasonably believed that his position was more likely than not to be the proper tax treatment.
• Where there was an underpayment of tax of at least $1,000 due to an overstatement of property valuation, the IRS may assert an additional penalty by authority of Code Section 6659. A valuation overstatement occurs when the claimed value of the property is at least 150 percent of the correct value or adjusted basis. In the case of a valuation overstatement of property related to a charitable contribution deduction, the penalty is an additional 30 percent of the tax. In all other situations the penalty ranges from 10 percent to 30 percent of the underreported tax depending upon the ration of claimed valuation to the correct valuation.
• Beginning in 1985, if the value of the property you donate to a charitable organization exceeds $5,000 (or $10,000 for privately traded stocks), you must get a written "qualified" appraisal of the property's fair market value and attach an appraisal is one not done by the taxpayer, a party to the transaction in which the taxpayer acquired the property, the donee, or an employee or related party of any of the preceding persons listed.
• If you are audited by the IRS and the IRS proposes over $1,000 in additional tax as a result of your "tax-motivated transaction," you not only may be subject to negligence or civil fraud penalties, but you will have to pay a higher interest rate on the deficiency equal to 120 percent of IRS's underpayment rate.

A tax-motivated transaction is one that includes:
1. Any valuation overstatement of 150 percent or more;
2. Any activity with respect to which a loss or investment credit is disallowed
by reason of the at-risk rules;
3. Tax straddles; or
4. Use of any accounting method prescribed by regulations as potentially
resulting in a substantial distortion of income.
5. Any sham or fraudulent transaction.

IRS Selection Criteria for Program Enforcement

Returns with tax shelters features that are caught during the processing cycles will be classified in the Service Center by personnel who have sufficient training or experience to determine if the return should be included in the program. Though not inclusive, the following criteria is being used, when the return shows: * A large net loss. * Low gross income. * Large amounts of investment credit. * Is a first year return, or a final return. * A Section 761(a) election to be excluded from the partnership provisions of the tax code. * The business is really a nonoperating entity. * The taxpayer is a passive investor. * Nonrecourse or not-at-risk questions are not answered or answered affirmatively. * The activity engaged in has already been identified as a tax shelter area. * A negative capital account for a partnership not involved in real estate.

The IRS not only maintains complete computerized records of all tax shelter investor returns, but also of all promoters they are aware of. The IRS also has discovery procedures and examination techniques for those tax shelters sold by some promoters in which investors are instructed to claim deductions directly on their tax returns, rather than as a flow-through loss from another entity. If necessary, the IRS will not hesitate to use their summons powers to obtain names of investors from promoters.

The promoter penalty under Code Section 6700 is broad in scope. Almost anyone connected with a tax shelter could be subject to the penalty, including organizers, sales people, appraisers, accountants, attorneys, and persons "who are in active concert with them."

The following criteria may be considered by the IRS in targeting appropriate shelter promoters and their schemes:

• Past History of Promoter: The prior promotion of abusive shelters raises the possibility that the current offering may be abusive.
• Type of Shelter: Asset sale or lease, charitable contribution, research and development, mining, family trust/protester, time share, etc., are some examples of potentially abusive tax shelters. They type of shelter ordinarily indicates the degree of difficulty and time necessary to conduct an examination.
• Size of Promotion: The potential number of investors and potential revenue loss must justify pre-filing action and resources required to develop the case.
• National Impact: To the extent that handling a promotion with "up-front" actions will have a favorable impact, resources will most likely be concentrated on National shelters/promoters. District IRS personnel are advised not to overestimate the weight of this factor since abusive tax shelters may surface at the local level and these must be considered for compliance impact.
• Issues Involved: Asset overvaluation (see IRC 6700(b)), false or fraudulent statements (see IRC 6700(a)(2)(A)), or aberrational use of a technical position(s) are indicators of a potential IRC 6700 case.

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