IRS’s Current Position on Assessing Code Section 6707A Penalties
How the IRS is taking a “formalistic approach” in interpreting its own section 6011 regulations on disclosing reportable transactions and not following its own rules on which tax years to assess the Section 6707A penalty.
March 19, 2012
The IRS has again commenced assessing penalties under Code Section 6707A, the penalty provision applicable to failure to disclose Congress-enacted reportable transactions in 2004. Congress amended Section 6707A in 2010 to help alleviate its draconian consequences. Under newly amended Section 6707A, applicable to all penalties assessed after December 31, 2006, the penalty, subject to certain maximum and minimum amounts, is equal to 75% of the decrease in reported tax as a result of the reportable transaction. How the IRS is applying the Section 6707A penalty can be described as “troubling.” The following case shows how troubling the IRS position is.
In 2004 and 2005, a taxpayer took deductions for life insurance premiums paid to a Code Section 419(e) plan (419(e) plan). Transactions similar to the 419(e) plan were declared “listed transactions” in Notice 2007-83 on October 17, 2007. Under the applicable version of Treasury Regulation § 1.6011-4(e)(2)(i), the taxpayer was required to file Form 8886 with its “next filed tax return” after the transaction became a listed transaction. Accordingly, the taxpayer was required to file Form 8886 with its 2007 tax return, which it filed on October 14, 2008. The taxpayer did not file Form 8886 with its 2007 tax return. On October 14, 2008, the taxpayer was under audit for its participation in the 419(e) plan.
An IRS letter dated January 15, 2008 informed the taxpayer that it was under examination because of its participation in a widely marketed 419(e) plan. The taxpayer gave the IRS agent (the agent) all of the information requested by the agent. On September 8, 2008, the agent asked the taxpayer to extend until June 30, 2009 the statute of limitations regarding any deficiency related to the 419(e) plan for the 2004 taxable year. The taxpayer agreed to the extension. The agent issued Form 4549 showing the final deficiencies owed by the taxpayer relating to the 419(e) plan on November 7, 2008. The agent didn’t include any penalties on the Form 4549 issued — neither a Section 6662 penalty nor a Section 6707A penalty. The taxpayer paid the deficiencies shown on Form 4549 for its 2004 and 2005 tax years. On December 29, 2008, the group manager informed the taxpayer that the examination report was accepted for 2004 and 2005.
On February 22, 2012, the taxpayer received notification that the IRS was proposing to assess a Section 6707A penalty against the taxpayer for the year 2007 because of the taxpayer’s failure to include Form 8886 with its 2007 income tax return. The IRS had requested that the taxpayer extend the statute of limitations for the 2007 tax year until December 31, 2013, which the taxpayer did.
The first question is whether the IRS has asserted the Section 6707A penalty for the correct taxable year. If a taxpayer fails to include the information required under Section 6011 for a listed transaction, Section 6501(c)(10), enacted in 2004 at the same time as Code Section 6707A, operates to extend the statute of limitations by one year after the earlier of (A) the date the Secretary is furnished the information, or (B) the date a material advisor meets a Section 6112(b) request. However, Section 6501(c)(10) cannot extend the statute of limitations if the tax years of participation in the transaction are closed prior to the transaction becoming a listed transaction. Proposed treasury regulation section 301.6501(c)-1(g)(3)(iii) states that “if the taxable year in which the taxpayer participated in the listed transaction is different from the taxable year in which the taxpayer is required to disclose the listed transaction under section 6011, the taxable year(s) to which the failure to disclose relates are each taxable year that the taxpayer participated in the transaction.” The Preamble to the proposed treasury regulation provides that “the taxable year(s) to which the failure to disclose relates is not the taxable year in which the disclosure is required to be filed, but each taxable year that the taxpayer participated in the listed transaction.” Based upon proposed treasury regulation section 301.6501(c)-1(g), the correct taxable years to assess the taxpayer a Section 6707A penalty are 2004 and 2005, the years the taxpayer participated in the listed transaction, not in 2007, the year the taxpayer failed to report the listed transaction.
Under a formalistic interpretation of the Section 6011 treasury regulations, the IRS could assert that the taxpayer is subject to a Code Section 6707A penalty in 2004 and 2005 because the taxpayer has never filed Form 8886. Its argument would be that Section 6505(c)(10) operates to keep the Statute open for those two years because those years were open when the 419(e) plan became a listed transaction on October 17, 2007. If the IRS were to assess the Section 6707A penalty in 2004 and 2005, its assessment in this situation would ignore the purpose of enacting Section 6707A in 2004. That legislative history clearly shows that Congress enacted the provision so that taxpayers would face a severe penalty if they did not give information to the IRS so that the IRS could effectively combat tax shelters. The point of the penalty is to require taxpayers to divulge information. Through treasury regulations issued under Code Section 6011, the IRS requires that the taxpayers divulge information regarding tax shelter investments by filing Form 8886. Because the IRS has information about the listed transaction from auditing the taxpayer, what does the IRS accomplish by penalizing the taxpayer for failing to file Form 8886? If the IRS wanted to punish the taxpayer for failing to file Form 8886, why didn’t the agent assess the section 6707A penalty before she closed her examination on November 7, 2008? Why didn’t her manager send the case back to the agent to assess the section 6707A penalty after reviewing the case?
The facts of the this case are analogous to one issue considered by the United States District Court for the Eastern District of Texas in Bemont Investments, LLC v. United States decided on August 2, 2010, which is on appeal by the government to the Fifth Circuit. The Bemont case involved a Son-of-Boss tax shelter, a listed transaction. In one part of the case, the Court had to decide whether the extended statute of limitations for listed transactions set forth in Code Section 6501(c)(10) had run. The question depended upon whether the IRS had been supplied the required information, which would cause the statute of limitations to commence running. The government maintained that it had not received the relevant information because it had not received a “list” under Section 6212 of the relevant information; that is, it was not required to take into account the information supplied to it because it was not in the proper form. The District Court held against the government on this issue because the government, in fact, had the information it needed to be aware that the plaintiffs had participated in a Son-of-Boss tax shelter.
The IRS decision to assert a Section 6707A penalty against the taxpayer is very troubling. Not only is the IRS taking a “formalistic approach” in interpreting its own section 6011 regulations on disclosing reportable transactions, it is not following its own rules on which tax years to assess the Section 6707A penalty.
Janice Eiseman, JD, LLM, is a principal at Cummings & Lockwood in Stamford, Conn. office where she focuses on the taxation of closely held businesses and tax planning for owners and investors. Eiseman has broad-based experience counseling clients on the formation, ownership and structuring of various business entities, as well as drafting and negotiating tax-based and transactional documentation for both individual and business clients. She has also done controversy work before the IRS and the New York State Department of Taxation and Finance. Prior to joining Cummings & Lockwood, she served as senior tax and benefits counsel at the New York City-based law firm Morrison & Cohen LLP.