November 09, 2005
On October 27, 2005 the IRS announced an initiative to settle twenty-one allegedly abusive transactions affecting more than 4,000 taxpayers. Taxpayers involved in one of these twenty-one transactions have until January 23, 2006 to make an election to participate in the settlement initiative.
Taxpayers who elect to participate in the settlement initiative will have to pay 100% of the tax liability owed on the transaction, 100% of the interest on the tax liability, and a penalty. The penalty assessed by the IRS will vary depending on the transaction. Some transactions will be assessed a 20% penalty, others will be subject to a 10% penalty, and others will be subject to a 5% penalty. Notably, taxpayers will be allowed to deduct transaction costs for the transactions, including professional and promoter fees.
The Transactions That Can Be Settled and the Penalties Imposed
The IRS has divided the twenty-one transactions that are eligible for the settlement initiative into four groups, based upon the amount of penalty the taxpayers are required to pay and the type of transaction.
The first group of transactions are “listed transactions” the IRS has previously announced it believes are abusive. Taxpayers who entered into these transactions and elect to participate in the settlement initiative will be required to pay a 20% penalty. There are three of these transactions:
- Transactions using inflated basis.
- Intermediary transactions.
- Transactions involving losses reported from inflated basis assets from lease strips.
The second group of transactions are also “listed transactions” and require taxpayers who elect to participate in the settlement initiative to pay a 10% penalty. There are four of these transactions:
- Lease strips and other stripping transactions.
- Certain common trust fund straddle tax shelters.
- Transactions using offsetting foreign currency option contracts.
- Transactions using distributions of encumbered property.
The third group of transactions are also “listed transactions” and require taxpayers who elect to participate in the settlement initiative to pay a 5% penalty. There are nine of these transactions:
- Transactions using specially designed life insurance policies in retirement plans.
- Transactions involving abusive treatment of Roth IRAs.
- Transactions involving certain S corporation employee stock ownership plans.
- Transactions involving transfers to trusts to satisfy contested liabilities.
- Transactions involving welfare benefit funds.
- Transactions involving the transfer of employee stock ownership plans that hold stock in S corporations.
- Debt straddles.
- Certain trust arrangements seeking exemption from Section 419.
- Certain distributions by charitable remainder trusts.
The fourth group of transactions are not “listed transactions,” but the IRS has concerns regarding their legitimacy. Taxpayers who entered into these transactions and elect to participate in the settlement initiative will also be required to pay a 5% penalty. There are five of these transactions:
- Transactions involving false reimbursements for employee parking expenses.
- Transactions involving false reimbursements for employee medical expenses.
- Certain transactions involving the management of S corporations and employee stock ownership plans.
- Abusive conservation easements.
- Abusive charitable contributions of patents and other intellectual property.
In the October 27 announcement, the IRS acknowledged that taxpayers often enter into the last two types of transactions – conservation easements and charitable contributions of patents and other intellectual property – for legitimate purposes. The IRS only intends to examine and disallow, and subject to this settlement initiative, those conservation easements and contributions of patents and other intellectual property transactions which are abusive. Notably, however, the IRS did not define what it meant by abusive.
Complete Penalty Relief Available to Some Taxpayers
Taxpayers who meet certain criteria will be eligible to settle with the IRS without paying any penalties. These taxpayers include (1) taxpayers that have properly disclosed the transaction according to IRS rules and (2) at the discretion of the IRS, taxpayers that received and relied on a written tax opinion which meets certain specified requirements, most notably that it concludes that all significant Federal tax issues arising out of the transaction would “more likely than not” be resolved in the taxpayer’s favor.
Taxpayers Who Can Not Participate in the Settlement
Certain taxpayers are ineligible for the settlement initiative. These taxpayers include:
Taxpayers who entered into one of the transactions and whom the IRS informs, prior to the taxpayer making an election to participate in the settlement, that the transaction is one the IRS has designated for litigation.
Taxpayers who are a party in litigation regarding one of the transactions.
Taxpayers against whom the IRS has asserted a fraud penalty.
Taxpayers under criminal investigation.
Certain other taxpayers are eligible for the settlement initiative only at the discretion of the IRS. These taxpayers are tax shelter promoters and certain persons related to and partners of the tax shelter promoter.
Other Procedural Issues
If a taxpayer elects to participate in the settlement initiative and the statute of limitations on the underlying tax will expire within twelve months after the election, the taxpayer must agree to extend the statute of limitations on assessment of the tax. If the taxpayer refuses to extend the statute of limitations on the assessment of tax, the IRS will treat the taxpayer as having withdrawn from the settlement initiative.
Unlike prior IRS settlement initiatives, taxpayers who do not elect to participate in the settlement and who are under examination will still have the option of presenting their case to the IRS Office of Appeals. The IRS stressed, however, that “such persons should not expect to receive a better offer in Appeals than that offered under this settlement initiative and may in fact receive a less favorable outcome.”
This settlement initiative is the most sweeping ever announced by the IRS. Taxpayers who wish to participate only have until January 23, 2006 to make an election. Taxpayers who have entered into one of the twenty-one transactions subject to this settlement initiative should discuss their options with a tax advisor as quickly as possible.