IRS Issues Guidance On Penalties For Potentially Abusive Transactions.

Notice 2005-12

The purpose of this notice is to alert taxpayers to the recent enactment of section 6662A and amendments to sections 6662 and 6664 of the Internal Revenue Code, provide interim guidance relating to these provisions and invite comments from the public regarding the rules and standards relating to section 6662A and sections 6662 and 6664, as amended.

BACKGROUND

The American Jobs Creation Act of 2004, Pub. L. No. 108-357, 118 Stat. 1418 (the Act), was enacted on October 22, 2004. Section 812 of the Act added section 6662A, which provides a new penalty for understatements with respect to reportable transactions. Section 812 also added section 6664(d), which provides a defense to the penalty under section 6662A if the taxpayer acted with reasonable cause and in good faith. Sections 812 and 819 of the Act amended section 6662(d) to modify the accuracy-related penalty under section 6662(d) for substantial understatements of income tax.

The penalty provided by section 6662A applies only (1) to listed transactions and (2) to reportable transactions (other than a listed transaction) if a significant purpose of the transaction is the avoidance or evasion of Federal income tax. In addition, a higher 30- percent penalty applies to a reportable transaction understatement if a taxpayer does not adequately disclose, in accordance with regulations prescribed under section 6011, the relevant facts affecting the tax treatment of the item giving rise to the reportable transaction understatement. The reasonable cause and good faith defense is not available with respect to the 30-percent penalty. See I.R.C. §§ 6662A(c) and 6664(d)(2)(A).

Section 6662A(e)(3) sets forth a special rule for amended returns. The tax treatment on an amendment or supplement to a return is not taken into account in determining the amount of a reportable transaction understatement if the amendment or supplement is filed after the earlier of (1) the date the taxpayer is first contacted by the IRS regarding an examination of the return or (2) any other date specified by the Secretary.

Under section 6662(d)(2), an understatement is the excess of (i) the amount of tax required to be shown on the return for the taxable year over (ii) the amount of tax imposed which is shown on the return, reduced by any rebate. This excess is determined without regard to items to which section 6662A applies. The reportable transaction understatement, however, is added to the understatement calculated under section 6662(d)(2) for purposes of determining whether an understatement is substantial under section 6662(d)(1). Under section 6662A(e)(1)(B), in the case of an understatement, the addition to tax under section 6662(a) applies only to the excess of the amount of the substantial understatement over the aggregate amount of the reportable transaction understatements. Accordingly, the accuracy-related penalty attributable to substantial understatement of income tax does not apply to an understatement on which the section 6662A penalty is imposed.

Section 6662A does not apply to any portion of an understatement on which the section 6663 fraud penalty or the section 6662(h) accuracy-related penalty for a gross valuation misstatement is imposed. Section 6662(e) (substantial valuation misstatement) does not apply to any portion of an understatement on which a penalty under section 6662A is imposed.

Under section 6662(d)(2), as amended, the understatement with respect to any item attributable to a tax shelter item, including tax shelter items of taxpayers other than corporations, will not be reduced even if the taxpayer has substantial authority and a reasonable belief that the tax treatment of an item attributable to a tax shelter item was more likely than not the proper treatment. The taxpayer may, however, demonstrate reasonable cause and good faith under section 6664(c).

An opinion of a tax advisor may not be relied upon to establish the reasonable belief of the taxpayer if the advisor or the opinion is disqualified. A tax advisor is disqualified if the tax advisor (1) is a material advisor under section 6111, as amended, and participates in the organization, management, promotion, or sale of the transaction or is related to any person who so participates; (2) is compensated directly or indirectly by a material advisor with respect to the transaction; (3) has a fee arrangement with respect to the transaction that is contingent on all or part of the intended tax benefits from the transaction being sustained; or (4) has any other disqualifying financial interest with respect to the transaction as identified by the Secretary.

An opinion is disqualified if the opinion (1) is based on unreasonable factual or legal assumptions (including assumptions as to future events); (2) unreasonably relies on representations, statements, findings or agreements of the taxpayer or any other person; (3) does not identify and consider all relevant facts; or (4) fails to meet any other requirement as the Secretary may prescribe.

INTERIM PROVISIONS

The Treasury Department and the IRS intend to issue regulations implementing the requirements of section 6662A and sections 6662 and 6664, as amended. Section 812 of the Act, which added section 6662A and amended sections 6662 and 6664 is effective for taxable years ending after October 22, 2004. Section 819 of the Act, which separately amended section 6662, is effective for taxable years beginning after October 22, 2004. The Treasury Department and the IRS provide the following interim rules to implement the requirements of sections 6662, 6662A and 6664. These interim rules will apply until further guidance is issued.

A material advisor is defined in Treas. Reg. § 301.6112-1. In addition, the existing rules under Treas. Reg. § 301.6112- 1(c)(2), (c)(3) and (d) (without regard to the provisions relating to a transaction required to be registered under former section 6111), including the minimum fee amounts for listed transactions under Treas. Reg. § 301.6112-1(c)(3)(ii), shall apply. See Notice 2004-80, 2004-50 I.R.B. 963 (December 13, 2004). The definition of material advisor, and the rules described here, will apply for purposes of section 6662A until the IRS issues further guidance.

A material advisor participates in the "management" of a transaction if the material advisor is involved in the decision- making process regarding any business activity with respect to the transaction. Participation in the management of a transaction includes managing assets, directing business activity, or acting as general partner, trustee, director or officer of an entity involved in the transaction.

A material advisor participates in the "promotion or sale" of a transaction if the material advisor is involved in the marketing of the transaction or tax strategy. Marketing activities include: (1) soliciting, directly or through an agent, taxpayers to enter into a transaction or tax strategy using direct contact, mail, telephone or other means; (2) placing an advertisement for the transaction in a newspaper, magazine, or other publication or medium; or (3) instructing or advising others with respect to marketing of the transaction or tax strategy.

Consistent with the legislative history, a tax advisor, including a material advisor, will not be treated as participating in the organization, management, promotion or sale of a transaction if the tax advisor's only involvement is rendering an opinion regarding the tax consequences of the transaction. In the course of preparing a tax opinion, a tax advisor is permitted to suggest modifications to the transaction, but the tax advisor may not suggest material modifications to the transaction that assist the taxpayer in obtaining the anticipated tax benefits. Merely performing support services or ministerial functions such as typing, photocopying, or printing will not be considered participation in the organization, management, promotion or sale of a transaction.

Until further guidance is issued, a tax advisor also will be treated as a disqualified tax advisor, even if not a material advisor, if the tax advisor has a referral fee or a fee-sharing arrangement by which the advisor is compensated directly or indirectly by a material advisor. In addition, an arrangement will be treated as a disqualified compensation arrangement if there is an agreement or understanding (oral or written) with a material advisor of a reportable transaction pursuant to which the tax advisor is expected to render a favorable opinion regarding the tax treatment of the transaction to any person referred by the material advisor. A tax advisor will not be treated as having a disqualified compensation arrangement if a material advisor merely recommends the tax advisor who does not have an agreement or understanding with the material advisor to render a favorable opinion regarding the tax treatment of a transaction.

In addition, a disqualified compensation arrangement includes a fee that is contingent on all or part of the intended tax benefits from the transaction being sustained, including agreements that provide that (1) a taxpayer has the right to a full or partial refund of fees if all or part of the tax consequences from the transaction are not sustained or (2) the amount of the fee is contingent on the taxpayer's realization of tax benefits from the transaction. Transactions described in Treas. Reg. § 1.6011-4(b)(4)(iii) do not give rise to a disqualified compensation arrangement.

REQUEST FOR COMMENTS

The Treasury Department and the IRS intend to issue regulations implementing section 6662A and the amendments to sections 6662 and 6664 and invite interested persons to submit comments regarding rules and standards under sections 6662, 6662A and 6664 in general and on the specific matters set forth below, including particularly item 2 under "Definition and Special Rules" regarding the extent to which a tax advisor should be permitted to suggest modifications to a transaction without becoming a "disqualified tax advisor."

2. Coordination of the reportable transaction understatement penalty with the substantial understatement penalty, including the methodology for calculating the excess of the aggregate reportable transaction understatement;

3. Coordination of the reportable transaction understatement penalty with the accuracy-related penalty on underpayments, including the penalty on underpayments attributable to negligence or disregard of rules or regulations, and the fraud penalty; and

4. Special rules for amended returns, including whether rules similar to the rules provided in Rev. Proc. 94-69, 1994-2 C.B. 804, should apply.

2. Providing suggested modifications regarding the transaction;

3. Definition of "disqualifying financial interest";

4. Additional requirements relating to "disqualified opinions."

Comments are encouraged to be submitted by February 28, 2005, to: Internal Revenue Service, CC:PA:LPD:PR (Notice 2005-12), room 5203, P.O. Box 7604, Ben Franklin Station, Washington, DC 20224. Submissions may be hand delivered Monday through Friday between the hours of 8 a.m. and 4 p.m. to: CC:PA:LPD:PR (Notice 2005-12), Courier's Desk, Internal Revenue Service, 1111 Constitution Avenue N.W., Washington, DC. Alternatively, taxpayers may submit electronic comments directly to the IRS e-mail address: notice.comments@irscounsel.treas.gov.

DRAFTING INFORMATION

The principal author of this notice is Heather L. Dostaler of the Office of Associate Chief Counsel (Procedure & Administration), Administrative Provisions and Judicial Practice Division. For further information regarding this notice, contact Heather L. Dostaler at (202) 622-4940 (not a toll-free call).