United States: IRS Tax Shelter Settlement Initiative

Originally published November 29, 2005

On October 27, 2005, the Internal Revenue Service announced a broad-based, limited-in-time opportunity for taxpayers to come forward and settle an array of transactions the IRS considers abusive. Taxpayers who undertook these deals will have until January 23, 2006, to submit their settlement papers to the IRS. The Tax Shelter Settlement Initiative identifies 21 transactions eligible for the program consisting of both listed and non-listed transactions. All eligible transactions carry the same settlement terms except the applicable penalty level. The eligible transactions involve a full spectrum of taxpayers and the schemes vary substantially in their specifics. They range from complicated, risk-free offsetting currency transactions to products sold to small businesses involving health insurance plans. The transactions were marketed to wealthy individuals, large corporations and small business taxpayers.

Under the settlement terms, participants will be required to pay 100% of the taxes owed, interest and, depending on the transaction, either ¼ or ½ of the penalty the IRS will otherwise seek. There is penalty relief for transactions disclosed to the IRS or where the taxpayer secured a tax opinion from an independent tax advisor. Transaction costs paid by the taxpayer to do the deal, including professional and promoter fees, will be allowed. This Initiative has been described by the IRS as a tax shelter investor's "last chance opportunity." According to the IRS, taxpayers choosing not to participate in the Initiative should not expect a better deal in Appeals and, in some instances, may do worse.

Overview

The Internal Revenue Service announced its limited-time settlement Initiative in Announcement 2005-80. The Announcement provides a settlement Initiative under which taxpayers and the IRS may resolve the tax treatment of certain tax transactions. The Announcement describes who is eligible to participate, the eligible transactions, the settlement terms and the settlement procedures.

A person that claimed a federal tax benefit from an eligible transaction may participate in the Initiative unless the person is an "ineligible person" defined as:

1. Promoters. A person who organized, managed, or sold the transaction; who participated in the organization, management, or sale of the transaction; or who received fees in connection with the organization, management or sale of the transaction.

2. Persons Related to Promoters. A partner in a partnership that would be considered a "promoter," a 5% or more shareholder of a corporation included within the definition of promoter, or a person otherwise related to a "promoter" within the meaning of Internal Revenue Code section 267(b) or 707(b).

3. "TEFRA Partners of Promoters." A partner in a "disqualified entity" in which (a) an "ineligible partner" claimed more than 2% of the improper tax benefits from the transaction at issue, or (b) "ineligible partners" in the aggregate claimed 5% or more of the improper tax benefits from the transaction. An "ineligible partner" is a person who is an ineligible person other than by reason of being included in the definition of "TEFRA Partners of Promoters." A "disqualified entity" is an entity that (a) is subject to the TEFRA provisions of the Internal Revenue Code, (b) engaged in one of the 21 eligible transactions described in the Announcement, and (c) includes one or more ineligible partners. A TEFRA Partner of a Promoter who is not an "ineligible partner" may settle with the IRS if the ineligible partner that caused the TEFRA Partnership to be described as a TEFRA Partner of Promoters executes a waiver under IRS section 6224(b) of his right under section 6224(c)(2) to a consistent settlement agreement.

4. Persons who engage in a transaction that has been designated for litigation. A person who directly or indirectly engaged in a transaction and, before the date on which the election is filed, the IRS has informed the person that the IRS has designated or is considering designating the transaction for litigation.

5. Persons in litigation. A person who individually or as a partner in a TEFRA partnership is a party in a court proceeding to determine the tax treatment of any aspect of the transaction is an ineligible person.

6. Fraud. A person against whom the IRS has imposed a fraud penalty or a person who has been notified before the date on which the election is filed that the IRS is considering imposing the fraud penalty against the person.

7. Persons under criminal investigation. A person under tax-related criminal investigation by the IRS or the Department of Justice or a person who has been notified, before the date on which the election is filed, that the IRS or the Department of Justice intends to commence a tax-related criminal investigation of that person.

Eligible Transactions

The following transactions are eligible for settlement under the Initiative. Stated by each transaction is the accuracy-related penalty on the underpayment attributable to the transaction that a person will be required to pay, unless subject to an exception.

1. Notice 2002-21, 2002-1 C.B. 730 (Tax Avoidance Using Inflated Basis) (20%).

2. Notice 2001-16, 2001-1 C.B. 730 (Intermediary Transactions Tax Shelter) (20%).

3. Notice 2003-55, 2003-2 C.B. 395 (Accounting for Lease Strips and Other Stripping Transactions (10%), and transactions involving losses reported from inflated basis assets from lease strips (20%)).

4. Notice 2003-54, 2003-2 C.B. 363 (Common Trust Fund Straddle Tax Shelters) (10%), but excluding transactions described in Notice 2002-50, 2002-1 C.B. 992, and Notice 2002-65, 2002-2 C.B. 690.

5. Notice 2003-81, 2003-2 C.B. 1223 (Tax Avoidance Using Offsetting Foreign Currency Option Contracts) (10%).

6. Notice 99-59, 1999-2 C.B. 761 (Tax Avoidance Using Distributions of Encumbered Property) (10%).

7. Rev. Rul. 2004-98, 2004-42 I.R.B. 664 ("Reimbursements" for parking expenses previously paid by an employer or previously paid by an employee through salary reduction) (5%).

8. Rev. Rul. 2004-20, 2004-1 C.B. 546, Situation 1 (Pension plan fails to satisfy § 412(i) where amounts accumulated under life insurance contracts and annuities held by the plan exceed benefits payable under plan terms) and Situation 2 (Employer contributions to pension plan are not currently deductible when used to pay premiums on life insurance contracts that provide for death benefits in excess of the participant's death benefit under the terms of the plan), and Rev. Rul. 2004-21, 2004-1 C.B. 544 (Pension plan fails to satisfy nondiscrimination requirements due to differences in the value of participants' rights to purchase life insurance contracts from the plan) (5%).

9. Notice 2004-8, 2004-1 C.B. 333 (Abusive Roth IRA Transactions) (5%).

10. Rev. Rul. 2004-4, 2004-1 C.B. 414 (Transactions that involve segregating the business profits of an employee stock ownership plan (ESOP)-owned S corporation in a qualified subchapter S subsidiary, so that rank-and-file employees do not benefit from participation in the ESOP) (5%).

11. Notice 2003-77, 2003-2 C.B. 1182 (Transfers to Trusts to Provide for the Satisfaction of Contested Liabilities) (5%).

12. Notice 2003-24, 2003-1 C.B. 853 (Tax Problems Raised by Certain Trust Arrangements Seeking to Qualify for Exception for Collectively Bargained Welfare Benefit Funds under § 419A(f)(5)) (5%).

13. Rev. Rul. 2003-6, 2003-1 C.B. 286 (Certain arrangements involving the transfer of ESOPs that hold stock in an S corporation for the purpose of claiming eligibility for the delayed effective date of § 409(p)) (5%).

14. Rev. Rul. 2002-3, 2002-1 C.B. 316; Rev. Rul. 2002-80, 2002-2 C.B. 925 ("Reimbursements" of employees for salary reduction amounts previously excluded from gross income under § 106; "Advance reimbursements" or "loans" without regard to whether an employee has incurred medical expenses) (5%).

15. Notice 2000-60, 2000-2 C.B. 568 (Stock Compensation Corporate Tax Shelter) (5%).

16. Rev. Rul. 2000-12, 2000-1 C.B. 744 (Certain transactions involving the acquisition of two debt instruments the values of which are expected to change significantly at about the same time in opposite directions) (5%).

17. Notice 95-34, 1995-1 C.B. 309 (Tax Problems Raised by Certain Trust Arrangements Seeking to Qualify for Exemption from § 419) (5%).

18. Treas. Reg. § 1.643(a)-8 (Certain Distributions by Charitable Remainder Trusts) (5%).

19. Certain abusive charitable contributions and conservation easements (Deductions under § 170 improperly claimed as a result of: (a) open space easements where the easement has no, or de minimis, value; (b) historic land or façade easements that have no, or de minimis, value; and (c) so-called conservation buyer transactions where the charitable organization purchases property, places an easement on it and then "sells" the property with the easement to a buyer at a price substantially less than that paid for it and the buyer also makes a charitable contribution that approximates the price differential. See Notice 2004-41, 2004-28 I.R.B. 31.) (5%).

20. Certain abusive charitable contributions of patents and other intellectual property (Transfers of patents or other intellectual property to charitable organizations where the property transferred has no, or de minimis, value. See Notice 2004-7, 2004-1 C.B. 310.) (5%).

21. Management S Corporation ESOP Transactions (Transactions where the taxpayer has claimed that it is entitled to exclude income of an operating business by asserting, incorrectly, that the taxpayer had established, on or before March 14, 2001, an employee stock ownership plan entitled to an exemption from unrelated business income and an S corporation that is a management corporation, and whatever actions that were taken to attempt to establish an employee stock ownership plan and a management S corporation were taken on or before March 14, 2001) (5%).

Settlement Terms

1. General Tax Adjustments. The IRS will settle with persons under the Initiative by disallowing the improperly claimed tax benefits associated with the transaction. For certain transactions, that may mean that the transaction will be treated as not having occurred for tax purposes and the person must concede all claimed tax benefits of the transaction for all taxable periods not barred by the statute of limitations on assessment. For other transactions, that may mean that the transaction will be recharacterized in a manner consistent with its substance, and the person must concede all tax benefits inconsistent with that substance. The person may also be required to make adjustments to basis, as appropriate, may be required to unwind or dissolve entities formed for the purpose of facilitating the transaction, and may be required to pay applicable excise tax, employment tax and self-employment tax liabilities.

a. Transaction Costs Generally Allowed as Ordinary Loss. A person settling under this Initiative will be allowed to treat as an ordinary loss those transaction costs, including promoter fees and fees paid for accounting, appraisal and legal services, actually paid by the taxpayer. If tax benefits, including benefits attributable to transaction costs, were claimed in a year barred by the period of limitations on assessment, then transaction costs will be allowed as an ordinary loss only to the extent the transaction costs exceed the tax benefits claimed in the barred year.

b. Tax Exempt Entities. Where a transaction includes a tax-exempt entity as a party, resolution for the taxpayer may require the tax-exempt entity to disburse any funds received as a result of the transaction. The tax-exempt entity may also in some circumstances be required to agree to the revocation of its exemption.

c. Multi-party Transaction. The IRS generally expects that all parties to a transaction (e.g., an employer and employee) will elect to resolve the transaction under this Initiative. The failure of all parties to the transaction to elect to resolve the transaction will not automatically preclude settlement for the electing parties. If all parties do not elect to participate in the Initiative, however, the IRS reserves the right to not settle with the electing parties if it is not in the interest of sound tax administration to do so.

2. Penalties. Except, as otherwise provided, a person that settles a transaction under the Initiative will pay an accuracy-related penalty on the underpayment attributable to the transaction in the percentage amount provided for in the Announcement. A person that properly disclosed the transaction under Announcement 2002-2, 2002-1 C.B. 304 will not pay a penalty on the underpayment attributable to the undisclosed transaction. For purposes of the Initiative at the discretion of the IRS, a person that received and relied upon a written tax opinion with respect to the treatment of the transaction under federal tax law before filing a return affected by the transaction will not pay a penalty on the underpayment attributable to that transaction if: (a) the tax opinion (i) concluded at a confidence level of at least "more likely than not" (a greater than 50% likelihood) that all significant federal tax issues arising out of the transaction will be resolved in the taxpayer's favor, and (ii) considered all the relevant facts and did not assume any unreasonable facts; and (b) the tax advisor: (i) was not a promoter or person related to a promoter, as defined above, (ii) was not referred to the taxpayer by a promoter or person related to a promoter, and (iii) did not have a fee arrangement contingent on the successful suspension of all or part of the intended tax benefit. All other applicable penalties and additions to tax will apply.

Application Process

A person who desires to resolve a transaction through the Initiative must send an election form (Form 13750, Election to Participate in Announcement 2005-80 Settlement Initiative) to the IRS on or before January 23, 2006. In addition to the information requested by the form, the IRS may request information relating to the transaction such as marketing materials and tax opinion letters. After the receipt of all the necessary information, the IRS will prepare a closing agreement reflecting the terms of the settlement. A person settling under the Initiative must pay all taxes, interest and penalties due under the terms of the settlement when the signed closing agreement is returned to the IRS. Any person unable to make full payment at the time must submit complete financial statements and agree to financial arrangements for payment acceptable to the IRS before the IRS will execute a closing agreement.

For more information, please contact Thomas W. Ostrander or any of the other attorneys of our Tax Practice Group or the attorney in the firm with whom you are regularly in contact.

This article is for general information and does not include full legal analysis of the matters presented. It should not be construed or relied upon as legal advice or legal opinion on any specific facts or circumstances. The description of the results of any specific case or transaction contained herein does not mean or suggest that similar results can or could be obtained in any other matter. Each legal matter should be considered to be unique and subject to varying results. The invitation to contact the authors or attorneys in our firm is not a solicitation to provide professional services and should not be construed as a statement as to any availability to perform legal services in any jurisdiction in which such attorney is not permitted to practice.

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