Introduction

Investments that yield tax benefits are sometimes called tax shelters. In some cases, Congress has concluded that the loss of revenue is an acceptable side effect of special tax provisions designed to encourage taxpayers to make certain types of investments. In many cases, however, losses from tax shelters produce little or no benefit to society, or the tax benefits are exaggerated beyond those intended. Those cases are called abusive tax shelters. An investment that is considered a tax shelter is subject to restrictions, including the requirement that it be registered, as discussed later, unless it is a projected income investment (defined later).

Topics

This chapter discusses:

• How to recognize an abusive tax shelter,
• Rules enacted by Congress to curb tax shelters,
• Investors' reporting requirements, and
• Penalties that may apply.

Useful Items

You may want to see:

Publication

• 538   Accounting Periods and Methods
• 556   Examination of Returns, Appeal Rights, and Claims for Refund
• 561   Determining the Value of Donated Property
• 925   Passive Activity and At-Risk Rules

Form (and Instructions)

• 8271   Investor Reporting of Tax Shelter Registration Number
• 8275   Disclosure Statement
• 8275-R   Regulation Disclosure Statement

See chapter 5 for information about getting these publications and forms.

Abusive Tax Shelters

Abusive tax shelters are marketing schemes that involve artificial transactions with little or no economic reality. They often make use of unrealistic allocations, inflated appraisals, losses in connection with nonrecourse loans, mismatching of income and deductions, financing techniques that do not conform to standard commercial business practices, or the mischaracterization of the substance of the transaction. Despite appearances to the contrary, the taxpayer generally risks little.

Abusive tax shelters commonly involve package deals that are designed from the start to generate losses, deductions, or credits that will be far more than present or future investment. Or, they may promise investors from the start that future inflated appraisals will enable them, for example, to reap charitable contribution deductions based on those appraisals. (But see the appraisal requirements discussed under Curbing Abusive Tax Shelters.) They are commonly marketed in terms of the ratio of tax deductions allegedly available to each dollar invested. This ratio (or write-off) is frequently said to be several times greater than one-to-one.

Since there are many abusive tax shelters, it is not possible to list all the factors you should consider in determining whether an offering is an abusive tax shelter. However, you should ask the following questions, which might provide a clue to the abusive nature of the plan.

• Do the tax benefits far outweigh the economic benefits?
• Is this a transaction you would seriously consider, apart from the tax benefits, if you hoped to make a profit?
• Do shelter assets really exist and, if so, are they insured for less than their purchase price?
• Is there a nontax justification for the way profits and losses are allocated to partners?
• Do the facts and supporting documents make economic sense? In that connection, are there sales and resales of the tax shelter property at ever increasing prices?
• Does the investment plan involve a gimmick, device, or sham to hide the economic reality of the transaction?
• Does the promoter offer to backdate documents after the close of the year? Are you instructed to backdate checks covering your investment?
• Is your debt a real debt or are you assured by the promoter that you will never have to pay it?
• Does this transaction involve laundering United States source income through foreign corporations incorporated in a tax haven and owned by United States shareholders?

Curbing Abusive
Tax Shelters

Congress has enacted a series of income tax laws designed to halt the growth of abusive tax shelters. These provisions include the following.

1. Passive activity losses and credits. The passive activity loss and credit rules limit the amount of losses and credits that can be claimed from passive activities and limit the amount that can offset nonpassive income, such as certain portfolio income from investments. For more detailed information about determining and reporting income, losses, and credits from passive activities, see Publication 925.
2. Registration of tax shelters. Generally, the organizers of certain tax shelters must register the shelter with the IRS. The IRS will then assign the tax shelter a registration number. If you are an investor in a tax shelter, the seller (or the transferor) must provide you with the tax shelter registration number at the time of sale (or transfer) or within 20 days after the seller or transferor receives the number if that date is later. See Investor Reporting, later, for more information about reporting this number when filing your tax return.
3. List of tax shelter investors. Organizers and sellers of any potentially abusive tax shelter must maintain a list identifying each investor. The list must be available for inspection by the IRS, and the information required to be included on the list generally must be kept for 7 years. See Transfer of interests in a tax shelter, later, for more information.
4. Appraisals of donated property. Generally, if you donate property valued at more than $5,000 ($10,000 in the case of privately traded stock), you must get a written qualified appraisal of the property's fair market value and attach an appraisal summary to your income tax return. The appraisal must be done by a qualified appraiser who is not the taxpayer, a party to a transaction in which the taxpayer acquired the property, the donee, or an employee or related party of any of the preceding persons. (Related parties are defined under Related Party Transactions in chapter 4.) For more information about appraisals, see Publication 561.
5. Interest on penalties. If you are assessed an accuracy-related or civil fraud penalty (as discussed under Penalties, later), interest will be imposed on the amount of the penalty from the due date of the return (including any extensions) to the date you pay the penalty.
6. Accounting methods and capitalization rules. Tax shelters generally cannot use the cash method of accounting. Also, uniform capitalization rules generally apply to producing property or acquiring it for resale. Under those rules, the direct cost and part of the indirect cost of the property must be capitalized or included in inventory. For more information, see Publication 538.

Projected income investment.   Special rules apply to a projected income investment. To qualify as a projected income investment, a tax shelter must not be expected to reduce the cumulative tax liability of any investor during any year of the first 5 years ending after the date the investment was offered for sale. In addition, the assets of a projected income investment must not include or relate to more than an incidental interest in:

1. Master sound recordings,
2. Motion picture or television films,
3. Videotapes,
4. Lithograph plates,
5. Copyrights,
6. Literary, musical, or artistic compositions, or
7. Collectibles (such as works of art, rugs, antiques, metals, gems, stamps, coins, or alcoholic beverages).

Tax shelters that qualify as projected income investments are not subject to the registration rules for tax shelters, described earlier. However, the requirement to maintain a list of investors that is in effect for tax shelters also applies to any projected income investment, except for one an investor later transfers. See Transfer of interests in a tax shelter, later.

A tax shelter that previously qualified as a projected income investment may later be disqualified if, in one of its first 5 years, it reduces the cumulative tax liability of any investor. In that case, the tax shelter becomes subject to the registration rules for tax shelters, described earlier.

Pre-filing notification letter.   If you are an investor in an abusive tax shelter promotion, the IRS may send you a pre-filing notification letter if it determines that it is highly likely that there is:

1. A gross valuation overstatement, or
2. A false or fraudulent statement regarding the tax benefits to be derived from the tax shelter entity or arrangement.

This letter will advise you that, based upon a review of the promotion, it is believed that the purported tax benefits are not allowable. The letter also will advise you of the possible tax consequences if you claim the benefits on your income tax return.

You also may receive a notification letter after you file your tax return. If you have already claimed the benefits on your tax return, you will be advised that you can file an amended return. However, any penalties that apply still can be asserted.

If you claim the benefits after receiving the pre-filing notification or if you fail to amend your return, you will be notified that your tax return is being examined. Normal audit and appeal procedures will be followed during the examination, and accuracy-related, civil or criminal fraud, and other penalties will be considered and, when appropriate, asserted. For information on the examination of returns, see Publication 556.

Revenue rulings.   The IRS has published numerous revenue rulings concluding that the claimed tax benefits of various abusive tax shelters should be disallowed. A revenue ruling is the conclusion of the IRS on how the law is applied to a particular set of facts. Revenue rulings are published in the Internal Revenue Bulletin for taxpayers' guidance and information and also for use by IRS officials. So, if your return is examined and an abusive tax shelter is identified and challenged, a published revenue ruling dealing with that type of shelter, which disallows certain claimed tax shelter benefits, could serve as the basis for the examining official's challenge of the tax benefits that you claimed. In such a case, the examiner will not compromise even if you or your representative believes that you have authority for the positions taken on your tax return.

The courts have generally been unsympathetic to taxpayers involved in abusive tax shelter schemes and have ruled in favor of the IRS in the majority of the cases in which these shelters have been challenged.

Investor Reporting

You may be required to provide the following information.

1. Tax shelter disclosure statement.
2. Tax shelter registration number.

Tax Shelter Disclosure Statement

For each reportable tax shelter transaction in which you participated directly or indirectly, you must attach a disclosure statement to your return for each year that your tax liability is affected by your participation in the transaction. In addition, for the first year a disclosure statement is attached to your return, you must send a copy to:

Internal Revenue Service
LM:PFTG:OTSA
Large & Mid-Size Business Division
1111 Constitution Avenue, NW
Washington, DC 20224.

Reportable tax shelter transaction.    Disclosure is required for a reportable tax shelter transaction that is a listed transaction. A transaction is a listed transaction if it is the same as or substantially similar to a transaction determined to be a tax avoidance transaction and identified as a listed transaction in a notice, regulation, or other published guidance. Notice 2001-51, in Internal Revenue Bulletin 2001-34, identifies these transactions. There may be subsequent guidance identifying additional listed transactions.

See section 1.6011-4T of the regulations for more details including:

• Definitions of reportable transaction, listed transaction, and substantially similar.
• Form and content of the disclosure statement.
• Filing requirements for the disclosure statement.

Beginning January 1, 2003, certain transactions not previously classified as reportable transactions must also be disclosed. You must use Form 8886, Reportable Transaction Disclosure Statement, to report transactions entered into after 2002. For more information, see the instructions for Form 8886.

Tax Shelter Registration Number

If you include on your tax return any deduction, loss, credit or other tax benefit, or any income, from an interest in a tax shelter required to be registered, you must report the registration number that the tax shelter provided to you. (See Registration of tax shelters, earlier.) Complete and attach Form 8271 to your return to report the number and to provide other information about the tax shelter and its benefits. You must also attach Form 8271 to any application for tentative refund (Form 1045) and to any amended return (Form 1040X) on which these benefits are claimed or income is reported. If you do not include the registration number with your return, you will be subject to a penalty of $250 for each such failure, unless the failure is due to reasonable cause.

Transfer of interests in a tax shelter.   If you hold an investment interest in a tax shelter and later transfer that interest to another person, you must provide the tax shelter's registration number to each person to whom you transferred your interest. (However, this does not apply if your interest is in a projected income investment, described earlier.) You must also provide a notice substantially in the following form:

You have acquired an interest in [name and address of tax shelter] whose taxpayer identification number is [if any]. The Internal Revenue Service has issued [name of tax shelter] the following tax shelter registration number: [number]. You must report this registration number to the Internal Revenue Service, if you claim any deduction, loss, credit, or other tax benefit or report any income by reason of your investment in [name of tax shelter]. You must report the registration number (as well as the name and taxpayer identification number of [name of tax shelter]) on Form 8271. Form 8271 must be attached to the return on which you claim the deduction, loss, credit, or other tax benefit or report any income. Issuance of a registration number does not indicate that this investment or the claimed tax benefits have been reviewed, examined, or approved by the Internal Revenue Service.

The following requirements also apply.

1. Maintaining a list. You must maintain a list identifying each person to whom you transferred your interest. Or, you may require a designated person or seller to maintain the list. However, see Special rule for projected income investment, later, for an exception to this requirement. If you choose to delegate this requirement, you must give the designated person or seller all of the information that you would otherwise have to maintain on the list.
2. Providing notice. If the tax shelter is not a projected income investment, described earlier, you must provide a notice to each person to whom you transferred your interest. This notice must be substantially in the following form:

If you do not maintain the required list of investors, or do not delegate a designated person or seller to maintain the list, you will be subject to a penalty of $50 for each person required to be on the list. But, you will not have to pay the penalty if you can show that the failure to comply with this requirement was due to reasonable cause and not willful neglect. The maximum penalty under this provision is $100,000 for each tax shelter in each calendar year.

Penalties

Investing in an abusive tax shelter may be an expensive proposition when you consider all of the consequences. First, the promoter generally charges a substantial fee. If your return is examined by the IRS and a tax deficiency is determined, you will be faced with payment of more tax, interest on the underpayment, possibly a 20% accuracy-related penalty, or a 75% civil fraud penalty. You may also be subject to the penalty for failure to pay tax. These penalties are explained in the following paragraphs.

Accuracy-related penalties.   An accuracy- related penalty of 20% can be imposed for underpayments of tax due to:

1. Negligence or disregard of rules or regulations,
2. Substantial understatement of tax, or
3. Substantial valuation misstatement.

This penalty will not be imposed if you can show that you had reasonable cause for any understatement of tax and that you acted in good faith.

If you are charged an accuracy-related penalty, interest will be imposed on the amount of the penalty from the due date of the return (including extensions) to the date you pay the penalty.

Negligence or disregard of rules or regulations.   The penalty for negligence or disregard of rules or regulations is imposed only on the part of the underpayment that is due to negligence or disregard of rules or regulations. The penalty will not be charged if you can show that you had reasonable cause for understating your tax and that you acted in good faith.

Negligence includes any failure to make a reasonable attempt to comply with the provisions of the Internal Revenue Code.

Disregard includes any careless, reckless, or intentional disregard. The penalty for disregard of rules and regulations can be avoided if both of the following are true.

• You have a reasonable basis for your position on the tax issue.
• You make an adequate disclosure of your position.

Use Form 8275 to make your disclosure, and attach it to your tax return. To disclose a position contrary to a regulation, use Form 8275-R.

Substantial understatement of tax.   An understatement is considered to be substantial if it is more than the greater of:

1. 10% of the tax required to be shown on the return, or
2. $5,000.

An understatement is the amount of tax required to be shown on your return for a tax year minus the amount of tax shown on the return, reduced by any rebates. The term rebate generally means a decrease in the tax shown on your original return as the result of your filing an amended return or claim for refund.

Two special rules apply in the case of an understatement due to a tax shelter.

1. An understatement of tax does not include any tax due to a tax shelter item (such as an item of income, gain, loss, deduction, or credit) if you had substantial authority for the tax treatment of the item and reasonably believed that the tax treatment chosen was more likely than not the proper one.
2. Disclosure of the tax shelter item on a tax return does not reduce the amount of the understatement.

For other than tax shelters, you can file Form 8275 or Form 8275-R to disclose items that could cause a substantial understatement of income tax. In that way, you can avoid the substantial understatement penalty if you have a reasonable basis for your position on the tax issue.

Also, the understatement penalty will not be imposed if you can show that there was reasonable cause for the underpayment caused by the understatement and that you acted in good faith. An important factor in establishing reasonable cause and good faith will be the extent of your effort to determine your proper tax liability under the law.

Valuation misstatement.   In general, you are liable for a 20% penalty for a substantial valuation misstatement if all of the following are true.

1. The value or adjusted basis of any property claimed on the return is 200% or more of the correct amount.
2. You underpaid your tax by more than $5,000 because of the misstatement.
3. You cannot establish that you had reasonable cause for the underpayment and that you acted in good faith.

You may be assessed a penalty of 40% for a gross valuation misstatement. If you misstate the value or the adjusted basis of property by 400% or more of the amount determined to be correct, you will be assessed a penalty of 40%, instead of 20%, of the amount you underpaid because of the gross valuation misstatement. The penalty rate is also 40% if the property's correct value or adjusted basis is zero.

Civil fraud penalty.   If there is any underpayment of tax on your return due to fraud, a penalty of 75% of the underpayment will be added to your tax.

Joint return.   The fraud penalty on a joint return applies to a spouse only if some part of the underpayment is due to the fraud of that spouse.

Failure to pay tax.   If a deficiency is assessed and is not paid within 10 days of the demand for payment, an investor can be penalized with up to a 25% addition to tax if the failure to pay continues.

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