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Senator seeks support to scale back the IRS’s assault on nondisclosure of alleged tax shelters due to constitutional concerns

Pursuant to requirements related to practice before the Internal Revenue Service, any tax advice contained in this communication is not intended to be used and cannot be used, for purposes of (i) avoiding penalties imposed under the United States Internal Revenue Code or (ii) promoting, marketing or recommending to another person any tax related matter.

Senator Ben Nelson (D-Nebraska) has sponsored legislation (S.765) to curtail the IRS and its nearly unlimited authority and power under Code section 6707A.  Senator Nelson is actively seeking co-sponsors of the bill.   The bill seeks to scale back the scope of the section 6707A reportable/listed transaction nondisclosure penalty to a more reasonable level.  The current law provides for penalties that are draconian by nature and offer no flexibility to the IRS to reduce or abate the imposition of the 6707A penalty.  This has served as a weapon of mass destruction for the IRS and has nit many small businesses and their owners with unconscionable results.

Internal Revenue Code 6707A was enacted as part of the American Jobs Creation Act on October 22, 2004.  It imposes a strict liability penalty for any person that failed to disclose either a listed transaction or reportable transaction per each occurrence.  Reportable transactions usually fall within certain general types of transactions (e.g. confidential transactions, transactions with tax protection, certain loss generating transaction, and transactions of interest arbitrarily so designated as by the IRS) that have the potential for tax avoidance. Listed transactions are specific transactions which have been publically designated by the IRS, including anything that is substantially similar to such a transaction (a phrase which is given very liberal construction by the IRS).  There are currently 34 listed transactions, including certain retirement plans under Code section 412(i) and certain employee welfare benefit plans funded in part with life insurance under Code sections 419A(f)(5), 419A(f)(6) and 419(e).  Many of these plans were implemented by small businesses seeking to provide retirement income or health and welfare benefits to their employees.

Strict liability mandates the IRS to impose the 6707A penalty regardless of the innocence of a person (i.e. whether the person knew that the transaction needed to be reported or not or whether the person made a good faith effort to report) or the level of the person’s reliance on professional advisors. A section 6707A penalty is imposed when the transaction becomes a reportable/listed transaction.  Therefore, a person has the burden to keep up to date on all transactions requiring disclosure by the IRS into perpetuity for transactions they have entered into in the past.

Additionally, the 6707A penalty strictly penalizes nondisclosure irrespective of taxes owed.  Accordingly, the penalty will be assessed even in legitimate tax planning situations when no additional tax is due but an IRS required filing was not properly and timely filed.  It is worth noting that a failure to disclose in the views of the IRS encompasses both a failure to file the proper form as well as a failure to include sufficient information as to the nature and facts concerns the transaction.  Hence, a person may find themselves subject to the 6707A penalty if the IRS determines that a filing did not contain enough information on the transaction.  A penalty is also imposed when a person does not file the required duplicate copy with a separate IRS office in addition to filing the required copy their return.

The imposition of a 6707A penalty is not subject to judicial review regardless of whether the penalty is imposed for a listed or reportable transaction.  Accordingly, the IRS’s determination is conclusive, binding, and final.  The next step from the IRS is sending your file to collection, where your assets may be forcibly taken, publically recorded liens may be placed against your property, and/or garnishment of your wages or business profits may occur, amongst other measures.

The 6707A penalty amount for each listed transaction is generally $200,000 per year per each person that is not an individual and $100,000 per year per each individual that failed to properly disclose each listed transaction. The 6707A penalty amount for each reportable transaction is generally $50,000 per year per each person that is not an individual and $10,000 per year per each individual that failed to properly disclose each reportable transaction.  The IRS is obligated to impose the listed transaction penalty by law and cannot remove the penalty.  The IRS is obligated to impose the reportable transaction penalty by law, as well, but may remove the penalty when the IRS determines that removal of the penalty would promote compliance and support effective tax administration.  As previously mentioned, the IRS’s decision to impose a 6707A penalty is final and not subject to judicial review, regardless of which penalty is imposed.

The 6707A penalty is particularly harmful in the small business context, where many business owners operate through an S corporation or limited liability company in order to provide liability protection to the owner/operators.  Numerous cases are coming to light where the IRS is imposing a $200,000 penalty at the entity level and then imposing a $100,000 penalty per individual shareholder or member per year.  The individuals are generally left with one of two options: 1.) declare bankruptcy or 2.) face a $300,000 penalty per year. Keep in mind that taxes do not need to be due nor does the transactions have to be proven illegal or illegitimate for this penalty to apply.   The only proof required from the IRS is that the person did not properly and timely disclose a transaction that the IRS believes the person should have disclosed.  It is important to note in this context that for nondisclosed listed transactions the statute of limitations does not begin until a proper disclosure is filed with the IRS.

Many practitioners believe the scope and authority given to the IRS under 6707A, which allows the IRS to act as judge, jury and executioner, is unconstitutional.  Numerous real life stories abound illustrating the punitive nature of the 6707A penalty and its application to small businesses and their owners.  In one case the IRS demanded that the business owner pay a 6707A total penalty of $600,000 for his and his business’ participation in a Code section 412(i) plan.  The actual taxes and interest on the transaction, assuming the IRS was correct in its determination that the tax benefits were not allowable, was $60,000.  Regardless of the IRS’s ultimate determination as to the legality of the underlying 412(i) transaction, the $600,000 was due as the IRS’s determination was final and absolute with respect to the 6707A penalty.   Another case involved a taxpayer who was a dentist and his wife whom the IRS determined had engaged in a listed transaction with respect to a limited liability company.   The IRS determined that the couple owed taxes on the transaction of $6,812, since the tax benefits of the transactions were not allowable.  In addition, the IRS determined that the taxpayers owed a $1,200,000 section 6707A penalty for both their individual nondisclosure of the transaction along with the nondisclosure of the offending transaction by the limited liability company.

Even IRS personnel continue to question both the legality and the fairness of the IRS’s imposition of 6707A penalties.   An IRS appeals officer in an email to a senior attorney within the IRS wrote that “…I am both an attorney and CPA and in my 29 years with the IRS I have never {before} worked a case or issue that left me questioning whether in good conscience I could uphold the government’s position even thought it is supported by the language of the law.”  The Taxpayer Advocate, an office with the IRS, even went so far as to publically assert that the 6707A should be modified as it “raises significant constitutional concerns, including possible violations of the Eighth Amendment’s prohibition against excessive government fines and due process protections.”

Senate bill 765, the bill sponsored by Senator Nelson, seeks to alleviate some of above cited concerns.  Specifically, the bill makes three major changes to the current version of Code section 6707A.  First, the bill would allow an IRS imposed 6707A penalty for nondisclosure of a listed transaction to be rescinded if a taxpayer’s failure to file was due to reasonable cause and not willful neglect.  Second, the bill would make a 6707A penalty proportional to an understatement of any tax due.  Third, would only allow the IRS to impose 6707A penalty on actual taxpayers.  Accordingly, nontax paying entity such as S corporations and limited liability companies would not be subject a 6707A penalty (individuals, C corporations, and certain trusts and estates would remain subject to the 6707A penalty).

As previously mentioned, Senator Nelson is currently seeking co-sponsors for Senate bill 765.  Additionally, the movement for a similar bill is currently gaining steam in the House.  Please contact your local Congressman and your Senators to voice your support for modifying Code section 6707A to adopt a fairer and more reasonable approach to disclosure.  Please feel free to contact our office if you would like assistance in any of your tax and penalty controversy needs.

David M. Henderson, CPA, JD, LLM
DUGGAN BERTSCH, LLC
Attorneys and Counselors at Law