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IRS explains how to apply accuracy related penalty to undisclosed listed transaction

Program Manager Technical Advice 2015-11

Click here for Program Managers Technical Advice 2015-11.

In legal advice issued to program managers (PMTA), IRS has explained how to apply the 30% accuracy-related penalty under Code Sec. 6662A(c), to taxpayers who didn’t disclose participation in a listed transaction that used cash value life insurance policies to provide welfare benefits.

Background. Under Code Sec. 6662A(a), a 20% accuracy-related penalty is imposed on reportable transactions understatements. However, Code Sec. 6662A(c) increases the penalty rate to 30% for the portion of any reportable transaction understatement for which the relevant facts affecting the tax treatment of the item were not adequately disclosed in accordance with regs under Code Sec. 6011.

A reportable transaction understatement is the sum of:

  • the amount of the increase (if any) in taxable income resulting from a difference between the proper tax treatment of an item subject to the penalty rules and the taxpayer’s treatment of the item (on the taxpayer’s tax return) multiplied by the highest noncorporate rate (corporate tax rate, in the case of a corporation), (Code Sec. 6662(b)(1)(A)) and
  • the amount of the decrease (if any) in the total amount of income tax credits which results from a difference between the taxpayer’s treatment of an item subject to the penalty rules (on the taxpayer’s tax return) and the proper tax treatment of the item. (Code Sec. 6662A(b)(1)(B))

Taxpayers who participate in reportable transactions and who are required to file tax returns must file a disclosure statement with their tax return and with each amended return reflecting their participation. (Reg. § 1.6011-4(a), Reg. § 1.6011-4(e)) A listed transaction is a type of reportable transaction. When a transaction becomes a listed transaction after a return is filed and before the end of the period of limitations on assessment for any year the taxpayer participated in the listed transaction, the taxpayer must file a disclosure statement within 90 days after the date the transaction became a listed transaction. (Reg. § 1.6011-4(e)(2)(i)) For years with assessment periods that ended before IRS issued the listing notice, Reg. § 1.6011-4(e) did not impose any disclosure obligation.

Facts. From 2003 through 2011, taxpayers participated in, but did not disclose, a listed transaction described in Notice 2007-83, 2007-2 CB 960, which describes abusive arrangements using cash-value life insurance policies purportedly to provide welfare benefits. On Oct. 17, 2007, when IRS issued Notice 2007-83, tax years 2004 and later were open for assessment.

One or more provisions applicable to the taxation of the benefits provided through the arrangement requires the taxpayer to include in income each year the fair market value of the insurance policy(ies) on the life of the taxpayer, but reduced by amounts previously included in income. Thus, where a taxpayer had not yet included any amount in income before the adjustment year, the entire amount would be includible in the adjustment year. Generally this amount would be the accumulation value (the policy’s cash value without regard to surrender charges) of the policy.

IRS made a single adjustment for the accumulated value of the insurance policies, in a year for which the assessment period remains open (the adjustment year).

Application of penalty tax to transaction. The PMTA answers a number of technical questions on how the Code Sec. 6662A penalty should be applied to the listed transaction that the taxpayers participated in from 2003 to 2011.

1. Where part of the accumulated value derives from a year before Notice 2007-83 was issued, but IRS is making the accumulated value adjustment in an open year after Notice 2007-83 was issued and for which the taxpayer failed to disclose the transaction, is the entire Code Sec. 6662A reportable transaction understatement penalty imposed at the 30% rate? The PMTA says the answer is “yes,” reasoning that IRS is making the accumulated-value adjustment in a year with an open assessment period, and the taxpayers did not disclose their participation on the return for that year. The fact that some of the accumulated value could have been reported in a closed year is not relevant. Of course, if the taxpayers had included any of the cash value in income in any year before the adjustment year, that amount would not be part of the accumulated-value adjustment in the adjustment year.
2. When computing the Code Sec. 6662A penalty, must IRS apportion the penalty between the closed year the transaction was not listed and the open years when it was listed and for which the taxpayers failed to disclose? The PMTA says the answer is “no,” because the reportable transaction understatement occurs in the adjustment year. Thus, under Code Sec. 6662(b)(1)(A), the increase (if any) in taxable income which results from a difference between the proper tax treatment of an item subject to the penalty rules and the taxpayer’s treatment of the item (on the taxpayer’s tax return) occurs in that adjustment year.
3. When proposing for the adjustment year an accumulated-value adjustment resulting from several years of participation in the listed transaction, which highest rate of tax applies for computing the Code Sec. 6662A penalty? The PMTA says that in the taxpayers’ case, to determine the reportable transaction understatement, the increase in taxable income resulting from the difference between the proper tax treatment and the taxpayers’ treatment is multiplied by the highest rate of tax imposed by IR 1for individuals for the year of adjustment, namely 39.6%.
4. Should IRS apportion the accumulated-value to a number of years and compute the penalty using the highest applicable tax rate for each year to that year’s portion? The PMTA says the answer is “no.” The penalty shouldn’t be apportioned over several years, nor should the highest rate be some blend of the highest rate from several years. Rather, the Code Sec. 6662A penalty is calculated from the adjustment made in the adjustment year, using the highest rate for that year.

References: For penalty for understatements regarding reportable transactions, see FTC 2d/FIN ¶  V-2281  ; United States Tax Reporter ¶  66,62A4  ; TaxDesk ¶  868,101  ; TG ¶  71645  .

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