Draconian Penalties and Second Opinions
(February 17, 2005)
Congressional reaction to the marketing of tax shelters has led to what can only be described as two draconian anti-tax avoidance penalties in the recently passed "Jobs Act" ("Act"). The Act includes two new, stiff, and accretive penalties of 20% and 30% of the tax on underreported income for taxpayers who engage in "reportable transactions" with a “significant” tax avoidance purpose. A "reportable transaction" is one that falls within any of six broad categories that must be disclosed to the IRS, e.g., a transaction that produces a large book to tax difference, and not just a transaction the IRS has listed as a tax shelter.
1. 30% Penalty – The 30% penalty applies when the IRS successfully challenges a “reportable transaction” that the taxpayer fails to report. There is no way to avoid this penalty if you fail to disclose the transaction, and it is extremely unlikely that the IRS would waive it. This penalty is in addition to other penalties that may apply, such as the negligence penalty.
2. 20% Penalty – The 20% penalty applies when the IRS successfully challenges a "reportable transaction" with claimed tax benefits that are supported only by the opinion of "a disqualified advisor," i.e., someone who promoted, implemented, or modified the transaction. This penalty also is in addition to other penalties that may apply.
A taxpayer can avoid the 20% penalty if it satisfies three requirements: 1) there was "substantial authority" for its position; 2) the taxpayer disclosed the transaction on a tax return affected by the transaction; and 3) the taxpayer reasonably believed that the tax treatment more likely than not was proper. The third requirement – reasonable belief that the tax treatment was proper – may be based upon either an in-house opinion or an opinion of an outside advisor who is not a disqualified advisor. An opinion from a non-disqualified outside advisor generally is preferable to an in-house opinion because IRS personnel are likely to view an in-house opinion as non-objective.
If cost or time constraints are a barrier to obtaining a second opinion, taxpayers can get the protection of a second opinion cheaper and faster by having an outside advisor review and comment upon an in-house opinion supporting the transaction. Alternatively, the outside advisor may give an opinion incorporating an in-house opinion by reference, and concurring with that opinion's conclusions and rationale.
In sum, the advent of the 30% and 20% penalties requires taxpayers to do two things: 1) have procedures in place to identify all "reportable transactions"; 2) disclose all "reportable transactions"; and suggests a third, i.e., obtain a second opinion on all "reportable transactions," either ab initio, or as a review of the taxpayer's in-house opinion.
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