Table of Contents
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 disclosed, as discussed later.
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How to recognize an abusive tax shelter,
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Rules enacted by Congress to curb tax shelters,
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Investors' reporting requirements, and
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Penalties that may apply.
Publication
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538 Accounting Periods and Methods
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556 Examination of Returns, Appeal Rights, and Claims for Refund
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561 Determining the Value of Donated Property
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925 Passive Activity and At-Risk Rules
Form (and Instructions)
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8275
Disclosure Statement -
8275-R
Regulation Disclosure Statement -
8283
Noncash Charitable Contributions -
8886
Reportable Transaction Disclosure Statement
See chapter 5 for information about getting these publications and forms.
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 Rules To Curb Abusive Tax Shelters, later.) 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.
Because 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.
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Do the tax benefits far outweigh the economic benefits?
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Is this a transaction you would seriously consider, apart from the tax benefits, if you hoped to make a profit?
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Do shelter assets really exist and, if so, are they insured for less than their purchase price?
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Is there a nontax justification for the way profits and losses are allocated to partners?
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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?
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Does the investment plan involve a gimmick, device, or sham to hide the economic reality of the transaction?
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Does the promoter offer to backdate documents after the close of the year? Are you instructed to backdate checks covering your investment?
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Is your debt a real debt or are you assured by the promoter that you will never have to pay it?
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Does this transaction involve laundering United States source income through foreign corporations incorporated in a tax haven and owned by United States shareholders?
Congress has enacted a series of income tax laws designed to halt the growth of abusive tax shelters. These provisions include the following.
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Disclosure of reportable transactions. You must disclose information for each reportable transaction in which you participate. See Reportable Transaction Disclosure Statement, later.
Material advisors with respect to any reportable transaction must disclose information about the transaction on Form 8918. This requirement applies to material advisors who provide material aid, assistance, or advice on any reportable transaction after October 22, 2004.
Material advisors will receive a reportable transaction number for the disclosed reportable transaction. They must provide this number to all persons to whom they acted as a material advisor. They must provide the number at the time the transaction is entered into. If they do not have the number at that time, they must provide it within 60 days from the date the number is mailed to them. For information on penalties for failure to disclose and failure to maintain lists, see Internal Revenue Code sections 6707, 6707A, and 6708.
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Requirement to maintain list. Material advisors must maintain a list of persons to whom they provide material aid, assistance, or advice on any reportable transaction after October 22, 2004. Before October 23, 2004, organizers and sellers who acted as material advisors with respect to any potentially abusive tax shelter (including a reportable transaction, discussed later) were required to maintain a list of persons involved in the tax shelter. 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 Regulations section 301.6112-1 for more information (including what information is required to be included on the list).
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Confidentiality privilege. The confidentiality privilege between you and a federally authorized tax practitioner does not apply to written communications made after October 21, 2004, regarding the promotion of your direct or indirect participation in any tax shelter.
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Appraisal requirement for donated property. If you claim a deduction of more than $5,000 for an item or group of similar items of donated property, you generally must get a qualified appraisal from a qualified appraiser and you must attach section B of Form 8283 to your tax return. If you claim a deduction of more than $500,000 for the donated property, you generally must attach the qualified appraisal to your tax return. For more information about appraisals, including exceptions, see Publication 561.
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Passive activity loss and credit limits. 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.
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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.
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Accounting method restriction. Tax shelters generally cannot use the cash method of accounting.
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Uniform capitalization rules. The 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.
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Denial of deduction for interest on an underpayment due to a reportable transaction. You cannot deduct any interest you paid or accrued on any part of an underpayment of tax due to an understatement arising from a reportable transaction (discussed later) if the relevant facts affecting the tax treatment of the item are not adequately disclosed. This rule applies to reportable transactions entered into in tax years beginning after October 22, 2004.
The IRS has published guidance concluding that the claimed tax benefits of various abusive tax shelters should be disallowed. The guidance is the conclusion of the IRS on how the law is applied to a particular set of facts. Guidance is published in the Internal Revenue Bulletin for taxpayers' information and also for use by IRS officials. So, if your return is examined and an abusive tax shelter is identified and challenged, published guidance 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.
You may be required to file a reportable transaction disclosure statement.
Use Form 8886 to disclose information for each reportable transaction in which you participated. Generally, you must attach Form 8886 to your return for each tax year in which you participated in the transaction. In certain circumstances, a transaction must be disclosed within 90 days of the transaction being identified as a listed transaction or a transaction of interest. In addition, for the first year Form 8886 is attached to your return, you must send a copy of the form to:
Internal Revenue Service
OTSA Mail Stop 4915
1973 North Rulon White Blvd.
Ogden, Utah 84404
If you fail to file Form 8886 as required or fail to include any required information on the form, you may have to pay a penalty. See Penalty for failure to disclose a reportable transaction later under Penalties.
The following discussion briefly describes reportable transactions. For more details, see the instructions for Form 8886.
A reportable transaction is any of the following.
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A listed transaction.
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A confidential transaction.
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A transaction with contractual protection.
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Loss transactions.
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Transactions of interest entered into after November 1, 2006.
Note.
Transactions with a brief asset holding period were removed from the definition of reportable transaction for transactions entered into after August 2, 2007.
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“Toggling” grantor trusts as described in Notice 2007-73, 2007-36 I.R.B. 545, available at www.irs.gov/irb/2007-36_IRB/ar20.html.
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Certain transactions involving contributions of a successor member interest in a limited liability company as described in Notice 2007-72, 2007-36 I.R.B. 544, available at www.irs.gov/irb/2007-36_IRB/ar19.html.
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% or 30% 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.
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Negligence or disregard of rules or regulations,
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Substantial understatement of tax, or
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Substantial valuation misstatement.
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10% of the tax required to be shown on the return, or
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$5,000.
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The value or adjusted basis of any property claimed on the return is 150% or more of the correct amount.
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You underpaid your tax by more than $5,000 because of the misstatement.
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You cannot establish that you had reasonable cause for the underpayment and that you acted in good faith.
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He or she knows, or reasonably should have known, that the appraisal would be used in connection with a return or claim for refund, and
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The claimed value of the property on a return or claim for refund, which is based on that appraisal, results in a substantial valuation misstatement or a gross valuation misstatement as discussed above.
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