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Accuracy-Related Penalties:

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Audit Techniques Guide

Accuracy-Related Penalties for Taxpayers Involved In Tax Shelter Transactions

Chapter 1 - Introduction

Publication Date - August, 2004

NOTE: This guide is current through the publication date. Since changes may have occurred after the publication date that would affect the accuracy of this document, no guarantees are made concerning the technical accuracy after the publication date.

Chapter 1: Introduction

Coverage
This audit technique guide (“ATG”) was developed to support the field in the consistent development and application of penalties when a taxpayer was involved in an abusive tax shelter, including “technical” tax shelters. This ATG is a Service-wide document, discussing penalty policy and considerations applicable to all taxpayers involved in tax shelter transactions.

This guide is not intended to be all inclusive. In most cases, the examiner should refer to additional sources of information, including listing notices and disclosure initiatives, even if there is a thorough discussion of the issue in this guide. Although this ATG includes information from existing position papers, audit technique guides, and CPE materials that deal with specific listed transactions and identified transactions that have not been listed, it is not intended to replace these materials. The examiner should consult the penalty handbook, related audit technique guides, appeals settlement guidelines, as well as subject matter advisors, technical advisors and local Chief Counsel Attorneys.

Overview
The consideration and assertion of penalties in audits involving tax shelters is vital to the Service’s efforts in addressing the proliferation of tax shelters. Appropriate administration of penalties seeks to ensure fairness and consistency in the administration of the tax law and seeks to effectively discourage noncompliant behavior. Examiners and managers should not use penalties as a bargaining point in the development or processing of cases. See Service Penalty Policy Statement (P–1–18) at .

Penalties should be considered and developed simultaneously with the examination of the tax shelter transaction, and not at the conclusion of the audit. Proper consideration and application of penalties will:

Encourage voluntary compliance;
Conserve IRS resources due to early disposition of tax shelter issues;
Provide clear guidance to taxpayers and practitioners;
Ensure consistent and fair treatment of the issues; and
Ensure that noncompliant behavior is penalized in appropriate circumstances.

Focus
This ATG focuses primarily on components of the accuracy-related penalty under IRC § 6662, the fraud penalty under IRC § 6663 and the definitions and special rules under IRC § 6664. Consider and develop the following penalties, if they apply:

Failure to file or to pay under IRC § 6651 (See IRM 20.1.2)
Failure to pay estimated taxes under IRC §§ 6654 or 6655 (See IRM 20.1.3)
Frivolous income tax return under IRC § 6702 (See IRM 20.1.10)
Failure to include tax shelter identification number on a return under IRC § 6707(b)(2) (See IRM 20.1.10)

In cases involving offshore arrangements, consider and develop the following penalties, if they apply:

Failure to file information returns under IRC §§ 6038, 6038A, 6038B, 6038C or 6039F (See IRM 20.1.9)
Failure to file information with respect to certain foreign trusts under IRC § 6677 (See IRM 20.1.9)
Failure to file returns, etc., with respect to foreign corporations or foreign partnerships under IRC § 6679 (See IRM 20.1.9)
Failure to file report of foreign bank and financial accounts under 31 USC § 5321(a)(5)(B)

In the most egregious cases, the examiner should consider whether criminal penalties might apply and the case should be referred to Criminal Investigation for further development of these issues. Some criminal penalties that may apply include:

Attempt to evade or defeat tax under IRC § 7201
Willful failure to file return, supply information, or pay tax under IRC § 7203
Fraudulent returns, statements, or other documents under IRC § 7207
Failure to obey summons under IRC § 7210

More information relating to penalty issues may be found on the IRS webpage at http://abusiveshelter.web.irs.gov/ATG/Penalties_atg.htm.

Tax Shelters
A tax strategy or scheme that shelters income from normal taxation is a tax shelter. Depending on the facts and legal analysis, a specific transaction or scheme may represent either lawful tax avoidance or unlawful tax evasion. For purposes of IRC § 6662, tax shelter includes, among other things, any plan or arrangement a significant purpose of which is the avoidance or evasion of Federal income tax. See discussion of the IRC § 6662 definition of tax shelter, infra.

A tax transaction or scheme that shelters income from normal taxation by taking a tax position that is not supported by tax law or manipulates the law in a manner that is not consistent with the intent of the law is considered to be an abusive tax shelter. Abusive tax shelters take various forms.

“Schemes or scams” are some of the easiest abusive tax shelters to detect and generally fall under the “too good to be true” category. These transactions are clearly unallowable or have no existing basis in law. Some of the schemes and scams that the Service has detected include claim of right (Rev. Rul. 2004-29); corporation sole (Rev. Rul. 2004-27); home-based business (Rev. Rul. 2004-32); removal from the tax system and chargeback debts (Rev. Rul. 2004-31); reparations (Rev. Rul. 2004-33); Section 861 (Rev. Rul. 2004-30); Section 911 (Rev. Rul. 2004-28); zero returns (Rev. Rul. 2004-34); and other frivolous arguments. In a news release and on the IRS webpage, the IRS publicizes, each year, the “dirty dozen” warning taxpayers of 12 common scams. The examiner should refer to this list and other sources, including “The Truth about Frivolous Tax Arguments,” located on the IRS webpage, when determining whether a taxpayer has engaged in a scheme or scam or has advanced other frivolous tax arguments.

The term abusive tax shelter commonly refers to a tax transaction or scheme that is highly technical and represents a strategy that is often marketed by an accounting or law firm. A “technical” tax shelter is distinguishable from a "scheme or scam" that finds no support in either the law or the facts. In the case of a technical tax shelter, the promoted tax benefits from the transaction may be supported by a strained, technical reading of the Code, regulations or rulings. In many cases, however, the promoted tax benefits are not actually available because the form of the transaction does not reflect its substance. In other cases, a tax avoidance strategy may find support in a possible interpretation of the law, although not the reading of the Code and regulations intended by Congress or the Secretary.

Technical tax shelters include “listed transactions” and other potentially abusive tax shelter transactions that have not been listed. A “listed transaction” is a transaction that the Service has officially notified taxpayers by notice, regulation, or other form of published guidance as potentially abusive and therefore subject to the disclosure requirements of the regulations under IRC § 6011. A listed transaction may include a transaction that is the same as or substantially similar to one of the types of transactions that the Service has determined to be a tax avoidance transaction and identified by notice, regulation, or other form of published guidance as a listed transaction for purposes of IRC §§ 6011 and 6112.

A technical tax shelter may take many different forms and can utilize many different structures. A single comprehensive definition of abusive tax shelters is difficult to formulate. Nevertheless, abusive technical tax shelters may have the following characteristics:

Lack of meaningful economic risk of loss or potential for gain;
Inconsistent financial and accounting treatment;
Presence of tax-indifferent parties;
Complexity without a reasonable business purpose;
Unnecessary steps or novel investments;
Promotion or marketing of tax benefits as a central component;
Confidentiality;
High transaction costs;
Risk reduction arrangements.

An abusive tax scheme is a specific tax transaction or scheme that reduces tax liability by taking a tax position that is not supported by tax law or manipulates the law in a manner inconsistent with the intent of the law. Abusive tax transactions or schemes may apply to either a large number of taxpayers or a limited number of taxpayers. These strategies and schemes may be organized and marketed and, if so, are often referred to as an abusive tax shelter.

Penalty Policy: Facts and Documentation to be Developed During the Examination
Consideration of penalties must be documented in all taxpayer examinations, including those involving tax shelters. A penalty must be developed as the audit progresses. Only after all facts and circumstances surrounding a penalty have been developed can a determination be made as to the application of appropriate penalties.

Audit technique guidelines for proper penalty development in LMSB and SB/SE examinations are included below.

Large and Mid-Size Businesses (LMSB)
On December 20, 2001, the LMSB Commissioner issued a memorandum providing guidelines for the consideration of the accuracy-related penalty in LMSB examinations. See 2. This memorandum requires agents to develop the accuracy-related penalty in all cases in which there is an underpayment of tax attributable to a listed transaction. On July 10, 2003, the LMSB Commissioner issued a memorandum providing that examiners should not develop the accuracy-related penalty in cases where the taxpayer filed and was considered qualified under the terms of Announcement 2002-2. This determination should be confirmed by the team manager, with no other approval required. The July 10, 2003 memorandum provides that, for cases not qualifying for treatment under the Disclosure Initiative outlined in Announcement 2002-2, consideration of penalties remains mandatory. See discussion of Announcement 2002-2, infra. If an underpayment of tax is attributable to a taxpayer’s participation in a listed transaction, the examiner must develop the accuracy-related penalty issues and prepare a written report supporting the recommendation to impose or not to impose the penalty. When an LMSB examiner identifies a new potentially abusive tax shelter transaction or promoter information, the examiner must contact LMSB Field Counsel as well as the Office of Tax Shelter Analysis (OTSA). See also Joint LMSB-SB/SE Memorandum dated August 21, 2003 at 4.

For a corporate tax shelter case involving a listed transaction, the decision to impose or not impose an accuracy-related penalty must be approved by the respective Director of Field Operations (DFO), in accordance with LMSB Commissioner Memorandum dated December 20, 2001.

Small Business/Self Employed (SB/SE)
Examiners should send promoter information to the Lead Development Center and contact the appropriate Technical Advisor in Compliance Policy, Reporting Enforcement, who is responsible for coordinating and assisting in the identification of the shelters. See Joint LMSB-SB/SE Memorandum dated August 21, 2003 at .

SB/SE employees should follow existing penalty provisions regarding managerial approval for imposing penalties in a tax shelter involving a listed transaction. See Joint LMSB-SB/SE Memorandum dated August 21, 2003. Existing penalty provisions for managerial approval of penalties are found in the IRM at 20.1.1.2.3 (Rev. 05/29/2002).

Managerial Approval of Penalties
IRC § 6751(b) requires that all penalties assessed after June 30, 2001, must first be personally approved in writing by either the immediate supervisor of the individual making the determination or a designated higher level official. See IRM 20.1.7.1.5(7).