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:: Accuracy - Development of Potential Penalty Issues for Tax
Shelter Cases
Chapter 10: Audit
Techniques – Development of Potential Penalty Issues for Tax Shelter Cases
Objective
In developing a penalty, the examiner needs to determine what efforts
the taxpayer made to determine the correctness of the return position. The
examiner’s objective is to determine accountability for the return position, and
determine whether the paper trail corroborates the taxpayer’s position.
Of course, every effort
should be made to apply penalties in a fair and consistent manner. Penalties
should not be applied as "bargaining chips" or because the taxpayer was
uncooperative during the examination.
Inquiries
relating to accuracy-related penalty
Examiners should obtain information and documentation relating to the
following:
Does the taxpayer have
an underpayment of tax?
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What was the amount
shown on the return? Did the taxpayer file a qualified amended return?
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Are there any amounts
assessed before the return was filed that were not shown on the return, such as
termination assessment under IRC § 6861 or a jeopardy assessment under IRC §
6861?
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Are there any rebates?
Was the taxpayer
negligent?
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Did the taxpayer make a
reasonable attempt to comply with the Federal tax laws?
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Is the return position
reasonably based on one or more authorities? What type of authority? Does
the taxpayer have contemporaneous documentation to demonstrate consideration of
authorities?
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Did the taxpayer
disclose the return position on Form 8275? Did the taxpayer disclose a
reportable transaction on Form 8886?
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Did the taxpayer keep
adequate books and records?
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Can the taxpayer
substantiate the items properly?
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Is the transaction one
which would appear to a reasonable person “too good to be true”?
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Does the taxpayer have
an approval process to enter into a transaction of the size or dollar amount
involved? Did the taxpayer comply with this approval process? Obtain
copies of approval documents. Compare documents to similar approval
documents of like size company or taxpayer transactions for the same time
period.
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Who was responsible for
the decision to take the reporting position? Did the taxpayer obtain
advice from outside counsel or other tax professional? From whom?
What is the relationship, if any, between the outside counsel and the promoter?
Did the promoter refer the taxpayer to outside counsel? Did the taxpayer’s
inside counsel review or comment on the tax aspects of the transaction?
Did the taxpayer obtain the views of tax professionals other than the promoter,
the promoter’s agent or persons otherwise having a financial interest in the
promotion?
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After the transaction
began, what did the taxpayer do to monitor its progress? Did the taxpayer
have a “checksheet” or evaluation process in place to see that the various steps
in the transaction were accomplished?
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Did the taxpayer obtain
an appraisal or other valuation?
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Are there in-house, tax
advisor and/or consultant memoranda questioning the proposed return position?
Did the taxpayer
disregard a rule or regulation?
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Did the taxpayer
carelessly, recklessly or intentionally disregard a revenue ruling or a notice
(other than a notice of proposed rulemaking)?
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Does the taxpayer’s
position which is contrary to a revenue ruling or notice have a 1 in 3
likelihood of being sustained on the merits?
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Did the taxpayer
disclose the position that is contrary to a revenue ruling or notice on Form
8275?
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Is the transaction
reportable?
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Did the taxpayer
carelessly, recklessly or intentionally disregard a regulation?
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Is the taxpayer taking
the position that a regulation is invalid?
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Does the position
represent a good faith challenge to a regulation?
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Did the taxpayer
disclose the position that is contrary to a regulation on Form 8275-R? Did
the taxpayer disclose the position that the regulation is invalid on Form
8275-R?
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Did the taxpayer
disclose a reportable transaction on Form 8886?
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Is the Service’s
position which is believed to be contrary to the taxpayer’s position a
longstanding position or very recent position? In what manner was the
Service’s position disseminated?
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What evidence is there
in the return preparation workpapers that the taxpayer knew about the existence
of a contrary position?
Is there a substantial
understatement?
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What is the correct
income tax liability?
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What is the tax
reported by the taxpayer?
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Is the taxpayer
entitled to a reduction in the amount of the understatement under IRC §
6662(d)(2)(B)?
Is the amount of the
understatement $5,000 ($10,000 for a corporation)
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or 10% of the tax
required to be shown on the return?
Is the transaction a
tax shelter?
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Is the transaction a
plan or arrangement? Is a significant purpose of the transaction to avoid
or evade Federal income tax?
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Is there a legitimate
business purpose other than tax savings? To what extent was the taxpayer
influenced by tax benefits as opposed to investment potential?
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Why did the taxpayer
enter into the transaction?
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Why did the taxpayer
structure the transaction, adopt the accounting treatment or characterize the
assets in the manner that the taxpayer used?
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To what extent did the
taxpayer take steps to conceal the transaction (e.g., netting inside a
partnership or grantor trust)?
If the taxpayer is
not a corporation, did he have substantial authority and a
reasonable belief that the tax treatment of the item was more likely than not
the proper treatment?
Substantial
Authority:
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What authority supports
the taxpayer’s position? What authority contradicts the taxpayer’s
position? Note that different authorities carry different weight, e.g., a
regulation holds greater weight than a private letter ruling.
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Did the taxpayer
request, and rely on, a private letter ruling or a determination letter?
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Does the taxpayer have
contemporaneous documentation?
Reasonable
Belief:
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Did the taxpayer
analyze the facts and authorities? Did the taxpayer reasonably conclude in
good faith that there is a greater than 50 percent likelihood that the tax
treatment of the item will be upheld if challenged by the Service?
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Did the taxpayer
reasonably rely upon the opinion of a tax advisor? (See below for
inquiries relating to reliance on a tax opinion.) Did the tax advisor
unambiguously conclude that there is a greater than 50 percent likelihood that
the tax treatment of the item will be upheld if challenged by the Service?
Is there a valuation
misstatement?
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What is the value of
the property? What is the claimed value of the property?
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What is the adjusted
basis of the property? What is the claimed adjusted basis of the property?
Is the underpayment due
to fraud? The examiner should coordinate closely with local Chief Counsel
attorneys on cases involving potential fraud.
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What was the taxpayer’s
intent? Did the taxpayer intend to evade tax?
Was the underpayment due to inadvertence, reliance on incorrect advice, honest
indifference, negligence or carelessness?
Inquiries
relating to Reasonable Cause & Good Faith
What effort did the taxpayer make to assess the proper tax liability?
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Did the taxpayer rely
on an erroneous information return? Is the information contained on the
information return inconsistent with other information reported or otherwise
furnished to the taxpayer or with the taxpayer’s knowledge of the transaction?
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Was the underpayment
due to an isolated mathematical error?
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Is the taxpayer’s
position one in which the Service would issue a private letter ruling or
determination letter? If so, did the taxpayer request a private letter
ruling or determination letter? What was the outcome of the private letter
ruling or determination letter, e.g., favorable, adverse, withdrawal? Did
the taxpayer abide by the private letter ruling or determination letter?
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Did the taxpayer
attempt to conceal the transaction? If applicable, was the M-1 analysis
misleading? Did the taxpayer net transactions or provide incorrect or
misleading labels?
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Did the taxpayer
provide the difference between financial statements and tax returns without
concealment?
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Were there assurances
or statements made to a third party that characterized the transaction
differently for tax purposes?
What is the
sophistication of the taxpayer?
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What is the taxpayer’s
background, business experience, sophistication and education?
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Was there an honest
misunderstanding of fact or law that is reasonable in light of the facts?
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Does the taxpayer have
a history of entering into sophisticated or complex tax related transactions?
Did the taxpayer rely
upon the advice of a tax advisor? See below for inquiries relating to tax
advice.
Are there other facts
and circumstances that might apply that mitigate the taxpayer’s behavior or
suggest that a penalty should be imposed?
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Did the taxpayer
disclose under Announcement 2002-2, even though the taxpayer was not eligible to
do so? While taxpayers cannot avoid penalty consideration under
Announcement 2002-2, disclosure could be a mitigating factor.
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Has the taxpayer
engaged in other listed transactions or is this the only listed transaction the
taxpayer has attempted?
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Was the transaction
listed after the taxpayer filed the return? Did the taxpayer notify the
Service of the position after it was listed?
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Are there any meeting
notes, board statements, etc., consistent with the taxpayer’s assertion of
reasonable cause and good faith?
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If the transaction is
related to another segment of the business, was the other unit consulted or
informed?
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Were there assurances
or statements made to third parties that characterized the transaction in a
manner different from the characterization for tax purposes?
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Was the taxpayer’s
participation in the transaction subject to a confidentiality agreement?
Provide details.
In the case of a
corporation with a substantial understatement attributable to a tax shelter
item:
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Can the corporation
show legal justification?
Substantial
Authority:
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What authority supports
the taxpayer’s position? What authority contradicts the taxpayer’s
position? Note that different authorities carry different weight, e.g., a
regulation holds greater weight than a private letter ruling.
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Did the taxpayer
request, and rely on, a private letter ruling or a determination letter?
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Does the taxpayer have
contemporaneous documentation?
Reasonable
Belief:
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Did the taxpayer
analyze the facts and authorities? Did the taxpayer reasonably conclude in
good faith that there is a greater than 50 percent likelihood that the tax
treatment of the item will be upheld if challenged by the Service?
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Did the taxpayer
reasonably rely upon the opinion of a tax advisor? (See below for
inquiries relating to reliance on a tax opinion.) Did the tax advisor
unambiguously conclude that there is a greater than 50 percent likelihood that
the tax treatment of the item will be upheld if challenged by the Service?
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Did the corporation
participate in a tax shelter lacking significant business purpose?
Are the benefits
claimed by the taxpayer unreasonable compared to the benefits? What were
the risks to the taxpayer? Did the taxpayer have an out-of-pocket
investment?
Inquiries
Relating to Reliance on Advice
When a taxpayer claims reasonable reliance on the advice of a tax
advisor, always obtain a copy of the opinion(s). If the taxpayer refuses
to turn over the opinion(s) on privilege or other grounds, contact your subject
matter technical advisors or local Chief Counsel Attorney.
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How did the taxpayer
choose the tax advisor? Did they have a long standing relationship?
Did a promoter or other person with a financial interest in the transaction
refer the taxpayer to the advisor?
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Does the taxpayer have
a regular tax advisor? If the taxpayer did not consult with its regular
tax advisor, why not?
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Did the advisor prepare
the return? Why did the taxpayer use a different person to prepare the
return?
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How was the
compensation for the outside advice determined (e.g., time based, a flat fee, a
percentage of the tax savings, etc.)? Was there a compensation
arrangement, such as a referral fee or fee sharing arrangement, between the
author of the opinion and the person promoting, marketing or recommending the
tax shelter? Did the taxpayer have knowledge of any fee arrangement
between the advisor and a promoter? Obtain a copy of the invoice to
identify the source of the opinion, number of hours or other method used to
determine the fee and the date the work was done.
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What are the
credentials of the tax advisor? Does the tax advisor have any special
knowledge or expertise relating to the transaction or the underlying industry?
Did the advisor do its own research?
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Was the advice in
writing? In what format, e.g., opinion letter, offering materials, e-mail,
etc.? Did the taxpayer discuss the opinion or advice with the author of
the advice? If not, who explained the advice, e.g, in-house counsel?
Are there any contemporaneous notes or minutes relating to these discussions?
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Is the advice dated?
Are there contemporaneous documents that discuss the transaction or the advice?
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Is there an engagement
letter defining the scope of the opinion or advice? Does the opinion or
advice reflect the intent of the parties as outlined in the engagement letter?
Obtain a copy of the engagement letter to determine any limitations or
restrictions placed on the advice agreed to by the advisor and taxpayer.
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Does the opinion
identify and ascertain the facts and determine which are relevant? What
was the source of the documents used to ascertain the facts? Are the
facts in the opinion supported by the documents provided to the advisor?
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Are pertinent facts
assumed, and, if so, are the assumptions reasonable? For example, if the
opinion depends on a valuation, has an independent confirmation of the valuation
been made?
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Does the opinion relate
the applicable law (including potentially applicable judicial doctrines such as
the step transaction, business purpose, economic substance, substance over form,
and sham doctrines) to the relevant facts?
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If the opinion is based
upon hypothetical facts and assumptions, did the taxpayer seek independent
advice based on individual circumstances?
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Was the opinion or
advice marketed to several taxpayers? Were there additional marketing
and/or offering materials? Obtain a copy of the marketing and/or offering
materials.
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Did any of the
materials contain disclaimers, disclosures or other warnings that would suggest
the taxpayer should obtain outside advice based on individual circumstances?
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Does the opinion
consider all material Federal tax issues? Is the opinion limited to one or
more material Federal tax issue?
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Did the taxpayer seek
independent legal advice on the feasibility of the transaction or merely rely
upon a legal opinion provided by the outside vendor/promoter of the product at
issue or an agent of that vendor/promoter? Did the taxpayer obtain an
appraisal or a valuation?
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What kind of scrutiny
did the taxpayer perform of the outside advice before it was adopted? Did
the taxpayer have meetings or prepare analyses?
Did the taxpayer
actually follow the advice? Did the taxpayer enter into a transaction as
described in the advice, or were there material differences between the
transaction described in the advice and the transaction into which the taxpayer
entered?
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