I have attached a penalty notice to this blog. Take a look . The IRS is assessing $14,385 for the 2008 tax year, and the description given is a “Section 6707A” penalty.
This is one
of the most abusive penalties the IRS wields, in my opinion. As too often
happens, it may have been hatched for legitimate reasons, but it has degenerated
into something else altogether.
Let’s time
travel back to the early aughts. The IRS was taking a new direction in its
efforts against tax shelters: mandatory disclosure. There was a time when tax shelters involved
oil and gas or real estate and were mostly visible above the water line, but
the 1986 changes to the tax Code had greatly limited those schemes. In their
place were more sophisticated – and very hard to understand – tax constructions.
The planners were using obscure tax rules to separate wealth from its tax
basis, for example, with the intent of using the orphaned basis to create losses.
The IRS
promulgated disclosure Regulations under Section 6011. At first, they applied
only to corporations, but by 2004 they were expanded to include individual taxpayers.
The IRS wanted taxpayers to disclose transactions that, in the IRS’ view, were
potentially abusive. The IRS quickly recognized that many if not most taxpayers
were choosing not to report. There were several reasons for this, including:
· Taxpayers could consider a number of
factors in determining whether a transaction was reportable
· The gauzy definition of key terms and
concepts
· The lack of a uniform penalty
structure for noncompliance
The IRS
brought this matter to Congress’ attention, and Congress eventually gave them a
new shiny tax penalty in the 2004 American Jobs Creation Act. It was Section
6707A.
One of the
things that the IRS did was to disassociate the penalty from the taxpayer’s
intent or purpose for entering the transaction. The IRS published broad classes
of transactions that it considered suspicious, and, if you were in one, you
were mandated to disclose. The transactions were sometimes described in broad
brush and were difficult to decipher. Additionally, the transactions were
published in obscure tax corners and publications. No matter, if the IRS
published some transaction in the Botswana Evening Cuspidor, it simply assumed
that practitioners – and, by extrapolation, their clients – were clued-in.
If the IRS
decided that your transaction made the list, then you were required to disclose
the transaction on every tax return that included a tax benefit therefrom. If
the IRS listed the transaction after you filed a tax return but before the
statute of limitations expired, then you had to file disclosure with your next
tax return. You had to file the disclosure with two different offices of the
IRS, which was just an accident waiting to happen. And the disclosure had to be
correct and complete. If the IRS determined that it was not, such as if you
could not make heads or tails of their instructions for example, the IRS could consider
that the same as not filing at all. There were no brownie points for having
tried.
There’s
more.
The penalty applied
regardless of whether taxpayer’s underlying tax treatment was ultimately
sustained. In fact, the IRS was publishing reportable transactions BEFORE
proving in Court that any of the transactions were illegal or abusive. If you took
the IRS to Court and won, the IRS said it could still apply the penalty. There was
no exception to the imposition of the penalty, even if you could demonstrate
reasonable cause and good faith.
But there
was some mercy. Although you could not take the penalty to Court, you could
request the IRS Commissioner for rescission if it would “promote compliance …
and effective tax administration.” Oh please.
Can this get
worse? You bet.
Let’s decouple
the penalty from any possible tax benefit you may have gotten. If the transaction
was particularly suspicious (termed “listed’), the penalty was $100,000. Double
that if you were a company. What if the transaction occurred in your S
corporation and then on your personal income tax return because of the K-1 pass-through?
Well, add $200,000 plus $100,000 for a penalty of $300,000. Per year. What if
the tax benefit was a fraction of that amount? Tough.
This was a
fast lane to Tax Court. Wait, the penalty could not be appealed. Think about
that for a moment. The IRS has a penalty that cannot be appealed. What if the
system failed and the IRS assessed the penalty abusively or erroneously? Too bad.
The Taxpayer
Advocate publicly stated that the 6707A penalty should be changed as it “raises
significant constitutional concerns, including possible violations of the Eight
Amendment’s prohibition against excessive government fines and due process
protections.”
In response
to public clamor and pressure from Congress, the IRS issued moratoriums on
6707A enforcement actions. It wound up reducing the penalty for years after
2006 to 75% of the decrease in tax resulting from the transaction. There was
finally some governor on this runaway car.
My client
walked into Section 6707A long before I ever met him/her. How? By using a retirement
plan.
Yep, a
retirement plan.
The plan is
referred to as a 412(i), for the Code section that applies. A company would set
up a retirement plan and fund it with life insurance. Certain rules relaxed
once one used life insurance, as it was considered a more reliable investment
than the stock market. I was a fan of these plans, and I once presented a
412(i) plan to a former client who is (still) a sports commentator at ESPN.
Then you had
the promoters who had to ruin 412(i)) plans for everyone else. For example, here
is what I presented to the ESPN person. We would set up a company, and the company
would have one employee and one retirement plan. The plan would be funded with
life insurance. The plan would have to exist for several years (at least five),
and - being a pension plan - would have to be funded every year. Because life
insurance generally has a lower rate of return than the stock market, the IRS
would allow one to “over” fund the plan. After five years or more, we would
terminate the plan and transfer the cash value of the insurance to an IRA.
The
promoters made this a tax shelter by introducing “springing” life insurance.
They were hustling products that would have minimal cash value for a while –
oh, let’s say … the first five years. That is about the time I wanted to close the
plan and transfer to an IRA. Somehow, perhaps by magic, all that cash value
that did not previously exist would “spring” to life, resulting in a very tidy
IRA for someone. Even better, if there was a tax consequence when the plan
terminated, the cost would be cheap because the cash value would not “spring” until
after that point in time.
I thought a
412(i) plan to be an attractive option for a late-career high-income
individual, and it was until the promoters polluted the waters with springing
insurance nonsense. It then became a tax shelter, triggering Section 6707A.
My client
got into a 412(i). From what I can tell, he/she got into it with minimal understanding
of what was going on, other than he/she was relying on a professional who otherwise
seemed educated, sophisticated and impartial. The plan of course blew up, and
now he/she is facing 6707A penalties – for multiple tax years.
And right
there is my frustration with penalties of this ilk. Perhaps it makes sense if
one is dealing with the billionaires out there, but I am not. I am dealing with
businesspeople in Cincinnati who have earned or accumulated some wealth in
life, in most cases by their effort and grit, but nowhere near enough to have
teams of attorneys and accountants to monitor every fiat the government decides
to put out. To say that there is no reasonable cause for my client is itself abusive.
He/she could no more describe the tax underpinnings of this transaction any
more than he/she could land a man on the moon.
What
alternative remains to him/her? To petition the Commissioner for “rescission?”
Are you kidding me? That is like asking a bully to stop bullying you. I have
ten dollars on how that exercise will turn out.
