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Abusive Trust Arrangements Utilizing Cash Value Life Insurance Policies Purportedly to Provide Welfare Benefits


Internal Revenue Bulletin:  2007-45 

November 5, 2007 

Notice 2007-83

Abusive Trust Arrangements Utilizing Cash Value Life Insurance Policies Purportedly to Provide Welfare Benefits



Table of Contents

The Internal Revenue Service (IRS) and Treasury Department are aware of certain trust arrangements claiming to be welfare benefit funds and involving cash value life insurance policies that are being promoted to and used by taxpayers to improperly claim federal income and employment tax benefits. This notice informs taxpayers and their representatives that the tax benefits claimed for these arrangements are not allowable for federal tax purposes. This notice also alerts taxpayers and their representatives that these transactions are tax avoidance transactions and identifies certain transactions using trust arrangements involving cash value life insurance policies, and substantially similar transactions, as listed transactions for purposes of § 1.6011-4(b)(2) of the Income Tax Regulations and §§ 6111 and 6112 of the Internal Revenue Code. This notice further alerts persons involved with these transactions of certain responsibilities that may arise from their involvement with these transactions.
Concurrently with this notice, the IRS is publishing Rev. Rul. 2007-65 (concluding that for purposes of deductions allowable to an employer under § 419, a welfare benefit fund’s qualified direct cost does not include premium amounts for cash value life insurance policies paid by the fund, whenever the fund is directly or indirectly a beneficiary under the policy within the meaning of § 264(a)), and Notice 2007-84 (describing trust arrangements involving purported welfare benefit funds that, in form, provide post-retirement medical and life insurance benefits to employees on a nondiscriminatory basis but, in operation, result in the owner or owners receiving all or a substantial portion of the post-retirement and other benefits, and all or a substantial portion of any assets distributed from the trust).

BACKGROUND

1. Promoted Arrangements

Trust arrangements utilizing cash value life insurance policies and purporting to provide welfare benefits to active employees are being promoted to small businesses and other closely held businesses as a way to provide cash and other property to the owners of the business on a tax-favored basis. The arrangements are sometimes referred to by persons advocating their use as “single employer plans” and sometimes as “419(e) plans.” Those advocates claim that the employers’ contributions to the trust are deductible under §§ 419 and 419A as qualified cost, but that there is not a corresponding inclusion in the owner’s income.
A promoted trust arrangement may be structured either as a taxable trust or a tax-exempt trust, i.e., a voluntary employees’ beneficiary association (VEBA) that has received a determination letter from the IRS that it is described in § 501(c)(9). The plan and the trust documents indicate that the plan provides benefits such as current death benefit protection, self-insured disability benefits, and/or self-insured severance benefits to covered employees (including those employees who are also owners of the business), and that the benefits are payable while the employee is actively employed by the employer. The employer’s contributions are often based on premiums charged for cash value life insurance policies. For example, contributions may be based on premiums that would be charged for whole life policies. As a result, the arrangements often require large employer contributions relative to the actual cost of the benefits currently provided under the plan.
Under these arrangements, the trustee uses the employer’s contributions to the trust to purchase life insurance policies. The trustee typically purchases cash value life insurance policies on the lives of the employees who are owners of the business (and sometimes other key employees), while purchasing term life insurance policies on the lives of the other employees covered under the plan.
It is anticipated that after a number of years the plan will be terminated and the cash value life insurance policies, cash, or other property held by the trust will be distributed to the employees who are plan participants at the time of the termination. While a small amount may be distributed to employees who are not owners of the business, the timing of the plan termination and the methods used to allocate the remaining assets are structured so that the business owners and other key employees will receive, directly or indirectly, all or a substantial portion of the assets held by the trust.
Those advocating the use of these plans often claim that the employer is allowed a deduction under § 419(c)(3) for its contributions when the trustee uses those contributions to pay premiums on the cash value life insurance policies, while at the same time claiming that nothing is includible in the owner’s gross income as a result of the contributions (or, if amounts are includible, they are significantly less than the premiums paid on the cash value life insurance policies). They may also claim that nothing is includible in the income of the business owner or other key employee as a result of the transfer of a cash value life insurance policy from the trust to the employee, asserting that the employee has purchased the policy when, in fact, any amounts the owner or other key employee paid for the policy may be significantly less than the fair market value of the policy. Some of the plans are structured so that the owner or other key employee is the named owner of the life insurance policy from the plan’s inception, with the employee assigning all or a portion of the death proceeds to the trust. Advocates of these arrangements may claim that no income inclusion is required because there is no transfer of the policy itself from the trust to the employees.

2. Intent to Challenge Transactions

The IRS intends to challenge the claimed tax benefits for the above-described transactions for various reasons. Depending on the facts and circumstances of a particular arrangement, contributions to a purported welfare benefit fund on behalf of an employee who is a shareholder may properly be characterized as dividend income to the owner, the value of which is includible in the owner’s gross income, and for which amounts are not deductible by the corporation. See Neonatology Associates v. Commissioner, 299 F.3d 221 (3d Cir. 2002). Depending on the facts and circumstances of a particular arrangement, the arrangement may properly be characterized as a plan deferring the receipt of compensation for purposes of § 404(a)(5), resulting in the application of the rules under § 404(a)(5) governing the timing of any otherwise available deductions. See Wellons v. Commissioner, 31 F.3d 569 (7th Cir. 1994). In addition, an arrangement may properly be characterized as a nonqualified deferred compensation plan for purposes of § 409A. Application of § 409A may result in immediate inclusion of income and additional taxes to the employee, as well as income tax withholding liabilities to the employer. The facts and circumstances of a particular arrangement may result in it coming within the definition of a split-dollar life insurance arrangement, so that the tax consequences to the employer and the employees are subject to the rules governing those types of arrangements, including potentially § 409A. Under the economic benefit regime of the split-dollar life insurance arrangement rules set forth in § 1.61-22, the employee must include in income the full value of the economic benefits provided to the employee under the arrangement for the taxable year without a corresponding employer deduction.
If, based on the facts and circumstances, an arrangement described above is properly characterized as a welfare benefit fund for purposes of §§ 419 and 419A (rather than a dividend arrangement, a plan deferring the receipt of compensation, or a split-dollar life insurance arrangement), an employer is allowed a deduction for contributions to the trust or other welfare benefit fund only to the extent allowed under §§ 419 and 419A. Under §§ 419 and 419A, no deduction is allowed with respect to premiums paid for life insurance coverage provided to current employees if the welfare benefit fund or the employer is directly or indirectly a beneficiary under the life insurance policy within the meaning of § 264(a). In the promoted arrangements discussed above, the trust typically retains rights in the life insurance policies and is directly or indirectly a beneficiary under the policies, so that no deduction is allowed with respect to the life insurance premiums. See Situation 1 in Rev. Rul. 2007-65. Further, any deduction with respect to uninsured benefits (for example, uninsured medical, disability, or severance benefits) is not based on the premiums paid on the life insurance policies, but is generally limited to claims incurred and paid during the year.[1] See Situation 2 in Rev. Rul. 2007-65. Thus, contrary to the claims made by persons advocating the use of the arrangements discussed above, premiums on cash value life insurance policies paid through the trust are not a justification for claiming a deduction under §§ 419 and 419A.
Moreover, in appropriate cases, the IRS intends to challenge the value claimed by the taxpayer for property distributed from the trust, including cash value life insurance policies.
The above conclusions apply whether the trust used to provide the plan benefits is a taxable trust or a VEBA. While the trust may have received a determination letter stating the trust is exempt under § 501(c)(9), a letter of this type does not address the tax deductibility of contributions to the trust with respect to the employer nor the income inclusion with respect to the employees.
The IRS has previously identified certain other transactions that claim to be welfare benefit funds as listed transactions, concluding that the tax benefits claimed to be generated by these transactions are not allowable for federal income tax purposes. Notice 2003-24, 2003-1 C.B. 853, describes certain transactions purporting to meet the exception under § 419A(f)(5) for collectively bargained plans and identifies those and substantially similar transactions as listed transactions, and Notice 95-34, 1995-1 C.B. 309, describes transactions that purport to meet the 10-or-more employer plan exception under § 419A(f)(6). The transactions described in Notice 95-34 and substantially similar transactions have also been identified as listed transactions. See Notice 2004-67, 2004-2 C.B. 600.

LISTED TRANSACTIONS

1. Transactions Identified As Listed Transactions

Any transaction that has all of the following elements, and any transaction that is substantially similar to such a transaction, are identified as “listed transactions” for purposes of § 1.6011-4(b)(2) and §§ 6111 and 6112, effective October 17, 2007, the date this notice is released to the public.
(1) The transaction involves a trust or other fund described in § 419(e)(3) that is purportedly a welfare benefit fund.
(2) For determining the portion of its contributions to the trust or other fund that are currently deductible the employer does not rely on the exception in § 419A(f)(5)(A) (regarding collectively bargained plans).
(3) The trust or other fund pays premiums (or amounts that are purported to be premiums) on one or more life insurance policies and, with respect to at least one of the policies, value is accumulated either:
(a) within the policy (for example, a cash value life insurance policy); or
(b) outside the policy (for example, in a side fund or through an agreement outside the policy allowing the policy to be converted to or exchanged for a policy which will, at some point in time, have accumulated value based on the purported premiums paid on the original policy).
(4) The employer has taken a deduction for any taxable year for its contributions to the fund with respect to benefits provided under the plan (other than post-retirement medical benefits, post-retirement life insurance benefits, and child care facilities) that is greater than the sum of the following amounts:
(a) With respect to any uninsured benefits provided under the plan,
(i) an amount equal to claims that were both incurred and paid during the taxable year; plus
(ii) the limited reserves allowable under § 419A(c)(1) or (c)(3), as applicable; plus
(iii) amounts paid during the taxable year to satisfy claims incurred in a prior taxable year (but only to the extent that no deduction was taken for such amounts in a prior year); plus
(iv) amounts paid during the taxable year or a prior taxable year for administrative expenses with respect to uninsured benefits and that are properly allocable to the taxable year (but only to the extent that no deduction was taken for such amounts in a prior year).
(b) With respect to any insured benefits provided under the plan,
(i) insurance premiums paid during the taxable year that are properly allocable to the taxable year (other than premiums paid with respect to a policy described in (3)(a) or (b) above); plus
(ii) insurance premiums paid in prior taxable years that are properly allocable to the taxable year (other than premiums paid with respect to a policy described in (3)(a) or (b) above); plus
(iii) amounts paid during the taxable year or a prior taxable year for administrative expenses with respect to insured benefits and that are properly allocable to the taxable year (but only to the extent that no deduction was taken for such amounts in a prior year).
(c) For taxable years ending prior to November 5, 2007, with respect to life insurance benefits provided through policies described in (3)(a) and (b) above, the greater of the following amounts:[2]
(i) in the case of an employer with a taxable year that is the calendar year, the aggregate amounts reported by the employer as the cost of insurance with respect to such policies on the employees’ Forms W-2 (or Forms 1099) for that year, plus an amount equal to the amounts that would have been reportable on the employees’ Forms W-2 for that year, but for the exclusion under section 79 (relating to the cost of up to $50,000 of coverage); or, in the case of an employer with a taxable year other than the calendar year, the portions of the aggregate amounts reported by the employer on the Forms W-2 (or Forms 1099) as described in (i), above, (or that would have been reported absent the exclusion under § 79) that are properly allocable to the employer’s taxable year; and
(ii) with respect to each employee insured under a cash value life insurance policy, the aggregate cost of insurance charged under the policy or policies with respect to the amount of current life insurance coverage provided to the employee under the plan (but limited to the product of the current life insurance coverage under the plan multiplied by the current year’s mortality rate provided in the higher of the 1980 or 2001 CSO Table).
(d) The additional reserve, if any, under § 419A(c)(6) (relating to medical benefits provided through a plan maintained by a bona fide association), but only to the extent amounts are not already included above in this paragraph (4), and only to the extent that no deduction was taken for such amounts in a prior taxable year.

2. Participation in the Listed Transactions

Whether a taxpayer has participated in the listed transaction described in this notice will be determined under § 1.6011-4(c)(3)(i)(A). However, an individual who is not the employer will be treated as a participant for a taxable year if, and only if the individual owns, directly or indirectly, 20 percent or more of an entity, other than a C corporation, that is a participant in the listed transaction for the taxable year. For this purpose, indirect ownership is determined under rules similar to the rules of § 318 but without regard to the family attribution rules of § 318(a)(1).

3. Disclosure, List Maintenance, and Registration Requirements; Penalties; Other Considerations

In general, if a taxpayer has participated in a listed transaction, the rules of §  1.6011-4(e) determine when a disclosure statement must be filed by the taxpayer. However, if, under § 1.6011-4(e), a taxpayer is required to file a disclosure statement with respect to the listed transaction described in this notice after October 17, 2007, and prior to January 15, 2008, that disclosure statement will be considered to be timely filed if the taxpayer alternatively files the disclosure statement with the Office of Tax Shelter Analysis (OTSA) by January 15, 2008.
Some transactions described in Notice 95-34 and substantially similar transactions may be identified as a listed transaction in this notice also. It should be noted that, independent of their classification as “listed transactions” for purposes of § 1.6011-4(b)(2) and §§ 6111 and 6112, transactions that are the same as, or substantially similar to, the transaction identified in this notice may already be subject to the requirements of §§ 6011, 6111, 6112, or the regulations thereunder. Persons required to disclose these transactions under § 1.6011-4 and who fail to do so may be subject to the penalty under § 6707A.[3] Persons required to disclose or register these transactions under § 6111 who have failed to do so may be subject to the penalty under § 6707(a). Persons required to maintain lists of investors under § 6112 who fail to do so (or who fail to provide such lists when requested by the IRS) may be subject to the penalty under § 6708(a).
In addition, the IRS may impose other penalties on persons involved in this transaction or substantially similar transactions (including the accuracy-related penalty under § 6662 or 6662A) and, as applicable, on persons who participate in the promotion or reporting of this transaction or substantially similar transactions (including the return preparer penalty under § 6694, the promoter penalty under § 6700, and the aiding and abetting penalty under § 6701).
Further, under § 6501(c)(10), the period of limitations on assessment may be extended beyond the general three-year period of limitations for persons required to disclose transactions under § 1.6011-4 who fail to do so. See Rev. Proc. 2005-26, 2005-1 C.B. 965.
The IRS and the Treasury Department recognize that some taxpayers may have filed tax returns taking the position that they were entitled to the purported tax benefits of the types of transactions described in this notice. These taxpayers should consult with a tax advisor to ensure that their transactions are disclosed properly and to take appropriate corrective action.


Accountants Get Fined By IRS And Sued By Their Clients


Accountants Get Fined By IRS And Sued By Their Clients



    By Lance Wallach, CLU, CHFC Abusive Tax Shelter, Listed Transaction, Reportable Transaction 
Expert Witness




Form 8886 is required to be filed by any taxpayer who is participating, or in some cases has participated, in a listed or reportable transaction.

New BISK CPEasy™ CPE Self-Study Course

CPA’s Guide to Life Insurance

Author/Moderator: Lance Wallach

Below is an exert from one of Lance Wallach’s new books.
Lance Wallach

What attracted the most attention with respect to it, until very recently, were the penalties for failure to file, which were $100,000 annually for individuals and $200,000 annually for corporations. Recent legislation has reduced those penalties in most cases. However, there is still a minimum penalty of $5,000 annually for an individual and $10,000 annually for a corporation for failure to file. And those are the MINIMUM penalties. If the minimum penalties do not apply, the annual penalty becomes 75 percent of whatever tax benefit was derived from participation in the listed transaction, and the penalty is applied both to the business and to the individual business owners. Since the form must be filed for every year of participation in the transaction, the penalties can be cumulative; i.e., applied in more than one year. For example, a corporation that participated in five consecutive years could find itself, depending on the amount of claimed tax deductions, looking at several hundred thousand dollars in fines, even under the recently enacted legislation, before even thinking about back taxes, penalties, interest, etc., that could result from an audit. Even the minimum fine would be $15,000 per year, again in addition to all other applicable taxes and penalties, etc. So even the minimum fines could mount up fast.

The penalties can also be imposed for incomplete, inaccurate, and/or misleading filings. And the Service itself has not provided totally clear, unequivocal guidance to those hoping to avoid errors and penalties. To illustrate this point, Lance Wallach, a leading authority in this area who has received hundreds of calls and whose associates have literally aided dozens of taxpayers in completing these forms, reports that his associates, on numerous occasions, have sought the opinions and assistance of Service personnel, usually from the Office of Chief Counsel, with respect to questions arising while assisting taxpayers in completing and filing the form. The answers are often somewhat vague, and tend to be accompanied by a disclaimer advising not to rely on them.

One popular type of listed transaction is the so-called welfare benefit plan, which once relied in IRC Section 419A(F)(6) for its authority to claim tax deductions, but now more commonly relies on Section 419(e). The 419A(F)(6) plans used to claim that that section completely exempted business owners from all limitations on how much tax could be deducted. In other words, it was claimed, tax deductions were unlimited. These plans featured large amounts of life insurance and accompanying large commissions, and were thus aggressively pushed by insurance agents, financial planners, and sometimes even accountants and attorneys. Not to mention the insurance companies themselves, who put millions of dollars in premiums on the books and, when confronted with questions about the outlandish tax claims made in marketing these plans, claimed to be only selling product, not giving opinions on tax questions.

In the summer of 2003, the Service issued guidance that had the effect of severely curtailing those plans, and they began to largely, though not completely, disappear from the landscape. Most welfare benefit plans now claim Section 419(e) as the authority to claim a corporate tax deduction, though the promoters of these plans no longer claim that tax deductions are unlimited. Instead, they acknowledge that the amount of possible tax deductions is limited by the limitations of Section 419A, which Code section is a limitation on tax deductions that are authorized by other sections.

With respect to Section 419(e) welfare benefit plans, and of particular importance in this listed transaction/penalties arena, were the events of October 17, 2007, which over time have had roughly the same effect on Section 419(e) welfare benefit plans as the aforementioned 2003 developments had on Section 419A(F)(6) plans. On that date, the Service issued Notice 2007-83, which identified certain trust arrangements involving cash value life insurance policies, and substantially similar arrangements, as listed transactions. Translation: Section 419(e) welfare benefit plans that are funded by cash value life insurance contracts are listed transactions, at least if a tax deduction is taken for the amount of premiums paid for such policies. On that same day, the Service also issued Notice 2007-84 and Revenue Ruling 2007-65. The combined effect of these three IRS pronouncements was that not only was the use of cash value life insurance in welfare benefit plans, if combined with claiming tax deductions for the premiums paid, sufficient to cause IRS treatment of these plans as listed transactions, but that discrimination as between owners and rank and file employees in these plans was also being targeted.
To illustrate, in many of these promoted arrangements, these Section 419(e) welfare benefit plans, cash value life insurance policies are purchased on the lives of the owners of the business, and sometimes on key employees, while term insurance is purchased on the lives of the rank and file employees. The plans in question tend to anticipate that the plan will be terminated within five years or so, at which time the cash value policies will be distributed to the owners, and possibly key employees, with very little distributed to rank and file employees. In general, the Internal Revenue Code will not countenance the claiming of a tax deduction in connection with a welfare benefit plan where such blatant unequal treatment (discrimination) is exhibited. Nevertheless, plan promoters claim that insurance premiums are currently deductible by the business, and that the insurance policies, when distributed to the owners, can be done so virtually tax-free. And this also despite the fact that an employer’s deductions for contributions to an arrangement that is properly characterized as a welfare benefit fund are subject to the limitations and requirements of the rules in IRC sections 419 and 419A, including the use of reasonable actuarial assumptions and the satisfaction of nondiscrimination requirements.

With respect to the preparation and filing of Form 8886, incidentally, it should not surprise that welfare benefit promoters have been active in this area. This would include both the promoters of plans that have been listed transactions for years as well as those that became listed transactions, at least arguably, by virtue of the previously discussed October 2007 IRS activities. Some promoters take the position that their plans are completely compliant and that, therefore, there is no need to file Form 8886. Others take a more precautionary approach. While never admitting to being a listed transaction, they do urge clients to file on a protective basis. At least one went so far as to offer plan participants complete guidance and instructions about precisely how to file protectively. Many, if not most, plan promoters have, at the very least, forwarded completed sample forms to plan participants for guidance and use in completing Form 8886. It is certainly possible to file protectively. Any remotely good faith belief that the transaction is not a listed one justifies the protective filing. In fact and practice, the Service is actually treating protective filings in the same manner as other filings.

But while many plan promoters have recognized the filing obligation and recommended filing, this has led to another problem. As previously noted, they have been instructing taxpayers on how to complete and file the form, and the problem is that their guidance, in many cases, has not been particularly helpful and sometimes dangerous. In some cases, though this is difficult if not impossible to ascertain, the suggestions of the plan promoters seem designed more to protect the promoters than to assist the taxpayer. While this is a difficult call to make, it is absolutely clear, Wallach says, that more than one promoter, whether carelessly or otherwise, has sent taxpayers outdated forms to complete and file. Wallach, who you may recall has, between himself and his associates, aided dozens of taxpayers in completing and filing Form 8886, notes that his associates have frequently reported this problem. They also report never having seen a Form 8886 prepared completely correctly, especially where a promoter’s instructions were relied on. So, because the fines may be imposed for incomplete, misleading, or incorrect filings, the danger to plan participants can be clearly seen. And the taxpayer who discovers errors subsequent to filing must decide whether to amend the filing or not, which some plan participants are reluctant to do.



Burdens On Professionals With Clients In Welfare Benefit Plans And Other Listed Transactions



Form 8918 must be filed with the Internal Revenue Service by all “material advisors” to clients who are participating in listed transactions. Exactly who, then, is a material advisor? You are a material advisor if three requirements are satisfied. First, the client must actually be participating in the listed transaction. Second, you must have given the client tax advice with respect to the transaction. This does not necessarily mean that you recommended participation. For example, signing off on a tax return claiming a tax deduction for participation in the listed transaction surely qualifies as having given tax advice with respect to the transaction. In fact, even if you recommended against participation, you would satisfy this threshold so long as you rendered tax advice, be it positive, negative, or neutral.

The third threshold is that you must have received $10,000 or more in compensation (yourself and/or a related entity). This is not quite as simple as it sounds. The money need not all be received as a commission (as might be the case with a CPA who is insurance licensed), or even in a lump sum for accounting services rendered in connection with the client’s participation. The money could be received periodically over time. It is even possible that, so long as $10,000 in fees has been received from the client for whatever reason over whatever period of time, the threshold is met. Lance Wallach, previously referred to in the discussion about Form 8886 and whose associates are also expert in assisting CPAs and others in the preparation and filing of Form 8918, reports that one of his associates put this question directly to an attorney in the Office of the Chief Counsel who actually wrote published IRS guidance with respect to Form 8918. While the gentleman from the IRS was very courteous and professional, trying his best to be of assistance, a clear, unqualified, unequivocal answer that could be “taken to the bank” proved impossible to elicit.

Like Form 8886, however, Form 8918 can be filed protectively. Failure to file or incomplete, misleading, or inaccurate filings can lead to the penalties that used to apply to Form 8886, to wit: $100,000.00 for individuals and $200,000.00 for corporations. For this purpose, it is CRITICAL to note that the recent legislation reducing penalties applied ONLY to Form 8886. The penalties for failure to file Form 8918, or for filing it incorrectly, remain the same as they were, to wit: $100,000 for individuals and $200,000 for corporations.

A good faith belief that either you did not receive $10,000 in income or that the transaction in question is not a listed one enables you to file on a protective basis. And, in fact, as with the 8886 form, the IRS is, in fact, treating all filings identically in any event.

When the CPA files this form (it need only be filed once, not on an annual basis, as Form 8886 must be), the CPA is assigned a number by the IRS. The CPA or other professional then gives this number to all of his affected clients, who are required to report it on the 8886 forms that they must file. Also, as a perusal of Form 8918 makes clear, there is also a section where the material advisor is to give all pertinent information with respect to other material advisors who participated in and/or advised the client with respect to the transaction in question.

As with Form 8886, this area is replete with horror stories about advisors who, mostly innocently, have fallen into this trap. One that we know of was sold by one promoter on a questionable plan, recommended it to about fifteen clients, and now has been forced to file the 8918 form, help all those involved who have to file Form 8886, and expend a fair amount of his own funds, both to find people who can assist his clients with Form 8886 and in “rescuing” clients who want to get out of this plan. Another called about something else, and was horrified to discover that he had six clients in a plan that is a listed transaction. When he was apprised of his situation, he sank into a depression. These are only two of the dozens of sad, and worse, stories in this area that we have been privy to. The second person, for example, had no idea that anything was wrong. He initially called about something totally unrelated. There have even been instances of professional discipline being imposed in connection with this area, of CPAs being threatened with and perhaps even actually suffering loss of their licenses. Such is the terrain in which the CPA must now operate.

Another problem is possible, especially if you recommended that the client participate. Most practitioners are familiar with situations where, when things go wrong, clients often develop selective memory failure. This happens here, as it does elsewhere. At best, it can lead to you spending an inordinate amount of time, and perhaps money, on what is essentially a thankless exercise. At worst, if the situation worsens to the point where a lawsuit may be in the air, you could find yourself the subject of some sort of client complaint or, worse, a named defendant in a lawsuit, in which case your malpractice carrier would become involved, with all of the negative effects upon yourself and your practice that that could entail.

Section 6707A – Past, Present, and Future


Returning now to the Form 8886 aspect of Section 6707A, the disclosure requirement that applies to actual participants in listed transactions, it has been noted, and discussed, that Congress recently reduced the penalties under Section 6707A for many taxpayers. But it is still imperative to realize that this is only a partial solution to the continuing problem caused by the penalties imposed by that section. While the penalties have been reduced from the prior patently ridiculous, and probably illegal, level that until so recently prevailed, they are still sufficient, in many cases, to put business owners out of business, just as the prior penalties obviously were. And since the new legislation did not address or affect obligations and penalties with respect to Form 8918 at all, accountants, insurance professionals and other material advisors are as likely to be hurt as ever.

Whatever the underlying Congressional intent was in enacting the original Section 6707A in 2004, whatever Congress hoped to accomplish, the statute as it was written imposed clearly unconscionable burdens on taxpayers. Penalties of up to $300,000 annually could be imposed on taxpayers who had not underpaid tax and who had no knowledge that they had entered into transactions that the IRS deems “listed”.

Tax provisions are seldom found to violate the United States Constitution, but it is certainly arguable that the imposition of such a large penalty on a taxpayer who entered into a transaction that produced little or even no tax savings and without regard to the taxpayer’s knowledge or intent violates the Eighth Amendment prohibition on excessive fines, etc. In practice, the requirement that this penalty be imposed without regard to culpability often had the effect of bankrupting middle class families who had no intention of entering into a tax shelter – an outcome that dismayed even hardened IRS enforcement personnel.

The section previously imposed a penalty of $100,000 per individual and $200,000 per entity for each failure to make special disclosures with respect to a transaction that the Treasury Department characterizes as a “listed transaction” or “substantially similar” to a listed transaction. A listed transaction is one that is specifically identified as such by published IRS guidance. The question of what is “substantially similar” to such a transaction is increasingly troublesome, especially given the ever broadening IRS definition of the term, beginning with Treasury Decision 9,000, which declared, on June 18, 2002, that, from that date forward, the term “substantially similar” would be construed more broadly by the Service than it had up until that time. This started a trend that continues to this day.

It is important for the reader to understand that the only thing that was accomplished by the new, amended Section 6707A is a reduction in the penalties. The penalties are still severe, severe enough to seriously damage or even bankrupt most small businesses. And professional readers must understand that there has been no effect on their obligations at all, and that the same (in their case, even more severe) fines still apply.

For example, the following eleven statements are equally applicable to the new Section 6707A as they are to its predecessor:

1. The penalty applies without regard to whether the small business or the small business owners have knowledge that the transaction has been listed.

2. The penalty applies even if the small business and/or the small business owners derived no tax benefit from the transaction. Even under the new legislation, there are substantial minimum penalties that are applied even if there has been no tax benefit.

3. The penalty is applied at multiple levels, which is devastating to small businesses; the result is that the small business and its owners are hit with multiple penalties. The two most common problems are that fines are imposed on both the business entity and the owners as individuals, and also that fines are imposed each year, and thus are sometimes imposed for five years or more. In the case of a small business, the penalties can easily exceed the total earnings of the business and cause bankruptcy – totally out of proportion to any tax advantage that may or may not have been realized.

4. The penalty is final, must be imposed by the IRS (this is mandatory), and cannot be rescinded. There is no right of appeal, and there is no “good faith” exception, as business advocates had hoped would be a part of the new legislation.

5. Judicial review is expressly prohibited, which raises another Constitutional issue, this time a separation of powers argument, as it amounts to one branch of government prohibiting another from functioning.

6. The taxpayer’s disclosure must initially be made twice – once with the IRS Office of Tax Shelter Analysis and again with the tax return for the year in which the transaction is first required to be disclosed. Thereafter, for each year that the taxpayer “benefits” from the transaction, it must be reflected on the tax return. Aside: As a practical matter, the form should be filed with the tax return. The IRS directions assume a timely filing. There are no directions on how to file late, which most taxpayers must do, since few realized the need to disclose in this manner when they still could have timely filed. A few experts have figured out how to file late and simultaneously avoid penalties, after months of study and numerous conversations with IRS personnel. Those conversations were with IRS people that drafted the regulations, those that receive the forms, and others.

7. A taxpayer that discloses a transaction is subject to penalty if the Service deems the disclosure to be incomplete, incorrect, and/or misleading. I have had numerous conversations with people who filed the disclosure forms and got fined. They did not properly prepare and/or file the forms.

8. If a transaction is not “listed” at the time the taxpayer files a return but it subsequently becomes listed, the taxpayer becomes responsible for filing a disclosure statement and will be penalized for failing to do so. This is true even if the taxpayer has no knowledge that the transaction has been listed. This sort of thing is exactly why business interests, albeit unsuccessfully, pushed for a “good faith” exception in the new legislation.

9. The penalty is imposed on transactions that the IRS, in its sole discretion, determines are “substantially similar” to a listed transaction. Accordingly, taxpayers may never know or realize that they are in a listed transaction and, accordingly, the penalties compound annually because they never made any disclosure. At least, if a transaction is specifically identified, people can find out that it is a listed transaction. But how can anyone be sure that something is “substantially similar”, or not?

10. The taxpayer must disclose each year, which can result in compounding of already large penalties; and

11. The Statute of Limitations, usually three years, does not apply. IRC 6501(c)(10) tolls the statute until proper disclosure is made.



The Treasury Department usually announces on a somewhat ad hoc basis what is a listed transaction. There is no regulatory process or public comment period involved in determining what should be a listed transaction. Once that a transaction is deemed to be a listed transaction, the Draconian Section 6707A penalties are triggered. Section 6707A penalties not only apply to specifically listed transactions, but also to transactions that are deemed by Treasury to be “substantially similar” to any of the specifically listed transactions. Some have said that under Section 6707A, IRS and Treasury are the judge, jury and executioner. Be that as it may, once again Constitutional concerns need to be addressed, this time possible due process violations pursuant to the Fourteenth Amendment.

Some Examples



A business owner bought a type of life insurance policy featuring what is known as a “springing cash value” as an alternative to a pension plan. Two years later, this type of transaction was specifically identified as an abusive tax shelter, a listed transaction, meaning that the business owner was now obligated to file Form 8886. But the financial advisor, who years before had actually recommended this course of action, either willfully or out of ignorance failed to advise the business owner to disclose.
The IRS demanded back taxes and interest in the neighborhood of $60,000. It also assessed $600,000 of penalties under Section 6707A for failing to disclose participation in a listed transaction for two separate years.

Another taxpayer filed Form 8886 with his tax returns, but failed to file, in the first year, with the Office of Tax Shelter Analysis. The penalty was assessed for that failure, even though the IRS had the form, though perhaps in a different place. Again, this scenario cries out for the “good faith” exception that was not included in the new legislation.

Then there was the doctor who thought that he had settled his 419 welfare benefit plan issues with the Service. He entered into a closing agreement and paid all taxes due and owing. Later, he was assessed the penalty for failing to file Form 8886. Of course, this issue had been neither raised nor even discussed in the doctor’s prior communications, negotiations, etc. with the Service.

I could go on and on with these horror stories, but the reader probably gets my drift by now. I have been urging business owners to properly file Form 8886 for years. A surprising number of accountants have little or no knowledge in this area, even being unaware of the fines that can be imposed on “material advisors” which, as previously noted, have NOT changed as a result of the new legislation. And if a professional assumes that he has no clients in “listed transactions”, he should realize that there are numerous types of listed transactions. They are not restricted to welfare benefit plans. For example, they include the popular Section 412(i) defined benefit pension plan, and even some of the ubiquitous 401(k) plans. No business owner, and especially no financial, insurance or accounting professional should ever assume that he or she is immune from any or all of the possible repercussions outlined herein.

Summing up, the new legislation does reduce possible Section 6707A penalties for most taxpayers. That, in my view, is its only benefit. And the reduction is not as great as one might expect. Depending on surrounding circumstances, penalties of hundreds of thousands of dollars are still quite possible. Even the minimum penalties, which are applied in the event that there is no tax benefit, amount to $15,000 annually. Who can afford to just brush that aside? Over a period of years, and the fines in the 8886 area are still applied annually, the minimum fines all be themselves can add up to a considerable amount.

Both the 8886 and 8918 forms must still be filed properly. The fines and penalties for failure to do so remain substantial and unfair.

The information provided herein is not intended as legal, accounting, financial or any type of advice for any specific individual or other entity. You should contact an appropriate professional for any such advice.

ABOUT THE AUTHOR: Lance Wallach
Lance Wallach, National Society of Accountants Speaker of the Year and member of the AICPA faculty of teaching professionals, is a frequent speaker on retirement plans, abusive tax shelters, financial, international tax, and estate planning. He writes about 412(i), 419, Section79, FBAR and captive insurance plans. He speaks at more than ten conventions annually, writes for more than 50 publications and is quoted regularly in the press. He does expert witness testimony and has never lost a case. Contact him at 516.938.5007, or visit www.taxadvisorexpert.com.

Form 8886 is required to be filed by any taxpayer who is participating


Robert Sherman



Form 8886 is required to be filed by any taxpayer who is participating, or in some cases has participated, in a listed or reportable transaction. What attracted the most attention with respect to it, until very recently, were the penalties for failure to file, which were $100,000 annually for individuals and $200,000 annually for corporations. Recent legislation has reduced those penalties in most cases. However, there is still a minimum penalty of $5,000 annually for an individual and $10,000 annually for a corporation for failure to file. And those are the MINIMUM penalties. If the minimum penalties do not apply, the annual penalty becomes 75 percent of whatever tax benefit was derived from participation in the listed transaction, and the penalty is applied both to the business and to the individual business owners. Since the form must be filed for every year of participation in the transaction, the penalties can be cumulative; i.e., applied in more than one year. For example, a corporation that participated in five consecutive years could find itself, depending on the amount of claimed tax deductions, looking at several hundred thousand dollars in fines, even under the recently enacted legislation, before even thinking about back taxes, penalties, interest, etc., that could result from an audit. Even the minimum fine would be $15,000 per year, again in addition to all other applicable taxes and penalties, etc. So even the minimum fines could mount up fast.

The penalties can also be imposed for incomplete, inaccurate, and/or misleading filings. And the Service itself has not provided totally clear, unequivocal guidance to those hoping to avoid errors and penalties. To illustrate this point, Lance Wallach, a leading authority in this area who has received hundreds of calls and whose associates have literally aided dozens of taxpayers in completing these forms, reports that his associates, on numerous occasions, have sought the opinions and assistance of Service personnel, usually from the Office of Chief Counsel, with respect to questions arising while assisting taxpayers in completing and filing the form. The answers are often somewhat vague, and tend to be accompanied by a disclaimer advising not to rely on them.   

One popular type of listed transaction is the so-called welfare benefit plan, which once relied in IRC Section 419A(F)(6) for its authority to claim tax deductions, but now more commonly relies on Section 419(e). The 419A(F)(6) plans used to claim that that section completely exempted business owners from all limitations on how much tax could be deducted. In other words, it was claimed, tax deductions were unlimited. These plans featured large amounts of life insurance and accompanying large commissions, and were thus aggressively pushed by insurance agents, financial planners, and sometimes even accountants and attorneys. Not to mention the insurance companies themselves, who put millions of dollars in premiums on the books and, when confronted with questions about the outlandish tax claims made in marketing these plans, claimed to be only selling product, not giving opinions on tax questions.

In the summer of 2003, the Service issued guidance that had the effect of severely curtailing those plans, and they began to largely, though not completely, disappear from the landscape. Most welfare benefit plans now claim Section 419(e) as the authority to claim a corporate tax deduction, though the promoters of these plans no longer claim that tax deductions are unlimited. Instead, they acknowledge that the amount of possible tax deductions is limited by the limitations of Section 419A, which Code section is a limitation on tax deductions that are authorized by other sections.

With respect to Section 419(e) welfare benefit plans, and of particular importance in this listed transaction/penalties arena, were the events of October 17, 2007, which over time have had roughly the same effect on Section 419(e) welfare benefit plans as the aforementioned 2003 developments had on Section 419A(F)(6) plans. On that date, the Service issued Notice 2007-83, which identified certain trust arrangements involving cash value life insurance policies, and substantially similar arrangements, as listed transactions. Translation: Section 419(e) welfare benefit plans that are funded by cash value life insurance contracts are listed transactions, at least if a tax deduction is taken for the amount of  premiums paid for such policies. On that same day, the Service also issued Notice 2007-84 and Revenue Ruling 2007-65. The combined effect of these three IRS pronouncements was that not only was the use of cash value life insurance in welfare benefit plans, if combined with claiming tax deductions for the premiums paid, sufficient to cause IRS treatment of these plans as listed transactions, but that discrimination as between owners and rank and file employees in these plans was also being targeted.
To illustrate, in many of these promoted arrangements, these Section 419(e) welfare benefit plans, cash value life insurance policies are purchased on the lives of the owners of the business, and sometimes on key employees, while term insurance is purchased on the lives of the rank and file employees. The plans in question tend to anticipate that the plan will be terminated within five years or so, at which time the cash value policies will be distributed to the owners, and possibly key employees, with very little distributed to rank and file employees. In general, the Internal Revenue Code will not countenance the claiming of a tax deduction in connection with a welfare benefit plan where such blatant unequal treatment (discrimination) is exhibited. Nevertheless, plan promoters claim that insurance premiums are currently deductible by the business, and that the insurance policies, when distributed to the owners, can be done so virtually tax free. And this also despite the fact that an employer’s deductions for contributions to an arrangement that is properly characterized as a welfare benefit fund are subject to the limitations and requirements of the rules in IRC sections 419 and 419A, including the use of reasonable actuarial assumptions and the satisfaction of nondiscrimination requirements.

With respect to the preparation and filing of Form 8886, incidentally, it should not surprise that welfare benefit promoters have been active in this area. This would include both the promoters of plans that have been listed transactions for years as well as those that became listed transactions, at least arguably, by virtue of the previously discussed October 2007 IRS activities. Some promoters take the position that their plans are completely compliant and that, therefore, there is no need to file Form 8886. Others take a more precautionary approach. While never admitting to being a listed transaction, they do urge clients to file on a protective basis. At least one went so far as to offer plan participants complete guidance and instructions about precisely how to file protectively. Many, if not most, plan promoters have, at the very least, forwarded completed sample forms to plan participants for guidance and use in completing Form 8886. It is certainly possible to file protectively. Any remotely good faith belief that the transaction is not a listed one justifies the protective filing. In fact and practice, the Service is actually treating protective filings in the same manner as other filings.

But while many plan promoters have recognized the filing obligation and recommended filing, this has led to another problem. As previously noted, they have been instructing taxpayers on how to complete and file the form, and the problem is that their guidance, in many cases, has not been particularly helpful and sometimes dangerous. In some cases, though this is difficult if not impossible to ascertain, the suggestions of the plan promoters seem designed more to protect the promoters than to assist the taxpayer. While this is a difficult call to make, it is absolutely clear, Wallach says, that more than one promoter, whether carelessly or otherwise, has sent taxpayers outdated forms to complete and file. Wallach, who you may recall has, between himself and his associates, aided dozens of taxpayers in completing and filing Form 8886, notes that his associates have frequently reported this problem. They also report never having seen a Form 8886 prepared completely correctly, especially where a promoter’s instructions were relied on. So, because the fines may be imposed for incomplete, misleading, or incorrect filings, the danger to plan participants can be clearly seen. And the taxpayer who discovers errors subsequent to filing must decide whether to amend the filing or not, which some plan participants are reluctant to do.



Burdens On Professionals With Clients In Welfare Benefit Plans And Other Listed Transactions



Form 8918 must be filed with the Internal Revenue Service by all “material advisors” to clients who are participating in listed transactions. Exactly who, then, is a material advisor? You are a material advisor if three requirements are satisfied. First, the client must actually be participating in the listed transaction. Second, you must have given the client tax advice with respect to the transaction. This does not necessarily mean that you recommended participation. For example, signing off on a tax return claiming a tax deduction for participation in the listed transaction surely qualifies as having given tax advice with respect to the transaction. In fact, even if you recommended against participation, you would satisfy this threshold so long as you rendered tax advice, be it positive, negative, or neutral.

The third threshold is that you must have received $10,000 or more in compensation (yourself and/or a related entity). This is not quite as simple as it sounds. The money need not all be received as a commission (as might be the case with a CPA who is insurance licensed), or even in a lump sum for accounting services rendered in connection with the client’s participation. The money could be received periodically over time. It is even possible that, so long as $10,000 in fees have been received from the client for whatever reason over whatever period of time, the threshold is met. Lance Wallach, previously referred to in the discussion about Form 8886 and whose associates are also expert in assisting CPAs and others in the preparation and filing of Form 8918, reports that one of his associates put this question directly to an attorney in the Office of the Chief Counsel who actually wrote published IRS guidance with respect to Form 8918. While the gentleman from the IRS was very courteous and professional, trying his best to be of assistance, a clear, unqualified, unequivocal answer that could be “taken to the bank” proved impossible to elicit.

Like Form 8886, however, Form 8918 can be filed protectively. Failure to file or incomplete, misleading, or inaccurate filings can lead to the penalties that used to apply to Form 8886, to wit: $100,000.00 for individuals and $200,000.00 for corporations. For this purpose, it is CRITICAL to note that the recent legislation reducing penalties applied ONLY to Form 8886. The penalties for failure to file Form 8918, or for filing it incorrectly, remain the same as they were, to wit: $100,000 for individuals and $200,000 for corporations.

A good faith belief that either you did not receive $10,000 in income or that the transaction in question is not a listed one enables you to file on a protective basis. And, in fact, as with the 8886 form, the IRS is, in fact, treating all filings identically in any event.

When the CPA files this form ( it need only be filed once, not on an annual basis, as Form 8886 must be), the CPA is assigned a number by the IRS. The CPA or other professional then gives this number to all of his affected clients, who are required to report it on the 8886 forms that they must file. Also, as a perusal of Form 8918 makes clear, there is also a section where the material advisor is to give all pertinent information with respect to other material advisors who participated in and/or advised the client with respect to the transaction in question.

As with Form 8886, this area is replete with horror stories about advisors who, mostly innocently, have fallen into this trap. One that we know of was sold by one promoter on a questionable plan, recommended it to about fifteen clients, and now has been forced to file the 8918 form, help all those involved who have to file Form 8886, and expend a fair amount of his own funds, both to find people who can assist his clients with Form 8886 and in “rescuing” clients who want to get out of this plan. Another called about something else, and was horrified to discover that he had six clients in a plan that is a listed transaction. When he was apprised of his situation, he sank into a depression. These are only two of the dozens of sad, and worse, stories in this area that we have been privy to. The second person, for example, had no idea that anything was wrong. He initially called about something totally unrelated. There have even been instances of professional discipline being imposed in connection with this area, of CPAs being threatened with and perhaps even actually suffering loss of their licenses. Such is the terrain in which the CPA must now operate.

Another problem is possible, especially if you recommended that the client participate. Most practitioners are familiar with situations where, when things go wrong, clients often develop selective memory failure. This happens here, as it does elsewhere. At best, it can lead to you spending an inordinate amount of time, and perhaps money, on what is essentially a thankless exercise. At worst, if the situation worsens to the point where a lawsuit may be in the air, you could find yourself the subject of some sort of client complaint or, worse, a named defendant in a lawsuit, in which case your malpractice carrier would become involved, with all of the negative effects upon yourself and your practice that that could entail.

Section 6707A – Past, Present, and Future


Returning now to the Form 8886 aspect of Section 6707A, the disclosure requirement that applies to actual participants in listed transactions, it has been noted, and discussed, that Congress recently reduced the penalties under Section 6707A for many taxpayers. But it is still imperative to realize that this is only a partial solution to the continuing problem caused by the penalties imposed by that section. While the penalties have been reduced from the prior patently ridiculous, and probably illegal, level that until so recently prevailed, they are still sufficient, in many cases, to put business owners out of business, just as the prior penalties obviously were. And since the new legislation did not address or affect obligations and penalties with respect to Form 8918 at all, accountants, insurance professionals and other material advisors are as likely to be hurt as ever.

Whatever the underlying Congressional intent was in enacting the original Section 6707A in 2004, whatever Congress hoped to accomplish, the statute as it was written imposed clearly unconscionable burdens on taxpayers. Penalties of up to $300,000 annually could be imposed on taxpayers who had not underpaid tax and who had no knowledge that they had entered into transactions that the IRS deems “listed”.

Tax provisions are seldom found to violate the United States Constitution, but it is certainly arguable that the imposition of such a large penalty on a taxpayer who entered into a transaction that produced little or even no tax savings and without regard to the taxpayer’s knowledge or intent violates the Eighth Amendment prohibition on excessive fines, etc. In practice, the requirement that this penalty be imposed without regard to culpability often had the effect of bankrupting middle class families who had no intention of entering into a tax shelter – an outcome that dismayed even hardened IRS enforcement personnel.

The section previously imposed a penalty of $100,000 per individual and $200,000 per entity for each failure to make special disclosures with respect to a transaction that the Treasury Department characterizes as a “listed transaction” or “substantially similar” to a listed transaction. A listed transaction is one that is specifically identified as such by published IRS guidance. The question of what is “substantially similar” to such a transaction is increasingly troublesome, especially given the ever broadening IRS definition of the term, beginning with Treasury Decision 9,000, which declared, on June 18, 2002, that, from that date forward, the term “substantially similar” would be construed more broadly by the Service than it had up until that time. This started a trend that continues to this day.

It is important for the reader to understand that the only thing that was accomplished by the new, amended Section 6707A is a reduction in the penalties. The penalties are still severe, severe enough to seriously damage or even bankrupt most small businesses. And professional readers must understand that there has been no effect on their obligations at all, and that the same (in their case, even more severe) fines still apply.

For example, the following eleven statements are equally applicable to the new Section 6707A as they are to its predecessor:

  1. The penalty applies without regard to whether the small business or the small business owners have knowledge that the transaction has been listed.

  1. The penalty applies even if the small business and/or the small business owners derived no tax benefit    from the transaction. Even under the new legislation, there are substantial minimum penalties that are applied even if there has been no tax benefit.

  1. The penalty is applied at multiple levels, which is devastating to small businesses; the result is that the small business and its owners are hit with multiple penalties. The two most common problems are that fines are imposed on both the business entity and the owners as individuals, and also that fines are imposed each year, and thus are sometimes imposed for five years or more. In the case of a small business, the penalties can easily exceed the total earnings of the business and cause bankruptcy – totally out of proportion to any tax advantage that may or may not have been realized.

  1. The penalty is final, must be imposed by the IRS (this is mandatory), and cannot be rescinded. There is no right of appeal, and there is no “good faith” exception, as business advocates had hoped would be a part of the new legislation.

  1. Judicial review is expressly prohibited, which raises another Constitutional issue, this time a separation of powers argument, as it amounts to one branch of government prohibiting another from functioning.

  1. The taxpayer’s disclosure must initially be made twice – once with the IRS Office of Tax Shelter Analysis and again with the tax return for the year in which the transaction is first required to be disclosed. Thereafter, for each year that the taxpayer “benefits” from the transaction, it must be reflected on the tax return. Aside: As a practical matter, the form should be filed with the tax return. The IRS directions assume a timely filing. There are no directions on how to file late, which most taxpayers must do, since few realized the need to disclose in this manner when they still could have timely filed. A few experts have figured out how to file late and simultaneously avoid penalties, after months of study and numerous conversations with IRS personnel. Those conversations were with IRS people that drafted the regulations, those that receive the forms, and others.

  1. A taxpayer that discloses a transaction is subject to penalty if the Service deems the disclosure to be incomplete, incorrect, and/or misleading. I have had numerous conversations with people who filed the disclosure forms and got fined. They did not properly prepare and/or file the forms.

  1. If a transaction is not  “listed” at the time the taxpayer files a return but it subsequently becomes listed, the taxpayer becomes responsible for filing a disclosure statement and will be penalized for failing to do so. This is true even if the taxpayer has no knowledge that the transaction has been listed. This sort of thing is exactly why business interests , albeit unsuccessfully, pushed for a “good faith” exception in the new legislation.

  1. The penalty is imposed on transactions that the IRS, in its sole discretion, determines are “substantially similar” to a listed transaction. Accordingly , taxpayers may never know or realize that they are in a listed transaction and, accordingly, the penalties compound annually because they never made any disclosure. At least, if a transaction is specifically identified, people can find out that it is a listed transaction. But how can anyone be sure that something is  “substantially similar”, or not?

  1. The taxpayer must disclose each year, which can result in compounding of already large penalties; and

  1. The Statute of Limitations, usually three years, does not apply. IRC 6501(c)(10) tolls the statute until proper disclosure is made.



The Treasury Department usually announces on a somewhat ad hoc basis what is a listed transaction. There is no regulatory process or public comment period involved in determining what should be a listed transaction. Once that a transaction is deemed to be a listed transaction, the Draconian Section 6707A  penalties are triggered. Section 6707A penalties not only apply to specifically listed transactions, but also to transactions that are deemed by Treasury to be “substantially similar” to any of the specifically listed transactions. Some have said that under Section 6707A, IRS and Treasury are the judge, jury and executioner. Be that as it may, once again Constitutional concerns need to be addressed, this time possible due process violations pursuant to the Fourteenth Amendment.

Some Examples



A business owner bought a type of life insurance policy featuring what is known as a “springing cash value” as an alternative to a pension plan. Two years later, this type of transaction was specifically identified as an abusive tax shelter, a listed transaction, meaning that the business owner was now obligated to file Form 8886. But the financial advisor, who years before had actually recommended this course of action, either willfully or out of ignorance failed to advise the business owner to disclose.
The IRS demanded back taxes and interest in the neighborhood of $60,000. It also assessed $600,000 of penalties under Section 6707A for failing to disclose participation in a listed transaction for two separate years.

Another taxpayer filed Form 8886 with his tax returns, but failed to file, in the first year, with the Office of Tax Shelter Analysis. The penalty was assessed for that failure, even though the IRS had the form, though perhaps in a different place. Again, this scenario cries out for the “good faith” exception that was not included in the new legislation.

Then there was the doctor who thought that he had settled his 419 welfare benefit plan issues with the Service. He entered into a closing agreement and paid all taxes due and owing. Later, he was assessed the penalty for failing to file Form 8886. Of course, this issue had been neither raised nor even discussed in the doctor’s prior communications, negotiations, etc. with the Service.

I could go on and on with these horror stories, but the reader probably gets my drift by now. I have been urging business owners to properly file Form 8886 for years. A surprising number of accountants have little or no knowledge in this area, even being unaware of the fines that can be imposed on “material advisors” which, as previously noted, have NOT changed as a result of the new legislation. And if a professional assumes that he has no clients in “listed transactions”, he should realize that there are numerous types of listed transactions. They are not restricted to welfare benefit plans. For example, they include the popular Section 412(i) defined benefit pension plan, and even some of the ubiquitous 401(k) plans. No business owner, and especially no financial, insurance or accounting professional should ever assume that he or she is immune from any or all of the possible repercussions outlined herein.

Summing up, the new legislation does reduce possible Section 6707A penalties for most taxpayers. That, in my view, is its only benefit. And the reduction is not as great as one might expect. Depending on surrounding circumstances, penalties of hundreds of thousands of dollars are still quite possible. Even the minimum penalties, which are applied in the event that there is no tax benefit, amount to $15,000 annually. Who can afford to just brush that aside? Over a period of years, and the fines in the 8886 area are still applied annually, the minimum fines all be themselves can add up to a considerable amount.

Both the 8886 and 8918 forms must still be filed properly. The fines and penalties for failure to do so remain substantial and unfair.   








 
    

Lines from Lance


NEW JERSEY ASSOCIATION OF PUBLIC ACCOUNTANTS
Lines from Lance - Newsletter - updated 


If you were or are in a 412(i), 419, Captive Insurance, or section 79 plan you are probably in big trouble. If you signed a tax return for a client in one of these plans, you are probably what the IRS calls a material advisor and subject to a maximum $200,000 fine. If you are an Insurance Professional that sold or advised on one of these plans, the same holds true for you. Business Owners and Material Advisors needed to properly file under section 6707A, or face large IRS fines. My office has received thousands of phone calls, many after the business owner has received the fine. In many cases, the accountant files the appropriate forms, but the IRS still levied the fine because the Accountant made a mistake on the form. My office has reviewed many forms for Accountants, Tax Attorneys and others. We have not yet seen a form that was filled out properly. The improper preparation of these forms usually results in the client being fined more quickly then if the form were not filed at all. I have been an expert witness in law suites on point. None of my clients have ever lost where I was their Expert Witness.

The IRS will be soon attacking section 79 scams I am told. My early articles by AICPA and others in the 90s predicted attacks on 419s, which came true. My 412(i) article predictions came true. The section 79 scams soon will be attacked. Everyone in them should file protectively. Anyone that has not filed protectively in a 419 or older 412(i) had better get some good advise from someone who knows what is going on, and has extensive experience filing protectively. IRS still has their task forces auditing these plans. Then they will move on to 79 scams etc. including many of the illegal captives pushed by the insurance companies and agents. Not all captives are illegal. I am an expert witness in a lot of cases involving the 412(i) and 419. It does not go well for the agents, accountants, plan promoters, insurance companies etc. The insurance companies settle first leaving the agents hanging out there. Then in many cases they fire the agents. I was just in a case as an expert witness where a large well know New England mutual based insurance company did just that.

If you are an insurance professional do not count on your insurance company to back you up. More likely they will stab you in the back, based on what I have seen. One of the agents was with the company over 25 years and was a leading producer with lots of company awards. Be careful. If you sold, gave tax advice, or signed a tax return and got paid a certain amount of money you may be a material advisor. Under the newest proposed regulations you had to file with the IRS to avoid the $200,000 $100,000 fines. You had to fill out the forms properly. You had to advise those that you advised about the plans or sold the plan to. You had to send them a note, or call them, giving them the number that the IRS had assigned to you as a Material Advisor. This is the number that you obtain after you file the appropriate forms for yourself. Even though you obtain a number you still may have filed your forms improperly or completed them wrong. Many accountants have called me after their clients were fined $800,000 or more by IRS for improperly filing, or not filing under 6707A. A plan administrator called me after a lot of his clients were fined millions. He told their accountants to file 8886, and most of them did. All of the clients were fined shortly thereafter. The forms need to be filled in exactly correct. In our numerous talks with IRS we were told if filed out wrong the fine is still imposed. BE CAREFUL please be advised we have not seen a form that has been filed out properly. Many accountants, tax attorneys, etc., send us their forms to be reviewed, most after they file for one client who then gets fined about one million dollars under the regulations. I DO NOT do the forms. A former IRS agent of 37 years, CPA, tax professor does them, as does another person that I know.
_______________________________________________________________
The moratorium on collection has been extended for two additional months until March 1st.
_____________________________________________________________________


If you are a small business owner, accountant or insurance professional you may be in big trouble and not know it.  IRS has been fining people like you $200,000.  Most people that have received the fines were not aware that they had done anything wrong.  What is even worse is that the fines are not appeal-able.  This is not an isolated situation.  This has been happening to a lot of people.

Currently, the Internal Revenue Service (“IRS”) has the discretion to assess hundreds of thousands of dollars in penalties under §6707A of the Internal Revenue Code (“Code”) in an attempt to curb tax avoidance shelters. This discretion can be applied regardless of the innocence of the taxpayer and was granted by Congress.  It works so that if the IRS determines you have engaged in a listed transaction and failed to properly disclose it, you will be subject to a potentially draconian penalty regardless of any other facts and circumstances concerning the transaction. For some, this penalty has been assessed at almost a million dollars and for many it is the beginning of a long nightmare.

The following is an example:  Pursuant to a settlement with the IRS, the 412(i) plan was converted into a traditional defined benefit plan.  All of the contributions to the 412(i) plan would have been allowable if they had initially adopted a traditional defined benefit plan.  Based on negotiations with the IRS agent, the audit of the plan resulted in no income and minimal excise taxes due.   This is because as a traditional defined benefit plan, the taxpayers could have contributed and deducted the same amount as a 412(i) plan.
Towards the end of the audit the business owner received a notice from the IRS.  The IRS assessed the client penalties under the §6707A of the Code in the amount of $900,000.00.  This penalty was assessed because the client allegedly participated in a listed transaction and allegedly failed to file the form 8886 in a timely manner.     

The IRS may call you a material advisor and fine you $200,000.00. The IRS may fine your clients over a million dollars for being in a retirement plan, 419 plan, etc. As you read this article, hundreds of unfortunate people are having their lives ruined by these fines. You may need to take action immediately. The Internal Revenue Service said it would extend until the end of March 1, 2010 a grace period granted to small business owners for collection of certain tax-shelter penalties.


"Clearly, a number of taxpayers have been caught in a penalty regime that the legislation did not intend," wrote Shulman. "I understand that Congress is still considering this issue, and that a bipartisan, bicameral, bill may be in the works."  The issue relates to penalties for so-called listed transactions, the kinds of tax shelters the IRS has designated most egregious. A number of small business owners that bought employee retirement plans so called 419 and 412(i) plans and others, that were listed by the IRS, and who are now facing hundreds and thousands in penalties, contend that the penalty amounts are unfair.
Leaders of tax-writing committees in the House and Senate have said they intend to pass legislation revising the penalty structure.

The IRS has suspended collection efforts in cases where the tax benefit derived from the listed transaction was less than $100,000 for individuals, or less than $200,000 for firms. They are still however sending out notices that they intend to fine.

Senator Ben Nelson (D-Nebraska) has sponsored legislation (S.765) to curtail the IRS and its nearly unlimited authority and power under Code Section 6707A. The bill seeks to scale back the scope of the Section 6707A reportable/listed transaction nondisclosure penalty to a more reasonable level. The current law provides for penalties that are Draconian by nature and offer no flexibility to the IRS to reduce or abate the imposition of the 6707A penalty. This has served as a weapon of mass destruction for the IRS and has hit many small businesses and their owners with unconscionable results.

 Internal Revenue Code 6707A was enacted as part of the American Jobs Creation Act on October 22, 2004. It imposes a strict liability penalty for any person that failed to disclose either a listed transaction or reportable transaction per each occurrence. Reportable transactions usually fall within certain general types of transactions (e.g. confidential transactions, transactions with tax protection, certain loss generating transaction and transactions of interest arbitrarily so designated as by the IRS) that have the potential for tax avoidance. Listed transactions are specified transactions, which have been publicly designated by the IRS, including anything that is substantially similar to such a transaction (a phrase which is given very liberal construction by the IRS). There are currently 34 listed transactions, including certain retirement plans under Code section 412(i) and certain employee welfare benefit plans funded in part with life insurance under Code sections 419A(f)(5), 419(f)(6) and 419(e). Many of these plans were implemented by small business seeking to provide retirement income or health benefits to their employees.

 Strict liability requires the IRS to impose the 6707A penalty regardless of innocence of a person (i.e. whether the person knew that the transaction needed to be reported or not or whether the person made a good faith effort to report) or the level of the person’s reliance on professional advisors. A Section 6707A penalty is imposed when the transaction becomes a reportable/listed transaction. Therefore, a person has the burden to keep up to date on all transactions requiring disclosure by the IRS into perpetuity for transactions entered into the past.

Additionally, the 6707A penalty strictly penalizes nondisclosure irrespective of taxes owed. Accordingly, the penalty will be assessed even in legitimate tax planning situations when no additional tax is due but an IRS required filing was not properly and timely filed. It is worth noting that a failure to disclose in the view of the IRS encompasses both a failure to file the proper form as well as a failure to include sufficient information as to the nature and facts concerning the transaction. Hence, people may find themselves subject to the 6707A penalty if the IRS determines that a filing did not contain enough information on the transaction. A penalty is also imposed when a person does not file the required duplicate copy with a separate IRS office in addition to filing the required copy with the tax return. Lance Wallach Commentary. In our numerous talks with IRS, we were also told that improperly filling out the forms could almost be as bad as not filing the forms. We have reviewed hundreds of forms for accountants, business owners and others. We have not yet seen a form that was properly filled in. We have been retained to correct many of these forms.

For more information see www.vebaplan.com, www.lawyer4audits.com, or e-mail us at lawallach@aol.com

 The imposition of a 6707A penalty is not subject to judicial review regardless of whether the penalty is imposed for a listed or reportable transaction. Accordingly, the IRS’s determination is conclusive, binding and final. The next step from the IRS is sending your file to collection, where your assets may be forcibly taken, publicly recorded liens may be placed against your property, and/or garnishment of your wages or business profits may occur, amongst other measures.

The 6707A penalty amount for each listed transaction is generally $200,000 per year per each person that is not an individual and $100,000 per year per individual who failed to properly disclose each listed transaction. The 6707A penalty amount for each reportable transaction is generally $50,000 per year for each person that is not an individual and $10,000 per year per each individual who failed to properly disclose each reportable transaction. The IRS is obligated to impose the listed transaction penalty by law and cannot remove the penalty by law. The IRS is obligated to impose the reportable transaction penalty by law, as well, but may remove the penalty when the IRS determines that removal of the penalty would promote compliance and support effective tax administration.

The 6707A penalty is particularly harmful in the small business context, where many business owners operate through an S corporation or limited liability company in order to provide liability protection to the owner/operators. Numerous cases are coming to light where the IRS is imposing a $200,000 penalty at the entity level and them imposing a $100,000 penalty per individual shareholder or member per year.

The individuals are generally left with one of two options:
  • Declare Bankruptcy
  • Face a $300,000 penalty per year.

Keep in mind, taxes do not need to be due nor does the transaction have to be proven illegal or illegitimate for this penalty to apply. The only proof required by the IRS is that the person did not properly and timely disclose a transaction that the IRS believes the person should have disclosed. It is important to note in this context that for non-disclosed listed transactions, the Statue of Limitations does not begin until a proper disclosure is filed with the IRS.

Many practitioners believe the scope and authority given to the IRS under 6707A, which allows the IRS to act as judge, jury and executioner, is unconstitutional. Numerous real life stories abound illustrating the punitive nature of the 6707A penalty and its application to small businesses and their owners. In one case, the IRS demanded that the business and its owner pay a 6707A total of $600,000 for his and his business’ participation in a Code section 412(i) plan. The actual taxes and interest on the transaction, assuming the IRS was correct in its determination that the tax benefits were not allowable, was $60,000. Regardless of the IRS’s ultimate determination as to the legality of the underlying 412(i) transaction, the $600,000 was due as the IRS’s determination was final and absolute with respect to the 6707A penalty. Another case involved a taxpayer who was a dentist and his wife whom the IRS determined had engaged in a listed transaction with respect to a limited liability company. The IRS determined that the couple owed taxes on the transaction of $6,812, since the tax benefits of the transactions were not allowable. In addition, the IRS determined that the taxpayers owed a $1,200,000 section 6707A penalty for both their individual nondisclosure of the transaction along with the nondisclosure by the limited liability company.

Even the IRS personnel continue to question both the legality and the fairness of the IRS’s imposition of 6707A penalties. An IRS appeals officer in an email to a senior attorney within the IRS wrote that “…I am both an attorney and CPA and in my 29 years with the IRS I have never {before} worked a case or issue that left me questioning whether in good conscience I could uphold the Government’s position even though it is supported by the language of the law.” The Taxpayers Advocate, an office within the IRS, even went so far as to publicly assert that the 6707A should be modified as it “raises significant Constitutional concerns, including possible violations of the Eighth Amendment’s prohibition against excessive government fines, and due process protection.”

Senate bill 765, the bill sponsored by Senator Nelson, seeks to alleviate some of above cited concerns. Specifically, the bill makes three major changes to the current version of Code section 6707A. The bill would allow an IRS imposed 6707A penalty for nondisclosure of a listed transaction to be rescinded if a taxpayer’s failure to file was due to reasonable cause and not willful neglect. The bill would make a 6707A penalty proportional to an understatement of any tax due.

Accordingly, non-tax paying entities such as S corporations and limited liability companies would not be subject to a 6707A penalty (individuals, C corporations and certain trusts and estates would remain subject to the 6707A penalty).

There are a number of interesting points to note about this action:
1.     In the letter, the IRS acknowledges that, in certain cases, the penalty imposed by section 6707A for failure to report participation in a “listed transaction” is disproportionate to the tax benefits obtained by the transaction.
2.     In the letter, the IRS says that it is taking this action because Congress has indicated its intention to amend the Code to modify the penalty provision, so that the penalty for failure to disclose will be more in line with the tax benefits resulting from a listed transaction.
3.     The IRS will not suspend audits or collection efforts in appropriate cases.  It cannot suspend imposition of the penalty, because, at least with respect to listed transactions, it does not have the discretion to not impose the penalty.  It is simply suspending collection efforts in cases where the tax benefits are below the penalty threshold in order to give Congress time to amend the penalty provision, as Congress has indicated to the IRS it intends to do. 
4.          The legislation does not change the penalty provisions for material advisors.

This is taken directly from the IRS website:
“Congress has enacted a series of income tax laws designed to halt the growth of abusive tax avoidance transactions. These provisions include the disclosure of reportable transactions. Each taxpayer that has participated in a reportable transaction and that is required to file a tax return must disclose information for each reportable transaction in which the taxpayer participates. Use Form 8886 to disclose information for each reportable transaction in which participation has occurred. Generally, Form 8886 must be attached to the tax return for each tax year in which participation in a reportable transaction has occurred. If a transaction is identified as a listed transaction or transaction of interest after the filing of a tax return (including amended returns), the transaction must be disclosed either within 90 days of the transaction being identified as a listed transaction or a transaction of interest or with the next filed return, depending on which version of the regulations is applicable.”

January 15, 2010: Brand New Update: The new proposed regulations specify a requirement that reporting forms filed under 6707A filed late must have additional attachments. Where in is described many additional details not covered in the original regulations. In addition, various parties must sign a statement on the attachments under penalty of perjury. The proposed regulations also specify that the late filing must be done in a specific manner.  If this filing is not done according to these rules, the one-year period for statute of limitations will not commence, etc. In addition, the form should include a statement at the top in the manner the IRS suggests.  If a tax payer fails to include, on any return or statement, for any taxable year, any information with respect to a listed transaction as defined in CODE SECTION 6707A, which is required to be included with such return or statement the time for assessment of any tax imposed by this title with respect to such transaction shall not expire before the date, which is one year after the earlier of; the date on which the secretary is furnished the information so required, or the date that a material advisor meets the requirements relating to such transaction with respect to such tax  payer. As you know, Congress has armed the IRS with many weapons for enforcement. Usually there is three-year statute of limitations granted to all taxpayers. In the situation above there will be no statute of limitations, unless the forms are filed in correctly with no errors at all.  In addition, the forms must be sent to the proper IRS authorities at their various locations. Lance Wallach’s commentary: It seems to me and to the only two people that I know who have been filing these forms correctly that that the IRS has purposely made it almost impossible for accountants and tax attorneys to properly fill out these forms and to comply with regulations under SECTION 6707A. The result is that a business owner in one of these plans asks his accountant or attorney to file the disclosures. The Business Owner then gets fined, on average, ABOUT A MILLION DOLLARS. Or the Business Owner does not file the forms and gets the same fine. The same goes for the Material Advisor. The two people that have been filing these forms properly to my knowledge have repeatedly had discussions with the authors of these regulations and various other IRS personnel, including the Office of Tax Shelter Analysis.  Based on those many conversations with IRS personnel, repeatedly re-reading the various regulations and experience in filing many of the form under these code sections, these two people have developed their expertise. I only have their word that no one has been fined that they have helped. One of these individuals has been preparing the forms after the fact, late, for the last few years. I am not endorsing using anyone in particular for these forms. I am just writing about my experience in this area.

Lance Wallach, CLU, ChFC, speaks and writes about benefit plans, tax reductions strategies, and financial plans. He has authored numerous books for the AICPA books, Bisk Total tapes, Wiley and others.

Lance Wallach, the National Society of Accountants Speaker of the Year also writes about retirement plans, 412(1) and 419 and Captive plans. He speaks at more than ten conventions annually, writes for over fifty publications, is quotes regularly in the press and has written numerous best-selling AICPA books including Common Abusive Business Hot Spots. He does Expert Witness work and has never lost a case. Contact him at 516.938.5007, lawallach@aol.com or visit www.vebaplan.com or www.taxlibrary.us.

           
The information provided herein is not intended as legal, accounting, financial or any other type of advice for any specific individual or other entity.  You should contact an appropriate professional for any such advice.