Tax
NOVEMBER 2004
New Tax Law Turns Up Heat on Executives
Executives of companies, both public and private, with
responsibility for tax, finance or legal affairs have a
new reason to lose sleep. The recently enacted
American Jobs Creation Act of 2004 (the “Act”) creates
new penalties (and modifies existing penalties by
making them more harsh) for taxpayers who fail to
disclose on their federal income tax returns details
regarding so-called “reportable” transactions.
Although the requirement to disclose reportable
transactions is not new, the Act adds sharp teeth to this
requirement through new, significant penalties for
failures to disclose. Public companies will be
particularly affected since they will find that their
efforts to comply with the various tax-related
prohibitions and restrictions imposed by SarbanesOxley may be insufficient to insulate them from the
new penalties. Of particular note, the Act requires
public companies to disclose in their public filings with
the SEC the imposition of these penalties in certain
circumstances even if the dollar amount of the penalty
is immaterial for financial reporting purposes. Legal
counsel to public companies (both internal and
external) now have much more to worry about with
regard to the companies’ tax return preparation.
In response to the Act, taxpayers need to review
carefully their current tax reporting procedures. Return
preparation procedures should be designed and
implemented to ensure that reportable transactions are
identified and documented. Moreover, to satisfy
stringent new penalty abatement rules, taxpayers and
their legal counsel should undertake a critical
evaluation of the procedures applied to request, obtain
and review tax opinions that support a taxpayer’s tax
reporting position. In short, the Act should encourage
the tax return preparation function to be a multidisciplinary approach among tax and finance
professionals and legal advisors.
This Alert summarizes briefly some key provisions of
the Act inasmuch as they relate to these new penalty
regimes. The Alert then outlines a number of action
items that taxpayers should consider strongly before
they file their next federal income tax return.
THE NEW PENALTY FOR FAILING TO
DISCLOSE “REPORTABLE TRANSACTIONS”
The Act creates a new, non-deductible penalty for any
person who fails to include on its tax return any
required information with respect to a “reportable
transaction.” The penalty is steep — $50,000 for each
failure and $200,000 if the failure to disclose relates to
a “listed” transaction. It is the failure to disclose that
triggers the penalty and, thus, the penalty will apply
even if the transaction’s tax treatment ultimately is
reviewed and approved by the IRS.
A “reportable transaction” is a transaction that fits
within one or more of six categories: (1) a transaction
specified by the Treasury Department as a tax
avoidance transaction (a so-called “listed transaction”);
(2) a transaction offered under conditions of
confidentiality; (3) a transaction for which the taxpayer
has a right to a full or partial refund of fees paid if the
tax consequences are not sustained or if the fees are
contingent on the intended tax consequences from the
transaction being sustained; (4) certain transactions
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resulting in a deductible loss; (5) certain transactions
that create book-to-tax differences; and (6) certain
transactions resulting in tax credits. Notwithstanding
recent IRS guidance limiting the scope of reportable
transactions, transactions that are not abusive or
otherwise controversial can nonetheless be captured.
Importantly, whether a transaction is a “reportable
transaction” may hinge on facts that are known only by
persons who are not currently directly involved in the
preparation of the tax return (for example, an in-house
counsel). Thus, persons outside of the traditional tax
function will need to understand what is, and what is
not, a reportable transaction and collaborate with the
taxpayer’s tax and finance professionals.
If a penalty is imposed, a taxpayer bears a heavy
burden to get it rescinded. The IRS is directed to
rescind the penalty only if doing so would promote
compliance with the tax laws and effective tax
administration. In making this determination, the IRS
is to take into account whether (1) the taxpayer has a
history of complying with the tax laws, (2) the violation
is due to an unintentional mistake of fact, and (3)
imposing the penalty would be against equity and good
conscience. How this standard will be applied in
practice is uncertain. What is certain, however, is that
IRS examining agents and appeals officers already take
a hard-line approach to rescinding penalties with
respect to transactions that are viewed as bearing
indicia of a “tax shelter.”
In the event that a public company either fails to
disclose a “listed transaction” or becomes subject to the
tax penalty described below because it underpaid its tax
liability due to an undisclosed “reportable transaction,”
the public company will be required to include in its
SEC filings a disclosure regarding the penalty even
though the amount of the penalty is not material from a
financial accounting perspective. Failure to make this
disclosure to the SEC would result in an additional
$200,000 nondeductible penalty.
THE HEIGHTENED “REASONABLE CAUSE”
STANDARD
The Act revamps existing penalty rules in the case of
reportable transactions that place a large premium on
adequate disclosure of reportable transactions. Under
prior law, taxpayers who were found to have
substantially understated their income tax liability
would be assessed a penalty of 20 percent of the
understatement. Taxpayers would try to get this
penalty abated by showing that they acted with
reasonable cause and in good faith. Often, taxpayers
would rely on an opinion from a tax professional to
make this showing.
The Act changes the ground rules in at least two
significant ways: First, the “reasonable cause” defense
to the 20-percent understatement penalty is no longer
available (i.e., strict liability applies) if the taxpayer did
not disclose adequately its participation in the
reportable transaction. This automatic penalty is also
increased to 30 percent of the understated tax liability
rather than 20 percent. As noted above, a public
company is additionally hit with the requirement that
this penalty be publicly disclosed to the SEC even if the
dollar amount of the penalty is immaterial to the
company.
Second, even if the taxpayer identifies that it has
participated in a reportable transaction and discloses
that participation adequately on its tax return, the 20percent understatement penalty will apply unless the
taxpayer can show (1) that there was substantial
authority for the reported tax treatment, and (2) that the
taxpayer reasonably believed that the treatment was
more likely than not the proper treatment. In the past,
many taxpayers relied on opinions issued by various
tax advisors to establish this reasonable belief. The
Act, however, prescribes new rules that automatically
disqualify opinions if they are rendered by tax advisors
that have certain relationships with the taxpayer.
Examples of “disqualified” tax advisors include
advisors (1) who participated in the organization,
management, sale or promotion of the transaction at
issue and whose fee exceeds certain levels, (2) who are
compensated, directly or indirectly, by certain other
advisors to the taxpayer with respect to the transaction,
or (3) whose fee is contingent on the hoped-for tax
treatment being sustained. Tax opinions that come as
part of a “package” from a promoter no longer can be
relied upon for these purposes.
Establish a system that allows for a timely review of
filing positions with respect to reportable
transactions that have been identified. If a tax
opinion is determined to be necessary or advisable
to support the filing position, procedures need to be
established to ensure that any such opinion (1) is not
issued by a “disqualified” tax advisor, and (2)
satisfies the Act’s quality standards.
■
Moreover, even if a tax opinion is issued by a tax advisor
who is not disqualified, the Act disqualifies certain tax
Any member of our tax group would be pleased to
opinions by reason of their content. The Act provides
discuss questions or concerns that you have regarding
that opinions that unreasonably rely on factual or legal
assumptions, unreasonably rely on representations from this Alert and the Act.
the taxpayer, or do not identify all relevant facts are
automatically ignored for purposes of determining
J. STEPHEN BARGE
whether the taxpayer meets the reasonable cause
sbarge@kl.com
412.355.8330
standard. Accordingly, a substantive review of opinions
that are received will be required in order to ensure that
W. HENR
Y SNYDER
HENRY
they will be acceptable to the IRS upon examination.
hsnyder@kl.com
412.355.6720
ACTION ITEMS FOR EXECUTIVES
RONALD T
T.. AULBACH
Taxpayers can reduce the risk of incurring these
penalties and, in the case of public companies,
potentially damaging disclosure to the SEC by
establishing meaningful procedures to (1) identify and
disclose reportable transactions, and (2) document
appropriately the legal support for the taxpayer’s
reporting position. The precise procedures and methods
that will be attractive and effective among taxpayers will
depend on their differing management structure, styles
and degree of centralization. However, some broad
recommendations can be made as to actions that should
be undertaken before the next federal income tax return
is filed:
■
Examine current systems and procedures for
identifying and reporting reportable transactions and
procuring and examining tax opinions from outside
tax advisors.
■
Establish systems and procedures that ensure sharing
of all necessary information among the tax, finance
and legal functions.
■
Establish a system whereby information from each
function can be synthesized to perform a meaningful
legal analysis of whether “reportable transactions”
have been entered into for the tax year.
BOSTON
■
DALLAS
■
HARRISBURG
■
LOS ANGELES
■
MIAMI
■
raulbach@kl.com
412.355.6249
FOR FURTHER INFORMATION, please contact one of the
following K&L lawyers:
Boston
Martin S. Allen
mallen@kl.com
617.261.3212
Joel D. Almquist
jalmquist@kl.com 617.261.3104
Walter G. Van Dorn wvandorn@kl.com 617.951.9102
New York Jeff M. Cole
Scott D. Newman
jcole@kl.com
212.536.4823
snewman@kl.com 212.536.4054
Pittsburgh Ronald T. Aulbach
J. Stephen Barge
Andrew B. Pullman
W. Henry Snyder
raulbach@kl.com
sbarge@kl.com
apullman@kl.com
hsnyder@kl.com
412.355.6249
412.355.8330
412.355.8369
412.355.6720
Washington Theodore L. Press
tpress@kl.com
212.778.9025
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This bulletin is for informational purposes and does not contain or convey legal advice. The information herein
should not be used or relied upon in regard to any particular facts or circumstances without first consulting a lawyer.
© 2004 KIRKPATRICK & LOCKHART LLP.
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