Heavy Penalties Under the American Jobs
Creation Act of 2004
James G.S. Yang, Agatha E. Jeffers, and Beixin Lin
2006 - In August 2003, the New York Times reported
that abusive tax shelters cost the U.S. federal government
$85 billion in lost tax revenue from 1993 through 2003. They
also cost state governments an additional $12 billion a year.
According to a 2001 report from the Multistate Tax Commission,
this represents approximately one-third of states’ tax
sold tax shelters to at least 350 people, which brought
the firm $124 million in fees and cost the Treasury $1.4
billion in unpaid taxes between 1996 and 2002. On June 16,
2005, KPMG issued a statement acknowledging “full
responsibility for unlawful conduct by former partners during
that period.” As a consequence, KPMG, LLP, agreed
to pay $456 million in fines, restitution, and penalties
as part of an agreement to defer prosecution. Subsequently,
KPMG reached a $225 million settlement in a class-action
suit covering 275 former tax-shelter clients.
shelters have become so widespread and abusive that Congress
has taken action. The American Jobs Creation Act (AJCA)
of 2004 includes provisions that impose hefty penalties
for failure to report tax shelters. In addition, the IRS
amended Circular 230 to enhance its ethical standards for
attorneys, CPAs, enrolled agents and actuaries, and tax
professionals regarding tax-shelter advice.
information return. Under the AJCA, each material
advisor with respect to any reportable transaction is required
to file a new information return that includes information
identifying and describing the transaction, information
describing any potential tax benefits expected to result
from the transaction, and any other information sought by
of advisees. Each material advisor to any
reportable transaction must maintain a list that identifies
each person advised with respect to the reportable transaction,
and that contains any other information that may be required
by regulations. The filer must make the list available to
the IRS for inspection upon written request, and must retain
the information for seven years.
statute of limitations. As a general rule,
a three-year statute of limitations applies to most tax
returns. Under the AJCA, however, if a taxpayer fails to
include any required information in a tax return or statement
relating to a listed transaction, the statute of limitations
with respect to that transaction will not expire before
one year after the earlier of the date on which the information
is furnished to the IRS or the date that a material advisor
meets the list-maintenance requirements of IRC section 6112.
In other words, the statue of limitations for tax shelters
may possibly be extended from three to as long as four years.
and reportable transactions. A listed transaction
is a reportable transaction that is the same as, or substantially
similar to, a transaction specifically identified by the
Treasury Department as a tax avoidance transaction; in other
words, a tax shelter determined by the IRS to be abusive
and therefore unlawful. A reportable transaction is any
transaction for which information is required to be included
with a return or statement because the Treasury Department
has determined such a transaction has the potential for
tax avoidance or evasion. A reportable transaction has a
much broader scope than a listed transaction. Therefore,
a listed transaction is a reportable transaction, but not
vice versa. In this sense, the treatment of a reportable
transaction can be very ambiguous and can be contested by
Andy is engaged in a partnership transaction
as a tax shelter that results in tax benefits on his income
tax returns filed on April 15 of 2006 and 2007, but he failed
to disclose the required tax-shelter information in the
return. On May 15, 2009, the IRS disallowed the partnership
transaction as an abusive tax shelter. For the 2006 tax
return, the statute of limitations expires after three years,
on April 15, 2009. Because the IRS’s decision was
made on May 15, 2009, after the close of the statute for
the 2006 return, the 2006 tax return is not subject to the
extended statute of limitations.
the 2007 tax return, however, the statute of limitations
will not expire until after April 15, 2010. Because the
IRS’s decision was made well before this date, the
2007 tax return is subject to the extended statute of limitations
as a listed transaction. The IRS has the right to audit
Andy’s 2007 return until April 15, 2011.
Penalty for Failure to Disclose Tax Shelters
of penalty. The AJCA imposes a new, separate
penalty on any person who fails to include on his tax return
any required information or statement with respect to a
tax shelter. The penalty depends upon whether it is a reportable
transaction or a listed transaction. It further depends
upon whether the transaction is committed by a natural person
or by a business entity. The penalty amounts are:
penalty is in addition to any other penalty, such as an
accuracy-related penalty, that may be imposed on the taxpayer.
of penalty. The IRS may abate or rescind a
penalty in whole or in part, but only if the transaction
at issue is not a listed transaction and the rescission
would promote effective tax administration and compliance
with the tax laws. In the case of a reportable transaction,
however, the IRS can waive the penalty. Further, the IRS’s
decision regarding the rescission of a penalty is not subject
to judicial review. Although the Tax Court has no authority
to review the IRS’s rescission determination, the
court can review whether the transaction at issue is reportable.
Bob, an individual taxpayer, failed to report
a reportable transaction that resulted in a $10,000 penalty.
He also failed to report a listed transaction that entailed
a $100,000 penalty. The IRS decided to reduce the penalty
on the reportable transaction from $10,000 to $8,000, but
not to reduce the $100,000 penalty on the listed transaction.
Bob were to file a petition claiming rescission for all
penalties on both transactions, the court cannot do anything,
because it is the IRS’s sole authority to decide by
how much the penalty on the reportable transaction can be
reduced, and whether the penalty on the listed transaction
can be rescinded at all.
receiving a refusal of hearing by the court, Bob can file
another petition to the court contending that both the reportable
transaction and the listed transactions were not reportable
in the first place. In this case, the court can hold a hearing
to decide whether both transactions are reportable and thus
subject to penalties. The issue of whether a transaction
is reportable is not the same as the rescission determination
of a penalty.
Penalty on Tax-Shelter Promoters
IRC imposes a civil penalty on promoters of abusive tax
shelters. Before the AJCA, the penalty for making a false
or fraudulent statement was the lesser of $1,000 or 100%
of the gross income derived, or to be derived, from the
tax-shelter activity by the person. For purposes of computing
this penalty, the organization of an entity, plan, or arrangement
and the sale of each interest in an entity, plan, or arrangement
are separate activities subject to penalty. In other words,
the penalty for each activity is counted separately, and
those amounts are then added together to derive the total
amount of the penalty.
the AJCA, for a person who knowingly makes, or causes another
to make, a false or fraudulent tax benefit statement of
a material matter pertaining to a tax-shelter plan, the
penalty is increased to 50% of the gross income derived,
or to be derived, from the abusive plan. Nevertheless, for
purposes of computing this penalty, all activities are added
together first, and the 50% penalty is then applied to the
In 2004, Charles was engaged in establishing a cattle-breeding
tax-shelter arrangement for his clients. This tax shelter
was determined to be abusive and thus unlawful. Charles
made a false representation to his clients claiming benefits
of an income tax deduction. He received $900 in fees from
the first client and an additional $3,000 in fees from each
of the next 10 clients. What is the amount of penalty for
promoting the abusive tax shelter after the 2004 Act? What
would have the penalty been before the AJCA?
the AJCA, the penalty was computed for each client separately.
The penalty for the first client would have been the lesser
of $1,000 or 100% of $900, resulting in a penalty of $900.
For each of the next 10 clients, the penalty would have
been the lesser of $1,000 or 100% of $3,000, resulting in
a penalty of $1,000 for each client. Therefore, the total
penalties for all 11 of Charles’ clients would have
been $10,900 [$900 + ($1,000 x 10)].
the AJCA, the penalty is computed on the basis of gross
income in the aggregate amount for all 11 clients as a whole.
Because the gross income is $30,900 [$900 + ($3,000 x 10)],
the 50% penalty would be $15,450 ($30,900 x 50%).
penalties have increased by $4,550 ($15,450 – $10,900)
as a result of the AJCA. These larger penalties are aimed
at deterring tax-shelter abuses.
increased penalty does not apply to gross valuation overstatements.
Any person who makes, or causes another to make, a gross
valuation overstatement continues to be subject to a penalty
equal to the lesser of $1,000 or 100% of the gross income
derived, or to be derived, from such activity. This penalty
may be waived if a reasonable basis for the valuation is
shown and the statement was made in good faith.
Penalty for Failure to Furnish Information on Reportable
organizer of a tax shelter is required to register the tax
shelter with the IRS on Form 8264, Application for Registration
of a Tax Shelter, on the first day the tax shelter is offered
for sale. The registration must provide information identifying
and describing the tax shelter, the tax benefits expected
by investors in the tax shelter, and other required information.
If the tax shelter is registered but the organizer provides
false or incomplete information, an additional penalty is
encourage compliance with the disclosure requirements of
a reportable transaction, the penalty for failure to furnish
required information with respect to a reportable transaction
has been increased to $50,000 under the AJCA. More important,
in the case of a listed transaction, the penalty is the
greater of $200,000 or 50% of the gross income derived by
the individual. This 50% limit is raised to 75% if an intentional
failure or action is involved.
Penalty for Failure to Maintain Investor Lists
person who organizes and sells potentially abusive tax shelters
is required to maintain a list identifying each person who
purchases an interest in any such tax shelter, along with
any additional information required by the IRS. Upon receipt
of a written request from the IRS, an individual must make
those lists available within 20 business days, or be subject
to a $10,000 penalty per day thereafter. Prior to the AJCA,
the penalty for maintaining an incomplete investor list
was $50 per name omitted, with a maximum penalty of $100,000
Accuracy-Related Penalty for Listed and Reportable Transactions
tax underpayment arising from negligence or disregard of
the regulations is subject to an accuracy-related penalty.
This includes tax-shelter transactions. Any taxpayer who
participates in a tax-shelter transaction must file Form
8886, Reportable Transaction Disclosure Statement. Prior
to the AJCA, the penalty was equal to 20% of the amount
the AJCA’s provisions, a new accuracy-related penalty
is provided for understatement resulting from any listed
transaction and reportable transactions designed with a
significant tax-avoidance purpose. The penalty is generally
20% of the understatement if the taxpayer disclosed the
transaction and 30% if the transaction was not disclosed.
The penalty applies only to the amount of the understatement
that is attributable to the listed or reportable transaction.
accuracy-related penalty on abusive tax shelters is always
35% for individuals or corporations, regardless of a taxpayer’s
marginal tax bracket.
David is an individual taxpayer in the 15% bracket. He invested
in an oil-drilling partnership intended to be a tax shelter,
but never participated in its management. He did not register
by filing Form 8886. In 2004, the business incurred a loss,
and David’s share was $40,000. The partnership also
claimed a business energy tax credit, and David’s
share was $1,000. He filed his 2004 tax return by claiming
the $40,000 loss as a deduction from compensation income,
alongside the $1,000 tax credit. The IRS ruled the business
an abusive tax shelter. What is the amount of tax understatement?
What is David’s accuracy-related penalty? What is
his final tax liability?
tax understatement for the $40,000 disallowed loss deduction
is $14,000 ($40,000 x 35%). Together with the $1,000 disallowed
tax credit, the total tax understatement is $15,000. Because
David failed to register the tax shelter, the penalty is
30% of the $15,000 total tax understatement, or $4,500.
Therefore, David’s total tax liability is $19,500
($15,000 + $4,500). Although David’s tax bracket is
only 15%, his $40,000 excess-loss deduction is taxed at
the highest individual tax rate of 35%. It results in an
additional tax understatement of $8,000 [$40,000 x (35%
– 15%)], of which the additional penalty is $2,400
($8,000 x 30%). In total, the additional tax liability is
$10,400 ($8,000 + $2,400).
David registered the tax shelter with the IRS by filing
Form 8886, the accuracy-related penalty rate would have
been only 20%, meaning his penalty would have been only
$1,600, rather than $2,400.
David “materially participated” in the management
of the partnership business and also registered with the
IRS by filing Form 8886, the $40,000 loss would have been
deductible, the $1,000 tax credit would have been allowed,
and the 30% penalty on the tax understatement would have
been eliminated. The entire additional $19,500 tax liability
could have been avoided. The penalty for nonregistration
can be hefty indeed.
this business is most likely a “listed transaction,”
the IRS, under the AJCA, could probably impose an additional,
highly punitive, $100,000 penalty for failure to register
coordination. In sum, the listed and reportable
transactions penalty is coordinated with three other penalties:
Accuracy-related penalties: The understatement attributable
to listed and reportable transactions is included in the
amount of the taxpayer’s total understatement for
purposes of determining whether the taxpayer has a substantial
understatement of tax. However, the understatement attributable
to a listed or reportable transaction is not included
in the taxpayer’s total understatement for purposes
of calculating the accuracy-related penalty.
Fraud penalties: An understatement for purposes of the
fraud penalty includes understatements attributable to
listed and reportable transactions.
Valuation misstatement penalties: These valuation misstatement
penalties do not apply to any portion of an understatement
on which the listed and reportable avoidance transaction
penalty was imposed.
of Interest Deduction
the AJCA, interest paid or accrued on delinquent federal
or state taxes and on debt used to pay such taxes was nondeductible
for individuals, but it was deductible for corporations
as an ordinary and necessary business expense. The AJCA
made the interest related to the underpayment of tax in
connection with an undisclosed tax shelter also nondeductible
Authority to Enjoin Material Advisors
government may seek an injunction against any person—a
material advisor—who knowingly aids and abets in the
understatement of the tax liability of another person by
failing to file an information return with respect to a
reportable tax-shelter transaction as required by regulations
and subject to penalty, or by failing to maintain, or to
timely furnish upon written request by the IRS, a list of
investors with respect to each reportable tax-shelter transaction
as required by regulations.
Ethical Standards: Amended Circular 230
Treasury Department upgraded Circular 230 to enhance ethical
standards through the following best practices:
Communicating clearly with the client regarding the terms
of the engagement.
the relevant facts, evaluating the reasonableness of assumptions,
relating the applicable law to the relevant facts, and
arriving at a conclusion.
Advising the client regarding the importance of the conclusions
reached and the reliance that can be placed on the advice.
with integrity in practice before the IRS.
is hoped that these measures will curb many of the abuses
of the past.
here to read Sidebar.
G.S. Yang, MPh, CPA, CMA, is a professor of accounting,
Agatha E. Jeffers, PhD, CPA, is an assistant
professor of accounting, and
Beixin Lin, PhD, is an assistant professor
of accounting, all at Montclair State University, Montclair,