The Small Business Council of America calls for Congress to place an immediate moratorium on the assessment and collection of the IRC Section 6707A penalty until the statute can be thoroughly reviewed and recommendations can be made to carry out the intention of Congress without the disproportionate and probable unconstitutional impact of current law on small businesses and their owners.
The National Taxpayer Advocate 2008 Annual Report to Congress, page 421, states:
“Notwithstanding the underlying congressional intent in enacting Section 6707A, the statute as written can impose unconscionable hardship on taxpayers. Even the penalty for proven cases of civil fraud is capped at 75 percent of the tax underpayment. Yet this statute allows penalties of up to $300,000 per year to be imposed on taxpayers with no underpayment of tax and no knowledge that they entered into transactions that the IRS has “listed.”
It is rare that a tax provision is found to violate the United States Constitution, but we believe 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 raises significant constitutional concerns, including possible violation of the Eighth Amendment’s prohibition against excessive government fines and due process protections. In practice, the requirement that this penalty be imposed without regard to culpability may have the effect of bankrupting middle class families who had no intention of entering into a tax shelter – an outcome that has dismayed even hardened IRS enforcement personnel.”
Section 6707A of the Internal Revenue Code imposes 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. The 2008 National Taxpayer Advocate report at 419-420 notes the following problems with the Listed Transaction penalty.
- The penalty applies without regard to whether the small business or the small business owners have knowledge that the transaction has been listed.
- The penalty applies even if the small business and/or the small business owners derived no tax benefit from the transaction. The penalty also applies even if on audit the IRS accepts the derived tax benefit.
- The penalty is applied at multiple levels which is devastating to small businesses; the result is that small business and its owners are hit with multiple penalties. Clearly, in the context of a publicly traded company, IRS would assess the $200,000 penalty against the company and not impose a penalty on the shareholders so the penalty is not even a bee sting. 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.
- The penalty is final and must be imposed by the IRS and cannot be rescinded under any circumstances.
- There is no judicial review allowed.
- 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 the taxpayer “benefits” from the transaction it must be reflected on the tax return. It cannot be filed on an amended return but must be a timely filed return.
- A taxpayer that discloses a transaction is subject to the penalty if the IRS deems the disclosure to be incomplete.
- If a transaction is not “listed” at the time the taxpayer files a return but it becomes listed years later, the taxpayer becomes responsible for filing a disclosure statement and will be liable for this penalty for failing to do so. This is true even if the taxpayer has no knowledge that the transaction has been listed.
- 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 involved in a listed transaction, and accordingly the penalties compound because they never made any disclosure. See the first example below.
- The taxpayer must disclose each year, which can result in compounding of the already large penalties.
- The usual three-year statute of limitations does not apply.
Because the penalty is required to be imposed without regard to culpability, it may have the effect of bankrupting small business and/or their owners, even if they had no knowledge nor intention of entering into a listed transaction.
The Treasury Department announces on an 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 a transaction is deemed to be a listed transaction, the draconian Section 6707A penalties are triggered. Section 6707A penalties not only apply to listed transactions but also to transactions that are deemed by Treasury to be “substantially similar” to any of the listed transactions. Some have said that under Section 6707A, IRS and Treasury are the judge, jury and the executioner. We are not aware of any other tax code provision that operates in this unfair and potentially unconstitutional fashion. This penalty, which cannot be abated by either IRS or a court, even for reasonable cause, belies the underlying fairness of our tax system which is essential for a system which largely relies upon voluntary compliance.
While the penalties were aimed at transactions that the IRS considers abusive, the penalty is tied to disclosure so that, even if a court finds that the IRS is wrong in the assumption of a transaction being abusive, the penalty still applies.
Disproportionate Penalty to Tax Underpayment:
In 2002, the taxpayers (husband and wife), who owned and worked together in a small business, were concerned about how best to save for retirement. Their accountant introduced them to a tax consultant who was a CPA and MBA and professed expertise in the area of retirement plans. The taxpayers were advised to establish a LLC along with Roth IRAs for the purpose of building a retirement fund. After being assured that the Roth IRA proposal had validity and complied with all applicable federal laws and regulations, they engaged in certain transactions with their Roth IRAs.
In 2008, the IRS audited the LLC and the small business owners. The IRS informed them that it had predetermined that the Roth IRAs transaction was “substantially similar” to the listed transactions under Notice 2004-8. The IRS dismissed the taxpayers’ claim that the transactions were not similar to the actual listed transaction, and the taxpayers have no right to challenge that determination in court. The IRS completed its audit of the taxpayers and proposed to assess income tax deficiencies of totaling $6,812 respecting the disallowed Roth IRA transactions.
In addition, the IRS proposed Section 6707A penalties totaling $1,200,000. The proposed penalties under Code Section 6707A are almost 180 times the proposed income tax deficiency. IRS imposed $100,000 to the Husband and to the Wife who filed jointly for four years – this totaled $400,000 of the penalties. Additionally, IRS assessed the LLC (the entity) $200,000 for each of the four years for a total of $800,000. ($800,000 plus $400,000 for a total of $1,200,000 in penalties.)
As a result, these small business owners have had to consider bankruptcy and could lose all of their assets and home.
One such taxpayer is Robert Mathew, who owns a small Indiana asphalt-paving company. In 2002, Mr. Mathew purchased a type of life-insurance policy known as a “springing cash value” plan as an alternative to a straightforward pension plan for his employees. Two years later, the IRS added this type of plan to its list of abusive tax shelters, and Mr. Mathew should have disclosed his purchase to the IRS. But he says the financial adviser who sold him the insurance plan at no point told him he needed to make such a disclosure.
Now, Mr. Mathew says, the IRS is demanding taxes and interest totaling $60,000. On top of that, the IRS has set penalties in the amount of $600,000, but has so far granted him several extensions, he says.
“I trusted people, my adviser, to take care of this. Then the IRS came and said, ‘Here’s $600,000 you’re going to have to pay.’ If I had to pay these fees, I would actually have to go bankrupt,” Mr. Mathew said.
In a report to Congress this month, Nina Olson, the IRS National Taxpayer Advocate, said such penalties are “unconscionable.” She said the law as it’s written could affect hundreds of business owners “who had no intention of entering into a tax
Taxpayer filed his Form 8886 with his tax returns, but failed to submit the Form 8886 also to the Office of Tax Shelter Analysis. The IRS assessed the Section 6707A penalty because the taxpayer had not disclosed “perfectly.”
Small Business Owner Paid All Taxes, Interest, etc with IRS Global Settlement Initiative
A Midwest dentist thought he had settled his welfare benefit plan issues with the IRS through the Global Settlement Initiative, IRS Announcement 2005-80. He entered into a closing agreement and paid his tax. After the closing agreement was executed, in full, the dentist received a letter from the IRS telling him he was subject to an additional assessment of penalty for failing to file a Form 8886 in the amount of $300,000. The IRS publications on the Global Settlement Initiative did not disclose to the dentist that he might be assessed Code Section 6707A penalties even though he settled his tax issues through the IRS’ national settlement program.
The Small Business Council of America (SBCA) is a national nonprofit organization which represents the interests of privately-held and family-owned businesses on federal tax, health care and employee benefit matters. The SBCA, through its members, represents well over 20,000 enterprises in retail, manufacturing and service industries, virtually all of which provide health insurance and retirement plans. The SBCA has many of the country’s leading small business tax, healthcare and employee benefit advisors included on its Board and Advisory Boards.
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Roberta Watson, Legal Advisory Board, at (813) 227-7487 or firstname.lastname@example.org