Taxpayers that discover after filing their returns that they indirectly participated in a reportable transaction through a passthrough entity may be able to rely on Prop. Regs. Sec. 1.6011-4(e)(1) to avoid reportable transaction penalties. The preamble to the proposed regulations (REG-103038-05, 11/2/06) provided that this relief was effective immediately.
Reportable Transaction Basics
Currently, under Regs. Sec. 1.6011-4(b), there are five categories of reportable transactions: listed transactions, confidential transactions, transactions with contractual protection, Sec. 165 loss transactions and transactions with a brief asset-holding period. Taxpayers that have participated in one of these are required to disclose it on Form 8886, Reportable Transaction Disclosure Statement, attached to their federal income tax return. The first time a taxpayer discloses the transaction, a copy of Form 8886 must also be sent to the Office of Tax Shelter Analysis (OTSA); see Regs. Sec. 1.6011-4(d).
For partnerships, S corporations and trusts, the entity and the interest holder must each separately determine whether the taxpayer has participated in a reportable transaction and, thus, whether the taxpayer is required to disclose it on Form 8886. Instructions for Schedule K-1 require passthrough entities to provide interest holders with information so that the latter can determine if they have a disclosure obligation (see, e.g., p. 13 of the Instructions to Form 1065, U.S. Return of Partnership Income, Schedule K-1, Partner’s Share of Income, Deductions, Credits, etc., under the heading “Code Q, Other Information”). Based on these rules, it is possible for a partner to have a disclosure obligation even though the partnership does not or, alternatively, for a partnership to have a disclosure obligation even though its partners do not.
Example: In 2007, Partnership X has a $10 million Sec. 165 loss that is not a Sec. 988 loss. Partners A (a corporation) and B (an individual) each have a 50% allocable share of the loss. Under the reportable transaction regulations, X has a disclosure obligation, because the loss exceeds the $2 million reporting threshold for Sec. 165 losses for partnerships under Regs. Sec. 1.6011-4(b)(5)(i)(C). In addition, B has a disclosure obligation, because his allocable share of the loss, $5 million, exceeds the $2 million reporting threshold for individuals under Regs. Sec. 1.6011-4(b)(5)(i)(C). However, A does not have a disclosure obligation, because the loss does not meet the $10 million reporting threshold for corporations under Regs. Sec. 1.6011-4(b)(5) (i)(A).
Penalties: In 2004, Congress enacted Sec. 6707A, which provides a penalty for failure to disclose a reportable transaction, and Sec. 6662A, which provides a special accuracy-related penalty for listed transactions and reportable transactions with a significant purpose of avoiding or evading Federal tax. For listed transactions, the Sec. 6707A penalty is $200,000 for corporations and $100,000 for other taxpayers; it may not be waived or rescinded. For other reportable transactions, the penalty is $50,000 for corporations and $10,000 for other taxpayers; it may be waived or rescinded only in limited circumstances (see Sec. 6707A(d) and Rev. Proc. 2007-21).
In general, the accuracy-related penalty under Sec. 6662A is 20% of the reportable transaction understatement. The penalty increases to 30% if the reportable transaction is not disclosed. Under Sec. 6664(d), a strengthened reasonable cause exception may be available to avoid the Sec. 6662A penalty, but no defense is available if the transaction was not disclosed.
Thus, a taxpayer that fails to disclose timely a reportable transaction is potentially exposed to significant penalties whose effect is exacerbated by the limited defenses available. Although there are no statutory provisions to forgive unintentional errors resulting in a failure to disclose, the Service has provided limited relief for certain passthrough-entity interest holders, permitting them additional time to file Form 8886 while still avoiding the Sec. 6707A penalty. A taxpayer can correct a failure to disclose a transaction for purposes of the Sec. 6662A accuracy-related penalty, by filing a qualified amended return meeting the requirements of Temp. Regs. Sec. 1.6664-2T. However, a qualified amended return cannot be used to correct a failure to disclose a transaction for purposes of avoiding the Sec. 6707A penalty.
Partners, shareholders and beneficiaries struggle to report accurately the allocable share of income from passthrough entities, primarily because the extended due date for Schedule K-1 coincides with or is later than the extended due date for federal income tax returns. This may also prevent a Schedule K-1 recipient from timely disclosing indirect participation in a reportable transaction through ownership of a passthrough entity that participated in one. If the interest holder receives a Schedule K-1 reporting an allocable share of a reportable transaction close to or after its filing due date (which often occurs even if the interest holder has requested an extension), the interest holder will likely not even know that there is a disclosure obligation resulting from ownership of an interest in the passthrough entity. However, the interest holder is still required to disclose the transaction if it “participated” in the transaction and may be exposed to potential penalties for failure to do so.
Unlike accuracy-related penalties, the penalty for failure to disclose a reportable transaction can be waived (rescinded) only in extremely limited circumstances (if at all). Thus, even though a taxpayer may be able to establish reasonable cause to avoid an accuracy-related penalty under Sec. 6662 (e.g., due to receipt of a Schedule K-1 after the taxpayer filed a return), that relief would not excuse a failure to disclose a reportable transaction on the original filed return, which is subject to the Sec. 6707A penalty.
Prop. Regs. Sec. 1.6011-4 provides limited relief for passthrough-entity interest holders who receive Schedules K-1 close to their return filing due date. Under Prop. Regs. Sec. 1.6011-4(e)(1), relief is provided if a partner, an S shareholder or a beneficiary receives a timely Schedule K-1 less than 10 calendar days before the due date of the taxpayer’s return (including extensions). If, in those situations, the taxpayer determines (based on the Schedule K-1) that it participated in a reportable transaction, the disclosure will be deemed timely if filed with the OTSA within 45 calendar days of the return due date (including extensions). Under this relief provision, filing with the OTSA is sufficient, and no amended return is required. The preamble to the proposed regulations explains that even though they are not final, taxpayers may currently rely on this relief.
Determining Whether Relief Is Available
The relief provided to passthrough-entity interest holders in the proposed regulations is very limited. To be eligible, three requirements must be met:
1. Schedule K-1 received less than 10 days before return due date: To be eligible, a Schedule K-1 must be received less than 10 calendar days before the due date of the taxpayer’s return (including extensions). A reportable transaction reported on a Schedule K-1 received on the tenth calendar day before the due date of the recipient’s return is not eligible for relief. The arbitrary choice of 10 days means that eligibility will depend on when the passthrough entity completes its Schedules K-1 and on the mail system. It is likely that issues will arise about when the recipient received the Schedule K-1. How will a taxpayer be able to prove receipt for purposes of determining eligibility for this relief?
2. Schedule K-1 is timely: Even if Schedule K-1 is received on the ninth calendar day before the return’s due date (including extensions), relief will not apply if the Schedule K-1 is not timely. This criterion is patently unfair to the interest holder, because the passthrough entity, not the interest holder who needs relief, is the one required to satisfy it. If the interest holder is unaware that it has participated in a reportable transaction indirectly through the passthrough entity, it is likely that the interest holder also has little control over the timeliness of the Schedule K-1.
3. File with the OTSA within 45 calendar days of the return due date: The disclosure must be made to the OTSA within 45 calendar days of the return’s due date, including extensions. This time seems sufficient (provided the taxpayer actually receives a timely Schedule K-1). In addition, the government created a more administrable rule by requiring disclosure to the OTSA only, rather than also requiring the taxpayer to amend its return.
Passthrough-entity interest holders welcome this relief, but many commentators have requested broader help with the reportable transaction requirements. The IRS and Treasury should reconsider the need for duplicate filings by partnerships and partners, giving special consideration to eliminating disclosure requirements for partners who have de minimis interests in a partnership or who own interests in widely held investment vehicles. In these cases, the interest holders have no decisionmaking authority. Thus, whether these interest holders participate in a reportable transaction is in the control of the passthrough entity, not the partner. Until the Service and Treasury issue broader relief, the relief provided in the proposed regulations should be extended to late Schedules K-1, because their timeliness is generally outside the control of the passthrough-entity interest holder. To avoid abuses, this extended relief could be limited to taxpayers with a de minimis ownership interest or control in the passthrough entity.
Mr. Miller is a member of the AICPA Tax Division’s IRS Practice and Procedures Committee. Mr. Brennan is the chair, and Messrs. Snow and Tierney and Ms. Hodes are members, of that committee. For further information about this column, contact Mr. Miller at email@example.com.