The days of handing the IRS a big box of receipts in an audit have long since passed. Amid pressure to collect tax revenue, notable frauds perpetrated by businesses, and greater technological capabilities, the federal government has drastically increased its examination tools over the past decade. Although technological advances have skyrocketed, the main result of this trend has been increasing disclosure burdens on both taxpayers and preparers. Examples abound, but perhaps the most notable changes over the past decade concern reportable transactions, the introduction of Schedule M-3, and most recently the potential disclosure of uncertain tax positions to be submitted with annual tax returns. Taxpayers are being left increasingly exposed, and practitioners are being burdened with additional time, effort, and risk for these compliance clients.
Under the IRS Restructuring and Reform Act, P.L. 105-206, the Joint Committee on Taxation conducted a number of studies in 1999 that were primarily concerned with corporate tax shelters. One of the main products of those studies was Regs. Sec. 1.6011-4, requiring disclosure of certain “reportable transactions” in which taxpayers have participated.
Under the regulation as it stands today, there are essentially six main categories of transactions that trigger mandatory disclosures for taxpayers on IRS Form 8886, Reportable Transaction Disclosure Statement (see Regs. Sec. 1.6011-4(b) for more details):
- Listed transactions;
- Confidential transactions;
- Transactions with contractual protection;
- Loss transactions;
- Transactions of interest; and
- Transactions involving a brief asset-holding period.
The IRS has identified these transactions as having a risk of abuse by taxpayers and/or tax advisers. The IRS wants full disclosure of these items, including the tax treatment and expected benefit, a complete description of the transaction, and identification of all related parties. Initially, the IRS had issues with noncompliance due to a lack of penalties associated with nondisclosure, so in the American Jobs Creation Act of 2004, P.L. 108-357, substantial new or increased penalties were imposed without regard to taxpayer intent (i.e., tax avoidance). Currently, under Sec. 6707A, individuals are required to pay a penalty of $10,000 and all other entities a $50,000 penalty for failure to report. These penalties are in addition to any other penalties the IRS has in place, including accuracy-related penalties.
Practitioners must be diligent in discussions with taxpayers in order to identify any potential reportable transactions and ensure they are properly disclosed. These discussions can prove to be difficult because they may be perceived as accusatory in nature, but the risk of noncompliance is too substantial for advisers to be complacent. Cooperating taxpayers are seemingly “thrown to the wolves”; instead of having to discover these items upon audit, the IRS now has these items at its fingertips. However, the IRS stated that disclosure of these items does not necessarily mean that any adjustments in tax will ensue.
Schedule M-3: Net Income (Loss) Reconciliation
Another disclosure-related examination tool the IRS has added in the past decade is Schedule M-3, Net Income (Loss) Reconciliation, for corporations. Prior to 2006, significant book-tax differences were included as a category of reportable transactions. This went away partially due to the introduction of the Schedule M-3 in 2004, which provides the IRS with much greater detail of certain corporations’ (or consolidated groups of corporations for reporting purposes) and partnerships’ book income and book-tax differences. The schedule breaks out book-tax differences more plainly than Schedule M-1, so the IRS can more easily identify these differences by category, dollar amount, and status as permanent or temporary. The increased transparency creates additional work for practitioners in preparing the form, while again exposing taxpayers to greater IRS scrutiny for audit purposes.
In January, the IRS announced a plan to require applicable taxpayers to disclose uncertain tax positions in their annual income tax return. (For a more complete discussion of this development, see “Reporting Uncertain Tax Positions to the IRS,” p. 313.) This disclosure will be more encompassing than FIN 48 for GAAP financial statements by also requiring disclosure of uncertain positions that taxpayers expect to litigate or that they believe the IRS has an administrative policy to not audit. Under the plan, applicable taxpayers must disclose the maximum liability if the position is disallowed in its entirety without regard to any risk analysis. Noncompliance may result in additional penalties, which have yet to be determined.
In addition to creating reportable transactions, Schedule M-3, and Announcement 2010-9, the IRS has also drastically increased other reporting requirements, including, but not limited to, amplified related-party disclosures on Schedule K of Form 1120, U.S. Corporation Income Tax Return, and Schedule B on Form 1065, U.S. Return of Partnership Income. As taxpayers are meeting these additional compliance burdens, they may wonder how intrusive the IRS can be. One case to keep an eye on for how much access the IRS has to taxpayer information is Textron Inc. In that case, the taxpayer challenged under the work product doctrine the IRS’s policy of routinely demanding the tax accrual workpapers of taxpayers that have engaged in listed transactions, as provided in Internal Revenue Manual Section 4.10.20. The First Circuit held that the tax accrual workpapers are discoverable by the IRS ( Textron Inc. , No. 07-2631 (1st Cir. 8/13/09) ( en banc )). Textron has appealed to the Supreme Court for review, but the Court has yet to decide if it is going to hear the case. If the Supreme Court rules in this case, it may provide guidance on just how exposed taxpayers and preparers will be.
The IRS has more examination tools than ever to evaluate tax compliance, and, if Announcement 2010-9 is any indication, this trend is not likely to reverse. Increased technological and information-storage capabilities have allowed the IRS to push for more and more taxpayer disclosures. Information that used to rest solely in taxpayer workpapers is moving to the face of forms, and disclosures are being enforced with the threat of steep penalties. The question is, where will this road end?
Editor: Kevin D. Anderson, CPA, J.D.
Kevin Anderson is a partner, National Tax Services, with BDO Seidman, LLP, in Bethesda, MD.
For additional information about these items, contact Mr. Anderson at (301) 634-0222 or firstname.lastname@example.org.
Unless otherwise noted, contributors are members of or associated with BDO Seidman, LLP.