The American Jobs Creation Act of 2004 (2004 Act) imposed new penalties on taxpayers who fail to adequately disclose “reportable transactions” to the IRS. Before the 2004 Act, taxpayers were generally only penalized for not disclosing a reportable transaction if the IRS was successful in challenging the transaction. Accordingly, many taxpayers were not overly concerned about disclosing transactions with legitimate tax benefits and/or little chance of a successful IRS challenge.
In an attempt to curb the use of abusive tax shelters, the 2004 Act enacted new, stiff penalties of $10,000 for a natural person’s failure to adequately disclose a reportable transaction to the IRS on a return due after October 22, 2004 (the date the 2004 Act became law). Other non-reporting taxpayers were subject to a $50,000 penalty. The penalties increased to $100,000 and $200,000, respectively, for natural persons and other taxpayers who failed to disclose a reportable transaction that is a listed transaction.
In an effort to achieve proportionality between the penalty and the tax savings resulting from the reportable transaction, the Small Business Jobs Act of 2010 (2010 Act) revised the penalty structure for all reportable transaction penalties assessed after December 31, 2006. Under the 2010 Act, a participant in a reportable transaction who fails to disclose is subject to a penalty equal to 75 percent of the reduction in tax reported on the participant’s tax return as a result of participation in the transaction. Regardless of the amount determined under the general rule, the penalty for each such failure may not exceed $10,000 in the case of a natural person and $50,000 for all other taxpayers. For listed transactions, the maximum penalties are increased to $100,000 and $200,000, respectively, for natural persons and other taxpayers. The 2010 Act also establishes a minimum penalty with respect to failure to disclose a reportable or listed transaction. The minimum penalty is $5,000 for natural persons and $10,000 for all other taxpayers.
If a reportable transaction is not disclosed and results in an understatement of tax, the statute of limitations is suspended and an additional penalty in the amount of 30 percent of the understatement may be assessed.
Even with proper disclosure, taxpayers are still subject to a 20 percent penalty on the understatement of tax.
Unlike most other penalties, the law significantly limits the IRS’s ability to rescind or abate these penalties for reasonable cause or other reasons. Accordingly, it is very important that reportable transactions be adequately disclosed and material advisors timely register transactions as required and maintain sufficient documentation.
Taxpayers should not fall into the trap of thinking reportable transactions are limited to abusive tax shelters. The definition of a reportable transaction is very broad and includes many transactions that are routine and perfectly legitimate. A breach of these rules can result in significant penalties. If you think you are a participant or material advisor in one of these transactions, contact us.