CPAs at Risk As Government Continues to Attack Abusive Tax Shelters
How the new rules and penalties can result in criminal prosecution and civil litigation against practitioners involved in abusive tax avoidance schemes.
by John McGowan/The Tax Adviser
Tax avoidance can be defined as legally using tax rules to reduce the amount of tax payable by lawful means. Examples of tax avoidance include: accelerating tax deductions, deferring income, changing one's tax status through incorporation, or setting up a charitable trust or foundation. These strategies are often identified as legal tax shelters.
On the other end of the spectrum is tax evasion, which is generally defined as a plan to reduce the amount of tax payable through illegal means. Abusive tax shelter transactions typically have no economic purpose other than to reduce taxes with predictable tax losses or tax consequences. Abusive tax shelters fall under the heading of tax evasion. Taxpayers must exercise caution to ensure that their legitimate tax strategies do not evolve into what would be considered "abusive tax shelters" promoted purely for the promise of tax benefits with no meaningful change in a taxpayer's income or net worth.
Many abusive tax shelters became popular in the 1990s among individuals and businesses with one-time large capital gains. At that time, the penalties associated with participating in abusive tax shelters were too small to have a deterrent effect. However, the tide has turned against promoters of such abusive tax shelters.
Rules Governing Tax Shelters
It is difficult for CPAs and attorneys to argue that tax shelters without economic substance are legal, given prevailing statutes, Treasury regulations and IRS rules. The IRS has dealt with the issue numerous times in various forms of guidance, beginning in 1999. The first major notice dealing with tax shelters was Notice 99-59, in which the Service informed taxpayers that certain types of transactions involving the distribution of encumbered property would not be accepted. Specifically, the introduction of Notice 99-59 alerted taxpayers and their representatives that non-economic losses generated through tax avoidance transactions are not properly allowable for federal income tax purposes.
Notice 99-59, citing Regs. Sec. 1.165-1(b), states that "[a] loss is allowable as a deduction for federal income tax purposes only if it is bona fide and reflects actual economic consequences. An artificial loss lacking economic substance is not allowable." The notice also warns taxpayers that the IRS may impose certain penalties on participants or promoters of these transactions, including the Sec. 6662 accuracy-related penalty, the Sec. 6694 return preparer penalty, the Sec. 6700 promoter penalty and the Sec. 6701 aiding and abetting penalty.
CPAs' Professional Requirements
CPAs and tax preparers have a professional duty to be aware of pertinent tax rules regarding transactions on which they offer advice, including any rules contained in IRS notices. This obligation is clearly spelled out in the AICPA Statements on Standards for Tax Services (SSTS).
CPAs must follow the SSTS, which are known as practice standards. The SSTS define the professional and ethical tax practice standards for AICPA members. The courts, the IRS, state accountancy boards and other professional organizations have recognized and relied on these standards as the appropriate articulation of professional conduct in a CPA's tax practice. In and of themselves, they have become de facto enforceable standards of professional practice. State disciplinary organizations and malpractice cases in effect regularly hold CPAs accountable for failure to follow these standards.
Standard No. 1, Tax Return Positions, declares that an AICPA member should not recommend a tax return position on any item unless the member has a good-faith belief that the position has a realistic possibility of being sustained administratively or judicially on its merits if challenged. The explanation of this standard reads as follows: "In order to meet the standards contained in paragraph 2, a member should in good faith believe that the tax return position is warranted in existing law or can be supported by a good-faith argument for an extension, modification or reversal of existing law." For these purposes, existing law embodies federal and state statutes, Treasury regulations, pertinent court cases and relevant IRS rulings.
Abusive Tax Shelter Penalties
Criminal penalties: Both taxpayers and preparers accept a certain level of responsibility by signing a tax return. CPAs and lawyers sometimes claim ignorance of relevant tax rules and statutes as a defense against the willfulness element. In fact, the Department of Justice's Criminal Tax Manual specifies that a defense to a finding of willfulness is that the defendant was ignorant of the law or of facts that made the conduct illegal. However, it also states that courts have held that "if a defendant deliberately avoids acquiring knowledge of relevant facts or laws, then a jury may infer that he or she actually knew about them and was merely trying to avoid giving the appearance (and incurring the consequences) of knowledge."
Civil penalties: The American Jobs Creation Act of 2004, P.L. 108-357 (AJCA), imposed substantial new penalties on tax shelter–related transactions. The AJCA created a penalty that applies to a person who fails to disclose on a return or statement any required information about a reportable transaction. The penalty applies whether or not the transaction resulted in an understatement of tax and is in addition to any accuracy-related penalty. The amount of the penalty is $10,000 for individuals and $50,000 for all others ($100,000 and $200,000, respectively, for failure to disclose a listed transaction). The AJCA also created a 20 percent accuracy-related penalty that applies to adequately disclosed reportable transaction understatements. The 20 percent penalty can be waived if the taxpayer acted in good faith and meets a strengthened reasonable cause exception. The penalty jumps to 30 percent for understatements with respect to reportable transactions that are not adequately disclosed and it cannot be waived.
Implications for Tax Practitioners
Individuals across the nation have lost millions of dollars as a result of abusive tax shelters they were convinced to purchase by overzealous promoters. A number of civil legal actions have been brought by taxpayers against the promoters of these tax shelters and criminal prosecutions have been brought by the government. Injured parties are now bringing actions against CPAs for their role in these tax shelters. While the number of investigations by the IRS Criminal Investigation Division has remained constant, the numbers of prosecutions, indictments and convictions have doubled in recent years. In fact, the list of CPAs who have been convicted of fraud in the aftermath of the abusive tax shelters has been growing steadily.
The results of the cases from the abusive tax shelter industry should serve as reminders for attorneys and CPAs that there is a fine line between legitimate tax avoidance and illegal tax evasion. CPAs and other tax practitioners should understand that the Service will not hesitate to impose certain penalties on both participants in and promoters of abusive tax shelters. Such penalties could include the accuracy-related penalty under Sec. 6662, the return preparer penalty under Sec. 6694, the promoter penalty under Sec. 6700 and the aiding and abetting penalty under Sec. 6701. In addition, a number of CPAs are now facing tax fraud charges in court and more will surely be indicted in the future. In addition to penalties, these tax fraud convictions can also lead to prison incarceration, home confinement or electronic monitoring.
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John R. McGowan, Ph.D., CPA, is a Professor of Accounting at the St. Louis University, St. Louis, MO. He is a contributing writer for The Tax Adviser. His views as expressed in this article do not necessarily reflect the views of the AICPA or The Tax Adviser.