Computing the Reportable Transaction Penalty

Published Categorized as IRS Penalties, Reportable Transactions, Tax Procedure
Subchapter S Corporation Losses Limited By Tax Basis
Subchapter S Corporation Losses Limited By Tax Basis

The Section 6707A reportable transaction penalty can be difficult to work with given the more limited avenues for contesting the penalty. The court addressed this in Bitter v. Commissioner, T.C. Memo. 2017-46, in the context of a Section 412(i) plan.

Tax advisors have been waiting for an answer to the very question of how to compute the penalty that is posed in the Bitter case. That question is whether the amount listed on the tax return must be used to compute the penalty or if the true decrease in tax is to be used.

The 6707A Reportable Transaction Penalty

As part of the American Jobs Creation Act of 2004, Congress enacted Section 6707A along with other penalty provisions related to the disclosure of certain transactions and the failure to report them properly on tax returns. The IRS, in carrying out its authority, requires taxpayers and certain third parties to maintain and submit records pertaining to any reportable transactions.

The Section 6707A reportable transaction penalty applies if the taxpayer fails to report certain transactions to the IRS on a Form 8886, Reportable Transaction Disclosure Statement, with their tax return.

Section 6707A covers two different kinds of transactions: reportable transactions, which are those the IRS has determined as having a potential for tax avoidance or evasion; and listed transactions, which are reportable transactions that are the same as or substantially similar to those that the IRS specifically identified as tax-avoidance transactions.

Treas. Reg. 1.6011-4(b) describes five categories of reportable transactions:

  • Listed transactions
  • Confidential transactions
  • Transactions with contractual protection
  • Loss transactions
  • Transactions of interest

The penalty amount is 75 percent of the decrease in tax shown on the return as a result of the reportable transaction subject to specified maximum and minimum amounts depending on the type of transaction (listed transaction vs. other reportable transaction), and type of participant (natural person vs. entity).

For purposes of calculating the penalty, the term “decrease in tax” means the difference between the amount of tax reported on the filed return and the amount of tax that would be reported on a hypothetical return without the reportable transaction. The amount of tax on the hypothetical return considers adjustments that result mechanically in backing out the reportable transaction. It also considers any other tax that results from reportable transactions not reported on the taxpayer’s return. The term “return” includes original returns, amended returns, and applications for tentative refunds in every case where all three terms are relevant.

Section 6707A does not provide any exception to imposition of the penalty for reasonable cause or good faith. However, except for listed transactions, the IRS may rescind the penalty if rescission would promote tax compliance and effective tax administration. Congress explicitly denied taxpayers the ability to challenge in court the commissioner’s denial of a request to rescind the penalty.

Unlike most other tax penalties, the Section 6707A reportable transaction penalty is an assessable penalty. This means that the IRS can assess the penalty without going through the statutory notice procedures.

This also means that taxpayers generally cannot contest the penalty in U.S. Tax Court. So taxpayers have to pay the penalty, file a refund claim, wait for the refund claim to be denied, and then sue for a refund in U.S. District Court or the Federal Claims Court.

Section 412(i) Plans

Section 412(i) plans are a type of retirement plan where the plan purchases life insurance on the participants and the participants receive death benefits from the plan. Unlike traditional pensions, Section 412(i) plans have the advantage of not requiring the business to made additional contributions if the investments held by the plan lose money or do not perform well.

The IRS’s View of Section 412(i) Plans

Section 412(i) plans were popular in the late 1990s and early 2000s. Their popularity waned shortly thereafter given the IRS’s tough stance on these plans. The then new Section 6707A reportable transaction penalty all but killed Section 412(i) plans, as the IRS designated the plans as listed transactions that had to be reported to the IRS.

The IRS has taken the position that the full amount of the deductions taken for the plan are to be used to determine the amount of the Section 6707A penalty.

Tax advisors have wondered whether the amount for the portion of the deductions for contributions that would be deductible under another Code section should be removed when calculating the Section 6707A penalty.

The IRS takes the position that the penalty is computed based only on the amount listed on the tax return. So for example, if the taxpayer made an error and grossly overreported the amount of the Section 412(i) deduction, the IRS would say that the penalty is computed based on this amount–which would produce a larger penalty. The same would be true if the taxpayer grossly underreported the deduction on his return–which would produce a smaller penalty.

This issue has not been considered by the courts, which is probably due in large part to the Section 6707A penalty not being subject to challenge in U.S. Tax Court.

Challenging the Section 6707A Penalty

This brings us to the Bitter case. The taxpayer in Bitter was asking the U.S. Tax Court to consider this question for the penalty as part of a challenge to a collection due process (“CDP”) hearing.

As noted by the court, the U.S. Tax Court can consider whether a taxpayer is liable for this penalty, but it can only do so if the taxpayer has not previously had an opportunity to contest his liability for the penalty.

The court noted that the taxpayer had challenged this penalty administratively by having a conference with the IRS Office of Appeals. Since the taxpayer was afforded this opportunity, he was precluded from challenging the penalty in the U.S. Tax Court.

So the question remains as to whether the Section 6707A penalty is to be computed using the full deduction amount under Section 412(i) (which has been re-numbered in the Code) or the difference between this amount and the amount of the deduction that would otherwise be allowable even though not reported on the taxpayer’s tax return.

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