Chief Counsel's Office: Abusive Tax Shelter Penalties Aren't Limited to Initial Promotion

(Parker Tax Publishing July 2021)

The Office of Chief Counsel advised that the penalty under Code Sec. 6700 for promoting an abusive tax shelter applies not just to income derived from the initial promotion and/or organizational activity that occurred before the formation of the tax shelter but to all gross income derived from the organization or sale of a tax shelter, including gross income derived after its formation. Thus, according to the Chief Counsel's Office, the gross income subject to the Code Sec. 6700 penalty includes ongoing maintenance, management, and other fees received related to the continued facilitation and organization of the promotion. CCM 202125008.

Background

Code Sec. 6700 imposes a penalty on persons who promote abusive tax shelters. Specifically, the penalty applies to any person who organizes or participates in the sale of an entity, plan, or arrangement and makes a statement with respect to the allowability of any deduction or credit, the excludability of any income, or the securing of any other tax benefit by reason of holding an interest in the entity or participating in the plan or arrangement which the person knows or has reason to know is materially false or fraudulent. Under Code Sec. 6700(a), the penalty equals 50 percent of the gross income derived (or to be derived) from such activity if the activity involves false or fraudulent statements.

In CCM 202125008, the Office of Chief Counsel was asked to advise whether the calculation of the penalty under Code Sec. 6700 includes the promoter's gross income derived from the organization or sale of a tax shelter after the formation of the tax shelter. The facts involved a corporation that engaged in the promotion of micro-captive insurance transactions (i.e., a promoter). In a typical micro-captive insurance transaction, a taxpayer attempts to reduce the aggregate taxable income of the taxpayer, related persons, or both, using contracts that the parties treat as insurance contracts and a related company that the parties treat as a captive insurance company. Each entity that the parties treat as an insured entity under the contracts claims deductions for premiums for insurance coverage. The related company that the parties treat as a captive insurance company elects under Code Sec. 831(b) to be taxed only on investment income and therefore excludes the payments directly or indirectly received under the contracts from its taxable income.

In this case, the promoter set up and provided ongoing services related to the continuing maintenance and management of a micro-captive insurance company. In response to the IRS's questions posed during a Code Sec. 6700 audit, the promoter asserted that Code Sec. 6700 penalties are calculated only on the income derived from initial promotional and/or organizational activity that occurred before the formation of the micro-captive insurance company. The promoter received ongoing maintenance and management fees relating to the micro-captive insurance companies. The promoter made false statements regarding available tax benefits while engaged in both organizational and sales activities.

Analysis

The Chief Counsel's Office advised that the Code Sec. 6700 penalty is 50 percent of the gross income derived or to be derived from the organization or sale of a tax shelter, if the organization or sale involves false or fraudulent statements. According to the Chief Counsel's Office, courts have found that Code Sec. 6700 allows the government to assess a penalty on all gross income derived from the organization or sale of a tax shelter, including gross income derived after the formation of the tax shelter.

The Chief Counsel's Office explained that in Tarpey v. U.S., 2019 PTC 437 (D. Mont. 2019), a district court held that the "activity" giving rise to a Code Sec. 6700 penalty encompassed the entire promotion facilitated and organized by the promoter, including the promoter's solicitation of timeshare donations, timeshare appraisals, and direct profits to his other organizations. In addition, in Davison v. Comm'r, T.C. Memo. 2020-58, the Tax Court found that Code Sec. 6700 penalties were appropriately assessed and accurately calculated based on the promoter's gross income derived from the entire promotion. In that case, the promoter's gross income included amounts paid as a retainer for the promoter's ongoing services for facilitating and organizing the tax shelter, including serving on a board of directors, years after the formation of the abusive tax shelter.

In the view of the Chief Counsel's Office, these cases illustrate that Code Sec. 6700 allows the government to assess a penalty on gross income derived from the facilitation and organization of the entire promotion, and the penalty is not limited temporally to activity occurring before the formation of the tax shelter. In the context of micro-captive insurance transactions, the Chief Counsel's Office found, Code Sec. 6700 allows the government to assess a penalty on a promoter's gross income derived from the facilitation and organization of the entire tax shelter by the promoter, not just gross income pre-dating the formation of the micro-captive insurance company. For example, the Chief Counsel's Office said that gross income derived would include ongoing maintenance and management fees received related to the continued facilitation and organization of the promotion as well as any other fees relating to the continued facilitation and organization of the promotion.

The Chief Counsel's Office was not persuaded by two cases cited by the promoter in support of its argument that the Code Sec. 6700 penalties are calculated only on income derived from the initial promotional and/or organizational activity that occurred before the formation of the micro-captive insurance company. In Schulz v. U.S, 2018 WL 3405240 (N.D.N.Y. 2018), a district court found that a promoter's tax shelter activity was the distribution of blue folders that promoted frivolous tax arguments and that the penalty should be calculated on the gross income derived from the tax shelter activity. The Chief Counsel's Office said that the case supported the legal conclusion that Code Sec. 6700 allows the government to assess a penalty on gross income derived or to be derived from the facilitation or organization of a tax shelter. In Hargrove & Costanzo v. U.S., 2008 PTC 185 (E.D. Cal. 2008), a district court analyzed a prior version of Code Sec. 6700(a)(1) and its application to 18 bond issuances that were the subject of assessments under Code Sec. 6700. The court considered whether each bond sale was to be treated as a separate activity for purposes of assessing multiple $1,000 minimum penalty amounts under that prior version of the statute. However, the Chief Counsel's Office found that the rule for activities occurring on or after October 23, 2004, provides that the penalty amount equals 50 percent of the gross income derived (or to be derived) from the organization or sale of a tax shelter by the person penalized. According to the Chief Counsel's Office, the legislative history shows that Congress believed that the pre-2004 penalty rate discussed in Hargrove was insufficient to deter the type of conduct that gave rise to the penalty. Accordingly, Congress amended Code Sec. 6700 to modify the penalty amount to equal 50 percent of the gross income derived by the person from the activity for which the penalty is imposed.

For a discussion of the penalty for promoting abusive tax shelters, see Parker Tax ¶262, 175.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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