United States: New Excise Taxes and Disclosure Rules With Respect to Potentially Abusive Tax Shelter Transactions Involving Tax-Exempt Entities

On May 17, 2006, Congress enacted the Tax Increase Prevention and Reconciliation Act of 2005 ("TIPRA"), which includes new excise taxes and disclosure rules targeting potentially abusive tax shelter transactions to which a tax-exempt entity is a party. TIPRA creates a new section 4965 and amends sections 6033(a)(2), 6011(g) and 6652(c)(3) of the Internal Revenue Code of 1986, as amended (the "Code"). The TIPRA amendments have broad application to tax-exempt entities and their managers; entities that may be affected by the new provision include, but are not limited to, charities, state and local governments, qualified pension plans, individual retirement accounts, health savings accounts, and similar tax-favored savings arrangements. The manager of these entities, and in some cases the entities themselves, may be subject to excise taxes if the entity is a party to a prohibited tax shelter transaction.

These excise taxes are in the nature of fines or penalties and intended to regulate behavior rather than raise revenue.

The excise taxes apply to taxable years ending after May 17, 2006, with respect to transactions entered into before, on, or after such date, except no excise tax applies to income or proceeds properly allocable to any period ending on or before August 15, 2006. Additionally, the new disclosure requirements and related penalties for failure to comply apply to disclosures due after May 17, 2006.

The Internal Revenue Service ("IRS") issued Notice 2006-65 on July 11, 2006 to ensure that affected entities are aware of the new TIPRA provisions and is seeking comments on the new excise tax and disclosure requirements by August 11, 2006. Additional guidance is expected to be issued promptly.

Section 4965 of the Code imposes an excise tax on certain tax-exempt entities that are parties to prohibited tax shelter transactions. It also imposes an excise tax on entity managers of tax-exempt entities who allow or cause the entity to be a party to a prohibited tax shelter transaction and know or have reason to know that the transaction is a prohibited tax shelter transaction.

Tax-exempt entities are divided into two categories: plan entities and non-plan entities. Plan entities include qualified pension plans, governmental pension plans, individual retirement accounts and health savings accounts. Non-plan entities include charities and state and local governments. Entity manager means, (i) in the case of plan entities, the person who approves or otherwise causes the entity to be a party to the prohibited tax shelter transaction, and (ii) in the case of non-plan entities, the person with authority or responsibility similar to that exercised by an officer, director or trustee. An individual beneficiary (including a plan participant) or owner of a tax-favored retirement plan, individual retirement arrangement or savings arrangement may be liable as an entity manager if he or she has broad investment authority under the arrangement.

The excise taxes are in addition to any other tax, addition to tax, or penalty imposed under the Code, and a non-plan entity who is party to a prohibited tax shelter transaction may be subject to both the entity-level and manager-level taxes.

Prohibited tax shelter transactions are listed transactions which are the same as, or substantially similar to, any transaction that has been specifically identified by the Secretary of the Treasury – i.e., the IRS - as either (i) a tax avoidance transaction, or (ii) a prohibited reportable transaction, which is a "confidential transaction" or a transaction with "contractual protection" as defined in Treasury Regulations.

• Only non-plan entities are subject to the entity-level excise tax, which is imposed on any non-plan entity that either becomes a party to a prohibited tax shelter transaction or is a party to a subsequently listed transaction.

• The excise tax applies for the taxable year in which the entity becomes a party to the prohibited tax shelter transaction and any subsequent taxable year. The following factors are considered when determining the entity-level tax:

• If the non-plan entity did not know and did not have reason to know that the transaction was a prohibited tax shelter transaction at the time the entity became party to the transaction, the tax is the highest marginal tax rate (currently 35%) multiplied by the greater of: (i) the entity’s net income with respect to the transaction (after taking into account any other applicable taxes with respect to such transaction) for the taxable year, or (ii) 75% of the proceeds received by the entity for the taxable year that are attributable to such transaction.
• If the non-plan entity knew or had reason to know that the transaction was a prohibited tax shelter transaction at the time the entity became a party to the transaction, the tax is the greater of (i) 100% of the entity’s net income with respect to the transaction (after taking into account any other applicable taxes with respect to such transaction) for the taxable year, or (ii) 75% of the proceeds received by the entity for the taxable year that are attributable to such transaction.
• The excise tax imposed on a non-plan entity party to a subsequently listed transaction is the highest marginal tax rate (currently 35%) multiplied by the greater of (i) the entity’s net income with respect to the subsequently listed transaction for the taxable year that is allocable to the period beginning on the later of the date such transaction is listed or the first day of the taxable year; or (ii) 75% of the proceeds received by the entity for the taxable year that are attributable to such transaction and allocable to the period beginning on the later of the date such transaction is listed or the first day of the taxable year.

• The manager level excise tax is imposed on any entity manager of a tax-exempt entity who approves the entity as a party to a prohibited tax shelter transaction and knows or has reason to know that the transaction is a prohibited tax shelter transaction.

• The excise tax is $20,000 for each approval or other act causing the entity to be a party to the prohibited tax shelter transaction.

• Every tax-exempt entity that is party to a prohibited tax shelter transaction is required to disclose to the IRS that it is a party to the prohibited tax shelter transaction and the identity of any other party to the transaction which is known to such tax-exempt entity.

• The penalty for non-disclosure is imposed on the tax-exempt entity in the case of non-plan entities, and imposed on the entity manager in the case of plan entities.

• A penalty of $100 per day, not to exceed $50,000 with respect to any one disclosure, is imposed for failure to file a required disclosure.

• The Secretary is authorized to make a written demand on any entity or manager, specifying a reasonable future date by which a required disclosure must be filed. Non-compliance with the Secretary’s demand is subject to an additional penalty of $100 per day after expiration of the time specified, not to exceed $10,000 with respect to any one disclosure.

• A taxable party to a prohibited tax shelter transaction is required to disclose by statement to any tax-exempt entity party to such transaction that the transaction is a prohibited tax shelter transaction. A taxable party is subject to penalties ranging from $10,000 to $200,000 for failure to comply with disclosure requirements.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.