On May 17, 2006, President Bush signed into law the Tax Increase Prevention and Reconciliation Act ("TIPRA" or "the Act"). TIPRA, combined with existing laws, is poised to inflict potentially devastating penalties on the tax-exempt world. TIPRA's new disclosure and participation provisions for "prohibited" transactions present many serious, potential pitfalls for tax-exempt entities and their managers.
TIPRA takes listed, confidential, and contractual protection transactions that are potentially abusive and "reportable" for all tax return filers and makes them "prohibited" transactions for nearly all tax-exempt entities. New disclosure requirements are imposed on parties (or their managers) for "prohibited" transactions involving tax-exempt entities. In addition, the Act imposes stiff new penalties on tax-exempt entities and "managers" (a term that includes directors and officers) that participate in or fail to report involvement in abusive or potentially abusive transactions. The new TIPRA-prescribed penalties relating to "prohibited" transactions are imposed in addition to the consequences already assessed for "reportable" transaction violations under current law.
Disclosure Requirements and Penalties
TIPRA requires nearly all taxexempts to report their participation in a "prohibited" transaction to the IRS. If an Indian tribe or section 501(c), 501(d), or 170(c) organization fails to report, the entity must pay $100 for each day the failure continues, up to a $50,000 maximum. The same monetary penalties are applicable should a tax-favored savings arrangement, such as an IRA or pension plan, fails to report. However, the IRS may not impose this penalty if there is a reasonable cause for the entity's failure to disclose.
The new law also states that the IRS may "make a written demand" for information on tax-exempt entities and managers. An entity and/or manager is fined $100 per day, up to a $10,000 maximum, for disregarding the demand. Again, the IRS may not impose this penalty if there is a reasonable cause for the failure to comply.
Additionally, TIPRA requires taxable parties to a "prohibited" transaction to inform any tax-exempt parties of the transaction's "prohibited" status. However, taxable parties are not required to do so before the tax-exempt entity becomes a party. A tax-exempt entity may thus unwittingly involve itself in a "prohibited" transaction and incur the accompanying reporting obligations and penalties for failure to report. Such involvement may also expose the tax-exempt to TIPRA's "prohibited" transaction participation penalties.
TIPRA's participation provisions apply to a smaller subset of tax-exempts— only Indian tribes and organizations (including managers) described in sections 501(c), 501(d), and 170(c) may be subject to TIPRA participation penalties. These tax-exempt entities and their managers are penalized merely for participation in "prohibited" transactions, regardless of whether the transaction resulted in a substantial understatement of tax liability. There is no reasonable cause exception for tax-exempts and managers involved in such "prohibited" transactions.
The amount of the penalties differs depending on whether the entity knew or had reason to know of a transaction's "prohibited" status. For tax-exempts that unknowingly participate in a "prohibited" transaction, the annual penalty is the highest corporate tax rate (currently 35 percent) multiplied by the greater of either (1) the entity's net income that is attributable to the "prohibited" transaction, or (2) 75 percent of the proceeds received by the entity as a result of the "prohibited" transaction. For tax-exempts that "knew or had reason to know" that a transaction was "prohibited," the annual penalty is increased to the greater of all of the entity's net income, or 75 percent of the proceeds, attributable to the "prohibited" transaction.
These organizations are also penalized if they participate in a transaction that is not "prohibited" at the time they enter into the transaction, but is subsequently listed by the IRS and thereafter deemed to be "prohibited." This penalty is imposed only on income resulting from participation after the date on which the transaction was deemed prohibited. In addition, managers of these tax-exempts must pay a $20,000 fine if the IRS determines that the manager approved (or otherwise caused) an entity's involvement in a "prohibited" transaction and "knew or had reason to know" that the transaction was "prohibited."
TIPRA's new disclosure and participation provisions for "prohibited" transactions present many serious, potential pitfalls for tax-exempt entities and their managers.
This article is designed to give general information on the developments covered, not to serve as legal advice related to specific situations or as a legal opinion. Counsel should be consulted for legal advice.