Abusive Tax Shelters Abusive tax shelters are marketing schemes that involve artificialtransactions with little or no economic reality. They often make useof unrealistic allocations, inflated appraisals, losses in connectionwith nonrecourse loans, mismatching of income and deductions,financing techniques that do not conform to standard commercialbusiness practices, or the mischaracterization of the substance of thetransaction. Despite appearances to the contrary, the taxpayergenerally risks little. Abusive tax shelters commonly involve package deals that aredesigned from the start to generate losses, deductions, or creditsthat will be far more than present or future investment. Or, they maypromise investors from the start that future inflated appraisals willenable them, for example, to reap charitable contribution deductionsbased on those appraisals. (But see the appraisal requirementsdiscussed under Curbing Abusive Tax Shelters.) They arecommonly marketed in terms of the ratio of tax deductions allegedlyavailable to each dollar invested. This ratio (or "write-off") isfrequently said to be several times greater than one-to-one. Since there are many abusive tax shelters, it is not possible tolist all the factors you should consider in determining whether anoffering is an abusive tax shelter. However, you should ask thefollowing questions, which might provide a clue to the abusive natureof the plan. Do the tax benefits far outweigh the economic benefits? Is this a transaction you would seriously consider, apartfrom the tax benefits, if you hoped to make a profit? Do shelter assets really exist and, if so, are they insuredfor less than their purchase price? Is there a nontax justification for the way profits andlosses are allocated to partners? Do the facts and supporting documents make economic sense?In that connection, are there sales and resales of the tax shelterproperty at ever increasing prices? Does the investment plan involve a gimmick, device, or shamto hide the economic reality of the transaction? Does the promoter offer to backdate documents after theclose of the year? Are you instructed to backdate checks covering yourinvestment? Is your debt a real debt or are you assured by the promoterthat you will never have to pay it? hotel near airport TurinDoes this transaction involve laundering UnitedStates-source income through foreign corporations incorporated in atax haven and owned by United States shareholders? Curbing AbusiveTax Shelters Congress has enacted a series of income tax laws designed to haltthe growth of abusive tax shelters. These provisions include thefollowing. Passive activity losses and credits. The passive activity lossand credit rules limit the amount of losses and credits that can beclaimed from passive activities and limit the amount that can offsetnonpassive income, such as certain portfolio income from investments.For more detailed information about determining and reporting income,losses, and credits from passive activities, see Publication 925. Registration of tax shelters. Generally, theorganizers of certain tax shelters must register the shelter with theIRS. The IRS will then assign the tax shelter a registration number.If you are an investor in a tax shelter, the seller (or thetransferor) must provide you with the tax shelter registration numberat the time of sale (or transfer) or within 20 days after the selleror transferor receives the number if that date is later. SeeInvestor Reporting, later, for more information aboutreporting this number when filing your tax return. List of tax shelter investors. Organizers andsellers of any potentially abusive tax shelter must maintain a listidentifying each investor. The list must be available for inspectionby the IRS, and the information required to be included on the listgenerally must be kept for 7 years. See Transfer of interests ina tax shelter, later, for more information. Appraisals of donated property. Generally, if youdonate property valued at more than $5,000 ($10,000 in the case ofprivately traded stock), you must get a written "qualified"appraisal of the property's fair market value and attach an appraisalsummary to your income tax return. The appraisal must be done by a"qualified" appraiser who is not the taxpayer, a party to atransaction in which the taxpayer acquired the property, the donee, oran employee or related party of any of the preceding persons. (Relatedparties are defined under Related Party Transactions inchapter 4.)For more information about appraisals, see Publication 561. Interest on penalties. If you are assessed anaccuracy-related or civil fraud penalty (as discussed underPenalties, later), interest will be imposed on the amountof the penalty from the due date of the return (including anyextensions) to the date you pay the penalty. Accounting methods and capitalization rules. Taxshelters generally cannot use the cash method of accounting. Also,uniform capitalization rules generally apply to producing property oracquiring it for resale. Under those rules, the direct cost and partof the indirect cost of the property must be capitalized or includedin inventory. For more information, see Publication 538. Projected income investment.Special rules apply to a projected income investment. To qualify asa projected income investment, a tax shelter must not be expected toreduce the cumulative tax liability of any investor duringany year of the first 5 years ending after the date the investment wasoffered for sale. In addition, the assets of a projected incomeinvestment must not include or relate to more than an incidentalinterest in: Master sound recordings, Motion picture or television films, Videotapes, Lithograph plates, Copyrights, Literary, musical, or artistic compositions, or Collectibles (such as works of art, rugs, antiques, metals,gems, stamps, coins, or alcoholic beverages). Tax shelters that qualify as projected income investments are notsubject to the registration rules for tax shelters, described earlier.However, the requirement to maintain a list of investors that is ineffect for tax shelters also applies to any projected incomeinvestment, except for one an investor later transfers. SeeTransfer of interests in a tax shelter, later. A tax shelter that previously qualified as a projected incomeinvestment may later be disqualified if, in one of its first 5 years,it reduces the cumulative tax liability of any investor. In that case,the tax shelter becomes subject to the registration rules for taxshelters, described earlier. Pre-filing notification letter.If you are an investor in an abusive tax shelter promotion, the IRSmay send you a "pre-filing notification letter" if it determinesthat it is highly likely that there is: A gross valuation overstatement, or A false or fraudulent statement regarding the tax benefitsto be derived from the tax shelter entity or arrangement. This letter will advise you that, based upon a review of thepromotion, it is believed that the purported tax benefits are notallowable. The letter also will advise you of the possible taxconsequences if you claim the benefits on your income tax return. You also may receive a notification letter after you file your taxreturn. If you have already claimed the benefits on your tax return,you will be advised that you can file an amended return. However, anypenalties that apply still can be asserted. If you claim the benefits after receiving the pre-filingnotification or if you fail to amend your return, you will be notifiedthat your tax return is being examined. Normal audit and appealprocedures will be followed during the examination, andaccuracy-related, civil or criminal fraud, and other penalties will beconsidered and, when appropriate, asserted. For information on theexamination of returns, see Publication 556. Revenue rulings.The IRS has published numerous revenue rulings concluding that theclaimed tax benefits of various abusive tax shelters should bedisallowed. A revenue ruling is the conclusion of the IRS on how thelaw is applied to a particular set of facts. Revenue rulings arepublished in the Internal Revenue Bulletin for taxpayers'guidance and information and also for use by IRS officials. So, ifyour return is examined and an abusive tax shelter is identified andchallenged, a published revenue ruling dealing with that type ofshelter, which disallows certain claimed tax shelter benefits, couldserve as the basis for the examining official's challenge of the taxbenefits that you claimed. In such a case, the examiner will notcompromise even if you or your representative believe that you haveauthority for the positions taken on your tax return. Caution: The courts have generally been unsympathetic to taxpayers involvedin abusive tax shelter schemes and have ruled in favor of the IRS inthe majority of the cases in which these shelters have beenchallenged. Investor Reporting If you include on your tax return any deduction, loss, credit orother tax benefit, or any income, from an interest in a tax shelterrequired to be registered, you must report the registration numberthat the tax shelter provided to you. (See Registration of taxshelters, earlier.) Complete and attach Form 8271 toyour return to report the number and to provide other informationabout the tax shelter and its benefits. You must also attach Form 8271to any application for tentative refund (Form 1045) and to any amendedreturn (Form 1040X) on which these benefits are claimed or income isreported. If you do not include the registration number with yourreturn, you will be subject to a penalty of $250 for each suchfailure, unless the failure is due to reasonable cause. Transfer of interests in a tax shelter.If you hold an investment interest in a tax shelter and latertransfer that interest to another person, you must provide the taxshelter's registration number to each person to whom you transferredyour interest. (However, this does not apply if your interest is in aprojected income investment, described earlier.) You must also providea notice substantially in the following form: You have acquired an interest in [name and addressof tax shelter] whose taxpayer identification number is [ifany]. The Internal Revenue Service has issued [name of taxshelter] the following tax shelter registration number:[number]. You must report this registration number to theInternal Revenue Service, if you claim any deduction, loss, credit, orother tax benefit or report any income by reason of your investment in[name of tax shelter]. You must report the registrationnumber (as well as the name and taxpayer identification number of[name of tax shelter]) on Form 8271. Form 8271 must beattached to the return on which you claim the deduction, loss, credit,or other tax benefit or report any income. Issuance of a registrationnumber does not indicate that this investment or the claimed taxbenefits have been reviewed, examined, or approved by the InternalRevenue Service. The following requirements also apply. Maintaining a list. You must maintain a listidentifying each person to whom you transferred your interest. Or, youmay require a designated person or seller to maintain the list.However, see Special rule for projected income investment,later, for an exception to this requirement. If you choose todelegate this requirement, you must give the designated person orseller all of the information that you would otherwise have tomaintain on the list. Providing notice. If the tax shelter is not aprojected income investment, described earlier, you must provide anotice to each person to whom you transferred your interest. Thisnotice must be substantially in the following form: You have acquired an interest in [name and addressof tax shelter]. If you transfer your interest in this taxshelter to another person, you are required by the Internal RevenueService to keep a list containing that person's name, address,taxpayer identification number, the date on which you transferred theinterest, and the name, address, and tax shelter registration numberof this tax shelter. If you do not want to keep such a list, you must(1) send the information specified above to [name and address ofdesignated person], who will keep the list for this tax shelter,and (2) give a copy of this notice to the person to whom you transferyour interest. If you do not maintain the required list of investors, or do notdelegate a designated person or seller to maintain the list, you willbe subject to a penalty of $50 for each person required to be on thelist. But, you will not have to pay the penalty if you can show thatthe failure to comply with this requirement was due to reasonablecause and not willful neglect. The maximum penalty under thisprovision is $100,000 for each tax shelter in each calendar year. Special rule for projected income investment.If you are an investor who later transfers an interest in aprojected income investment, described earlier, you are not requiredto maintain a list of investors unless the tax shelter was no longer aprojected income investment, or otherwise became subject to theregistration requirements, before the transfer. Penalties Investing in an abusive tax shelter may be an expensive propositionwhen you consider all of the consequences. First, the promotergenerally charges a substantial fee. If your return is examined by theIRS and a tax deficiency is determined, you will be faced with paymentof more tax, interest on the underpayment, possibly a 20%accuracy-related penalty, or a 75% civil fraud penalty. You may alsobe subject to the penalty for failure to pay tax. These penalties areexplained in the following paragraphs. Accuracy-related penalties.An accuracy- related penalty of 20% can be imposed forunderpayments of tax due to: Negligence or disregard of rules or regulations, Substantial understatement of tax, or Substantial valuation misstatement. This penalty will not be imposed if you can show that you hadreasonable cause for any understatement of tax and that you acted ingood faith. If you are charged an accuracy-related penalty, interest will beimposed on the amount of the penalty from the due date of the return(including extensions) to the date you pay the penalty. Negligence or disregard of rules or regulations.The penalty for negligence or disregard of rules or regulations isimposed only on the part of the underpayment that is due to negligenceor disregard of rules or regulations. The penalty will not be chargedif you can show that you had reasonable cause for understating yourtax and that you acted in good faith. Negligence includes any failure to make a reasonable attempt tocomply with the provisions of the Internal Revenue Code. Disregard includes any careless, reckless, or intentionaldisregard. The penalty for disregard of rules and regulations can beavoided if both of the following are true. You have a reasonable basis for your position on the taxissue. You make an adequate disclosure of your position. Use Form 8275 to make your disclosure, and attach itto your tax return. To disclose a position contrary to a regulation,use Form 8275-R. Substantial understatement of tax.An understatement is considered to be substantial if it is morethan the greater of: 10% of the tax required to be shown on the return, or $5,000. An "understatement" is the amount of tax required to beshown on your return for a tax year minus the amount of tax shown onthe return, reduced by any rebates. The term "rebate" generallymeans a decrease in the tax shown on your original return as theresult of your filing an amended return or claim for refund. Two special rules apply in the case of an understatement due to atax shelter. An understatement of tax does not include any tax due to atax shelter item (such as an item of income, gain, loss, deduction, orcredit) if you had substantial authority for the tax treatment of theitem and reasonably believed that the tax treatment chosen was morelikely than not the proper one. Disclosure of the tax shelter item on a tax return does notreduce the amount of the understatement. For other than tax shelters, you can file Form 8275 or Form8275-R to disclose items that could cause a substantialunderstatement of income tax. In that way, you can avoid thesubstantial understatement penalty if you have a reasonable basis foryour position on the tax issue. five star hotel in GroningenAlso, the understatement penalty will not be imposed if you canshow that there was reasonable cause for the underpayment caused bythe understatement and that you acted in good faith. An importantfactor in establishing reasonable cause and good faith will be theextent of your effort to determine your proper tax liability under thelaw. Valuation misstatement.In general, you are liable for a 20% penalty for a substantialvaluation misstatement if all of the following are true. The value or adjusted basis of any property claimed on thereturn is 200% or more of the correct amount. You underpaid your tax by more than $5,000 because of themisstatement. You cannot establish that you had reasonable cause for theunderpayment and that you acted in good faith. You may be assessed a penalty of 40% for a gross valuationmisstatement. If you misstate the value or the adjusted basis ofproperty by 400% or more of the amount determined to be correct, youwill be assessed a penalty of 40%, instead of 20%, of the amount youunderpaid because of the gross valuation misstatement. The penaltyrate is also 40% if the property's correct value or adjusted basis iszero. Civil fraud penalty.If there is any underpayment of tax on your return due to fraud, apenalty of 75% of the underpayment will be added to your tax. Joint return.The fraud penalty on a joint return applies to a spouse only ifsome part of the underpayment is due to the fraud of that spouse. Failure to pay tax.If a deficiency is assessed and is not paid within 10 days of thedemand for payment, an investor can be penalized with up to a 25%addition to tax if the failure to pay continues. Whether To Invest In light of the adverse tax consequences and the substantial amountof penalties and interest that will result if the claimed tax benefitsare disallowed, you should consider tax shelter investments carefullyand seek competent legal and financial advice.