Taxpayer’s Constitutional Challenges Denied

In Interior Glass Systems Inc. v. United States, No. 17-15713 (9th Cir. 2019), a three judge panel of the Ninth Circuit, per the opinion of Judge Watford, affirmed the holdings of the trial court below that the Service’s imposition of four penalties under section 6707A against the taxpayer for engaging in a transaction that was “substantially similar” to a “listed transaction” was proper. It rejected the same constitutional challenges that the taxpayer had made below on the denial of due process in having to pay the assessment in full before judicial review was possible as well as in finding that section 6707A did not suffer from “vagueness” with respect to the “substantially similar” standard as applied to the facts in the case. The fact that the statute is, in substance, a strict liability statute rendered irrelevant the taxpayer’s lack of knowledge or reasonable cause defense in not knowing that the transaction it entered into and participated in was “substantially similar” to a listed transaction.

Comment: The Ninth Circuit’s affirmation of the trial court’s decision agreeing with the government that section 6707A is, in substance, a “strict liability” statute and does not offend notions of procedural due process by only providing for post-assessment and payment judicial review is quite noteworthy.

Before addressing the Interior Glass Systems case, a summary of the reportable transactions, material advisor and list maintenance rules are set forth herein.

Reportable Transactions: Filing of Required Disclosure

In accordance with section 6011 and Treas. Regs. §§1.6011-4(a) and -4(d), a taxpayer that “participates” in a “reportable transaction” during a taxable year for which the taxpayer is required to file a tax return must include with the return a “disclosure statement” on the transaction, using Form 8886, Reportable Transaction Disclosure Statement. [1] The term “transaction” means all of the factual elements related to the expected tax treatment of any investment, entity, plan, or arrangement, and includes any series of steps carried out as part of a plan.” Treas. Reg. §1.6011-4(b)(1). [2]   A “reportable transaction” is comprised of several categories including: (i) a “listed transaction” or one which is “the same as or substantially similar to” a type of transaction that the IRS has determined to be a “tax avoidance transaction” and has identified in guidance; (ii) a “confidential transaction” , i.e. a transaction offered to a taxpayer under the condition of confidentiality and for which the taxpayer has paid an advisor a minimum fee which is $250,000 for corporations and $50,000 for other taxpayers; (iii) a transaction with “contractual protection” which applies (a) where the taxpayer or a related person has a “right to a full or partial refund of fees” in the event less than all of the “intended tax consequences from the transaction” are “sustained” or (b) the promoter’s or advisor’s fees are “contingent on the taxpayer’s realization of tax benefits from the transaction; and (iv) a “loss transaction” which is subject to certain quantitative threshold requirements based on the claimed loss deductions.[3] A fifth category of reportable transaction was added in 2007 which applies to a “transaction of interest” entered into on or after November 2, 2006. A transaction of interest is a transaction, identified in published guidance, that the government believes “has a potential for tax avoidance or evasion, but for which [it] lack[s] enough information to determine whether the transaction should be identified specifically as a tax avoidance transaction.”[4]

A taxpayer required to disclose a reportable transaction does so on Form 8886 with an income tax or information return for each taxable year during which the taxpayer participates in the transaction. Where a partnership, S corporation or trust participates in a reportable transaction, it is required to make the required filing and its partners, shareholders and beneficiaries may also have to report the transaction. There are various applicable rules for filing disclosures for the participating entity and its members or beneficiaries.[5]

There may be situations where a taxpayer is unsure whether it has engaged in a reportable transaction. In such instance, a “protective disclosure” may be made by checking a box in the form 8886 indicating that the taxpayer is uncertain whether disclosure is required and that the form “is being filed on a protective basis.” A protective election must still furnish to the IRS “all information requested by the IRS.”

The taxpayer must retain copies of all documents related to the reportable transaction until the statute of limitations for the last taxable year for which the Form 8886 is required. The required records in this context are defined quite broadly. See Treas. Reg. §1.6011-4(g).

The penalty for failure to file a disclosure statement where required, or the failure to include the required information or fails to mail a copy of the form to the Office of Tax Shelter Analysis is 75% of the decrease in tax shown on the return as a result of the decrease in tax from the transaction were it respected for Federal tax purpose. Under section 6707A(b), the penalty for an unreported (reportable) transaction may not, however, be less than $10,000 ($5,000 for a natural person) and it may not exceed $200,000 ($100,000 for a natural person) for a listed transaction or $50,000 ($10,000 for a natural person) for a reportable, but not a listed transaction. The penalty under section 6707A(b) is in additionto all other penalties, including accuracy related penalties under section 6662. No underpayment in tax is required in order for the penalty under section 6707A to be assessed. [6]

Material Advisor Rules With Respect to Reportable Transactions

A “material advisor” incurs two obligations with respect to being involved in a reportable transaction. Such obligations are: (i) the obligation to file an information return with respect to each reportable transaction in which the material advisor is involved or deemed to be involved; and (ii) the obligation to maintain a list of its clients n the transaction. These requirements are set out in sections 6111 and 6112 respectively.  There are essentially two factors used to identify who is a “material advisor” to-wit: (i) the person or persons who provide “material aid, assistance, or advice with respect to organizing, managing, promoting, selling, implementing, insuring, or carrying out” a reportable transaction and (ii) “directly or indirectly derives gross income” exceeding a “threshold amount” for providing such aid, assistance, or advice. There are a set of applicable rules and exceptions applied in determining whether an individual and/or entity is a material advisor in a particular instance.

As stated, a material advisor must file an information return as a result of its involvement in a reportable transaction. The return is Form 8918. A “material advisor” with respect to a reportable transaction must file an information return “identifying and describing the transaction,” “describing any potential tax benefits expected to result from the transaction,” and providing any other information that the IRS may require. Section 6111 and the regulations require the filing of Form 8918, Material Advisor Disclosure Statement. [7]A material advisor must supplement information disclosed on Form 8918 if the information becomes “no longer accurate” or if additional information not disclosed on the form “becomes available.” Form 8918 may be used to disclose two or more “substantially similar transactions.” An advisor that has filed Form 8918 with respect to a reportable transaction is not required to file again as more taxpayers enter into the same transaction or as taxpayers enter into transactions that are the same as or substantially similar to the transaction for which the advisor has filed Form 8918.[8] A material advisor must file the disclosure statement for a reportable transaction with OTSA no later than the last day of the month following the end of the calendar quarter during which (1) the advisor became a material advisor with respect to the transaction or (2) “circumstances necessitating an amended disclosure statement occur.” Where there are two or more material advisors with respect to a single reportable transaction, each material advisor must file unless otherwise provided in the regulations. Where a possible material advisor is uncertain whether a transaction must be disclosed, it can file, in the same manner as a protective Form 8886, a protective Form 8918.[9]

A potential material advisor who “is uncertain whether a transaction must be disclosed” may disclose the transaction by a disclosure statement indicating that it “is being filed on a protective basis.”The IRS “will not treat” protective disclosure statements “any differently than other disclosure statements.” A protective disclosure is only effective if it complies with all of the disclosure requirements.

The penalty for a material advisor’s failure to file a complete and accurate disclosure on Form 8918 as to a reportable transaction is $50,000 for each such failure. Where, however, the transaction is listed, the applicable penalty climbs to the greater of $200,000 or 50% of the gross income derived by the material advisor for aid, assistance or advice provided before the Form 8918 is filed. Where the failure to file with respect to a listed transaction is intentional, the penalty is the greater of $200,000 or 75% of gross income derived by the material advisor.

As with the reportable transaction provisions, the IRS may, upon timely request, rescind part or all of the proposed or assessed material advisor penalty.

As far as the “list maintenance” rules are concerned under section 6112, the material advisor with respect to a reportable transaction must maintain records as to such transactions that are set out in the regulations into three categories: (i) identification of the material advisor’s clients; (ii) detailed information concerning the tax structure and purported tax treatment of the transaction; and (iii) a copy of any designation agreement to which the material advisor is a party and copies of all other written materials as are set out in the regulations.[10] See also Form 13976, Itemized Statement Component of Advisee List.

A separate list is required for each reportable transaction or for all substantially similar transactions. The list maintenance rules apply regardless of whether the advisor is required to file an information return on the transaction. The list must be prepared within 30 calendar days from the date he or she becomes a material advisor. The list must be made available to the IRS when requested.

The penalty for failure to maintain the required list or make such list available to the IRS within 20 days after written request is made is $10,000 for each day of the failure to comply period after a 20 day period unless the advisor can demonstrate reasonable cause for such failure. The penalty for failure to comply with the list maintenance rules is also in addition to any other penalties which may be applicable.

Enhanced Accuracy Related Penalties Attributable to Reportable Transaction Understatements

Under section 6662A, where a taxpayer has a reportable transaction understatement, as defined in section 6662A(b)(1), an added tax amount of 20% of the amount of such understatement may be assessed. Under section 6662A(c) the add-on penalty will be 30% (and not 20% of the amount of the reportable transaction understatement) for undisclosed listed or other avoidance transactions. [11]


Interior Glass Systems, Inc. v. United States

A glass installation company located in San Jose, CA was approached in 2005 by insurance brokers marketing a plan which they claim permitted an employer to claim deductions for life insurance premiums paid on behalf of an employee and, at the same time, the employee would not have to report the economic benefit associated with the premium payment in his gross income. Interior Glass and its only employee started participating in such plan, i.e., the Insured Security Program (“ISP”) in 2006. In October, 2007, the IRS identified the same or similar strategies in Notice 2007-83, 200-2 CB 960, as a listed transaction as it regarded the transaction as “abusive”.[12]

In response to the listed transaction development, the insurance broker for the taxpayer in 2009 developed an alternative arrangement by forming a tax-exempt business league which would offer a group term life insurance plan (“GTLP”) to its member-companies/employers. The business league obtained the participation of approximately 140 member companies, including Interior Glass which adopted the plan in 2009 and started participating. The participating companies were told the new arrangement was not a “listed transaction” and was not subject to IRS Notice 2007-83, supra. As a result, Interior Glass did not disclose its participation in the GTLP for 2009, 2010 and 2011. In October, 2011 the IRS initiated an audit of Interior Glass after it reviewed the GTLP.

In November, 2012 the IRS notified Interior Glass it was imposing penalties under section 6707A because it failed to disclose its participation in the GTLP which it contended was “substantially similar” to a “listed transaction” described in Notice 2007-83, supra. A $10,000 penalty was imposed for the three years involved as well as for its failure to disclose its participation in the prior ISP arrangement in 2008. The taxpayer paid the assessments in 2013 and filed a claim for refund with the Federal District Court for the Northern District of California in August, 2016. [13]

The government filed its first motion for partial summary judgment with respect to three of the taxpayer’s legal arguments it asserted in maintaining that its claims for refunds should be allowed: (i) the penalties imposed under section 6707A violated its right to due process, and therefore constituted an unconstitutional taking; (2) section 6707A is unconstitutionally vague, and therefore the assessments are void, and (3) section 6707A penalties cannot be imposed, and therefore the claims for refund should be granted, since the taxpayer did not know it was participating in a reportable transaction, or relied on competent advice in failing to disclose the participation, a so-called reasonable cause defense.

The trial court ruled against Interior Glass on its constitutional claim of the denial of due process as well as its argument that the statutory language contained in section 6707A was impermissibly vague. The Court cited both Supreme Court and Ninth Circuit precedent in denying the constitutional and vagueness challenges. See, e.g., Phillips v. Comm’r, 283 US 589 (1931); Todd v. US, 849 F2d 364 (9th Cir. 1988).

As to the “vagueness” argument, the question was whether the revised GTLP was “substantially similar” to the ISP as such term is set forth in section 6707A and the regulations issued thereunder or was “so vague and indefinite as really to be no rule or standard at all.’ The Court applied a standard with respect to the interpretation of what is “substantially similar” to the listed transaction described in Notice 2007-83, supra as compared with the GTLP program on `whether a person of ordinary intelligence could understand’” what types of arrangements are “substantially similar”, within the meaning of Treas. Reg. §1.6011-4(c)(4), to a “listed transaction.” Ai v US, 809 F3d 503 (9th Cir. 2015). In other words, the standard used by the District Court was whether an “ordinary person exercising common sense can sufficiently understand and comply” with the requirements under section 6707A. Based on the similar features and tax benefits to be derived by Interior Glass and its employee with respect to the ISP and the GTLP, the District Court rejected the taxpayer’s challenge to the constitutionality of section 6707A based on “vagueness” as applied to the facts in the case.

As to the reasonable cause defense raised by the taxpayer, the Service contended that section 6707A is a strict liability penalty and whether the taxpayer’s failure to report was not willful or knowing or was the product of erroneous tax advice for which it relief in good faith is irrelevant. The taxpayer argued that some degree of knowledge was required on the part of the taxpayer in order for the section 6707A penalty to be properly assessed. The Court rejected the taxpayer’s argument that scienter or knowledge was required in order to be found to violate the reportable transaction rules.

With the constitutional arguments advanced by the taxpayer rejected, the District Court turned its attention to addressing the remaining motions for summary judgment which went to the merits of the case on whether the GTLP is substantially similar to the ISP. The ISP involved a trust which the taxpayer argued was not present in GTLP in as much as the GTLP was re-formulated into a business league or non-trust structure. The Court agreed and then asked whether the GTLP should be treated as an “other fund” described in section 419(e)(3) that is a welfare benefit fund. It again held that the GTLP was not an “other fund” for this purpose. Seems like the taxpayer was doing well at this point, but such thought was short-lived.

At this point the trial court noted that the GTLP should not be treated as the “listed transaction” described in Notice 2007-83, per se, but the Court had to decide whether it was “substantially similar” to a “listed transaction” based on whether it “is expected to obtain the same or similar types of tax consequences and that is either factually similar or based on the same or similar tax strategy.” The Court stated that the operative phrase “must be broadly construed in favor of disclosure.”[14]

Based on the record, the District Court held that the GTLP strategy was “substantially similar” to the listed transaction described in Notice 2007-83 and therefore the underlying regulations required the filing of a reportable transaction disclosure.

After the taxpayer was denied its request for a new trial based on what it viewed were errors made by the trial court, the taxpayer appealed to the Ninth Circuit.

Ninth Circuit Court of Appeals Affirms Lower Court’s Holdings

The Ninth Circuit, in a three judge panel decision issued last week, affirmed the trial court’s summary judgment in favor of the assessment of the penalties imposed on the taxpayer under section 6707A. The GTLP was held to be “substantially similar” to the listed transaction identified in Notice 2007-83, supra. The appeals court further held that the taxpayer’s procedural due process rights were not violated when it was assessed and required to pay the assessments in full before judicial review was available.  The Ninth Circuit looked to its three-factor test that it followed in Jolly v. United States, 764 F.2d 642 (9th Cir. 198) in upholding that the denial of pre-collection judicial review of a tax penalty was not required in this case. The Court opined that the Jolly criteria were present and therefore affirmed the assessments and affirmed the denial of the clams for refund.

This post is intended solely for educational and informational purposes and is neither intended nor may be relied upon as legal advice by any person reading the post. If you have questions concerning section 6707A (26 USC), the Interior Glass decision or the reportable transaction rules and regulations kindly counsel with your tax counsel. You may also contact your lead attorney at Fox Rothschild LLP or me to be of further assistance.

[1] The reportable transaction disclosure regulations also apply to reportable transactions pertaining to estate tax, gift tax, generation-skipping tax, and employment tax returns and with excise tax returns filed by foundations, pension plans, and public charities with excess lobbying expenditures. Treas. Regs. §§ 20.6011-4, 25.6011-4, 26.6011-4, 31.6011-4, 53.6011-4, 54.6011-4, 56.6011-4 (effective for transactions entered into after January 1, 2003, except for the generation-skipping tax, which is effective for transactions entered into after November 13, 2011),

[2] The IRS maintains a list of listed transactions on at See Notice 2009-59, 2009-31 IRB 170 (list as of July 15, 2009); Notice 2015-47, 2015-30 IRB 76 (adding “basket option contract” as listed transaction), revoked by Notice 2015-73, 2015-46 IRB 660 (providing additional details on the types of transactions that are the same as, or similar to, the basket option contract). Notice 2017-10, 2017-4 IRB 544 (syndicated conservation easement transactions).

[3] Treas. Reg. §1.6011-4(b)(5)(i).

[4] A proposed regulation would add a “patented transaction” as a reportable transaction effective for transactions entered into after September 25, 2007. Prop. Reg. §1.6011-4(h)(2). A “patented transaction” is a transaction for which a taxpayer pays a fee to a patent holder or patent holder’s agent for “the legal right to use a tax planning method” , i.e., “any plan, strategy, technique, or structure designed to affect Federal income, estate, gift, generation skipping transfer, employment, or excise taxes”. See Prop.Regs. §§1.6011-4(b)(7)(i), -4(b)(7)(ii)(F).

[5] A taxpayer may request a ruling on whether a transaction must be disclosed provided it is timely filed. Treas. Reg. §.6011-4(f)(1).

[6] The IRS has issued guidelines on when it may “rescind” a portion or all of the penalty with respect to the reportable transaction requirements. A taxpayer’s request for rescission must be timely made after the IRS sends a notice and demand for payment of the penalty. A taxpayer, prior to requesting rescission, must file Form 8886 and exhaust all of its administrative remedies with the IRS. A taxpayer may not request rescission by filing a refund claim, assert such “defense” to the penalty in a collection due process hearing, or through other procedures with the IRS. The denial of rescission is not reviewing although the penalty itself is subject to review by the courts. But see Yari v. Comm’r, 143 TC 157 (2014)(taxpayer may appeal a refusal to rescind §6707A penalty in a collection due process hearing). Cf. Smith v. Comm’r,133 T.C. 424 (2009)(Tax Court lacks jurisdiction to redetermine §6707A penalty in a deficiency proceeding.

[7] Treas. Reg. §301.6111-3(d)(1).

[8] Treas. Reg. §301.6111-3(d)1).

[9] Treas. Reg. §301.6111-3(g).

[10] Treas. Reg. §301.6112-1(b)(preparation and maintenance lists).

[11] McGehee Family Clinic, PA v. Comm’r, TC Memo. 2010-202 (2010) (30% penalty for failing to disclose reportable transaction); Brennan v. Comm’r, TC Memo. 2011-276 (2011) (30% penalty for failing to disclose reportable transaction and ignorance of requirement to disclose does not satisfy requirements for reasonable cause exception).

[12] Notice 2007-83, supra, warned that “trust arrangements claiming to be welfare benefit funds and involving cash value life insurance policies promoted to claim federal income and employment tax benefits are not allowable for federal tax purposes and are tax avoidance transactions. Certain transactions using trust arrangements involving cash value life insurance policies, and substantially similar transactions, were identified as listed transactions for purposes of Treas. Reg. § 1.6011-4(b)(2). Material advisor and list maintenance rules were also implicated but were not involved in the Interior Glass case. See also Rev. Rul. 2007-65, 2007-2 CB 949 (application to deduction by employer for contributions to welfare benefit funds under §419 and §419A where benefit provided through fund is life insurance).

[13] Case No. 5:13-cv-05563-EJD.

[14] The US asserted that the GTLP is a “listed transaction” because it is expected to obtain the same tax consequences as such an arrangement as its predecessor, the ISP. Under both plans, Interior Glass deducted its contributions while the employee who received economic benefits under the policy did not report the contributions as taxable income. The Government also argued the GTLP and ISP are similar in the following ways: (i) the language of both plans are similar if not close to identical; (ii) both plans had the same “plan administrator;” (iii) both plans attempted to provide “welfare benefits,” or group-term life insurance; and (iv) the insurance policy employed by the GTLP was the same policy that had been used by the ISP, a cash value life insurance policy No. xxxxx619V.