The Internal Revenue Service (IRS) famously—infamously—will penalize taxpayers for inaccurate returns, but, in some cases, disclosures can protect taxpayers from some penalties. Yet things get a bit more complicated since there are also penalties for incorrect disclosures. Therefore, taxpayers face a perennial challenge when filing a disclosure: They should reveal enough to make a valid and useful disclosure, but they usually want to avoid being so detailed that it inadvertently encourages further scrutiny.
Let's go over the different disclosure forms to understand how and when they apply.
Why Disclose at All?
In certain conditions, the IRS can order a taxpayer to pay penalties on top of any amounts it has concluded the taxpayer has underpaid.
Under Section 6662 penalties, if the IRS concludes that a tax underpayment resulted from a taxpayer's negligence or disregard of its regulations, these penalties can range between 20-40% of the underpayment.
Similarly, Section 6694 allows the IRS to penalize taxpayers who file a return. Under this provision of the law, the taxpayer is liable if they used an unreasonable position to justify their deductions, and they knew it was unreasonable when they filed the return.
With a compelling argument, a disclosure may sway an examiner that a taxpayer has paid enough. But a disclosure may be worth doing even if the IRS ultimately disagrees with the taxpayer. In that case, the IRS would still require the taxpayer to pay more, but it might forgo penalties since the taxpayer had a good faith basis for the filing and disclosed the return position.
Form 8275 and Form 8275–R
If a taxpayer takes a deduction that the IRS could conclude resulted in a tax underpayment, then the taxpayer can explain why the deduction is appropriate through Form 8275 or, alternatively, Form 8275-R.
With Form 8275 (filed along with a return), the taxpayer explains more about a transaction, so the IRS understands why the deduction is consistent with the Tax Code, regulations, and any other supporting authority. Taxpayers frequently file a Form 8275, so the filing is not considered an automatic flag for an audit.
With a Form 8275-R, a taxpayer admits the deduction is inconsistent with existing IRS regulations; nevertheless, they argue the deduction is appropriate and should still be allowed. A Form 8275-R is a much rarer filing, and taxpayers should consult with tax attorneys before filing an 8275-R.
Form 8886—Reportable Transactions Disclosure Statement
While filing a Form 8275 or a Form 8275-R is up to a taxpayer, taxpayers must disclose “reportable transactions” with a Form 8886. Significantly, the Form 8886 requirement applies to any individual, trust, estate, partnership, S corporation, or other corporation that must file a return. (Pass-through corporations are treated differently.)
There are five types of relevant transactions: confidential transactions, listed transactions, loss transactions, transactions with contractual protection, and transactions of interest.
Confidential transactions are those offered—for a minimum fee—by an advisor to a taxpayer or related party. The advisor requires the transaction's specifics, or the advisor's strategies are not disclosed. For individuals and others, the minimum fee is $50,000, while for partnerships, trusts, or corporations, the minimum fee is $250,000.
Listed transactions are transactions that, according to the IRS, are regularly used to avoid taxes. While the “list” of the transactions changes over time, the IRS has set out general principles for disclosure:
- The taxpayer's return suggests a tax strategy described in the IRS list.
- The taxpayer knows, or has reason to know, that they receive tax benefits from using one of those listed strategies.
- The taxpayer is an individual or entity the IRS considers a participant in the transaction.
Under section 165 of the tax code, taxpayers may take a deduction for any loss within the previous tax year if insurers or others have not reimbursed the amount. However, if the losses exceed certain amounts, they must be reported. The minimum amounts are generally as follows:
- For individuals, $2 million in one tax year or $4 million in a combination of tax years
- For corporations (excluding S corporations), $10 million in any tax year or $20 million in a combination of years
- For certain partnerships, at least $10 million in any tax year or $20 million in any combination of years
- For other partnerships and S corporations, at least $2 million in any single tax year or $4 million in a combination of years
- For trusts, at least $2 million in any single tax year or $4 million in a combination of tax years
Transactions with contractual protection are those where a taxpayer has the right to a refund of fees if the taxpayer doesn't receive the intended tax consequences of the transaction. The issue is determined by whether the tax refund was refundable or contingent.
Transactions of Interest are similar to listed transactions. They are transactions the IRS says have the potential to be used to avoid taxes, but more information is needed before it can make any determination.
Contact an Experienced Phoenix Tax Attorney
As discussed, IRS tax disclosures are a challenging issue, and the consequences can be positive or negative depending on several factors.
If you are preparing your return and wondering if you need to disclose information to reduce your liability, consult an attorney specializing in tax law. If you need help, call Senior Partner, Tax Controversy Attorney, and former IRS attorney Brandon A. Keim at (602) 200-7399 or contact him online to discuss your options.