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Internal Revenue Service Announces Sweeping Abusive Transaction Settlement Initiative

White Collar Alert

On October 27, 2005, the Internal Revenue Service ("IRS") announced a sweeping tax shelter settlement initiative which offers taxpayers the opportunity to settle on twenty-one different transactions covering a broad spectrum of alleged abusive tax shelters. Under the terms of the settlement initiative, taxpayers who want to settle will have to pay 100 percent of the taxes owed and interest, plus a penalty of either one-quarter or one-half of the penalty the IRS otherwise would seek. The transactions eligible for the program include a wide array of schemes involving employee benefits, charitable remainder trusts, offsetting foreign currency option contracts, debt straddles, lease strips and certain abusive conservation easements. The deadline for participation in the settlement initiative is January 23, 2006.

The settlement initiative is the latest development in the IRS's continuing attack on abuses in the tax system. The IRS estimates that the tax dollars at stake in the latest settlement will run into the billions. The IRS further emphasizes that this is not an amnesty program: anyone who participates in the settlement initiative will still have to pay 100 percent of the tax owed and interest, but a reduced penalty. Sixteen of the targeted transactions are "listed" transactions, i.e., those which have already been shut down by the IRS as abusive. The remaining five are non-listed, but nonetheless are a concern for the government due to their potential for abuse. The twenty-one transactions are separated into three groups, as follows.

In group one are six of the "listed" transactions that the IRS has already shut down. These include tax avoidance schemes using inflated basis, intermediary transactions, lease strips, tax avoidance using offsetting foreign currency contracts, common trust fund straddle shelters, and abusive distributions of unencumbered property. Taxpayers who engaged in any of these transactions and come forward under the initiative would pay only one-half of the penalty the IRS would otherwise seek.

In the second group, which covers ten "listed" transactions, penalties would be reduced to just one-quarter of what the IRS would otherwise seek. These transactions include specially designed life insurance policies and retirement plans, subchapter S corporation employee stock ownership plans, abusive treatment of Roth individual retirement accounts, contested liabilities, welfare benefit funds under tax code section 419A(f)(5), employee stock ownership plans holding stock in S corporations, debt straddles, distributions by charitable remainder trusts, and certain trust arrangements seeking exemption from section 419.

The third group is comprised of the five transactions that are not "listed." Penalties from these deals would also be one-quarter of what the IRS would ordinarily seek. These transactions include certain abusive conservation easements, certain abusive donations of patents and other intellectual property, manipulation of reimbursements for employee parking, manipulation of reimbursements for employees' medical expenses, and certain issues regarding management of S corporations and employee stock ownership plans. Because the third group includes transactions that could be legitimate in some cases, the IRS is targeting only deals where there is abuse.

To take advantage of the settlement initiative, taxpayers must file an election form with the IRS by January 23, 2006. For the most part, any person who claimed a federal tax benefit from any of the twenty-one transactions is eligible to participate. Taxpayers are not eligible for the initiative, however, if (1) their cases are designated for litigation by the IRS, (2) they are already in court, (3) they are facing fraud penalties, or (4) they are under criminal investigation. Promoters, their partners, and other related persons also are ineligible for participation. The IRS will offer further penalty relief for transactions that were previously disclosed to the IRS or for which taxpayers obtained independent professional opinions to support their participation in the transactions. Taxpayers will also be allowed to deduct transaction costs for their deals, including professional and promoter fees.

Whether to participate in the program will require an analysis of a variety of factors, including the precise structure and effects of the transactions in which the taxpayer engaged. For more information on the IRS settlement initiative, please contact Ian M. Comisky (comisky-i@blankrome.com) at (215) 569-5646 or Matthew D. Lee (lee-m@blankrome.com) at (215) 569-5352.