Many penalties are potentially applicable to investors in tax shelters and it is not always clear which ones might be applied in a particular situation.

The most important penalties for tax shelter investors to consider are the penalties relating to the “reportable transaction” rules. Under these rules, a participant in a “reportable transaction” is required to disclose it.

Reportable transactions are certain types of transactions that IRS has determined have a potential for tax avoidance or evasion. Reportable transactions include, for example, transactions offered under conditions of confidentiality, transactions in which the taxpayer is contractually protected against unintended tax consequences, and transactions that generate large losses or tax credits.

A taxpayer is generally required to file a disclosure statement, Form 8886, for each reportable transaction in which he participated, but more than one transaction can be reported on one form in the case of certain similar transactions. The taxpayer attaches the form to returns or amended returns for each tax year in which he participated in a reportable transaction. The taxpayer also must send a copy of the statement to the IRS Office of Tax Shelter Analysis (OTSA) when a disclosure statement is first filed by the taxpayer.

A $10,000 penalty is imposed on any person who fails to include on any return or statement information on a reportable transaction that is required to be included with the return or statement. The penalty is increased to $50,000 for persons other than natural persons.

A taxpayer who fails to attach a reportable transaction disclosure statement to an original or amended return and fails to provide a copy of a required disclosure statement to OTSA is subject to a single penalty. The penalty applies regardless of whether the transaction results in a tax understatement and it applies in addition to any other penalty that may be imposed under the tax law.

IRS may rescind all or part of the penalty if the violation relates to a reportable transaction that isn't a “listed transaction” and if rescission would promote compliance with tax law requirements and effective tax administration. A listed transaction is a reportable transaction that is the same as, or substantially similar to, a transaction specifically identified by IRS as a tax avoidance transaction. For “listed transactions” the $10,000 penalty increases to $100,000 and the $50,000 penalty increases to $200,000.

A 20% penalty applies to understatements resulting from reportable transactions for a tax year. The penalty is 30% for any portion of any reportable transaction understatement if the taxpayer doesn't disclose it.

No reasonable cause and good faith defense is available for the 30% penalty. A reasonable cause defense is available for the 20% penalty if disclosure requirements are met, and there is or was substantial authority for the taxpayer's tax treatment, and the taxpayer reasonably believed that his tax treatment was more likely than not the proper treatment.

In showing reasonable belief, a taxpayer can't rely on certain “disqualified tax advisors” (a term that generally means advisors who aren't objective because of ties to the tax shelter), or “disqualified tax opinions” (opinions that are based on unreasonable factual or legal assumptions, that unreasonably rely on representations, statements, findings, or agreements, that don't consider all relevant facts, or that otherwise fail to meet IRS-prescribed requirements).

The above reportable transaction understatements penalty doesn't apply to all reportable transactions. It applies to all listed transactions, but it only applies to other reportable transactions if a significant purpose of the transaction is federal income tax avoidance or evasion. However, tax shelter transactions not covered by the reportable transaction understatements penalty may be subject to the same accuracy-related penalties that apply to taxpayers generally. 20% accuracy-related penalties apply to underpayments attributable to, among other things, substantial understatements of income tax, and substantial valuation misstatements.

The term “substantial valuation misstatement” includes, among other things, a claim on a return that the value or the adjusted basis of any property was 150% or more of the correct value or adjusted basis. The 20% rate of the substantial valuation misstatements penalty increases to 40% if the valuation misstatement is 200% or more of the correct value or adjusted basis. Although this 200% trigger may seem high, the 40% penalty can easily become an issue in tax shelter cases where IRS claims that property used in the shelter was greatly undervalued.

Tax shelters have a significant disadvantage under the 20% accuracy-related penalty for substantial understatements. For purposes of this penalty, the understatement is reduced where a portion of the understatement is attributable to tax treatment of an item for which there was substantial authority, or where the relevant facts affecting the tax treatment of an item are adequately disclosed and there is a reasonable basis for that treatment. But these reductions do not apply to items attributable to tax shelters.

Aggressive tax shelters may give rise to the civil fraud penalty, which equals 75% of the portion of the underpayment attributable to fraud. But, IRS has the burden of proving fraud by clear and convincing evidence and, because civil fraud requires an element of willfulness, IRS's burden of proof is hard to meet in tax shelter cases unless the taxpayer is fairly sophisticated.

The 75% penalty is not the only adverse consequence of civil fraud. There is no time limit on the assessment and collection of tax if a fraudulent return is filed, and taxes shown on such a return are generally not discharged in bankruptcy.

The tax law provides rules coordinating the application of the reportable transaction understatements penalty with the fraud penalty and the generally applicable accuracy related penalties so that more than one penalty isn't imposed for the same understatement. The fraud penalty and the generally applicable accuracy related penalties don't apply with respect to any portion of an underpayment if the taxpayer shows that there was reasonable cause for that portion of the underpayment and that the taxpayer acted in good faith with respect to that portion of the underpayment. Reliance on the advice of a qualified tax practitioner is a common reasonable cause defense, but, in tax shelter cases, this defense has often been undermined where the practitioner had an interest in promoting the tax shelter.

In addition to penalties, underpayments resulting from tax shelters give rise to liability for interest. And, there's no deduction for interest paid or accrued on tax underpayments attributable to reportable transaction understatements for which the taxpayer hasn't satisfied the disclosure requirements of the reasonable cause exception to the penalty for such understatements.

In extreme cases, tax shelters have even given rise to criminal penalties for investors, such as the criminal tax evasion penalty and the criminal penalty for false returns. In trying to impose these penalties, however, the government must establish beyond a reasonable doubt that the defendant willfully committed the crime charged. Criminal charges are far more likely to be brought against promoters of tax shelters than against mere investors.

Tax shelter investors should keep in mind that each “material advisor” with respect to any reportable transaction must make a return setting forth information identifying and describing the transaction, information describing any potential tax benefits expected to result from the transaction, and any other information that IRS requests. Significant penalties are imposed for failure to make accurate returns. For this purpose, “material advisor” is broadly defined to include anyone who provides any material aid, assistance, or advice with respect to organizing, managing, promoting, selling, implementing, insuring, or carrying out any reportable transaction, and who directly or indirectly derives gross income in excess of a certain amount for that assistance or advice. Each material advisor also must, with respect to any reportable transaction, maintain a list identifying each person for whom the advisor acted as a material advisor on the transaction and containing any other information required by regulations. The lists must be made available to IRS on request and penalties are imposed for failure to maintain, or make available, the lists. The returns and lists required from material advisors are an important source of information on tax shelters.