IRS Notice 2002-8: Tax Shelter Disclosure Rules

IRS Notice 2003-81 is a public warning identifying a type of transaction involving foreign currency option contracts as an abusive tax shelter. The notice informs taxpayers that the IRS will disallow the tax benefits claimed from these arrangements. It officially designates this strategy as a “listed transaction,” a classification that carries significant disclosure obligations for participants.

This guidance was released to stop a scheme designed solely to generate artificial tax losses to offset other income. The notice makes it clear that the claimed tax outcomes are not allowable and that participants could be subject to penalties. The IRS will challenge the tax treatment of these option strategies in audits and in court.

The Targeted Transaction Explained

The transaction targeted by the IRS involves a specific and coordinated set of actions using foreign currency option contracts. A taxpayer simultaneously enters into both a long and a short position through a pair of option contracts. These options are structured to be offsetting, meaning that a gain in one position is designed to be almost perfectly matched by a loss in the other. This structure removes any genuine investment risk or profit motive from the arrangement.

To illustrate, a taxpayer might pay a premium of $1.1 million for a purchased call option on a foreign currency, while simultaneously receiving a premium of $1 million for a written call option on the same currency with slightly different terms. Because their values move in opposite directions, the net economic effect is close to zero, aside from the small net premium paid. The strategy depends on how these premiums are treated for tax purposes.

The structure is designed to exploit certain tax rules. The taxpayer takes the position that the premium paid for the purchased option, the $1.1 million, establishes their basis in that asset. The premium received for the written option, the $1 million, is not immediately recognized as income. Instead, it is deferred until that option position is closed. This mismatch in timing creates the shelter’s intended tax outcome.

Shortly after entering into the options, the taxpayer transfers these positions to a partnership. The taxpayer claims that their basis in the partnership interest is inflated by the full cost of the purchased option without being reduced by the premium received for the written option. The partnership then closes out the written option position, triggering a gain of $1 million, which is allocated to the taxpayer. Subsequently, the taxpayer sells their partnership interest, claiming a large capital loss based on the artificially high basis.

The IRS’s Position on the Transaction

The IRS’s primary argument against this transaction is its lack of economic substance. A transaction is considered to have economic substance only if it meaningfully changes a taxpayer’s economic position in a substantial way, apart from any federal income tax effects. In this case, the simultaneous purchase and sale of offsetting options neutralize any real potential for gain or loss.

The agency contends that the series of steps is a prearranged and contrived sequence intended solely to generate a tax benefit. The IRS does not view the purchase of the options, the contribution to the partnership, and the subsequent sale as independent events with their own business logic. Instead, it sees them as interlinked components of a single plan to create an artificial tax loss. This lack of a legitimate, non-tax business purpose indicates an abusive tax shelter.

The IRS asserts that the claimed tax loss does not reflect any actual economic loss. Tax deductions for losses are intended to account for real financial detriments, not artificial ones created through paper transactions. The agency argues that allowing such a loss would violate fundamental principles of tax law, which aim to tax income based on economic reality. Therefore, the IRS will disregard the purported basis creation and disallow the entire capital loss claimed upon the disposition of the partnership interest.

Tax Consequences and Penalties

The direct tax consequence for a taxpayer participating in this transaction is the complete disallowance of the claimed capital loss. An IRS audit will result in the removal of the deduction from the tax return, leading to a higher taxable income and a corresponding increase in tax liability for that year. This adjustment will also include interest charged on the underpayment, calculated from the original due date of the tax return.

Beyond the back taxes and interest, taxpayers face significant penalties. A specific penalty applies to understatements arising from listed transactions. This penalty is 20% of the tax understatement attributable to the transaction. If the transaction was not properly disclosed to the IRS as required, the penalty increases to 30%.

Disclosure and Reporting Requirements

Because the foreign currency option strategy is officially designated as a “listed transaction,” any individual, corporation, partnership, or trust participating in it has a mandatory reporting obligation. This disclosure is made using Form 8886, Reportable Transaction Disclosure Statement.

A taxpayer must identify the transaction by its official name or number as provided in IRS guidance. The taxpayer must also describe the transaction in detail, including all the steps involved, the parties who promoted or advised on the transaction, and the expected tax benefits. The form requires a factual summary and an explanation of how the taxpayer participated.

The official and most current version of Form 8886 and its accompanying instructions are available on the IRS website, IRS.gov. Taxpayers should download the latest version to ensure compliance. It is important to be thorough and accurate, providing all required details about the transaction’s structure, the tax year it affects, and the amount of the claimed tax loss or benefit.

How to File the Disclosure Statement

After a taxpayer has fully completed Form 8886, the submission process involves a specific dual-filing requirement. This procedure ensures that the information reaches both the regular processing functions of the IRS and its specialized unit for reviewing tax shelters.

First, a copy of the completed Form 8886 must be attached to the taxpayer’s federal income tax return for each year of participation. If the transaction affects multiple years, a separate form must be attached to the return for each of those years.

Second, for the initial year of filing, a separate copy of the same Form 8886 must be sent directly to the IRS Office of Tax Shelter Analysis (OTSA). This must be done concurrently with the filing of the tax return. The mailing address for this office is: Internal Revenue Service, OTSA Mail Stop 4915, 1973 North Rulon White Boulevard, Ogden, Utah 84404. This step is required even if the tax return itself is filed electronically.