The 442/6 Transaction: An IRS Listed Tax Shelter

The “442/6 transaction” is an abusive tax shelter designed to generate artificial tax losses for participants. These arrangements are structured to create the appearance of a significant financial loss on paper, which can then be used to offset other taxable income, without the individual ever experiencing a corresponding real-world economic loss. The Internal Revenue Service (IRS) has actively targeted these schemes, which exploit complex partnership tax rules to achieve their intended result.

The Mechanics of the 442/6 Transaction

The 442/6 transaction, often associated with a category of shelters the IRS calls “Son of BOSS,” operates by artificially inflating a taxpayer’s basis in a partnership interest. The process begins with a taxpayer and other parties forming a partnership. The taxpayer contributes cash or other assets to this partnership, establishing an initial “outside basis,” which is their investment cost in the partnership interest.

The core of the shelter involves the partnership taking on a substantial liability, often a contrived obligation like the purchase and sale of options or foreign currency contracts that largely offset each other. Under specific interpretations of partnership tax law, this large liability does not immediately reduce the taxpayer’s outside basis in their partnership interest. This manipulation results in the taxpayer having a partnership interest with a basis that is artificially high, far exceeding its actual fair market value.

The final step is the sale of this partnership interest. Because the taxpayer’s basis has been artificially inflated, selling the interest for its much lower actual market value generates a substantial capital loss on their tax return. This loss is purely a creation of the transaction’s structure, as the taxpayer has not suffered a genuine economic loss.

IRS Classification as a Listed Transaction

The IRS officially classifies transactions like the 442/6 scheme as “listed transactions.” A listed transaction is a specific type of tax avoidance scheme that the IRS has formally identified through published guidance as being abusive. This designation serves as a clear warning to taxpayers and financial advisors that the IRS views the transaction as illegitimate and will challenge it.

This classification stems from official pronouncements, most notably IRS Notice 2000-44. This notice specifically addresses transactions that use a series of steps to artificially inflate the basis of a partnership interest, putting participants on formal notice that the claimed tax benefits were not allowable.

The effect of this classification is that it moves the transaction from a gray area of tax interpretation into a category of known tax avoidance. When a transaction is “listed,” the burden of proof shifts significantly, and taxpayers can no longer claim they were unaware of the tax issue or had a reasonable basis for their tax position without significant evidence.

Penalties and Consequences for Participants

Engaging in a 442/6 transaction or any similar listed transaction carries financial and legal consequences. The first and most direct outcome is the complete disallowance of the claimed tax loss. This means the taxpayer becomes liable for the full amount of tax they originally attempted to shelter, as if the transaction never occurred.

On top of the back taxes owed, the IRS imposes substantial penalties. For transactions that are not properly disclosed, the accuracy-related penalty can be as high as 30%, calculated on the portion of the underpayment attributable to the listed transaction. In some cases, if the transaction is deemed part of a fraudulent scheme, the civil fraud penalty could apply, which is 75% of the underpayment attributable to fraud.

Interest charges accrue on both the unpaid tax liability and the penalties. The interest begins to accumulate from the original due date of the tax return, meaning the total amount can become substantial by the time the IRS uncovers the shelter.

Taxpayer Disclosure Requirements

Taxpayers who participate in a listed transaction have a strict duty to report their involvement to the IRS. The primary mechanism for this reporting is Form 8886, the “Reportable Transaction Disclosure Statement,” which must be filed for each taxable year that the individual or entity participates in the transaction. Form 8886 requires the taxpayer to provide detailed information about the transaction, including a description of the expected tax benefits, the steps involved, and the names of any advisors who promoted the shelter.

A copy of this form must be attached to the taxpayer’s income tax return for the relevant year. A separate copy must also be sent to the IRS’s Office of Tax Shelter Analysis (OTSA) the first time the form is filed for a specific transaction.

Failing to file Form 8886 carries its own penalties under Internal Revenue Code Section 6707A. These penalties apply regardless of whether the underlying tax shelter itself resulted in a tax deficiency. The penalty for failing to disclose a listed transaction is 75% of the decrease in tax shown on the return as a result of the transaction, with a maximum penalty of $100,000 for individuals and $200,000 for other entities. This penalty is separate from and in addition to any accuracy-related penalties.