What Qualifies as a Covered Transaction for the IRS?

The Internal Revenue Service (IRS) requires taxpayers to report certain financial activities known as “reportable transactions.” This disclosure provides the agency with insight into financial arrangements that might be abusive tax shelters or other forms of tax evasion, allowing the IRS to identify and challenge improper arrangements. The term “covered transaction” is often used interchangeably with reportable transaction.

This reporting requirement does not mean the transaction is illegal or that its tax benefits will be disallowed. It is a mechanism for the government to gather information. The responsibility is on the taxpayer to recognize when they have participated in such a transaction and provide the necessary details to the IRS to avoid penalties for non-disclosure.

Defining a Reportable Transaction

The IRS defines a “reportable transaction” under Treasury Regulation § 1.6011-4, which includes five categories. A transaction only needs to meet the criteria of one category to require disclosure. The IRS may also issue guidance that excludes certain transactions from these rules.

Listed Transactions

A listed transaction is an arrangement that the IRS has formally identified as a tax avoidance scheme in published guidance. These are arrangements that the agency has already reviewed and determined to be improper. A taxpayer must report their involvement if their activity is the same as or substantially similar to one of these listed schemes.

Confidential Transactions

This is a transaction offered to a taxpayer under conditions of confidentiality regarding its tax structure or benefits. The reporting requirement is triggered if the taxpayer paid an advisor a minimum fee. The fee threshold is $250,000 for corporations, or for partnerships and trusts where all owners are corporations, and $50,000 for all other taxpayers.

Transactions with Contractual Protection

This category includes any transaction where the taxpayer has a right to a full or partial refund of advisor fees if the intended tax benefits are not sustained. This contractual protection suggests the tax benefits are a primary driver of the transaction, as the agreement essentially provides insurance against an unfavorable IRS ruling.

Loss Transactions

Transactions resulting in a tax loss under Internal Revenue Code Section 165 must be reported if they meet certain thresholds. For individuals, partnerships, and S corporations, the threshold is a loss of at least $2 million in a single tax year or $4 million over a combination of years. For C corporations, the thresholds are $10 million in a single year or $20 million over a combination of years. A lower threshold of $50,000 in a single year applies to losses from certain foreign currency transactions.

Transactions of Interest

This is a transaction the IRS believes has the potential for tax avoidance but lacks enough information to designate as a listed transaction. The IRS identifies these in published notices to gather data and monitor emerging financial strategies. An example is an arrangement involving certain charitable contributions of property held by a pass-through entity.

Information Required for Disclosure

When a taxpayer participates in a reportable transaction, they must disclose it to the IRS on Form 8886, Reportable Transaction Disclosure Statement. This is required even if the transaction’s details are disclosed elsewhere on the tax return.

Completing Form 8886 requires specific information about the transaction. The filer must provide:

• The category of reportable transaction, and the official published guidance number if it is a “listed transaction” or “transaction of interest.”
• A factual description of the transaction detailed enough for the IRS to understand its tax structure and identify all parties.
• The expected tax benefits from the transaction, quantified in dollar amounts, including any deductions, credits, or income exclusions.
• The names and addresses of all material advisors who provided assistance or advice regarding the transaction.

The Filing Process for Form 8886

The submission process for Form 8886 has a dual-filing requirement. A completed form must be attached to the taxpayer’s income tax return for each year of participation. This includes original returns, amended returns, and applications for tentative refunds if the transaction results in a loss carried back to a prior year.

Simultaneously, a separate, identical copy of Form 8886 must be sent to the IRS Office of Tax Shelter Analysis (OTSA). This copy is sent independently of the tax return, either by mail to the address in the form’s instructions or by fax. The filing deadline for both submissions is the same as the tax return’s due date, including extensions.

The IRS does not send a confirmation of receipt for the copy filed with OTSA. Taxpayers who fax the form should keep their transmission log as proof of filing.

Penalties for Non-Disclosure

Failing to disclose a reportable transaction carries monetary penalties under Internal Revenue Code Section 6707A. These penalties apply for each failure to file a required Form 8886 and can be imposed even if there is no underlying tax deficiency.

The penalty is 75% of the decrease in tax from the transaction, but it is subject to minimum and maximum amounts. The minimum penalty is $5,000 for an individual or $10,000 for an entity. The maximum penalty for a listed transaction is $100,000 for an individual and $200,000 for other entities. For all other reportable transactions, the maximum is $10,000 for an individual and $50,000 for an entity.

A failure to disclose a listed transaction also extends the statute of limitations for the IRS to assess tax for that year indefinitely until the disclosure is made. The IRS has the authority to rescind penalties for non-listed transactions if doing so would promote compliance. This relief is not available for failing to disclose a listed transaction.