What Qualifies as a Reportable Transaction?

The Internal Revenue Service (IRS) uses a system of transaction reporting to gain insight into tax strategies that could be used for tax avoidance. This mechanism requires taxpayers to disclose their participation in certain “reportable transactions.” The purpose of this disclosure is to provide the IRS with timely information, allowing the agency to scrutinize new tax strategies as they develop.

The requirement to report a transaction does not, by itself, mean the transaction is improper or that the associated tax benefits will be disallowed. The reporting mandate is a tool for transparency, enabling the IRS to assess the facts and circumstances of specific financial arrangements.

Categories of Reportable Transactions

The IRS has established five categories of reportable transactions, each defined by specific characteristics. A transaction may fall into one or more of these categories, and participation triggers a disclosure requirement.

Listed Transactions

A listed transaction is a specific arrangement that the IRS has officially identified as a tax avoidance scheme in published guidance. The IRS maintains a public list of these transactions, and taxpayers must report their involvement in any arrangement that is the same as, or substantially similar to, one on this list.

An example is a syndicated conservation easement. In this arrangement, promoters syndicate ownership interests in a property to investors, obtain an inflated appraisal of a conservation easement, and then donate the easement. The investors then claim a charitable contribution deduction based on the inflated value, which is often far greater than their investment.

Confidential Transactions

A confidential transaction is an arrangement offered to a taxpayer under conditions of confidentiality, which involves a limitation on the disclosure of the tax treatment or tax structure of the transaction. The reporting requirement is triggered if the taxpayer pays an advisor a minimum fee for services related to the transaction.

For instance, a financial advisor presents a novel investment strategy to a client. If the client must sign a non-disclosure agreement about the strategy’s tax structure and the advisor’s fees exceed a certain threshold, it becomes a reportable transaction.

Transactions with Contractual Protection

This category includes any transaction where the taxpayer has a right to a full or partial refund of fees paid to an advisor if the intended tax consequences are not sustained. It also covers situations where the fees are contingent on the taxpayer’s realization of tax benefits.

For example, a company engages a consulting firm for a tax reduction strategy. If the engagement letter states that the firm’s fee will be refunded if the IRS successfully challenges the tax position, this contractual protection makes the transaction reportable.

Loss Transactions

A loss transaction involves a loss claimed under Section 165 of the Internal Revenue Code that exceeds specific monetary thresholds. These thresholds are designed to alert the IRS to unusually large losses that could be part of a tax avoidance strategy.

For an individual, a Section 165 loss is reportable if it is at least $2 million in any single tax year or $4 million in any combination of tax years. For corporations, the threshold is at least $10 million in a single year or $20 million over a combination of years. A threshold of $50,000 in a single year applies to losses from foreign currency transactions for individuals.

Transactions of Interest

A transaction of interest is one that the IRS believes has the potential for tax avoidance, but for which it lacks enough information to determine if it should be a listed transaction. This category is dynamic, as the IRS may add or remove transactions as it gathers more information.

This process allows the agency to gather data on questionable arrangements, such as those designed to shift the tax basis of assets between related parties, before making a final determination on their status.

Required Information for Disclosure

Taxpayers must disclose participation in a reportable transaction using Form 8886, Reportable Transaction Disclosure Statement. This form provides the government with the necessary details about the transaction and the taxpayer’s involvement. A material advisor is any individual or entity who provides material aid, assistance, or advice regarding the transaction and who receives a minimum level of compensation for those services.

Completing Form 8886 requires:

• The taxpayer’s identifying information, such as name, address, and taxpayer identification number.
• The transaction’s official name and number if it is a listed transaction, and the applicable reportable transaction category.
• A factual description of the transaction, including all steps, the expected tax treatment, and the anticipated tax benefits.
• The identity of all parties involved in the transaction, including any material advisors.

The Filing Process

The filing process for a reportable transaction is a two-part requirement. First, a completed copy of Form 8886 must be attached to the taxpayer’s income tax return for each year of participation in the transaction. This includes the initial year the transaction was entered into and any subsequent years in which tax consequences are reflected on the return. For example, if a transaction generates a loss that is carried forward, a Form 8886 must be attached to the tax return for each year the carryforward loss is claimed.

Second, for the initial disclosure, the taxpayer must send a separate, identical copy of the completed Form 8886 to the IRS Office of Tax Shelter Analysis (OTSA). This office is the central point within the IRS for the collection and analysis of these disclosures. This step must be completed concurrently with the filing of the tax return to which the form is attached.

Penalties for Non-Disclosure

Failing to properly disclose a reportable transaction results in penalties under Internal Revenue Code Section 6707A. The penalties apply for each failure to file a complete Form 8886, including failing to attach it to the tax return or failing to send the copy to the OTSA. The penalty amount is 75 percent of the decrease in tax shown on the return as a result of the transaction, subject to specific minimums and maximums.

For a reportable transaction that is not a listed transaction, the maximum penalty for an individual is $10,000, and for any other entity, it is $50,000. The minimum penalty is $5,000 for an individual and $10,000 for an entity.

For listed transactions, the penalties are higher. The maximum penalty for failing to disclose a listed transaction increases to $100,000 for an individual and $200,000 for an entity.

These penalties can be imposed even if the underlying transaction is proper and does not result in an understatement of tax, as the penalty is for the failure to disclose. While the law makes it difficult to waive this penalty, the IRS has at times offered relief, such as when a transaction was improperly listed or through specific penalty waiver programs.