Transaction Substantially Similar to Listed Transaction, Taxpayer Subject to Penalties for Failing to Disclose

The cry that the program being promoted to the client is “different” from those that have either lost in court or been identified as a listed transaction is one that most advisers have heard.  But in the case of Interior Glass System, Inc. v. United States[1], CA9, No. 17-15713, IRC §6707A’s disclosure rule is one thing that is like horseshoes and hand grenades—close counts and transactions that are close to listed ones must be disclosed.

IRC §6707A provides for penalties to be imposed on a taxpayer who fails to disclose a reportable transaction, with additional penalties imposed if the transaction is a listed transaction. 

The definitions of reportable and listed transactions are found at IRC §6707A(b) which provide:

(c) Definitions

For purposes of this section:

(1) Reportable transaction

The term “reportable transaction” means any transaction with respect to which information is required to be included with a return or statement because, as determined under regulations prescribed under section 6011, such transaction is of a type which the Secretary determines as having a potential for tax avoidance or evasion.

(2) Listed transaction

The term “listed transaction” means a reportable transaction which is the same as, or substantially similar to, a transaction specifically identified by the Secretary as a tax avoidance transaction for purposes of section 6011.

The question in this case revolved around whether the transaction the taxpayer participated in was “substantially similar to” a transaction identified by the IRS as a listed transaction in Notice 2007-83[2].

The notice described transactions being promoted as trust arrangements that claimed to be welfare benefit funds that used cash value life insurance that were being promoted to provide federal income tax and employment tax benefits.

As IRS describes the promoted programs in the Notice:

Trust arrangements utilizing cash value life insurance policies and purporting to provide welfare benefits to active employees are being promoted to small businesses and other closely held businesses as a way to provide cash and other property to the owners of the business on a tax-favored basis. The arrangements are sometimes referred to by persons advocating their use as “single employer plans” and sometimes as “419(e) plans.” Those advocates claim that the employers’ contributions to the trust are deductible under §§ 419 and 419A as qualified cost, but that there is not a corresponding inclusion in the owner’s income.

The Notice goes on to offer a more complete description of the program:

A promoted trust arrangement may be structured either as a taxable trust or a tax-exempt trust, i.e., a voluntary employees' beneficiary association (VEBA) that has received a determination letter from the IRS that it is described in § 501(c)(9). The plan and the trust documents indicate that the plan provides benefits such as current death benefit protection, self-insured disability benefits, and/or self-insured severance benefits to covered employees (including those employees who are also owners of the business), and that the benefits are payable while the employee is actively employed by the employer. The employer's contributions are often based on premiums charged for cash value life insurance policies. For example, contributions may be based on premiums that would be charged for whole life policies. As a result, the arrangements often require large employer contributions relative to the actual cost of the benefits currently provided under the plan.

Under these arrangements, the trustee uses the employer's contributions to the trust to purchase life insurance policies. The trustee typically purchases cash value life insurance policies on the lives of the employees who are owners of the business (and sometimes other key employees), while purchasing term life insurance policies on the lives of the other employees covered under the plan.

It is anticipated that after a number of years the plan will be terminated and the cash value life insurance policies, cash, or other property held by the trust will be distributed to the employees who are plan participants at the time of the termination. While a small amount may be distributed to employees who are not owners of the business, the timing of the plan termination and the methods used to allocate the remaining assets are structured so that the business owners and other key employees will receive, directly or indirectly, all or a substantial portion of the assets held by the trust.

Those advocating the use of these plans often claim that the employer is allowed a deduction under § 419(c)(3) for its contributions when the trustee uses those contributions to pay premiums on the cash value life insurance policies, while at the same time claiming that nothing is includible in the owner's gross income as a result of the contributions (or, if amounts are includible, they are significantly less than the premiums paid on the cash value life insurance policies). They may also claim that nothing is includible in the income of the business owner or other key employee as a result of the transfer of a cash value life insurance policy from the trust to the employee, asserting that the employee has purchased the policy when, in fact, any amounts the owner or other key employee paid for the policy may be significantly less than the fair market value of the policy. Some of the plans are structured so that the owner or other key employee is the named owner of the life insurance policy from the plan's inception, with the employee assigning all or a portion of the death proceeds to the trust. Advocates of these arrangements may claim that no income inclusion is required because there is no transfer of the policy itself from the trust to the employees.

Under IRC §6707A(b), the penalty for failing to report this transaction, or one substantially similar to it, falls is 75% of the decrease is tax shown on the return as a result of the transaction (or which would have resulted had the transaction been respected for tax purposes).[3]  The maximum amount of the penalty is $200,000 ($100,000 if a natural person)[4] and the minimum amount of penalty for failing to report is $5,000.[5]  The penalty applies to each return where the transaction has (would have for federal tax purposes if the transaction were considered acceptable for federal tax purposes) a tax consequence.[6]

For purposes of the case before the Court, the key tests for the listed transaction under Notice 2007-83 summarized in the opinion are:

  • the transaction involved “a trust or other fund described in [26 U.S.C.] § 419(e)(3) that is purportedly a welfare benefit fund”;

  • contributions to the trust or other fund were not governed by the terms of a collective bargaining agreement;

  • the trust or other fund paid premiums on one or more cash-value life insurance policies that accumulated value; and

  • the employer took a deduction that exceeded the sum of certain amounts.[7]

Reg. §1.6011-4(c)(4) defines substantially similar for these purposes as:

(4) Substantially similar. The term substantially similar includes any transaction that is expected to obtain the same or similar types of tax consequences and that is either factually similar or based on the same or similar tax strategy. Receipt of an opinion regarding the tax consequences of the transaction is not relevant to the determination of whether the transaction is the same as or substantially similar to another transaction. Further, the term substantially similar must be broadly construed in favor of disclosure. For example, a transaction may be substantially similar to a listed transaction even though it involves different entities or uses different Internal Revenue Code provisions. (See for example, Notice 2003-54 (2003-2 CB 363), describing a transaction substantially similar to the transactions in Notice 2002-50 (2002-2 CB 98), and Notice 2002-65 (2002-2 CB 690).)

The panel’s opinion outlines the transaction that the corporation entered into which was different from the plan outlined in Notice 2007-83 for only one of the four tests:

Interior Glass joined the Group Term Life Insurance Plan (GTLP) to fund a cash-value life insurance policy owned by its sole shareholder and only employee, Michael Yates. All agree that this transaction satisfies three of the Notice’s four elements. The GTLP transaction lacks the first element because its intermediary was a tax-exempt business league, rather than a trust or § 419(e)(3) welfare benefit fund. The business league, however, performed the same functions as the trust or welfare benefit fund described in the Notice.[8]

The taxpayer claimed that because it used a business league, rather than a trust for welfare benefit fund, this transaction is not required to be reported and no penalty is due.  In fact, the taxpayer cited two differences:

First, as noted above, the GTLP transaction was filtered through a tax-exempt business league instead of a trust or welfare benefit fund. Second, rather than invoking 26 U.S.C. § 419's rules for welfare benefits, the GTLP transaction purported to provide § 79 group-term life insurance benefits, even though it also involved a cash-value life insurance policy.[9]

The District Court did not agree with that view, imposing the penalty on the taxpayer.  The taxpayer did not find a sympathetic ear at the Ninth Circuit Court of Appeals on the matter either, finding that, despite these differences, the transaction was substantially similar to the one described in Notice 2007-83.[10]

The panel’s opinion outlined why this was deemed a similar transaction:

First, the GTLP transaction was “expected to obtain the same or similar types of tax consequences.” 26 C.F.R. §1.6011-4(c)(4). The transaction identified in the Notice seeks to “provide cash and other property to the owners of the business on a tax-favored basis.” 2007-2 C.B. at 960. Those favorable tax consequences are achieved through (1) a deduction of the contributions by the business and (2) a failure by the business owner to declare the payments as income. The GTLP transaction promised similar tax benefits. On that score, the plan documents represented that “[c]ontributions [were] currently deductible” by Interior Glass and that only the cost of group-term life insurance (in contrast to the premium on the cash-value policy) may have been includible in Yates' income.

Second, the GTLP transaction is both “factually similar” to the listed transaction described in the Notice and “based on the same or similar tax strategy.” 26 C.F.R. §1.6011-4(c)(4). As to factual similarity, the GTLP transaction involved a small business, a cash-value life insurance policy that benefits the business owner, and payment of the premiums on the policy through an intermediary. The GTLP combined those three aspects in pursuit of the same tax strategy discussed in the Notice. By using the intermediary, the business and its owner attempted to do what they could not do outright: deduct payments made to the owner's investment vehicle without declaring the benefits as income.[11]

The taxpayer complained that Congress had passed an unconstitutionally vague statute which meant they couldn’t determine if such reporting was required.  This argument also did go over well with the panel:

Interior Glass contends that, if read to encompass the GTLP transaction, the definition of “substantially similar” is unconstitutionally vague. That contention is without merit. For a civil penalty like 26 U.S.C. § 6707A, the definition is constitutionally valid so long as “a person of ordinary intelligence” could determine which transactions are substantially similar to the listed transaction identified in Notice 2007-83. Fang Lin Ai v. United States, 809 F.3d 503, 514 (9th Cir. 2015). As explained above, the regulation’s definition of “substantially similar” is detailed enough to make that determination an easy one in this case. The only differences between the GTLP transaction and the listed transaction are expressly addressed — and expressly rejected as immaterial — in the definition itself.[12]

[1], retrieved June 27, 2019

[2], retrieved June 27, 2019

[3] IRC §6707A(b)(1).

[4] IRC §6707A(b)(2)(A)

[5] IRC §6707A(b)(3)

[6] Reg. §1.6011-4

[7], retrieved June 27, 2019, p. 6

[8] Ibid, p. 7

[9] Ibid, p. 9

[10] Ibid, p. 8

[11] Ibid, p. 8

[12] Ibid, p. 9