New Excise Taxes and Additional Disclosure Requirements May Apply to Tax-Exempt Entities Involved in Prohibited Tax Shelter Transactions and Their Managers

Little noticed provisions enacted in May 2006 as part of the Tax Increase Prevention and Reconciliation Act of 2005 (“Act”), and highlighted in a recent IRS and Treasury Department notice, impose taxes and additional reporting requirements on certain tax-exempt investors and their managers.( 1 ) Tax-exempt entities investing in private funds, in particular, should be aware of these new rules. Unfortunately, until the IRS issues further guidance, many questions on how to apply these rules will remain unanswered.

PROHIBITED TAX SHELTER TRANSACTIONS
The new rules target three types of transactions, defined for these purposes as “prohibited tax shelter transactions,” which were (and remain) subject to disclosure requirements in effect prior to the Act:

  • Listed Transactions. A listed transaction is any transaction specifically identified by the IRS as a tax avoidance transaction. One difficulty under prior law, which now carries over to the new rules, is that this term includes any transaction that is “substantially similar” to a specifically identified transaction. The new rules can also apply to “subsequently listed transactions”—that is, transactions that were not prohibited tax shelter transactions on the date the tax-exempt entity became a party to the transaction, but that become listed transactions thereafter.
  • Confidential Transactions. In a confidential transaction, an advisor places a limitation on the disclosure of the tax treatment or tax structure of the transaction in order to protect the confidentiality of the advisor’s tax strategies. A transaction is not considered confidential if the advisor permits the taxpayer to disclose the tax treatment or tax structure of the transaction.
  • Transactions with Contractual Protection. A transaction with contractual protection is a transaction where the taxpayer or a related party has the right to a full or partial refund of fees if all or part of the intended tax consequences from the transaction are not sustained.

EXCISE TAXES ON TAX-EXEMPT ENTITIES AND THEIR MANAGERS
The new rules apply to a broad array of tax-exempt entities. Notice 2006-65 divides these into two broad groups:

  • Non-Plan Entities include charities described in Section 501©(3) of the Internal Revenue Code of 1986, as amended (the “Code”), trade associations, states and localities, and instrumentalities of the United States.
  • Plan Entities include qualified pension, profit sharing, and stock bonus plans, government employer retirement plans, qualified tuition programs under Section 529 of the Code, and tax-favored savings accounts such as individual retirement accounts.

An excise tax applies to any Non-Plan Entity that is a party to a prohibited tax shelter transaction. The excise tax does not apply to Plan Entities. The excise tax generally equals the highest corporate tax rate (currently 35%) multiplied by the greater of (i) the tax-exempt entity’s net income from the transaction or (ii) 75% of the entity’s proceeds from the transaction. Thus, it appears that the excise tax could apply even if the tax-exempt entity makes no profit on the transaction.

In cases where the tax-exempt entity knew, or had reason to know, that a transaction was a prohibited tax shelter transaction, the excise tax is increased to 100% of the greater of (i) or (ii) above. The conference committee report to the Act explains that, for an entity or entity manager to have reason to know that a transaction is a prohibited tax shelter transaction, the entity or entity manager “must have knowledge of sufficient facts that would lead a reasonable person to conclude that the transaction is a prohibited tax shelter transaction.” Certain factors, such as an exceptional return, absence of risk, or significant transaction size may indicate that the entity or entity manager has reason to know, unless the entity or entity manager inquires further. The conference committee report indicates that a tax-exempt entity will not have reason to know if the entity justifiably relies on an opinion of counsel that the transaction is not a prohibited tax shelter transaction.

The excise tax applies to a Non-Plan Entity that is a “party” to a prohibited tax shelter transaction. Although this term is not defined, it appears to sweep more broadly than the current disclosure regulations for reportable transactions, which apply to “participants” as defined in the regulations. A tax exempt entity that invests through a partnership may be considered a party to a prohibited tax shelter transaction even in circumstances when the tax exempt entity would not be considered a “participant” under the disclosure regulations for reportable transactions. The conference committee report explains that certain indirect involvement in a prohibited tax shelter transaction, such as a tax-exempt entity investing in a mutual fund that in turn invests in such a transaction, would not make the tax exempt entity a party to the transaction “absent facts or circumstances that indicate that the purpose of the tax exempt entity’s investment in the mutual fund was specifically to participate in such a transaction.” Whether a tax-exempt entity is a party to such a transaction will be informed by whether the entity or entity manager knew or had reason to know that an investment of the entity would be used in a prohibited tax shelter transaction.

Many tax-exempt entities, or funds in which they invest, make protective filings under the current disclosure rules for reportable transactions for certain transactions that might be considered “substantially similar” to a listed transaction. The effect of such a protective filing under the new rules is not clear.

A separate excise tax now will apply to any entity manager that approves a tax-exempt entity as (or otherwise causes such entity to be) a party to a prohibited tax shelter transaction and knows or has reason to know that the transaction is a prohibited tax shelter transaction. This excise tax is $20,000 for each approval or other act causing participation. For a Non-Plan Entity, the entity manager is the person with authority or responsibility similar to that exercised by an officer, director, or trustee of an organization and, with respect to any act, the person having authority or responsibility with respect to that act. For a Plan Entity, the entity manager is the person who approves or otherwise causes the entity to be a party to the prohibited tax shelter transaction. In the case of a qualified pension plan or individual retirement account, the conference committee report indicates that the person who is responsible for determining the pre-selected investment options, and not a participant or beneficiary choosing among those investment options, would be the entity manager. Whether similar reasoning would protect a Non-Plan Entity investing in a private partnership, or the manager of a fund-of-funds, is unclear.

In the case of a Non-Plan Entity, both the entity level excise tax and the manager-level excise tax can apply with respect to the same prohibited tax shelter transaction. These new excise taxes are also in addition to any other tax, addition to tax, or penalty.

DISCLOSURE REQUIREMENTS AND PENALTIES
Any tax-exempt entity, whether a Plan Entity or a Non-Plan Entity, that is a party to a prohibited tax shelter transaction must disclose to the IRS its participation in the transaction and the identity of any other party to the transaction that it knows. The IRS has not yet specified the form on which this disclosure would be made.

Failure to file this disclosure will result in a penalty of $100 per day, subject to a maximum of $50,000 with respect to any one disclosure, with an additional penalty of $100 per day, subject to a maximum of $10,000 with respect to any one disclosure, if the IRS makes a written demand for the disclosure. No penalty will be imposed if the failure to file is due to reasonable cause. These penalties are imposed on the Non-Plan Entity or, in the case of a Plan Entity, on the entity manager. Thus, to avoid penalties, the manager of a Plan Entity would need to ensure that the Plan Entity makes the required filings.

Any taxable party to a prohibited tax shelter transaction must also disclose to any participating tax exempt entity that the transaction is a prohibited tax shelter transaction. A taxable party that fails to comply with this new disclosure requirement will be subject to the same penalties that apply under current law for failure to comply with the disclosure requirements for reportable transactions. These penalties can be up to $200,000, and the taxable party may need to disclose imposition of the penalty in filings with the Securities and Exchange Commission. It appears that for this purpose a taxable party would include a partnership.

IMPLICATIONS
In light of the rules described above, a hedge fund should consider taking the following actions:

  • Adding language to the fund’s offering or private placement memorandum (“PPM”) and limited partnership or limited liability company agreement to permit investors to disclose the tax treatment and tax structure of the fund. This would help to ensure that an investment in the fund is not treated as a confidential transaction.
  • Revising the PPM disclosure on tax shelter reporting to discuss the new excise taxes, disclosure requirements, and related penalties.

In addition, hedge funds should carefully consider whether tax-exempt investors should invest through an offshore fund (treated as a corporation for U.S. tax purposes) rather than an onshore fund, even if unrelated business taxable income is not a concern. It is not clear, however, whether a tax-exempt investor in an offshore fund could still be considered a “party” to a prohibited tax shelter transaction undertaken by the fund.

EFFECTIVE DATES
The excise taxes described above generally apply to taxable years ending after May 17, 2006, and the disclosure requirements and related penalties apply to disclosures due after that date. However, no excise tax applies with respect to income or proceeds properly allocable to any period ending on or before August 15, 2006 (90 days after enactment). In addition, the increase in the entity-level tax that applies where the entity knew or had reason to know that the transaction was a prohibited tax shelter transaction will not apply if the tax-exempt entity became a party to the transaction on or before May 17, 2006.

Roger S. Wise
202.778.9023
[email protected]

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( 1 ) The Act was signed into law on May 17, 2006. The IRS and Treasury Department issued Notice 2006-65, IRB 2006-31, on July 11, 2006.

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Theodore L. Press 202.778.9025 [email protected]
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