Section 6700 penalty base includes post-formation promoter fees

Plain-English summary

A promoter organized micro-captive insurance companies and then received continuing maintenance and management fees. It argued that Section 6700 penalties could be calculated only on income earned from initial promotional or organizational work before each captive was formed. The IRS rejected that view. When false or fraudulent statements are involved, Section 6700 imposes a penalty equal to 50 percent of gross income derived or to be derived from the entire tax-shelter promotion. That base includes ongoing fees earned after formation when they relate to continued facilitation, organization, maintenance, or management of the promotion.

Ruling snapshot

• Question: Does the Section 6700 penalty base include promoter income earned after a tax shelter is formed?
• Outcome: Advice given: yes, including related ongoing maintenance and management fees.
• Key authorities: IRC § 6700(a); Tarpey v. United States; Davison v. Commissioner

Full text (IRS public release)

Office of Chief Counsel
Internal Revenue Service
memorandum
Number: 202125008
Release Date: 6/25/2021
CC:PA:02:MFRANKLIN
POSTU-112010-15

UILC: 6700.04-00

date: March 12, 2021

to: James D. Hill
Supervisory General Attorney
AC Area 3, Section 13 (Large Business and International)

from: Meghan M. Howard
Senior Technician Reviewer
Branch 1 (Procedure and Administration)

subject: Calculation of Penalties Under Section 6700, Promoting Abusive Tax Shelters

This Chief Counsel Advice responds to your email dated November 23, 2020. In
accordance with I.R.C. 6110(k)(3), Chief Counsel Advice may not be used or cited as
precedent.

LEGEND

X = -------

ISSUE

Does the section 6700 penalty calculation include a promoter’s gross income derived
from the organization or sale of a tax shelter after the formation of the tax shelter?

CONCLUSION

Yes. The statute provides that the government is directed to assess a section 6700
penalty that is 50 percent of the gross income derived or to be derived from the
organization or sale of a tax shelter, if the organization or sale involves false or
fraudulent statements. Courts have found that section 6700 allows the government to
assess a penalty on all gross income derived from the organization or sale of a tax
shelter, including gross income derived after the formation of the tax shelter.

FACTS
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X is a corporation that engaged in the promotion of micro-captive insurance
transactions. In a typical micro-captive insurance transaction, a taxpayer attempts to
reduce the aggregate taxable income of the taxpayer, related persons, or both, using
contracts that the parties treat as insurance contracts and a related company that the
parties treat as a captive insurance company. Each entity that the parties treat as an
insured entity under the contracts claims deductions for premiums for insurance
coverage. The related company that the parties treat as a captive insurance company
elects pursuant to section 831(b) to be taxed only on investment income and therefore
excludes the payments directly or indirectly received under the contracts from its
taxable income.

Here, X set up and provided ongoing services related to the continuing maintenance
and management of a micro-captive insurance company. In response to the Service’s
questions posed during the section 6700 audit of the promoter, promoter asserted that
section 6700 penalties are calculated only on the income derived from initial
promotional and/or organizational activity that occurred before the formation of the
micro-captive insurance company. X received ongoing maintenance and management
fees relating to the micro-captive insurance companies. X made false statements
regarding available tax benefits while engaged in both organizational and sales
activities.

LAW AND ANALYSIS

Since January 1, 1990, section 6700 of the Code has imposed a penalty
on persons who promote abusive tax shelters. In pertinent part, the penalty applies
to any person who

(1)(A) organizes (or assists in the organization of) –
(i) a partnership or other entity,
(ii) any investment plan or arrangement, or
(iii) any other plan or arrangement, or

(B) participates (directly or indirectly) in the sale of any interest in, an entity
plan or arrangement . . . ,and

(2) makes or furnishes or causes another person to make or furnish (in
connection with such organization or sale)-

(A) a statement with respect to the allowability of any deduction or credit, the
excludability of any income, or the securing of any other tax benefit by reason
of holding an interest in the entity or participating in the plan or arrangement
which the person knows or has reason to know is false or fraudulent as to any
material matter. . . .
Section 6700(a) provides that the “penalty shall be equal to 50 percent of the gross
income derived (or to be derived) from such activity by the person on which the penalty
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is imposed” if the activity involves false or fraudulent statements. 26 U.S.C. § 6700(a).
The “activity” giving rise to a section 6700 penalty encompasses the entire promotion
facilitated and organized by the promoter. Tarpey v. United States, No. CV-17-94-
BMM, 2019 WL 5820727, at *2–3 (D. Mont. Nov. 7, 2019). Courts have found that
“[s]ection 6700 allows the government to assess a penalty on ‘gross income derived or
to be derived’ from the tax shelter activity.” In re MDL-731 Tax Refund Litig. of
Organizers & Promoters of Inv. Plans Involving Book Properties Leasing, 989 F.2d
1290, 1302 (2d Cir. 1993); Davison v. Commissioner, T.C. Memo. 2020-58, appeal
dismissed, No. 20-9002, 2020 WL 7033850 (10th Cir. Aug. 18, 2020). This language
contemplates assessments on current earnings, but also assessments on earnings to
be derived in the future from the facilitation and organization of an abusive tax shelter.
Id.

Recently, in Davison v, Commissioner, T.C. Memo. 2020-58, the Tax Court found that
section 6700 penalties were appropriately assessed and accurately calculated based on
the promoter’s gross income derived from the entire promotion. The promoter’s gross
income included amounts paid as a retainer for the promoter’s ongoing services in 2009
and 2010 for facilitating and organizing the tax shelter, including serving on a board of
directors, years after the formation of the abusive tax shelter. Id. In Tarpey v. United
States, No. CV-17-94-BMM, 2019 WL 5820727, at *2–3 (D. Mont. Nov. 7, 2019), the
district court found that the “activity” giving rise to the penalty against Tarpey, the
promoter, encompassed the entire promotion facilitated and organized by the promoter,
and included the promoter’s solicitation of timeshare donations, timeshare appraisals,
and direct profits to his other organizations.

These cases illustrate that section 6700 allows the government to assess a penalty on
gross income derived from the facilitation and organization of the entire promotion, and
the penalty is not limited temporally to activity occurring prior to the formation of the tax
shelter. In the context of micro-captive insurance transactions, section 6700 allows the
government to assess a penalty on a promoter’s gross income derived from the
facilitation and organization of the entire tax shelter by the promoter, not just gross
income pre-dating the formation of the micro-captive insurance company. For example,
gross income derived would include ongoing maintenance and management fees
received related to the continued facilitation and organization of the promotion as well
as any other fees relating to the continued facilitation and organization of the promotion.

X cited two cases as standing for the proposition that 6700 penalties are calculated only
on income derived from initial promotional and/or organizational activity that occurred
before the formation of the micro-captive insurance company. The cases cited are
inapposite. In Schulz v. United States, 2018 WL 3405240 (N.D.N.Y. July 12, 2018), the
court found that the promoter’s tax shelter activity was the distribution of blue folders
that promoted frivolous tax arguments and that the penalty should be calculated on the
gross income derived from the tax shelter activity. The case supports the legal
conclusion that section 6700 allows the government to assess a penalty on gross
income derived or to be derived from the facilitation or organization of the tax shelter. In
Hargrove, an unreported case that analyzed a prior version of section 6700(a)(1), the
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court considered whether each sale was to be treated as a separate activity for
purposes of assessing multiple $1000 minimum penalty amounts under that prior
version of section 6700(a)(1). Hargrove & Costanzo v. United States, No.
CVF06046LJODLB, 2008 WL 4133928 (E.D. Cal. Sept. 4, 2008). But the rule for
activities occurring on or after October 23, 2004 provides that the penalty amount is
equal to 50 percent of the gross income derived (or to be derived) from the organization
or sale of a tax shelter by the person penalized. The legislative history of section 6700
shows that Congress believed that pre-2004 penalty rate discussed in Hargrove was
insufficient to deter the type of conduct that gave rise to the penalty. S. Rep. No. 180-
192 (2003). Accordingly, Congress amended section 6700 to modify the penalty
amount to equal 50 percent of the gross income derived by the person from the activity
for which the penalty is imposed. See IRC§ 6700(a).

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determined to be necessary, please contact this office for our views.

Please contact Branch 2 of Procedure and Administration if you have any further
questions.