In a 1031 exchange, a qualified intermediary (QI), accommodator or facilitator is engaged to provide exchange documentation and hold the exchange proceeds in an escrow account under the taxpayer’s tax identification number. Advice is provided to qualify the transaction as a 1031 exchange. For those accommodators who are not CPAs or attorneys, care must be given not to provide specific tax advice which subjects the accommodator to Circular 230 enrolled as agents who practice before the Internal Revenue Service. The QI is similar to a flagman warning a taxpayer driving along at 70 mph before a curve that the bridge not in view is out. Determining how to navigate the bridge is up to the taxpayer’s tax counsel, including their CPA and or tax attorney.
IRS Penalty Standards
When a 1031 exchange is audited and disallowed, the penalty standards include the income tax related to the sale of the relinquished property and the penalty and interest imposed on the underpayment of taxes, which is equal to the federal short term rate plus three percent. The accuracy related penalty is equal to 20 percent of the substantial understatement of the tax. A substantial understatement is defined as the greater of $5,000 or ten percent of the recognized gain.
Should the taxpayer have substantial authority for the disposition taken, the penalty can be avoided. Substantial authority is defined in Regulation Section 1.6662-4(d)(3)(iii) and based on the following:
(i) The Internal Revenue Code and other statutory provisions
(ii) Proposed, Temporary and final Regulations construing such statutes
(iii) Revenue Rulings and Revenue Procedures
(iv) Tax treaties and regulations thereunder and Treasury Department and other official explanations of such treaties
(v) Court cases
(vi) Congressional intent as reflected in committee reports, joint explanatory statements of managers included in conference committee reports and floor statements made prior to enactment by one of a bill’s managers
(vii) General Explanations of tax legislation prepared by the Joint Committee on Taxation
(viii) Private Letter Rulings and Technical Advice Memoranda issued after October 31, 1976
(ix) Actions on Decisions and General Counsel Memoranda issued after March 12, 1981 (as well as General Counsel Memoranda published in pre-1955 volumes of the Cumulative Bulletin)
(x) Internal Revenue Service information or press releases
(xi) Notices, Announcement and other administrative pronouncements published by the Service in the Internal Revenue Bulletin.
The penalty can be avoided if the relevant facts are adequately disclosed on the tax return and there is a reasonable basis for the position per Regulation Section 1.6662-4. In addition, the penalty can be assessed if there is negligence or disregard of regulations or rules per I.R.C. Section 6662(b). The taxpayer must maintain sufficient records to support their positions.
A fraud penalty is imposed of 75 percent of the underpayment if determined that taxpayer’s intent was to willfully evade the tax or to mislead.
I.R.C. Section 6701 levies penalties on persons who assist in the preparation of any portion of the taxpayer’s return knowing that such portion may result in an understatement of the tax liability. A $1,000 penalty is imposed; however, should a corporation tax return be subject to penalties, a $10,000 fine is assessed.
From a QI’s perspective who is not subject to Circular 230, knowing and acting within the boundaries of exchange advice is critically important. Telling the client they cannot provide tax advice protects the client and themselves. Taxpayers need to know the difference of what to expect and what not to ask. Ignorance is no excuse.
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