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PROHIBITED SHELTER TRANSACTIONS 
TIPRA Prohibitions on Shelter Transactions Leave Muddle for Exempts
Congress addressed the problem in a way that may have put a real solution out of reach.
Author: GRACE ALLISON
GRACE ALLISON is tax strategist with The Northern Trust Company in Chicago, IL. © 2006, Northern Trust Corporation. 
Before Congress passed the Pension Protection Act (P.L. 109-280, 8/17/06), it added new accommodation party penalty and disclosure provisions to the Code. Section 516 of TIPRA, the Tax Increase Prevention and Reconciliation Act of 2005 (P.L. 109-222, 5/17/06), created new Section 4965 and amended existing Sections 6033(a)(2), 6011(g), and 6652(c)(3). 
The purpose of the new provisions is obvious—to deter tax-exempt entities from becoming accommodation parties in abusive tax shelter transactions—and Congress deserves some credit for adding to the Service's arsenal in the tax gap war. Unfortunately, the language of Section 4965 is disappointingly complex and unclear, and has prompted practitioners to call for immediate guidance from the Treasury and the IRS. 1 The real question is whether this new section is simply unfixable. 
Entities subject to Section 4965
Section 4965 applies to "tax-exempt entities," which are defined to include not only those described in Section 501(c), but also a wide range of other tax-exempt organizations, governmental entities, plans, and accounts. 2 If a tax-exempt entity "becomes a party" to a "prohibited tax shelter transaction," Section 4965 will impose a penalty tax on the entity itself and/or (depending on what type of entity it is) on the entity's managers. 3 
As discussed below, the statute applies differently to "non-plan entities," which are subject to the entity-level tax, and "plan entities," which are not. 4 In addition, there are two different definitions of entity manager, one applying in non-plan entity situations and the other in plan entity situations. 5 
Notice 2006-65, 2006-31 IRB 102, 6 provides a useful listing, reproduced in the sidebar on page 100, of the non-plan entities and plan entities to which new Section 4965 applies. 
Notice 2006-65 and Section 4965
The non-plan entities to which new Section 4965 applies, listed in Notice 2006-65, 2006-31 IRB 102, are: 
(1.) Entities described in Section 501(c), including but not limited to the following common types of entities: 
•	Instrumentalities of the United States described in Section 501(c)(1).
•	Churches, hospitals, museums, schools, scientific research organizations, and other charities described in Section 501(c)(3).
•	Civic leagues, social welfare organizations, and local associations of employees described in Section 501(c)(4).
•	Labor, agricultural, and horticultural organizations described in Section 501(c)(5).
•	Business leagues, chambers of commerce, trade associations, and other organizations described in Section 501(c)(6).
•	Voluntary employees' beneficiary associations (VEBAs) described in Section 501(c)(9).
•	Credit unions described in Section 501(c)(14).
•	Insurance companies described in Section 501(c)(15).
•	Veterans' organizations described in Section 501(c)(19).
(2.) Religious or apostolic associations or corporations described in Section 501(d). 
(3.) Entities described in Section 170(c), including states, U.S. possessions, the District of Columbia, and political subdivisions of the states and possessions (but not the United States itself). 
(4.) Indian tribal governments within the meaning of Section 7701(a)(40). 
The plan entities to which new Section 4965 applies are: 
(5.) Qualified pension, profit-sharing, and stock bonus plans described in Section 401(a). 
(6.) Annuity plans described in Section 403(a). 
(7.) Annuity contracts described in Section 403(b). 
(8.) Qualified tuition programs described in Section 529. 
(9.) Retirement plans described in Section 457(b) maintained by a governmental employer. 
(10.) Individual retirement accounts within the meaning of Section 408(a). 
(11.) Archer Medical Savings Accounts (MSAs) within the meaning of Section 220(d). 
(12.) Individual retirement annuities within the meaning of Section 408(b). 
(13.) Coverdell education savings accounts described in Section 530. 
(14.) Health savings accounts within the meaning of Section 223(d). 
Why is Section 4965 so broad in its application? As the Panel on the Non-Profit Sector points out, 7 the IRS found from experience that the tax-exempt accommodation parties in listed tax shelter transactions were not always charities. For example, state and local governmental (and quasi-governmental) entities, exempt from tax under Section 115, were likely accommodation parties in the S corporation tax shelter listed in Notice 2004-30, 2004-17 IRB 828, because they are not subject to UBIT. 
Summary of Section 4965
For all that it requires, there is much that Section 4965 leaves unclear. 
'General' entity-level tax on non-plan entities.
The entity-level tax of Section 4965(a)(1) is imposed if a non-plan entity (1) "becomes a party" to a transaction that is, at the time it does so, a "prohibited tax shelter transaction" or (2) is a party to a transaction that becomes a "subsequently listed transaction." The entity tax applies in the year in which the non-plan entity becomes a party—or is a party—and in any subsequent tax year in which it continues to be a party. As discussed above, plan entities are not, under any circumstances, subject to entity-level tax. 
In general, this penalty tax is imposed at the highest corporate rate (35%) on the greater of (1) the entity's net income with respect to the transaction or (2) 75% of the proceeds received by the entity from the transaction. 8 In the case of a "subsequently listed transaction," a special allocation assures that the entity is not taxed on income or proceeds attributable to a period prior to the listing of the transaction. 9 Importantly, a non-plan entity is subject to this "general" tax whether or not it had (or should have had) knowledge of the potentially abusive nature of the transaction to which it becomes a party. 
The imposition of a penalty in the absence of knowledge is in keeping with the legislative intent. The Conference Committee Report notes, that "the conference agreement adds a tax in the event that a tax-exempt entity becomes a party to a prohibited tax shelter transaction without knowing or having reason to know that the transaction is a prohibited tax shelter transaction." 10 
Knowledge or reason to know.
If a non-plan entity "knows or had reason to know" that the transaction was a "prohibited tax shelter transaction" at the time it becomes a party to the transaction, an increased tax applies, equal to the greater of (1) 100% of the entity's net income from the transaction or (2) 75% of the proceeds received by the entity from the transaction. 11 
A manager-level tax is imposed on any "entity manager" that (1) "approves such entity as (or otherwise causes such entity to be) a party to a prohibited tax shelter transaction" and (2) "knows or has reason to know that the transaction is a prohibited tax shelter transaction." 12 This tax applies to managers of both non-plan entities and plan entities. 
Thus, if non-plan entities are parties to a prohibited tax shelter transaction, tax may be imposed at both the entity and the manager levels. If, however, plan entities are parties, tax may be imposed only at the manager level. Given the conditions for imposition of the tax set forth in Section 4965(a)(2), there will be no tax on an entity manager—whether plan or non-plan—unless the manager had or should have had the requisite knowledge about the transaction. 
Disclosure requirements and related penalties.
Closely allied to the penalty provisions of Section 4965 are disclosure provisions added by TIPRA section 516(b). 
By amending existing Section 6033(a)(2), TIPRA section 516(b)(1) adds the requirement that any tax-exempt entity (whether a non-plan entity or a plan entity) file with the IRS disclosure of (1) its status as a party to any prohibited tax shelter transaction and (2) the identity of other parties to the transaction, to the extent known by the tax-exempt entity. 
Under Section 6652(c)(3)(A), as amended by TIPRA section 516(c), the penalty for failure to make a Section 6033(a)(2) disclosure is a fine of $100 per day (up to a maximum of $50,000 for any one failure to disclose), payable at the entity level by non-plan entities and at the manager level by plan entities. In addition, the Treasury has discretion to make a written demand on any entity or manager for Section 6033(a)(2) disclosure, with an accompanying penalty for failure to comply of $100 a day (up to a maximum of $10,000 for any one failure to disclose.). 13 This penalty is to be paid at the entity level in the case of non-plan entities and, in the case of plan entities, by the entity manager. 
Finally, TIPRA section 516(b)(2) inserts a new subsection (g) in existing Section 6011. It requires that any taxable party to a prohibited tax shelter transaction disclose, to any tax-exempt entity that is a party to such transaction, that the transaction is a prohibited tax shelter transaction. Notice 2006-65 clarifies that the existing penalties in Section 6707A(b) will apply to any failure by a taxable party to so disclose. 14 
Definitions
Section 4965 is problematic largely because of the inadequacy of its definitions, which too often are either unclear or missing. Among the terms that the statute purports to define are those listed below. 
'Tax-exempt entity.'
As discussed earlier, the definition of "tax-exempt entity" that appears in Section 4965(c) is lengthy and very clear, incorporating by reference many other well-known provisions of the Code. 
'Entity manager.'
The definition of "entity manager," on the other hand, is troubling. For non-plan entities, "entity manager" is defined as "(A) the person with authority or responsibility similar to that exercised by an officer, director, or trustee of an organization, and (B) with respect to any act, the person having authority or responsibility with respect to such act." 15 
It is unclear whether these requirements apply conjointly or in the alternative. It is certainly possible to imagine situations in which a person other than an officer, director, or trustee—such as an investment manager—would be the person responsible for the entity's participation in a prohibited tax shelter transaction. 
The definition of "entity manager" for plan entities is a good deal clearer, defined broadly to include "the person who approves or otherwise causes the entity to be a party to the prohibited tax shelter transaction." 16 The Conference Committee Report clarifies the meaning of "approves" in this context: 
[A] participant or beneficiary [of a plan] is not an entity manager merely by reason of choosing among pre-selected investment options (as is typically the case if a qualified retirement plan provides for participant-directed investments). Similarly, if an individual has an IRA and may choose among various mutual funds offered by the IRA trustee, but has no control over the investments held in the mutual funds, the individual is not an entity manager under the provision." 17
'Prohibited tax shelter transaction.'
Section 4965 targets participation in "prohibited tax shelter transactions," defined to include any "listed transaction" and any "prohibited reportable transaction." 18 
'Listed transaction.' The definition of "listed transaction" is the first of several definitions to incorporate existing Section 6707A by reference. Under Section 4965(e)(1)(B), a listed transaction for purposes of Section 4965 has the "meaning given ... [in] Section 6707A(c)(2)," i.e., " ...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." 
"Reportable transaction." A reportable transaction is defined in Section 6707A(c)(1) to mean "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." 
As noted above, Section 6011 now includes a reporting requirement for taxable parties to a prohibited tax shelter transaction. Even so, the cross references to Section 6011 and Section 6707A are somewhat surprising, given that Section 4965 was largely enacted to resolve uncertainty as to whether the disclosure and penalty regimes of these sections apply to tax-exempt entities. 19 Used in the context of Section 4965, a transaction is apparently "reportable" if it must be disclosed under Section 6011 by any party to the transaction, whether or not that party is a tax-exempt entity. 
'Prohibited reportable transaction.' Under Section 4965(e)(1)(C), "prohibited reportable transaction" means "any confidential transaction or any transaction with contractual protection (as defined under regulations prescribed by the Secretary) which is a reportable transaction (as defined in Section 6707A(c)(1))." 
"Confidential transaction." Currently, Reg. 1.6011-4(b)(3) provides a lengthy definition of "confidential transaction" as a type of "reportable transaction." Integral to this definition is the concept of a transaction "offered to a taxpayer under conditions of confidentiality and for which the taxpayer has paid an advisor a minimum fee." 
This definition does not seem to fit the situation of a tax-exempt entity that becomes an accommodation party in an abusive tax shelter transaction. It is unlikely that a tax-exempt entity would pay a fee to become a party to such a transaction, for example. Hopefully, Treasury or the IRS will soon issue guidance on the meaning of "confidential" for purposes of Section 4965. Such guidance should also address the issue of how a transaction that is a "confidential transaction" for purposes of Section 4965 can also be a reportable transaction as defined in Section 6707A(c)(1). 
"Transaction with contractual protection." Similarly, "transaction with contractual protection" is currently defined in Reg. 1.6011-4(b)(4). Central to this definition is the concept that the taxpayer or a related party has a "right to a full or partial refund of fees ... if all or part of the intended tax consequences are not sustained." It is unlikely that a tax-exempt entity would pay a fee to become a party to such a transaction, again raising the issue of how a transaction that is a "transaction with contractual protection" for purposes of Section 4965 can also be a reportable transaction as defined in Section 6707A(c)(1) . 
'Subsequently listed transaction.' In addition to targeting participation in prohibited tax shelter transactions, Section 4945 also targets participation in a "subsequently listed transaction." Under Section 4965(e)(2), "subsequently listed transaction" means any transaction that becomes a listed transaction after the tax-exempt entity has become a party to the transaction. It does not include any transaction that is a "prohibited reportable transaction" at the time that the tax-exempt entity becomes a party to it. 
No definitions
Missing altogether are definitions for three key concepts—"party to a transaction," "know or have reason to know," and "approves." 
'Party to a transaction.'
A necessary condition for the imposition of tax under Section 4965(a) is that the tax-exempt entity (1) become a "party" to a prohibited tax shelter transaction or (2) be a "party" to a subsequently listed transaction. The statute does not define what it means to be a "party to a transaction." Based on the literal language of the statute, intent or purpose is not a required element. Significantly, the Conference Committee Report tells a different story. 
The relevant passage begins with a statement of congressional intent—a "facts and circumstances" test should be applied to determine whether or not a tax-exempt entity is a party to a particular transaction. 20 Reading on, however, it becomes clear that certain factors are to be given more weight than others, the most crucial factor being the tax-exempt entity's purpose in entering the transaction. As evidenced in the excerpt below, a finding of "purpose to participate in a prohibited tax shelter transaction" is, for the drafters, a strong indication that a tax-exempt entity is a "party" to that transaction. Purpose, in turn, is evidently imputed if the entity "knows or has reason to know" the prohibited nature of the transaction: 
In general, the conferees intend that in determining whether a tax-exempt entity is a "party" to a prohibited tax shelter transaction, all the facts and circumstances should be taken into account. Absence of a written agreement is not determinative. Certain indirect involvement in a prohibited tax shelter transaction would not result in an entity being considered a party to the transaction. For example, investment by a tax-exempt entity in a mutual fund that in turn invests in or participates in a prohibited tax shelter transaction does not, in general, make the tax-exempt entity a party to such 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. However, 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. Presence of such knowledge or reason to know may indicate that the purpose of the investment was to participate in the prohibited tax shelter transaction and that the tax-exempt entity is a party to such transaction. 21
What is the net result? Under the literal language of the statute, a tax-exempt entity may be a party to a prohibited tax shelter transaction without having "knowledge or reason to know." However, the presence of knowledge is nonetheless a critical factor in making such a determination. 
'Know or have reason to know.'
As shown above, "entity managers" are not liable for tax under Section 4965(a)(2) unless they "know or have reason to know" that a transaction is a prohibited tax shelter transaction. Similarly, entities are not subject to the increased penalty tax unless they know or have reason to know at the time that they enter into a transaction that it is a prohibited tax shelter transaction. 
Unfortunately, there is no definition in the statute of "know" or "reason to know." There is also no explanation of why "having knowledge," in the case of an entity manager, is not limited to having knowledge at the time the tax-exempt entity becomes a party to the "prohibited tax shelter transaction." 
There is, however, some discussion of "knowledge" in the Conference Committee Report: 
In general, the conferees intend that in order for an entity or entity manager to have reason to know that a transaction is a prohibited tax shelter transaction, the entity or manager must have knowledge of sufficient facts that would lead a reasonable person to conclude that the transaction is a prohibited tax shelter transaction.... [I]f a transaction is extraordinary for the entity, promises a return for the organization that is exceptional considering the amount invested by, the participation of, or the absence of risk to the organization, or the transaction is of significant size, either in an absolute sense or relative to the receipts of the entity, then, in general, the presence of such factors may indicate that the entity or entity manager has a responsibility to inquire further about whether a transaction is a prohibited tax shelter transaction, or absent such inquiry, that the reason to know standard is satisfied." 22
This general discussion in the Conference Committee Report does not focus on the three specific types of tax shelter transactions targeted by Section 4965, leaving at least three critical questions unanswered: 
•	With respect to a "listed" transaction, does "knowledge" or "reason to know" result automatically if a transaction is "specifically identified" by the IRS?
•	With respect to a "confidential transaction," does knowledge arise if the entity or entity manager has knowledge of the confidentiality agreement?
•	With respect to a "transaction with contractual protections," does "knowledge" or "reason to know" arise if the entity or entity manager has knowledge of the contractual protections?
Instead of answering these questions, the Conference Committee Report provides a less-than-satisfactory safe harbor. If the entity or entity manager acts in "justifiable reliance on a reasoned written opinion of legal counsel (including in-house counsel) or of an independent accountant with expertise in tax maters, after making full disclosure of relevant facts about a transaction to such counsel or accountant, that a transaction is not a prohibited tax shelter transaction, then absent knowledge of facts not considered in the reasoned written opinion that would lead a reasonable person to conclude that the transaction is a prohibited tax shelter transaction, the reason to know standard is not met." 23 
As a practical matter, this safe harbor (which one would expect to see mirrored in forthcoming regulations) gives tax-exempt entities an unpalatable choice—either pay for an opinion or pay the penalties under Section 4965! 
'Approves.'
Under Section 4965(a)(2), an entity manager is liable for penalty tax only if it "approves" the tax-exempt entity as a party to a prohibited tax shelter transaction. "Approval," as used in this context, is not defined, leaving room for clarification. For example, what result if an entity manager has knowledge of both (1) the nature of the transaction and (2) the status of the tax-exempt entity as a party to the transaction? Is failure to cause (or attempt to cause) the entity to withdraw from the transaction tantamount to approval? 
Effective dates
As a general rule, Section 4965 is effective for all tax years ending after 5/17/06 (the date of enactment) and expressly applies to transactions "before, on, or after that date." 24 
A special carve-out exists for taxes that would otherwise "apply with respect to income or proceeds properly allocable to any period beginning on or before 90 days after enactment." 25 The manager-level taxes described in Section 4965(b)(2) are expressed as a fixed dollar amount (i.e. $20,000) and do not "apply with respect to income or proceeds." Thus, it would appear that this carve-out protects only non-plan entities—and not the managers of either non-plan or plan entities. 
The harsher entity-level tax (imposed where the entity "knew or had reason to know a transaction was a prohibited tax shelter transaction at the time the entity became a party to the transaction") expressly does not apply to any prohibited tax shelter transaction to which the entity became a party before 5/18/06. 26 
Effective date for new disclosure and penalty provisions.
Under TIPRA section 516(d)(2), the new disclosure rules of Sections 6011(g) and 6033(a)(2), as well as the new penalty provision of Section 6652(c)(3), are effective with respect to disclosures "the due date for which are after the date of the enactment of this Act." It seems safe to assume that no disclosure will be due before further guidance is issued on the manner of the disclosure and the timing of the "due date." 
Application of Section 4965
Perhaps the best way to understand the operation of Section 4965 is to look at how it applies under different fact patterns. Key variables are: (1) whether the entity is a plan entity or a non-plan entity; (2) whether there is knowledge on the part of the entity; (3) whether there is knowledge on the part of the entity manager; (4) whether the transaction is listed at the time the entity becomes a party to the transaction; and (5) which statutory effective dates apply. 
Situation 1.
On 1/1/06, a non-plan entity (a calendar year taxpayer) becomes a party to a prohibited tax shelter transaction but does not, at the time it enters into the transaction, know or have reason to know that the transaction is a prohibited tax shelter transaction. Emily, the entity manager, approves the entity as a party to the transaction, but does not know or have reason to know, at the time that the entity enters into the transaction, that the transaction is a prohibited tax shelter transaction. 
Under TIPRA section 516(d)(1), Section 4965 applies to the transaction because it is entered into in a tax year that ends after the 5/17/06 effective date. (Query: what result if the subject entity is not required to do tax reporting—as is generally the case with governmental entities and churches, for example—and therefore does not have a tax year?) 
Because the entity is a non-plan entity, it is subject to the general entity-level tax, despite the absence of knowledge. It will be subject to this tax in 2006 and, under Section 4965(a)(1), "in any subsequent taxable year" in which it remains a party to the transaction. 
Thanks to the special transition rule of TIPRA section 516(d)(1), however, the non-plan entity will be subject to tax only on income or proceeds that are properly allocable to any period after 8/15/06. Under Section 4965(f), Treasury is authorized to issue regulations on how that allocation should be made. 
As discussed above, it is unclear how the IRS will determine whether an "entity" has knowledge and so would owe the higher entity-level tax for having knowledge or reason to know. One possibility would be to conclude that an entity has knowledge only if one or more of its entity managers has knowledge. Alternatively, knowledge on the part of any agent or employee of the entity, whether or not authorized and whether or not an entity manager, might be imputed to the entity. Another open issue is whether a situation could arise in which the entity has knowledge and the entity manager does not, or vice versa. 
Situation 1 assumes that Emily does not know or have reason to know that the transaction is a prohibited tax shelter transaction. As a result, she is not subject to the $20,000 fine imposed by Section 4965(b)(2). But what if she comes to know or have reason to know that the transaction is a prohibited tax shelter transaction after the entity enters into the transaction? Under the literal language of Section 4965(a)(2), she would appear to be subject to the $20,000 fine as long as the knowledge or reason to know is present during the same tax year in which she approves the entity as (or otherwise causes the entity to be) a party. 
Under Section 6033(a)(2), as amended by TIPRA, is the non-plan entity required to file disclosure with the IRS (1) that it is a party to a prohibited tax shelter transaction and (2) the identity of any other known party to the transaction? The literal language of the section says that "disclosure shall be in such form and manner and at such time as determined by the Secretary." Perhaps regulations will provide that disclosure is required only after the entity knows or has reason to know of the nature of the transaction. 
The answer may be that, under Section 6011(g), as amended by TIPRA, each taxable party to a prohibited tax shelter transaction must disclose to any tax-exempt entity-party that such transaction is a prohibited tax shelter transaction. Unfortunately, Section 6011(g) does not specify when (in relationship to the exempt entity's becoming a party) this disclosure must be made. 
Situation 2.
On 1/1/06, a non-plan entity (a calendar-year taxpayer) enters into a prohibited tax shelter transaction. It knows or has reason to know that the transaction is a prohibited tax shelter transaction at the time it enters into the transaction. One or more entity managers also know or have reason to know that the transaction is a prohibited tax shelter transaction. 
Under TIPRA section 516(d)(1), Section 4965 applies to the transaction because the non-plan entity became a party in a tax year that ends after the 5/17/06 effective date. 
Because it had the requisite knowledge, the non-plan entity is potentially subject to the increased fine of Section 4965(b)(1)(B). However, the special transition rule of Section 4965(b)(1)(B) provides that: "This subparagraph shall not apply to any prohibited tax shelter transaction to which a tax-exempt entity became a party on or before the date of the enactment of this section." 
As a result, the non-plan entity is subject to the general penalty of Section 4965(b)(1)(A) for 2006 and for all subsequent tax years in which it remains a party. As in Situation 1, however, the non-plan entity will be subject to the general tax only on income or proceeds properly allocable to periods after 8/15/06, as determined by forthcoming regulations. 
The entity managers will be subject to the $20,000 fine if they both (1) approved the non-plan entity as (or otherwise caused it to be) a party to the transaction and (2) have the requisite knowledge or reason to know. There is no special transition rule under Section 4965(b)(2). The requirement that the entity manager must have actively caused the entity to become a party to the transaction prevents the imposition of a fine where the entity becomes a party without the approval or knowledge of the entity managers. 
One open question is whether entity managers with the requisite knowledge will be deemed to have also "approved" the transaction in a subsequent tax year if their tax-exempt entity remains a party to the transaction in that year. If so, the $20,000 tax would be triggered in each such subsequent year. 
Under Section 6033(a)(2), the non-plan entity must make the necessary disclosure to the IRS and, under Section 6011(g), taxable parties to the transaction must make the necessary disclosure to the non-plan entity. The effective date provision of TIPRA section 516(b)(2) makes these provisions applicable whenever the due date of the disclosure follows the 5/17/06 effective date. As noted above, however, no guidance on that "due date" has been issued. 
Situation 3.
On 1/1/06, a non-plan entity (a calendar-year taxpayer) becomes party to a transaction that, on 6/30/06, becomes a subsequently listed transaction. The entity managers do not know or have reason to know, at the time they approve the transaction, that it will become listed. 
Under TIPRA section 516(d)(1), Section 4965 applies to the transaction because the non-plan entity became a party to the transaction in a tax year that ends after the 5/17/06 effective date. 
The non-plan entity is subject to the general tax imposed by Section 4965(b)(1)(A), as modified by the application of two separate transition rules. First, thanks to the express language of that section, it will be subject to tax only on income and proceeds that are "properly allocable to the period beginning on ... the date [here, 6/30/06] such transaction is identified by guidance as a listed transaction." How that allocation is to be made is at the moment unclear. Under Section 4965(f), Treasury is authorized to promulgate clarifying regulations on the allocation process. 
Second, the non-plan entity is subject to the special transition rule of TIPRA section 516(d)(1). As a result, the entity will not be taxed on any income or proceeds properly allocable to periods on or before 8/15/06. As discussed above, it also will be subject to the general tax in any subsequent tax year in which it remains a party. 
Here, the entity manager approved the transaction in the same tax year that it became listed. It is not clear whether an entity manager can ever be deemed not to have knowledge (or reason to know) that a transaction has been "specifically identified" by the IRS. If one assumes that knowledge will always be imputed in such a circumstance, it appears that the entity manager will be subject to the $20,000 fine. 
There is no language in Section 4965(a)(2) limiting liability of an entity manager to situations in which he or she had the requisite knowledge at the time the entity becomes a party to the transaction. The plain language of the statute says merely: "and knows or has reason to know." In the context of Situation 3, this suggests that the $20,000 fine may be imposed in any subsequent year during which the non-plan entity remains a party to the transaction. 
Under Section 6033(a)(2), the non-plan entity must make the necessary disclosure to the IRS. Under Section 6011(g), taxable parties to the transaction must make the necessary disclosure to the non-plan entity. 
Situation 4.
On 1/1/06, a plan entity (a calendar-year taxpayer) becomes a party to a transaction that it knows, or has reason to know, is a prohibited tax shelter transaction. One or more entity managers know or have reason to know that the transaction is a prohibited tax shelter transaction. 
Under TIPRA section 516(d)(1), Section 4965 applies to the transaction because the plan entity became a party to the transaction in a tax year that ends after the 5/17/06 effective date. 
Because the entity is a plan entity, it is not subject to any entity-level tax. However, every entity manager that knows or has reason to know that the transaction is a prohibited tax shelter transaction is subject to a $20,000 fine in the tax year in which approval is initially given, and, as discussed above, possibly in subsequent tax years as well. 
Note that no transition rule applies here. The transition rules apply only to "tax ... with respect to income or proceeds," and not, apparently, to a fixed fine. 
Under Section 6033(a)(2), a plan entity must make the necessary disclosure to the IRS. Under Section 6011(g), taxable parties to the transaction must make the necessary disclosure to the plan entity. 
Situation 5.
On 1/1/06, a plan entity (a calendar-year taxpayer) becomes a party to a prohibited tax shelter transaction that it does not know (or have reason to know) is a prohibited tax shelter transaction. The entity managers also do not know or have reason to know that the transaction is a prohibited tax shelter transaction. 
Under TIPRA section 516(d)(1), Section 4965 applies to the transaction because the plan entity became a party to the transaction in a tax year that ends after the 5/17/06 effective date. 
The plan entity is not subject to entity-level tax. The entity managers are not subject to tax because none of them had the requisite knowledge. 
Under Section 6033(a)(2), the plan entity must make the necessary disclosure to the IRS. Under Section 6011(g), taxable parties to the transaction must make the necessary disclosure to the plan entity. 
As in Situation 1, a critical question remains unanswered: how can the plan entity be expected to disclose a circumstance of which it is unaware? 
Situation 6.
On 1/1/06, a plan entity (a calendar-year taxpayer) becomes a party to a transaction. On 6/30/06, the transaction becomes a subsequently listed transaction. By the end of the day on June 30, all of the entity managers know that the transaction has been identified as a listed transaction. 
Under TIPRA section 516(d)(1), Section 4965 applies to the transaction because the plan entity became a party to the transaction in a tax year that ends after the 5/17/06 effective date. 
The plan entity is not subject to entity-level tax. Because the transaction is now a listed transaction, it is also a "prohibited tax shelter transaction." As discussed above, it appears that, under the literal language of Section 4965(a)(2), the entity managers each would be subject to a $20,000 fine and that no transition rule would apply. 
As discussed above, it is unclear whether liability for the $20,000 fine continues in each subsequent tax year that the plan entity remains a party to the transaction. 
Under Section 6033(a)(2), the plan entity must make the necessary disclosure to the IRS. Under Section 6011(g), taxable parties to the transaction must make the necessary disclosure to the plan entity. 
Recommendations
Further guidance is needed to make the provisions of new Sections 4965, 6033(a)(2), 6011(g), and 6652(c)(3) more easily understood by practitioners. The following would be helpful: 27 
•	Clarification of when and how a tax-exempt entity "becomes a party" to a transaction.
•	Clarification of the treatment of related entities—e.g., is a supported organization a party to a prohibited tax shelter transaction entered into by its supporting organization?
•	Definition of "net income."
•	Clarification of how the "knowledge/reason to know" determination (for both entities and entity managers) is to be made with respect to each type of "prohibited tax shelter transaction." Will knowledge by entity managers be imputed to the entity?
•	Clarification of under what circumstances an entity manager will be treated as having "approved an entity" as (or otherwise caused such entity to be) a party to a prohibited tax shelter transaction. Is "approval" deemed to occur in any tax year in which the entity continues to be a party to a transaction that the entity manager knows is a prohibited tax shelter transaction? In particular, if the entity managers approve an investment manager who subsequently enters into a prohibited tax shelter transaction, have they "approved" the transaction itself? Is the standard, as suggested by the Conference Report, whether the selection of the investment manager is part of a plan by the entity managers to participate in such a transaction?
•	Clarification of the treatment of tiered transactions. For example, if a tax-exempt entity invests in a fund that subsequently becomes a party to a prohibited tax shelter transaction, has it entered into a prohibited tax shelter transaction? Again, is the standard, as suggested by the Conference Report, whether the selection of the fund is part of a plan to participate in such a transaction?
•	Guidance regarding the consequences to tax-exempt entities of "protective disclosure" by funds.
•	Clarification of when an entity manager's "knowledge/reason to know" will make him or her subject to penalty tax—i.e. once approval is given, (1) is it sufficient to have knowledge at any time during the tax year, or (2) must there be knowledge at the time the approval is given?
•	Clarification of the requirements of Section 4965(d)(1). Is a person an entity manager only if described in both subparagraphs (A) and (B)? What does "authority or responsibility similar to" mean? Are unauthorized actions subject to tax?
•	Clarification of the meaning of "confidential transaction" and "transaction with contractual protection" with respect to tax-exempt entities that may not pay fees on becoming parties to such transactions.
•	Clarification of the meaning of "reportable" with respect to tax-exempt entities that may not be subject to the provisions of Section 6011.
•	Issuance of regulations regarding the determination of the allocation of net income or proceeds of a tax-exempt entity attributable to a transaction to various periods.
•	Guidance regarding the form, manner, and timing of disclosure under Sections 6033(a)(2) and 6011(g).
•	Guidance regarding the consequences to tax exempt entities of "protective disclosure" by taxable entities under Section 6011(g).
Conclusion
The best way of dealing with Section 4965 (as with most penalty provisions) is to avoid its application altogether. As the Conference Committee Report suggests, tax exempts and, in particular, their investment managers, should be counseled to view "extraordinary" or "exceptional" transactions with extreme caution, particularly if those transactions involve taxable parties. 

1
  "Analysis & Perspective," BNA Daily Tax Report, 7/17/06, J-1. 
2
  Section 4965(c). 
3
  Sections 4965(b)(1) and 4965(b)(2). 
4
  Notice 2006-65, 2006-31 IRB 102, uses the terms "non-plan entities" and "plan entities" to distinguish between the two entity groups to which section 4965 applies. 
5
  Sections 4965(d)(1) and 4965(d)(2). 
6
  Notice 2006-65, supra note 4, Appendix, Q&A-2. The Notice (1) requests public comments in anticipation of the publication of additional guidance and (2) presents, in a four-page Appendix, a plain-language summary of the new provisions in question and answer format. 
7
  Final Report, Panel on the Nonprofit Sector (June 2005) at 50, note 6. The Panel was formed under the auspices of Independent Sector. 
8
  Sections 4965(b)(1)(A)(i)(I) and (ii)(II). 
9
  Sections 4965 (b)(1)(A)(i)(II) and (ii)(II). 
10
  H. Rep't No. 109-455, 109th Cong., 2d Sess. (2006) (Conference Report). 
11
  Section 4965(b)(1)(B). 
12
  Section 4965(a)(2). 
13
  Section 6652(c)(3)(B). 
14
  Notice 2006-65, Q&A-18. The penalties provided in Section 6707A(b) are (1) in general, $10,000 in the case of a natural person and $50,000 in any other case, plus (2) with respect to a listed transaction, $100,000 in the case of a natural person and $200,000 in any other case. 
15
  Section 4965(d)(1). 
16
  Section 4965(d)(2). 
17
  Note 10, supra, at 112. 
18
  Section 4965(e)(1)(A). 
19
  Note 7, supra, at 49. 
20
  Note 10, supra, at 113. 
21
  Note 10, supra, at 113, emphasis added. 
22
  Note 10, supra, at 113. 
23
  Note 10, supra, at 112. 
24
  TIPRA, section 516(d). 
25
  Id. 
26
  Section 4965(b)(1)(B). 
27
  The author gratefully acknowledges the careful review of this section by Mary Lee Turk, a partner in McDermott Will & Emery in Chicago. Several of her comments are incorporated in the text. 

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