Highlights of the new taxpayer accuracy-related penalty rules.
On Dec. 30, 1991, the Treasury Department released final regulations on the taxpayer accuracy-related penalty under Sec. 6662. The new rules apply to tax returns due after Dec. 31, 1991 (without regard to extensions), and thus affect the preparation of returns for calendar year 1991. This article will summarize the key points in the new regulations, which replace the proposed regulations issued in March 1991, and will focus on defenses against imposition of the accuracy-related penalty and the new rules regarding disclosures to avoid the accuracy-related penalty.
(For a discussion of the new preparer penalty final regulations, see "The Final Return Preparer Regulations," in the April issue.(1))
Penalty - the Basics
Sec. 6662 imposes a 20% penalty on (1) substantial understatements of income tax and (2) underpayments attributable to negligence or disregard of rules or regulations. Sec. 6662 also includes penalties on valuation misstatements, pension liability overstatements, and gift or estate tax undervaluations. However, these provisions are beyond the scope of this article. Together, the five parts of the 20% taxpayer penalty under Sec. 6662 are referred to as the combined accuracy-related penalty. (The final regulations cover only the substantial understatement, negligence or disregard, and valuation misstatement parts of the combined accuracy-related penalty.)
The new regulations confirm that both the failure to file and accuracy-related penalties can apply to late filed returns. However, the accuracy-related penalty applies only if a return is filed, and late filing will not be taken into account by the IRS in determining if the accuracy-related penalty should be imposed.(2) The components of the 20% accuracy-related penalty cannot be stacked. For example, if both the substantial understatement and negligence parts of the accuracy-related penalty apply to the same item, the total accuracy-related penalty will be 20% of the underpayment caused by the item.(3)
The two accuracy-related provisions of greatest concern to most taxpayers are (1) the substantial understatement component and (2) the two-pronged component for negligence or disregard of the tax rules or regulations. Even though both the substantial understatement and negligence or disregard penalties are technically components of the combined accuracy-related penalty, they are, in reality, two separate penalties for all practical purposes. Thus, they will be discussed separately. Fortunately, both can be avoided if the taxpayer takes reasonable precautions.
Observation: In most cases, the best defense will involve making tax return disclosures. Taxpayers and practitioners will need to be careful to make disclosures that are sufficient to avoid both the substantial understatement penalty and the negligence or disregard penalty. Generally, disclosures that are sufficient to avoid the taxpayer substantial understatement penalty will also be sufficient to avoid the $250 per return preparer penalty imposed by Sec. 6694(a). Similarly, disclosures that are sufficient to avoid the taxpayer negligence or disregard penalty will generally also be sufficient to avoid the $1,000 per return preparer penalty under Sec. 6694(b). As will be discussed later, special disclosure rules apply to positions that are contrary to regulations.
Defenses Against Assessment
of the Taxpayer Substantial
While Sec. 6662(b)(2) imposes a 20% penalty on any substantial understatement of income tax, all of the following defenses are potentially available to the taxpayer.
Insubstantial understatement defense: Sec. 6662(d) (1) defines a substantial understatement of income tax as exceeding the greater of (1) 10% of the tax required to be shown on the return or (2) $5,000 ($10,000 for corporations that are not S corporations or personal holding companies (PHCs)). Understatements that fall below these parameters are not subject to the substantial understatement penalty. The final regulations include a definition of "understatement" and special rules for determining the amount of an understatement when carrybacks or carryovers are involved.(4)
Substantial authority defense: Sec. 6662(d)(2)(B) provides that no penalty can be assessed for a substantial understatement if the taxpayer can show that there was "substantial authority" for the tax treatment of the item causing the understatement. However, if a "tax shelter" is involved, the taxpayer must reasonably believe that the tax treatment was "more likely than not" the proper treatment.(5) More likely than not is a higher standard than substantial authority. See Exhibit I on pages 334-335 for further discussion of the substantial authority test and a listing of authorities for purposes of using the substantial authority defense. See Exhibit 3 on pages 338-339 for a comparison of the substantial authority standard with other potentially applicable penalty avoidance standards.
Adequate disclosure defense: Sec. 6662(d)(2)(B)(ii) provides that a taxpayer cannot be assessed the substantial understatement penalty if the tax position and relevant facts are "adequately disclosed" in the return or in a statement attached to the return - even if the tax position does not have substantial authority. The regulations contain new and stricter rules on what constitutes adequate disclosure. See Exhibit 2 on pages 336-337. The Treasury is taking the position that the final regulations provide for the only ways to make adequate disclosure. In other words, the disclosure rules in the regulations, are not merely a safe harbor. Note that disclosure will not help if the tax return position is frivolous (patently improper) or if a "tax shelter" - an entity or arrangement with the principal purpose of tax avoidance or evasion - is involved. Generally, it is fair to say that legitimate investments with a profit motive will not be defined as "tax shelters."(6)
Example 1: Taxpayer T is a state trooper who deducts $1,500 of on-duty meal expenses as unreimbursed employee business expenses on his 1991 tax return. T's position is based on the Eighth Circuit's decision in Christey.(7) Assume, for purposes of this example, that there is not substantial authority for this position and that it is disclosed by properly completing Form 2106, Employee Business Expenses, in accordance with Rev. Proc. 92-23.(8) Also assume that T's position is not contrary to any regulation, revenue ruling or notice. The tax liability understatement caused by the position is only $350. Therefore, the tax liability understatement is not significant enough to result in any exposure to the taxpayer substantial understatement penalty under Sec. 6662(b)(2). Even if the liability understatement was substantial, the disclosure made by properly filling out Form 2106 would insulate T (and the preparer) from penalties in this situation.
Reasonable cause/good faith defense: Even if the taxpayer does not have substantial authority for the position and failed to make adequate disclosure, the substantial understatement penalty does not apply if the taxpayer had reasonable cause for the tax underpayment and acted in good faith.(9) Under the new regulations, the reasonable cause/good faith rule is applied on a case-by-case (i.e., "facts and circumstances") basis. However, the key factor is whether the taxpayer made a reasonably energetic attempt to determine the correct tax liability. For example, an honest misunderstanding of fact or law, an isolated computational error, reliance on professional tax advice or reliance on information returns may all be indicative of reasonable cause/good faith. However, if the taxpayer "should have known better, " the reasonable cause/good faith defense will probably not apply. The same reasonable cause/good faith rules also apply to the two-pronged penalty for negligence or disregard of rules or regulations (discussed below). Finally, note that a recent Tax Court decision seems to clarify that the reasonable cause/good faith defense will not succeed if the taxpayer bases the defense on reliance on a tax professional who was not given complete and accurate information by the taxpayer.(10)
Example 2: Corporate taxpayer X deducted $1,200,000 of investment banker, attorney and accounting professional fees related to its takeover in an "unfriendly" transaction. The fees were deducted in its 1991 return without any disclosure on Form 8275, Disclosure Statement. The corporation's competent tax preparer recommended against disclosure after being given all relevant facts by X. X can probably successfully assert the reasonable cause/good faith defense because of the advice received from a competent tax professional - even if the substantial authority standard was not met. However, the tax preparer may be exposed to the $250 penalty under Sec. 6694(a) unless the realistic possibility standard was met.
Defenses Against Assessment
of the Two-Pronged Taxpayer
Negligence or Disregard Penalty
Sec. 6662(b)(1) imposes a two-pronged 20% taxpayer penalty on (1) negligence or (2) disregard of rules or regulations. in other words, the penalty can apply if the taxpayer is negligent, and the penalty can apply if the taxpayer is not negligent, but disregards rules or regulations. For practical purposes, the two prongs function as two separate, nonoverlapping, penalties. Taxpayers are exposed to the negligence prong when they fail to keep adequate books and records; fail to substantiate items properly; or take positions involving deductions, credits or exclusions that are "too good to be true." For the disregard prong, "rules or regulations" include the Code, temporary and final regulations, and revenue rulings and notices published in the Internal Revenue Bulletin.(11) Proposed regulations will not count as "rules or regulations." According to the preamble to the Sec. 6662 final regulations, revenue procedures may or may not constitute "rules" - depending on facts and circumstances.(12) However, revenue procedures are not listed as "rules" in the final regulations themselves. (This situation is not very helpful to taxpayers.)
Defenses against the negligence prong
Reasonable basis defense: The penalty for negligence can be avoided if the taxpayer can show that there is a "reasonable basis" for the tax position.(13) Reasonable basis is a lower standard than "substantial authority" or a "realistic possibility of being sustained on its merits," but the term does not include frivolous (patently improper) positions. Although the regulations do not explicitly say this, it seems that a position that satisfies the reasonable basis standard would have a chance of success in the 10%, or greater, range. (See Exhibit 3.)
Adequate disclosure defense: The negligence penalty can also be avoided by disclosure of a non-frivolous position - even if the taxpayer does not meet the reasonable basis standard. According to the regulations, a frivolous position is one that is "patently improper."(14) Disclosure must occur on Form 8275, Disclosure Statement, or Form 8275-R, Regulation Disclosure Statement. (See Exhibit 2 for a discussion of disclosure issues.) No other method of disclosure to avoid the negligence penalty is permitted, according to the regulations.(15)
Reasonable cause/good faith defense: Finally, the negligence penalty can be avoided by showing that the taxpayer satisfied the reasonable cause/good faith test. The same test applies to both the substantial understatement penalty and the negligence penalty. The reasonable cause/good faith defense is potentially available even if the taxpayer did not have a reasonable basis for the tax position and did not disclose the tax position.(16)
Example 3: Assume the same facts as in Example 1, except that T failed to keep any records to substantiate his claimed deduction for $1,500 of on-duty meal expenses. As a result, his tax preparer recommended against taking the deduction. T is exposed to the negligence penalty even though the tax liability understatement is "insubstantial." He had no reasonable basis for deducting the amount without any records. Even if T had made disclosure on Form 8275, it would have no effect because of the failure to keep books and records. Finally, since T went against the advice of his tax preparer, the reasonable cause/good faith defense would be unavailable. (In this situation, the preparer is also exposed to penalty under Sec. 6694.)
Defenses against the disregard
of rules or regulations prong
Positions contrary to regulations: if a taxpayer knowingly takes a good faith position contrary to a regulation, the only defense, in most cases, against potential assessment of the 20% Sec. 6662(b)(1) disregard penalty is to make disclosure on Form 8275-R.(17) (See Exhibit 2 for additional information on making such disclosure.) If a taxpayer unknowingly takes a position contrary to a regulation, he may be able to mount a reasonable cause/good faith defense. In addition, in limited circumstances, the reasonable cause/good faith defense could apparently apply to a position known to be contrary to a regulation. For example, if a regulation appears to be inconsistent with the statute itself, a taxpayer could apparently argue that the reasonable cause/good faith defense applies - even though no disclosure was made on Form 8275-R.(18)
According to the regulations, a position contrary to a regulation must be disclosed on Form 8275-R, even though the position has substantial authority under the substantial understatement penalty rules - unless the taxpayer is willing to rely on the reasonable cause/good faith defense.
Example 4: Assume the same facts as in Example 1, and that T's position is contrary to a temporary or final regulation. Because disclosure was not made on Form 8275-R, T is exposed to the disregard prong of the penalty. This is true even though T's disclosure (made by properly completing Form 2106) would have been sufficient to avoid the substantial understatement penalty. T probably cannot argue reasonable cause/good faith unless there is very strong technical support for his position (e.g., the regulation is an incorrect interpretation of the statute) or the position was based on professional advice. In this situation, the tax preparer is exposed to the $1,000 preparer penalty under Sec. 6694(b) even if the tax position is more likely than not correct.
Positions contrary to IRS revenue rulings and notices: A taxpayer can avoid the 20% disregard penalty by making adequate disclosure on Form 8275 or by showing that the position has a "realistic possibility of being sustained on its merits." Basically, the realistic possibility standard is met if there is approximately a 33%, or better, chance that the tax will be sustained on its merits.(19) (See Exhibit 3.) Finally, a taxpayer may be able to mount a reasonable cause/good faith defense.(20)
Example 5: Assume the same facts as in Example 1, except that T's position is contrary to a revenue ruling, but it does meet the realistic possibility standard. (See Exhibit 3.) In this situation, T is insulated against exposure to the disregard prong of the penalty because the realistic possibility standard is met. This is true even though no disclosure was made on Form 8275. In addition, there is no exposure to the negligence prong because the realistic possibility standard is higher than the reasonable basis standard. Note: Because the realistic possibility standard is met, the preparer is insulated from the $1,000 disregard penalty under Sec. 6694(b).
Example 6: Taxpayer M is a sales manager for a brokerage house in New York. On his 1991 return, M deducts $39,000 of expenses to entertain co-workers as unreimbursed employee business expenses. The expenses are deducted on a properly completed Form 2106. Because M's position goes against a revenue ruling, his tax preparer advises against taking the deduction. However, a circuit court decision favors M while a Tax Court decision goes against him. In this situation, M might conclude that the realistic possibility standard is met but that the substantial authority standard is not met. Thus, M could be exposed to the substantial understatement penalty even though he is insulated against the disregard prong because the realistic possibility standard is met. in this case, however, M's properly completed Form 2106 would constitute sufficient disclosure to avoid the substantial understatement penalty. Note: The fact that the realistic possibility standard is met would shield the tax preparer from the $1,000 disregard penalty under Sec. 6694(b).
Warning. The reasonable basis defense is not applicable to the disregard of rules or regulations prong. Also, it must be remembered that disclosure to avoid the disregard penalty with respect to positions contrary to regulations must be made on Form 8275-R. Until Form 8275-R is available, taxpayers should use Form 8275 and write "REGULATIONS" in the upper right hand corner of the form - according to the preamble to the Sec. 6662 regulations.
Effect of Amended Return on
Exposure to the Accuracy-Related Penalty
A "qualified amended return" that shows the proper tax liability or supplies disclosure missing on the original return can eliminate exposure to the 20% accuracy-related penalty. Generally, a qualified amended return is a return filed (1) before the taxpayer is first contacted regarding an examination, (2) before an IRS contact regarding an abusive tax shelter and (3) for a passthrough item, before the passthrough entity is first contacted in connection with an examination of the passthrough entity's return.(21)
Taxpayer Penalty Rules
and Preparer Penalty Rules
Unfortunately, the taxpayer and preparer penalty(22) rules will occasionally put the interests of the taxpayer and the interests of the preparer at odds. For example:
The taxpayer substantial understatement penalty applies only to fairly significant understatements of tax liability. If the understatement is relatively small, there is no need for the taxpayer to make disclosure - because the penalty simply does not apply. However, there is no de minimis understatement rule for purposes of the preparer penalties. Therefore, without disclosure, the preparer may be exposed to penalties while the taxpayer is not.
For purposes of the taxpayer substantial understatement penalty, substantial authority is determined as of either the end of the tax year or when the return is filed. For signing preparers, the realistic possibility standard is generally determined as of when the preparer signs the return.(23) This can lead to client/preparer conflicts of interest when the authorities for a position change between the end of the tax year and the return signing date.
There are differences between the substantial authority standard that applies to taxpayers and the realistic possibility standard that applies to preparers. The regulations do not quantify the substantial authority standard. To meet the realistic possibility standard, the position must have roughly a 33%, or better, chance of success. (See Exhibit 3.)
The reasonable cause/good faith defense is potentially available to taxpayers to avoid the Sec. 6662(b)(1) disregard of rules or regulations penalty on an undisclosed position contrary to a rule or regulation. However, there is no reasonable cause/good faith defense against the $1,000 per return preparer penalty on undisclosed positions contrary to a rule or regulation. For example, this could expose a preparer to the $1,000 penalty for not disclosing a position contrary to a regulation - even though the position was "more likely than not" correct. Presumably, the taxpayer could safely rely on the reasonable cause/good faith defense in this situation. (See Example 4.)
Observation: In most situations, preparers will be forced to bear the risks caused by inconsistencies between the taxpayer and preparer penalty rules. Unfortunately, most of the inconsistencies are in the statutory provisions themselves-they are not necessarily due to unreasonable interpretations by the Treasury in the regulations. Hopefully, the problem will eventually be addressed by amending the penalty statutes.
The final regulations on the taxpayer combined accuracy-related penalty are lengthy and complex. Probably the simplest and most effective way to deal with these complicated rules is to gain a clear understanding of the defenses available to taxpayers when the accuracy-related penalty becomes an issue.
However, understanding the defenses against the penalty is not a cure-all. Two significant areas of concern for tax practitioners are (1) inconsistencies between the Sec. 6662 taxpayer accuracy-related penalty rules and the preparer penalty rules under Sec. 6694, and (2) the risk that tax return disclosures made to avoid penalty exposure will lead to a much greater likelihood of IRS audits.
Unfortunately, there is no doubt that the new taxpayer (and preparer) penalty rules will substantially increase the compliance burden for tax practitioners as well as engender conflicts between clients' interests and those of practitioners.
(1) Gardner, Willey and Woehlke, "The Final Return Preparer Regulations," 23 The Tax Adviser 208 (Apr. 1992). (2) Regs. Sec. 1.6662-2(a). (3) Regs. Sec. 1.6662-2(c). (4) Regs. Sec. 1.6662-4(b) and (c). (5) Sec. 6662(d)(2)(C). (6) Sec. 6662(d)(2)(C)(ii) and Regs. Sec. 1.6662-4(g)(2). (7) Karl W. Christey, 841 F2d 809 (8th Cir. 1988)(61 AFTR2d 88-769, 88-1 USTC [paragraph] 9205). (8) Rev. Proc. 92-23, IRB 1992-13 (3/30/92). (9) Sec. 6664(c)(1) and Regs. Sec. 1.6664-4(a). (10) Jerrilynn A. Hull, TC Memo 1991-582. (11) Regs. Sec. 1.6662-3(b)(2). (12) TD 8381 (12/30/91). (13) Regs. Sec. 1.6662-3(b)(1). (14) Regs. Sec. 1.6662-3(b)(3). (15) Regs. Sec. 1.6662-3(c). (16) See note 9. (17) Regs. Sec. 1.6662-3(c)(2). (18) Sec. 6664(c) and Regs. Sec. 1.6664-4 do not explicitly say this. However, in the author's opinion, an overall reading of the Code and regulations seems to support this statement. (19) Regs. Sec. 1.6694-2(b)(1). (20) Sec. 6664(c). (21) Regs. See. 1.6664-2(c)(2) and (3). (22) Regs. Secs. 1.6694-0 through -4. (23) Regs. Secs. 1.6662-4(d)(3)(iv)(C) and 1.6694-2(b)(5).
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|Author:||Bischoff, William R.|
|Publication:||The Tax Adviser|
|Date:||Jun 1, 1992|
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