New guidance helps CPAs minimize tax penalties.

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The regulations now encourage voluntary self-assessment.

The Internal Revenue Service continues to attack problems of tax understatement, poor tax advice and careless return preparation. It released new regulations covering the accuracy-related penalty of Internal Revenue Code section 6662 and the section 6694 tax preparer penalties in December 1991. The IRS also issued revenue procedure 91-19 to update its rules of adequate disclosure to reduce a substantial understatement penalty and avoid a tax preparer penalty.

This article reviews both the regulations and the updated disclosure rules. CPAs who prepare federal income tax returns should become familiar with these rules and regulations so their exposure to the accuracy-related and tax preparer penalties is minimized.

ACCURACY-RELATED PENALTY REGULATIONS

Section 6662 imposes a 20% accuracy-related penalty on any portion of a tax underpayment attributable to one or more of the following types of misconduct:

* Negligence or disregard of rules or regulations.

* Substantial understatement of income tax.

* Substantial valuation misstatement under chapter 1 of the code.

* Substantial overstatement of pension liabilities.

* Substantial estate or gift tax valuation understatement. The penalty increases to 40% if the misconduct meets the section 6662 criteria for a goss valuation misstatement, a goss overstatement of pension liabilities or a gross estate or gift tax valuation understatement.

The regulations provide ordering rules for computing the total accuracy-related and fraud penalties imposed on a given return and define terms related to the first three types of misconduct. The new guidelines apply to all taxpayers who file income tax returns and generally are effective for returns due after 1989. The adequate disclosure regulations, however, apply only to returns due after 1991.

Ordering of penalties. The regulations clarify that only one accuracy-related penalty applies to a given return, even though the underpayment may be attributed to more than one type of misconduct. For example, the maximum penalty imposed on any portion of an underpayment attributable to both negligence (which alone triggers a 20% penalty) and a gross valuation misstatement (which alone triggers a 40% penalty) is 40%. The regulations also provide that an accuracy-related penalty may apply in addition to a section 6651 penalty for failure to timely file a tax return, but not in addition to a section 6663 fraud penalty.

Negligence or disregard of rules or regulations. This component of the accuracy-related penalty applies if any portion of a tax underpayment results from negligence or disregard of rules or regulations. The regulations define negligence to include any failure to make a reasonable attempt to comply with the tax laws or to exercise ordinary and reasonable care in the preparation of a return. A taxpayer is negligent if he or she fails to keep adequate books and records or to substantiate items properly. A position is considered negligent if it lacks a reasonable basis.

Negligence is strongly indicated when a taxpayer fails to include on a return income shown on an information return or fails to make a reasonable attempt to ascertain the correctness of a deduction, credit or exclusion that seems to be "too good to be true." Negligence also is strongly indicated when the returns of a partner and the partnership or an S corporation shareholder and the S corporation are not consistent.

Disregard of rules or regulations includes any careless, reckless or intentional disregard of the code, temporary or final regulations, revenue rulings or notices. A disregard is careless if the taxpayer fails to exercise reasonable diligence to determine the correctness of a return position contrary to a rule or regulation; reckless if the taxpayer makes little or no effort, as judged by the standard of conduct for a reasonable person, to determine whether a rule or regulation exists; and intentional if the taxpayer knows of the disregarded rule or regulation. A taxpayer taking a position that is contrary to a revenue ruling, however, has not disregarded the ruling if the position has a realistic possibility of being sustained on its merits.

The penalty for negligence or disregard of rules or regulations is not imposed if the taxpayer adequately discloses his or her position on Form 8275 ("Disclosure Statement"), or Form 8275-R ("Regulation Disclosure Statement") for a "good faith" challenge to a regulation, and attaches it to the return or a qualified amended return. If the position is contrary to a rule or regulation, the taxpayer also must adequately identify on form 8275 or 8275-R the ruling or regulatory position in question. This adequate disclosure exception does not apply if the position disclosed is frivolous-patently improper--or if the taxpayer fails to keep adequate books and records or to substantiate items properly.

Substantial understatement. This component applies to any portion of an underpayment attributable to an understatement of income tax exceeding the greater of (1) 10% of the tax required to be shown on the return for the taxable year or (2) $5,000 ($10,000 for corporations other than S corporations and personal holding companies). An understatement is the amount of tax required to be shown on the return less the amount actually shown, reduced by any rebates. Amounts that are attributed to items other than tax shelters for which there is substantial authority or with respect to which there is adequate disclosure reduce the understatement.

Exhibit 1, above, lists the types of authority for determining if an item is supported by substantial authority. The weight accorded an authority depends on its relevance, persuasiveness and the type and age of the document providing the authority. For example, a revenue ruling is accorded greater weight than a private letter ruling that addresses the same issue, and an older private letter ruling is accorded less weight than a more recent one.

The adequate disclosure exception applies only if the disclosure is made on form 8275 or 8275-R or made according to revenue procedure 91-19, which permits disclosure on the return itself. Exhibit 2, page 49, lists the return disclosures identified in revenue procedure 9119 as adequate for this purpose, provided all forms and attachments are completed in a clear manner and in accordance with their instructions and the dollar amounts entered on the forms are verifiable--that is, on audit, the taxpayer can demonstrate the origin of the number and show good faith in entering it on the applicable form. The regulations require disclosure for a recurring item (for example, the basis of recovery property) to be made for each tax year the item is taken into account.

Substantial (or gross) valuation misstatements. This component applies if any portion of a tax understatement exceeding $5,000 ($10,000 for corporations other than S corporations and personal holding companies) is attributable to a substantial (gross) valuation misstatement, defined as a claimed value or adjusted basis in excess of 200% (400%) of the correct amount and determined on a property-byproperty basis. A valuation misstatement automatically is considered gross, however, if the correct value or adjusted basis is zero.

The penalty for substantial valuation misstatements does not apply to any underpayment portion for which there was reasonable cause, assuming the taxpayer acted in good faith. Determination of whether this exception applies is made on a case-by-case basis--taking into account all pertinent facts and circumstances. The most important factor, however, is the extent of' the taxpayer's effort to assess the proper tax liability.

For charitable contribution property, the reasonable cause and good faith exception does not apply unless (1) the value claimed on the return for the property is based on a qualified appraisal by a qualified appraiser and (2) the taxpayer makes a good faith investigation of the property's value. These rules apply regardless of whether the charitable contribution regulations allow a deduction for property for which an appraisal has not been obtained.

PREPARER PENALTY REGULATIONS

Sections 6694(a) and (b), as changed by the Omnibus Budget Reconciliation Act of 1989, impose penalties on tax return preparers who prepare returns or refund claims containing certain understatements of tax liability. The regulations redefine "income tax return preparer"' for purposes of imposing a section 6694 penalty and provide guidelines for the section 6604(a) reasonable possibility standard and the section 6694 (b) willful, reckless or intentional conduct standard.

Income tax return preparer.

The regulations provide that, solely for the purposes of section 6694, no more than one individual associated with a firm is treated as the preparer-signing or nonsigning-of a given return or refund claim. The signing preparer is the person who signs the return or claim for refund as the preparer, while the nonsigning preparer is any person providing oral or written advice to the taxpayer or another preparer.

When two or more people associated with a firm work on a specific return but none is the signing preparer, the person with overall supervisory responsibility for the matter ordinarily is considered the nonsigning preparer. (Note: "Preparer" includes any commercial return preparer and is not limited to CPAs.)

Realistic possibility standard. Section 6694(a) imposes a $250 prepater penalty on each return or refund claim reflecting an understatement of tax liability that

* Is based on a nondisclosed position that does not have, and the tax preparer should know it does not have, a realistic possibility of being sustained on its merits.

* Cannot be justified by reasonable cause and the preparers good faith.

The regulations extend this $250 penalty to the firm (defined to include a sole proprietorship) or partnership of a preparer subject to the penalty if

* One or more of the of the firm or a branch office's principal managers participated in or knew of the proscribed conduct.

* The employer or partnership failed to provide reasonable and appropriate procedures for reviewing the position for which the penalty was imposed.

* The review procedures were ignored in formulating the advice.

IRS notice 90-40 says a position has a realistic possibility of being sustained on its merits if a reasonable and well-informed analysis by someone knowledgeable in tax law leads that person to conclude the position has about a one in three, or greater, chance of being sustained on its merits. The regulations retain this standard and further provide that the analysis and authorities used to determine if substantial authority is present for the accuracy-related penalty apply in determining if the realistic possibility standard is satisfied. Exhibit 3, page 50, presents examples included in the regulations to illustrate the realistic possibility standard.

A preparer is not penalized for a position that does not meet the realistic possibility standard if the position is not frivolous and is adequately disclosed. For signing preparers, the accuracy-related penalty disclosure provisions (disclosure on form 8275 or 8275-R or on the return in accordance with an annual revenue procedure) apply. Nonsigning preparers generally may satisfy the adequate disclosure requirement by advising (orally or in writing, depending on how the original advice was given) the taxpayer or another preparer that the position in question does not satisfy the realistic possibility standard and, thus, must be properly disclosed to avoid penalty.

A preparer also is not penalized for a position that will not meet the realistic possibility standard if the understatement is due to reasonable cause and the preparer acts in good faith. In determining the preparer's position, all relevant facts and circumstances are considered, including the nature of the error causing the understatement, the frequency of errors, the materiality of errors, the preparer's normal office practice and the extent the preparer reasonably relies on the advice of, or schedules prepared by, another preparer.

Willful or reckless understatement. Section 6694(b) imposes a $1,000 preparer penalty for each return reflecting an understatement of tax liability due to a preparer's willful attempt to understate the tax liability or intentional or reckless disregard of the rules or regulations. The regulations extend this penalty to the preparer's firm in the same manner and under the same conditions as the 6694(a) penalty and reduce it for any section 6694(a) penalty imposed on the same return or claim for refund.

A preparer is considered to have willfully attempted to understate liability if the preparer disregards, in an effort to wrongfully reduce the taxpayers tax liability, information furnished by the taxpayer or other persons. For example, a preparer who reports six dependents on the return of a taxpayer who told the preparer he had only two dependents has willfully attempted to understate tax liability.

A preparer is considered to have recklessly or intentionally disregarded a rule or regulation if the preparer takes a position contrary to a rule or regulation and knows of, or is reckless in not knowing of, the rule or regulation in question. A preparer is reckless in not knowing of a rule or regulation if he or she makes little or no effort, as judged by the standard of conduct for a reasonable preparer, to determine whether a rule or regulation exists.

A preparer taking a position contrary to a rule or regulation is not considered to have intentionally or recklessly disregarded the rule or regulation if the position is not frivolous and is adequately disclosed. The disclosure rules for this purpose are the same as those under section 6694(a), except disclosure on the return itself, even if in accordance with an annual revenue procedure, is not adequate disclosure for a signing preparer.

AVOIDING PENALTIES

CPAs who prepare federal income tax returns know the importance of avoiding penalties. The penalty guidance provided by the regulations encourages voluntary self-assessment, correction of errors, accurate tax return reporting and adequate disclosure of realistic return positions. An updated knowledge of this guidance should enable CPAs to minimize the exposure of both their clients and themselves to the penalty provisions of sections 6662 and 6694.

EXECUTIVE SUMMARY

* NEW GUIDANCE HAS BEEN issued addressing the accuracy-related penalty provisions of IRC section 6662, the section 6694 tax preparer penalties and the rules of adequate disclosure for purposes of reducing a substantial underpayment or avoiding a preparer penalty.

* SECTION 6662 IMPOSES a 20% penalty on tax understatements attributable to certain types of misconduct. Only one such penalty applies to a given return.

* SECTIONS 6694(a) and (b) impose penalties on tax return preparers who prepare returns or refund claims with certain tax liability understatements. Recently issued regulations define who is a preparer and offer guidelines for the section 6694(a) realistic possibility standard and the section 6694(b) willful, reckless or intentional conduct standard.

* THE RECENTLY ISSUED penalty guidance encourages voluntary self-assessment by preparers, correction of errors, accurate tax return reporting and adequate disclosure of realistic return positions.

* UNDERSTANDING THE NEW GUIDANCE can help CPAs minimize the exposure of themselves and their clients to the tax penalty provisions of sections 6662 and 6694.

Authority for demonstrating substantial authority for purposes of avoiding the substantial understatement penalty

1. Applicable Internal Revenue Code provisions and other statutory provisions.

2. Temporary and final regulations construing applicable statutes.

3. Revenue rulings and revenue procedures.

4. Tax treaties and regulations thereunder and Treasury Department and other official explanations of such treaties.

5. Federal court cases interpreting applicable statutes.

6. Congressional intent as reflected in committee reports, joint explanatory statements of managers included in conference committee reports and floor statements made before enactment by one of a bill's managers.

7. General explanations of tax legislation prepared by the Joint Committee on Taxation (the blue book).

8. Private letter rulings and technical advice memorandums issued after October 31, 1976.

9. Actions on decisions and general counsel memoranda issued after March 12, 1981,

10. Internal Revenue Service information or press releases.

11. Notices, announcements and other administrative, pronouncements published by the IRS in the Internal Revenue Bulletin,