Recent changes to accuracy-related penalty rules.

In past months, changes were made to the accuracy-related penalty rules as a result of new legislation and changes in IRS procedure.

Rev. Proc. 94-69 modifies penalty-avoidance procedures for Coordinated Examination Program (CEP) taxpayers. The revenue procedure, effective Oct. 31, 1994, supersedes Rev. Proc. 85-26 to reflect amendments to Sec. 6662 and the repeal of Sec. 6661. The primary purpose of the revenue procedure is to outline disclosure procedures taxpayers subject to the CEP must follow to avoid understatement of tax penalties under former Sec. 6661 and the accuracy-related penalties of Sec. 6662. The revenue procedure generally provides CEP taxpayers with a more definitive "deadline" for furnishing adequate disclosure regarding an item or position.

Former rules

Rev. Proc. 85-26 provided special procedures for CEP taxpayers to make adequate disclosure with respect to an item. Generally, a CEP taxpayer could file a qualified amended return with disclosure within 10 days after the earliest of (1) receiving a written confirmation of a meeting, (2) formally meeting with the examining agent for the first time with respect to the examination of the relevant tax year or (3) receiving an Information Document Request for that year. A qualified amended return for purposes of Rev. Proc. 85-26 was a written statement (not a Form 1120X, Amended U.S. Corporation Income Tax Return) which included, among other things, a description of the item and a perjury declaration submitted to the revenue agent responsible for examining the return.

Although Rev. Proc. 85-26 provided for a 10-day qualified amended return window for CEP taxpayers, the period may have started unexpectedly, and expired if the taxpayer did not keep close tabs on when the first IRS contact occurred. This was complicated further in the case of a taxpayer under continuous audit (a common occurrence for taxpayers under the CEP).

New rules

To avoid imposition of the Sec. 6662(b)(1) penalty for negligence or disregard of rules or regulations and the Sec. 6662(b)(2) substantial understatement penalty, a CEP taxpayer must furnish a specific written statement to the requesting IRS official. This statement will be treated as a qualified amended return if the written statement (1) is furnished after the tax return has been filed but no later than 15 days (with a possible extension if reasonable cause can be shown) from the date of written notice from the Service to the taxpayer requesting that such statement be furnished, (2) includes the caption furnished under Rev. Proc. 94-69, (3) includes a description of all items when substantial authority does not exist and (4) includes a perjury declaration.

Disclosure will be considered adequate if it consists of information "that reasonably may be expected to apprise the Internal Revenue Service of the identity of the item, its amount, and the nature of the controversy or potential controversy." Unlike Rev. Proc. 85-26, the new procedure asks for specific identification of accounts for disclosure to be considered adequate. If a position contrary to a rule or regulation has been taken with respect to an item, the statutory or regulatory provision or the ruling in question must be adequately identified.

The revenue procedure also provides safe harbor rules to avoid the former Sec. 6661 substantial understatement penalty and the Sec. 6662 accuracy-related penalty with respect to returns already filed by taxpayers no longer under the CEP.

Implications

Under the new revenue procedure, more CEP taxpayers will likely omit disclosure on an originally filed tax return, since they have only 15 days after written contact by the Service to file a qualified amended return (as defined by Rev. Proc. 94-69). Under the former procedure, caution had to be exercised when delaying disclosure, since the date of first contact by the IRS--written, formal or otherwise--was subject to different interpretations by the IRS and the taxpayer. Rev. Proc. 94-69 provides a clear date for the taxpayer to comply, eliminating much of the risk associated with delaying disclosure.

Proposed regulations issued implementing GATT "tax shelter" provision

Effective for transactions occurring after Dec. 8, 1994, legislation introduced as part of the Uruguay round of the General Agreement on Tariffs and Trade (GATT) eliminated the ability of corporations to rely on the substantial authority/more likely than not exception under Sec. 6662 to reduce the amount of an understatement attributable to a tax shelter item. As a result, a corporate taxpayer needs to meet the reasonable cause exception under Sec. 6664(c) to reduce the amount of understatement penalty attributable to tax shelter items. A tax shelter item, for purposes of Sec. 6662, includes any entity, plan or arrangement that has the principal purpose of avoiding or evading Federal income tax.

Proposed regulations implementing this GATT provision were released in January 1995 (IA-55-94) and provide additional guidance on what constitutes reasonable cause and good faith for purposes of applying the Sec. 6664(c) exception to a corporate tax shelter item.

Prop. Regs. Sec. 1.6664-4(e)(2) states that a corporation's legal justification may be taken into account in determining whether it acted in good faith in its treatment of a tax shelter item. A legal justification includes as minimum requirements an objective authority requirement, satisfied only if there is substantial authority supporting a position, and a subjective belief requirement--whether independently formed or based on the advice of others--that the treatment of an item was believed to be more likely than not the proper treatment. Prop. Regs. Sec. 1.6664-4(e)(4) also provides that facts and circumstances other than a corporation's legal justification may be taken into account in determining whether a corporation acted in good faith, regardless of whether the substantial authority and belief requirements are satisfied.

With respect to all taxpayers, tax shelter and nontax shelter items alike, the proposed regulations also clarify factors that the IRS will consider when determining whether taxpayers acted in good faith when they relied on advice from professional tax advisers that ultimately caused an understatement of taxes. Prop. Regs. Sec. 1.6664-4(c) would require that professional advice be based on all material facts, including the taxpayer's reasons for entering into such transactions. The advice must not be based on unreasonable factual or legal assumptions, or unreasonably rely on the representations, findings or agreements of the taxpayer or any other person.

Implications

The proposed regulations, if finalized in their current form, will make it more difficult to avoid understatement penalties related to corporate tax shelter items, even if taxpayers believed they acted in good faith in determining the position or relying on the advice of a professional tax adviser. Under the proposed regulations, a taxpayer who establishes that a position had substantial authority and that he reasonably believed the position was more likely than not the proper treatment could still be denied the reasonable cause exception. As a practical matter, however, it is difficult to envision situations in which a court would deny the reasonable cause exception if a position meets both the substantial authority and more likely than not standards.

Additionally, since the authority requirement is an objective standard, the fact that a position was initially believed to have substantial authority is of no consequence in establishing legal justification. Comments on the proposed regulations were given by various representatives of professional tax organizations at an April 28 hearing. The majority of comments stressed disagreement over the inclusion of this objective standard in the reasonable cause exception rules. Although the proposed regulations provide that factors other than a corporation's legal justification may be taken into account to establish reasonable cause and good faith, it is not clear how or to what extent this provision would be applied in practice.