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Current tax laws increase compliance concerns.

89 Treasury Regulation Section 1.6694-3(e)(2).

90 Treasury Regulation Section 1.6694-1(e).

91 IRC Section 6694(b).

92 Treasury Regulation Sections 1.6694-2 and 1.6694-3.

93 IRC Section 6695(d).

94 IRC Section 6695.

Because of taxpayer complaints, important changes have been made in recent years to the civil penalty provisions of the Internal Revenue Code. These recent provisions are designed to make the penalty structure more equitable. However, many complications and inequalities still exist.

The Code currently contains over 100 penalty provisions. This article identifies and analyzes the major civil penalties and the IRS's interpretations in several pronouncements. Actions taxpayers can take to avoid the more severe penalties are discussed.

The Code includes three general categories of penalties. The first two categories--assessable penalties|1~ and additions to the tax and additional amounts|2~--have been obscured by the continuous changes made in the penalty provisions. The third category is penalties that apply to tax preparers.|3~

The assessable penalties for the most part set a fixed dollar amount to be imposed for various commissions or omissions without regard to the procedures required under the notice of deficiency provisions.|4~ When the IRS imposes an assessable penalty, it is not required to send a letter of deficiency to the taxpayer. Therefore, the Tax Court does not have jurisdiction with respect to assessable penalties (and preparer penalties) and the taxpayer must resort to the refund procedures and a suit for refund in a district court or the Court of Claims to obtain judicial review. The additions to the tax and additional amounts generally are based on penalties computed by using the amount of the tax deficiency.

Assessable Penalties

Failure to File Information Returns and Payee Statements

In order to efficiently conduct a voluntary compliance tax system, taxpayers must receive information (payee statements) from third parties to enable them to prepare their income tax returns. Also, the government needs information (information returns) to administer the tax law. Since most penalties are based on the amount of tax due, the penalties that apply to payee statements and information returns are treated as assessable penalties.

The Code includes many sections that require certain firms to provide information returns to both the government and other taxpayers. Returns required to be filed with the government are referred to as information returns. Statements required to be provided to taxpayers are designated as payee statements. Many information returns (e.g., partnership returns) also have payee statement requirements (the K-1). Even though the information is similar for both types of returns, the distinction is important since they have different maximum penalties. Also, the intentional disregard penalties apply only to information returns.

Information Returns

A number of the current provisions that apply to information returns intend to encourage taxpayers to file correct information returns and payee statements. Some recent changes give taxpayers an incentive to correct their mistakes as quickly as possible.

A penalty is assessed for the taxpayer's failure to file an information return on or before the required filing date. Also, there is a penalty for the taxpayer's failing to include all of the information required to be shown on the return or the taxpayer's including any incorrect information.|5) An inconsequential error or omission is not considered a failure to include correct information.|6~ Any omission of or error in a taxpayer identification number, a surname of a payee, or a monetary amount is not considered inconsequential.|7~

General rules. The penalty structure is three-tiered, with the penalty based on the length of time the taxpayer takes to correct errors. If a taxpayer files a correct information return after the required filing date but within 30 days of the required filing date, the penalty is $15 per information return. The maximum penalty is $75,000 per calendar year. If the corrected return is filed between 30 days after the required filing date and before August 2, the penalty is $30 per return, with a maximum of $150,000 per calendar year. If a correct return is not filed before August 2, the penalty is $50 per return, with a $250,000 maximum for the calendar year.|8~

The "required filing date" is the date prescribed for filing an information return with the IRS or the Social Security Administration (including any extension of time for filing).|9~ If the failure is for an information return that is not due on February 28 or March 15 and the failure is corrected within 30 days of the required filing date, the penalty is $15. If the return is not corrected within 30 days, the penalty is $50.|10~

Certain small businesses are subject to lower maximum levels of the penalty and there is a de minimis exception for any failure to file a correct information return.|11~ Returns to which the de minimis exception apply are treated as having been originally filed with correct information. Only the number of returns exceeding the de minimis amount are subject to the penalty. If the taxpayer applies for the penalty to be waived due to reasonable cause, the calculation of the de minimis exception is computed only after applying any approved waivers.|12~

Intentional disregard. A failure is considered to be due to intentional disregard if it is a knowing or willful failure to timely file or to include correct information. Whether a person knowingly or willfully fails to timely file or include correct information is determined on the basis of all the facts and circumstances. Facts and circumstances include the pattern of conduct by the person who filed the return, whether the correction was made promptly upon discovery and whether the filer corrects a failure within 30 days of being notified by the IRS.|13~

If intentional disregard exists, the general $250,000 limitation and the $100,000 limitation for small businesses do not apply. Any penalty computed where intentional disregard exists will not be taken into account in applying any limitations to penalties where intentional disregard does not exist. The de minimis exception does not apply in cases where there is intentional disregard. Where there is intentional disregard, there is no reduction in the penalty for a correction within 30 days or before August 1.|14~

The intentional disregard penalty is the greater of $100 or 10% (5% for certain returns) of the aggregate dollar amount of the items required to be reported correctly. The aggregate dollar amount is the amount not reported or reported incorrectly. If the intentional disregard relates to a dollar amount, the penalty is computed on the difference between the amount reported and the correct amount. If the intentional disregard relates to any other item required to be included on the return, the penalty is computed on the aggregate amount of the items required to be reported correctly. In the case of returns required to be filed because the taxpayer receives cash in excess of $10,000, the penalty for intentional disregard is the greater of $25,000 or the amount of cash received in the transaction. There is a $100,000 maximum penalty amount.|15~

Reasonable cause. No penalty is imposed on a taxpayer's failure to comply with certain information-reporting requirements if the failure is due to reasonable cause and not willful neglect.|16~ The reasonable cause defense for information returns is now consolidated into one provision. Reasonable cause is established if there are significant mitigating factors present for the failure or the failure arose from events beyond the filer's control, and the taxpayer acts in a responsible manner before and after the failure.|17~

To establish reasonable cause, the filer may show there are significant mitigating factors. If the taxpayer has never previously been required to file a particular return or furnish a particular type of statement, or if the filer has established a history of complying with the information return requirements, the penalty may be waived. The IRS will look at whether the filer has incurred any such penalties in prior years. If the filer has incurred penalties in prior years, the IRS focus would be on the filer's success in lowering the error rate from one year to the next.|18~

The filing taxpayer can establish reasonable cause by demonstrating that the failure was due to events beyond the filer's control. Events that are considered beyond the control of the filer include unavailability of relevant business records, an undue hardship relating to filing on magnetic media, certain actions of the IRS, certain actions of an agent and certain actions of the payee or other person providing necessary information with respect to the return or payee statement.|19~

Acting in a responsible manner means the filer exercised reasonable care. Reasonable care is the standard of care that a reasonably prudent person would use under the circumstances in the course of his or her business in determining filing obligations and in handling account information such as account numbers and balances. Also, the filer must take action, where possible, to avoid or mitigate any failure.|20~

Taxpayer Identification Number. The taxpayer is required to include the payee's correct taxpayer identification number on the return. The penalty for failing to include the correct identification number is $50 per return (the maximum is $100,000 per calendar year). To have this penalty waived for reasonable care, the taxpayer must make an initial solicitation and, if required, annual solicitations to acquire a correct taxpayer identification number. This provision is coordinated with the other provisions covering information returns and payee statements and prevents the "stacking" of these penalty provisions.|21~

Payee Statements

If anyone fails to furnish a correct payee statement to a taxpayer by the required due date, the taxpayer is subject to a $50 penalty per statement. The maximum penalty is $100,000 per calendar year. No more than one penalty is imposed per payee statement even if more than one failure exists.|22~

If the failure to furnish timely a correct payee statement is due to intentional disregard, there is a penalty of $100 per statement or, if greater, 10% (5% for certain types of statements) of the amount required to be shown on the return.|23~ Due to the importance of taxpayers' receiving accurate payee statements on a timely basis, Congress maintains stricter rules for payee statements. For example, there are no provisions to decrease the penalties for corrected returns, no provisions for small businesses, and no de minimis exceptions.

Rules for intentional disregard with respect to filing payee statements are similar to the intentional disregard rules for information reporting failures. The penalty for intentional disregard of the rules for payee statements is the greater of $100 or 10% (5% for certain returns) of the aggregate amount of the items required to be reported. There is no maximum on this penalty and it is not taken into account to determine the maximum penalty that is not due to intentional disregard.|24~

Other Information Returns

A penalty is imposed for the taxpayer's failure to comply with certain specified information reporting requirements not covered by the information return and payee statement penalties. The penalty is $50 for each failure, and there is a $100,000 maximum for any calendar year.|25~

Four types of specified returns are covered:

* returns that require a partner to notify the partnership of any exchange of a partnership interest;

* returns filed under the provisions of Section 6109(a) that require the reporting of either the taxpayer's own or another taxpayer's identification number;

* returns that require individuals receiving alimony or separate maintenance payments to furnish their taxpayer's identification number to the person making those payments; and

* returns that require a taxpayer to include the identification number of any dependent claimed on the taxpayer's return.|26~

Multiple penalties are imposed on a document with multiple failures. However, no more than one penalty is imposed for each discrete failure on the document. This provision does not overlap the penalties for failure to file timely and accurate information returns or the penalties for failure to furnish correct payee statements.

There is a penalty for failure to file returns related to certain corporate transactions. The corporate transactions covered by this addition include changes in control, recapitalization or any substantial change in a corporation's capital structure. The penalty amount is $500 per day until the failure is corrected, not to exceed $100,000.|27~

Frivolous Proceedings and Returns

The Tax Court can impose punitive amounts on taxpayers who institute or maintain proceedings primarily for delay, maintain a frivolous or groundless position, or unreasonably fail to pursue available administrative remedies. The penalty amount is $25,000 for positions the taxpayer takes after December 31, 1989 (proceedings pending or begun after that date).|28~ The IRS is not required to prove it has incurred damages for the Tax Court to impose the penalty.

Also, there are stiff penalties for attorneys or others practicing before the Tax Court who "(multiply) the proceedings in any case unreasonably and vexatiously.|29~ In addition to the Tax Court, other courts may impose a penalty of up to $10,000 on taxpayers who bring frivolous or groundless suits, placing them in a position similar to the Tax Court with respect to collecting penalties and costs.|30~

A taxpayer who files a frivolous return must pay a $500 penalty in addition to any other penalties.|31~ If a taxpayer wants to contest the frivolous return penalty in court, the taxpayer must pay the full penalty first. This requirement puts taxpayers who contest the frivolous return penalty in the same position as taxpayers who contest that they owe additional tax to the IRS.

Additions to the Tax

Failure to File a Return or Pay Tax When Due

The most basic penalty provisions in the Code are for failure to file a timely return or to pay a tax when due. A taxpayer who fails to file a return by its due date is subject to a penalty of 5% (up to a maximum of 25%) on the amount of the underpayment for each month the return is late. If the return is more than 60 days past due, incomplete or unsigned, a minimum penalty equal to the lesser of $100 or 100% of the tax due will be assessed.|32~ The failure-to-file penalty is coordinated with the fraud penalty by substituting a 15% monthly rate for the 5% rate up to a maximum of 75% (equal to the fraud provision) if the failure to file a return is due to fraud.|33~

If a return is timely filed but the tax is not paid when due, the failure-to-pay penalty applies. If the taxpayer obtains an extension of time to file a return, an extension of time to pay the tax due is not automatic. The tax shown on the return (or on the extension request) must be paid, or a separate extension must be obtained to extend the payment date. A fine of 0.5% a month (up to a maximum of 25%) is imposed if the tax is not paid when due. The failure-to-pay penalty is based on the tax due.|34~ For a deficiency arising from other than the amount shown on the return, the penalty is assessed if the taxpayer fails to remit the full amount within 10 days of notice and demand by the IRS.|35~ This penalty does not apply to underpayment of estimated taxes. Estimated tax underpayment are subject to their own special requirements.|36~

These delinquency penalties are coordinated. In other words, the failure-to-pay penalty is reduced by the amount of the failure-to-file penalty imposed on the taxpayer.|37~ But when the return is not filed until 60 days or more after the due date, the failure to-file penalty will not be reduced below the lesser of $100 or 100% of the tax.|38~

The IRS may waive the failure-to-file and failure-to-pay penalties if the failure is due to reasonable cause and not willful neglect.|39~ Willful neglect indicates a deliberate act or failure to act, whereas lack of reasonable cause implies negligence on the part of the taxpayer. This wording differs from the reasonable cause and good faith language used in the defense for the accuracy-related and fraud penalties discussed below.

The Accuracy-Related Penalty

Prior to 1990, taxpayers were often subject to more than one penalty for the same offense.(40) Congress felt that this stacking of penalties by the IRS was abusive. As a partial solution, Congress consolidated five penalties into one|41~. This integrated penalty is known as the accuracy-related (accuracy) penalty. This important provision is well covered in a previous issue of The National Public Accountant|42~ and is only summarized here.

The accuracy penalty applies if underpayment of tax is due to: (1) negligence; (2) substantial understatement of income tax; (3) valuation overstatements; (4) overstatement of pension liabilities; and (5) understatement valuations for estate or gift tax.

The accuracy penalty applies only if a return has been filed.|43~ Thus, the delinquency penalties for failure-to-file and failure-to-pay discussed in the above section remain in the Code as separate statutes. Exercise of reasonable cause and good faith is now a defense to all components of the accuracy penalty and a facts and circumstances approach is used by the IRS to determine reasonable cause.|44~ Substantial authority and/or adequate disclosure are defenses which avoid the penalty for negligence or substantial underpayment of income tax, and may be helpful in avoiding the other components of the accuracy penalty.


The negligence component of the accuracy penalty applies where any tax underpayment is due to negligence or disregard of rules or regulations.|45~ The Code defines negligence as the failure to make a reasonable effort to comply with the Code and disregard includes carelessness and recklessness as well as intentional disregard.|46~ The courts have held that negligence is lack of due care or failure to do what a reasonable and prudent person would do under the circumstances. The IRS specifies there is negligence if the taxpayer's position lacks a reasonable basis. The IRS indicates that if the taxpayer takes a position on the return which is contrary to a Treasury regulation, the taxpayer's position must be adequately disclosed on new Form 8275-R.|47~

The negligence component applies only to the portion of the underpayment due to negligence. The penalty is 20% of the underpayment or 40% if gross negligence is involved.

Specific disclosure of an item on a non-frivolous return is a defense to the negligence component. The disclosure must be complete and clearly identified as being made to avoid the accuracy penalty. Specific reference should be made to regulations or other positions being challenged and adequate maintenance of books and records is essential.|48~ After December 31, 1991, Treasury Form 8275 (Form 8275-R if challenging a regulation) is to be used to make the required disclosure. Any statutory or regulatory ruling which is being disputed by the taxpayer must be adequately identified on the appropriate form.|49~

Substantial Understatement of Income Tax

This component of the accuracy penalty relates to a substantial understatement by the taxpayer of his income tax liability. The substantial understatement component applies only to the federal income tax. This component applies if the understatement of income tax liability exceeds 10% of the tax required to be shown on the return, or $5,000, whichever amount is larger. For corporations other than S corporations and personal holding companies, $10,000 is used in lieu of $5,000. An understatement is the excess of the amount of the tax required to be shown on the return over the amount of tax imposed on the return as filed (reduced by any rebate). As with the other components of the accuracy penalty, the applicable rate is 20% unless the understatement is due to gross negligence, in which case the rate is 40%.|50~ The determination of whether an understatement is substantial is made on a year by year basis, without aggregation.|51~

Except for items involving tax shelters, the understatement is reduced by any amount for which there is adequate disclosure on the return of the relevant facts that reflect the tax treatment of an item.|52~ Disclosure should alert the IRS to potential controversies. The disclosure requirements are detailed in the final Treasury regulations.|53~

Disclosure for one year is not effective for subsequent years. Particularity is required: any disclosure must identify the item in question, show the amount at issue, include all relevant facts, and state the legal issues involved. Effectively, the required disclosure procedure "red flags" any disagreements that the taxpayer has with an IRS position. Also, any supporting statements must be identified as being made to avoid the penalty.|54~ Unlike for the negligence component disclosure requirement, the regulations allow disclosure for substantial understatement to be made on either Form 8275 or according to annual revenue procedures to be issued by the IRS.|55~

The understatement penalty is not imposed where substantial authority exists for the position which the taxpayer takes on the return.|56~ There must be substantial authority for both facts alleged and legal positions taken. The "substantiality" criterion does not require that the taxpayer have a more likely than not prospect of prevailing on the issue (except for tax shelters). It does require that the authorities supporting the taxpayer's position be substantial when compared to the authorities contrary to the taxpayer's position. This test is very subjective and often difficult to apply. Treasury regulations and the committee reports to the 1989 Revenue Reconciliation Act set forth proper authorities. Relevance, persuasiveness and source of the authorities also must be considered.|57~

Substantial Valuation Overstatement

The accuracy penalty applies when there is a substantial valuation overstatement.|58~ A substantial valuation overstatement occurs where the value (or basis) of property shown on a return is 200% or more of its true value (or basis). The determination of valuation misstatements is to be made on a property by property basis.|59~ This component applies only if the amount of the underpayment due to the overstatement exceeds $5,000 ($10,000 for a regular corporation). This provision most likely will occur when the basis of property sold or depreciated, or the value of property given to charity, is grossly overstated.

The penalty rate is 20% if the amount of the overstatement is at least 200% but less than 400%. It goes to 40% if the overstatement is 400% or more.|60~ Good faith and a reasonable basis for the valuation shown on the return is a good defense. For charitable deductions, the taxpayer must base the valuation on a qualified appraisal and make a good faith investigation as to the value of the contributed property.|61~

Substantial Overstatement of Pension Liabilities

This component applies where there is an overstatement of a pension liability deduction by 200% or more of the true liability. This component is imposed only if the amount of the underpayment attributable to the overstatement exceeds $1,000. The rate is 20% if the overstatement is at least 200% but less than 400%, and 40% if the overstatement is 400% or more.|62~

Substantial Understatement of Estate or Gift Tax Valuations

The accuracy penalty applies if the value of property claimed on an estate or gift tax return is 50% or less of its correct value. This component does not apply unless the amount of the underpayment due to the incorrect valuation exceeds $5,000. The rate is 20% if the value claimed is 50% or less, but more than 25% or less of the correct value. If the claimed value is 25% or less of the correct value, the rate is 40%.|63~

This provision applies to estate and gift tax returns. However, because of the income tax substantial overvaluation provision, taxpayers also must be careful not to overvalue an estate item for future income tax bases purposes.

The Fraud Penalty

Fraud implies bad faith and an intent to evade a tax illegally. It may be proven by circumstantial evidence, i.e., lack of adequate records and by the taxpayer's entire course of conduct.|64~ Once fraud is established, the penalty is 75% of the amount of underpayment attributable to the fraud.|65~

The original burden of proof to establish fraud is on the IRS. However, the burden shifts to the taxpayer once the IRS establishes that any portion of the underpayment is due to fraud. Once fraud is established, the entire underpayment is treated as attributable to fraud, unless the taxpayer can prove otherwise.|66~

The Service must initially establish fraud by clear and convincing evidence.|67~ The taxpayer may overcome the presumption of fraud if he or she can establish by a preponderance of the evidence that a portion of the underpayment under question is not attributable to fraud.|68~ The fraud and the accuracy penalties are coordinated. The accuracy penalty will not be assessed on any portion of the tax underpayment to which the fraud penalty applies.|69) However, the accuracy penalty may be imposed on any nonfraudulent portion.

Estimated Taxes

The estimated tax provision applies to individuals, C corporations, S corporations (where applicable), trusts, and any estate with a taxable year which ends two or more years after the decedent's death.|70~ Although an interest rate is used to compute the penalty, this provision is a penalty provision; therefore, there is no interest deduction for the amount paid. Tax liability is defined broadly to include the regular income tax, recapture taxes, the alternative minimum tax and self-employment taxes.

Good faith and reasonable cause are not good defenses for failure to pay estimated taxes. Normally, no penalty is imposed where the tax paid equals the prior year's tax liability (except for large corporations, i.e., those with taxable income in excess of $1,000,000 in any of the three preceding years), 90% of the tax owed is paid or the tax is paid in amounts sufficient to equal the tax owed on an annualized basis. The Tax Extension Act of 1991 increased the percentage of tax required to be paid in to 93% for 1992 estimates, 95% for 1993-1996 and back to 90% for 1997 for corporations, S corporations and certain tax exempt organizations.

The 1991 Emergency Unemployment Compensation Act established new rules for certain taxpayers to compute their estimated tax payments. The rules begin to apply in the second quarter of 1992. While the new rules do not increase one's annual Federal income tax liability, they may increase the size of one's estimated tax payments which are made for the last three quarters of the year.

Generally, only a taxpayer who meets the following three criteria is subject to the new rules: (1) the taxpayer has more than $75,000 of adjusted gross income; (2) the taxpayer has an increase in income of more than $40,000 over the last taxable year; and, (3) the taxpayer made estimated tax payments, or was assessed an estimated tax penalty, in any of the three preceding tax years. Farmers and fishermen are exempt from the new rules.

Taxpayers who are subject to the new rules may not be able to compute their second, third and fourth quarterly estimated tax payments based on their prior year's tax. However, affected taxpayers may base their estimated tax payment for the first quarter on their prior year's tax.|71~

Failure to Deposit Taxes

There is a penalty if the taxpayer fails to make required deposits of taxes. The amount of the penalty depends on the length of time within which the employer corrects the failure. A specified percentage is multiplied by the amount of the underpayment to compute the penalty. The percentages are:

1. 2% of the underpayment if the failure is corrected within 5 days of the due date of the required deposit.

2. 5% of the underpayment if the failure is corrected within 6 to 15 days of the due date of the required deposit.

3. 10% of the underpayment if the failure is corrected within 16 days of the due date of the required deposit and 10 days after the date of the first delinquency notice to the taxpayer.

4. 15% of the underpayment for later corrections.|72~

The penalty is waived if the taxpayer's failure to make the deposit timely is due to reasonable cause and not willful neglect.|73~ It would seem, since due dates are fairly consistent for most employers, that the "reasonable cause but not willful neglect" defense might be difficult to establish. Congress intends that the penalty will not apply when the penalty for underpayment of estimated taxes applies.|74~

In Revenue Procedure 90-58|75~, the Internal Revenue Service provides guidance on how federal tax deposits will be credited in determining whether the failure-to-deposit penalty applies. Beginning with deposit liability periods after March 31, 1991, deposits will be applied in the order of the date they were made to the deposit liabilities in the order due (i.e., deposits and other credits will first be applied to the oldest underdeposit, then to the next oldest underdeposit, etc.). Examples of credits other than deposits include overpayments from the previous quarter and payments that are delivered to an IRS office rather than the required authorized depository.

Revenue Procedure 91-52 clarifies Revenue Procedure 90-58 by specifying that an overpayment of tax for a completed taxable period, at the election of the taxpayer, may be used to satisfy liabilities for the succeeding period. Alternatively, the taxpayer may claim a refund for the overpayment. If the taxpayer elects to use the overpayment to satisfy liabilities for the succeeding period, the amount of the overpayment will be deemed to be credited to the taxpayer's account as of the date(s) on which the overdeposit(s) occurred that formed the basis for the overpayment.

The IRS has two sets of "safe-haven" rules in Revenue Procedure 90-58. First, deposits of employment taxes and withheld income taxes by agents withholding from nonresident aliens and foreign corporation are protected by these rules. A failure-to-deposit penalty will not be assessed if at least 95% of the required deposit for employment taxes is timely made and the remainder is timely deposited as prescribed by Treasury regulations. The threshold is 90% for withholding from nonresident aliens and foreign corporations. For both situations, the make-up deposit must be deposited with the first deposit otherwise required after the 15th day of the following month, unless the safe-haven underdeposit occurs in the last month of the return period, in which case the balance then is due by the due date of the return.

Second, safe-haven rules also are established for deposits of excise taxes. Underdeposits of excise taxes have their own specific due dates. Safe-haven underdeposits will be credited in due date order.

Preparer Penalties

There is a preparer penalty for understating the client's income tax liability, if the understatement is due to an unrealistic position(s) which is taken on the return.|76~ This penalty imposes professional conduct standards on income tax preparers similar to the ethical standards applicable to attorneys and CPAs.|77~ The penalty is $250 for each return or claim for refund for which three conditions are met:

1. any part of an understatement of liability for a return or refund claim is due to a position for which there is not a realistic possibility of the position's being sustained on its merits;

2. the preparer knew or reasonably should have known of the position; and

3. the preparer did not disclose the position or the position was frivolous.|78)

A person may be considered to be an income tax preparer with respect to the individual returns of limited partners, if the person prepares both the partnership's return and the Schedule K-1's for the limited partners.|79)

The IRS has issued regulations which are quite subjective in determining if the position on the return has a realistic possibility of being sustained. A position taken on the client's tax return is considered to have a realistic possibility of being sustained on its merits if a reasonable and well-informed analysis by a person knowledgeable in the tax law would lead such a person to conclude that the position has approximately a one in three, or greater, likelihood of being sustained on its merits. The same analysis which is used to determine if substantial authority exists to avoid the substantial understatement of tax liability penalty for clients also applies to determine if the realistic possibility standard is satisfied.|80~

As an example, assume that the Internal Revenue Code is silent as to whether a taxpayer may take a certain position on his 1992 Federal income tax return. There were three private letter rulings which had been issued in 1988 and 1989, all of which support the taxpayer's position. However, in 1991, proposed regulations which are contrary to the taxpayer's position were issued by the Treasury Department. The private letter rulings no longer are authority and are not to be taken into account to determine if the taxpayer's position satisfies the realistic possibility standard. All other relevant authorities must be examined to determine if the position has a realistic possibility of being sustained.|81~

An individual and the firm with which the individual is associated both may be subject to the $250 penalty (as well as the $1,000 penalty for reckless disregard of rules and regulations). If an individual works for a sole proprietor and the individual is subject to the penalty, the sole proprietor is considered a firm with respect to the individual.|82~

The preparer may avoid the $250 penalty by adequately disclosing the position taken on a non-frivolous return. Adequate disclosure normally requires that a Form 8275 be properly completed and filed, or disclosure be made in some other manner to be specified through an annual revenue procedure.|83~

The penalty also will be waived by the IRS if, considering all of the facts and circumstances, the understatement was due to reasonable cause and the preparer acted in good faith. Factors which the IRS will consider in determining if this standard is met include the following:

* Nature of the error which causes the understatement;

* Frequency of errors;

* Materiality of errors;

* The preparer's normal office practice; or

* The preparer's reliance on the advice of another preparer.|84~

If an income tax preparer recklessly or intentionally disregards rules or regulations in understating liability on a return or refund claim, a $1,000 penalty may be assessed for each return or claim. The penalty applies also if the preparer willfully attempts to understate the liability.|85~ Formerly, the penalty for willful understatement of tax liability was $500.

An income tax preparer is considered to have recklessly or intentionally disregarded a rule or regulation if the preparer takes a position on the client's return or claim for refund which is contrary to a rule or regulation, and the preparer knows of, or is reckless in not knowing of, the rule or regulation in question.|86~ The penalty for reckless or intentional disregard can be avoided if the position is not frivolous and it is adequately disclosed. Adequate disclosure for a signing preparer entails a properly completed and filed Form 8275, where the rule or regulation which is challenged is adequately identified.|87~

A preparer willfully attempts to understate liability if he or she disregards, in an attempt wrongfully to reduce the tax liability of the taxpayer, information which is furnished by the taxpayer. As an example, if the preparer disregards information concerning certain items of taxable income furnished by the taxpayer, the preparer is subject to the penalty for a willful attempt to understate liability.|88~

Nonsigning preparers who give advice to taxpayers, where the advice is with respect to a position which is contrary to a rule or regulation, must be especially wary. The IRS indicates that advice for such a position is adequately disclosed if the advice includes a statement that the position is contrary to a specified rule or regulation and, therefore, is subject to a negligence penalty unless there is adequate disclosure. The IRS specifies that if the advice is in writing, then the statement concerning disclosure must be in writing. If it is oral advice, the preparer's advice to disclose may be oral. This, of course, could present a documentation problem for the preparer. However, the IRS indicates that contemporaneously prepared documentation of the oral advice regarding disclosure generally is sufficient to establish that the advice was given to the taxpayer.|89~ xxx With respect to the $250 and the $1,000 penalties, the preparer generally may rely in good faith without verification on information which the taxpayer furnishes. In other words, the preparer is not required to audit, examine or review books and records, business operations, or documents or other evidence in order to verify independently the taxpayer's information.

However, the preparer may not ignore the implications of information furnished to the preparer or actually known by the preparer.

The preparer must make reasonable inquiries if the information as furnished appears to be incorrect or incomplete. Additionally, some provisions of the Code or regulations require that specific facts and circumstances exist, for example that the taxpayer maintain specific documents before a deduction may be claimed. The preparer must make appropriate inquiries to determine the existence of facts and circumstances required by a Code section or regulation as a condition to the claiming of a deduction.|90~

The $1,000 penalty per return or claim is reduced by the $250 penalty paid for understating liability because of unrealistic positions, if the $250 penalty applies.|91~

The IRS states that with respect to the $250 and $1,000 preparer penalties, no more than one individual associated with a firm will be a preparer for the same return (signing preparer). Preparers from other firms who give advice on a return (nonsigning preparer), however, also could be subject to the penalties. Different disclosure rules are set forth for signing and nonsigning preparers.|92~

Other assessable preparer penalties deal primarily with some kind of ostensible omission on the preparer's behalf. These penalties are coordinated with the penalty for the preparer's failure to keep a completed copy of the return or refund claim or, as an alternative, to keep for three years a list containing the name and taxpayer identification number for each return or refund claim prepared.|93~ The amount of this penalty is $50 for each failure. These penalties are:

* failure to furnish the taxpayer a copy of the return or refund claim;

* failure to sign the return or refund claim;

* failure to show identification numbers on the return or refund claim;

* failure to maintain a copy of the return or refund claim or maintain a list with the name and taxpayer identification number; and

* failure to file information returns.|94~

For returns or refund claims prepared after December 31, 1989, the income tax preparer must pay a $50 penalty each time he or she does not furnish a copy of the completed document to the client. There is a $25,000 aggregate maximum which may be imposed for any calendar year.|95~

The penalty for the preparer's failing to sign a return or refund claim is $50 per occurrence. The penalty is subject to the $25,000 maximum for a calendar year.|96~ An equivalent penalty and maximum limit apply to income tax preparers who fail to put their taxpayer identification number on a return or refund claim.|97~ All of these failure penalties are excused for reasonable cause, if the failure is not due to willful neglect.|98~

For employers (of income tax preparers), information returns which set forth the names, taxpayer identification numbers and places of work for each return preparer who is an employee are to be filed no later than July 31, for each 12-month period ending on June 30.|99~ This requirement is satisfied by the employer's retaining records of the preparers whom he employs and making the records available for IRS inspection.|100~ A penalty is imposed if the employer fails to file the return (or, alternatively, to retain the list).

There is a single $50 penalty for each failure to file (or retain the record) and each failure to include an item on the required return (or on the record required to be retained). The maximum penalty is $25,000.|101~ As with the preparer penalties noted above, the penalty is avoided if there is a reasonable cause, and the failure is not due to willful neglect.|102)~

Penalties for ostensible omissions are: {1} the $50 penalty ($25,000 maximum) for preparer failure to retain a completed copy of the client's return or, as an alternative, a list containing the client's name and taxpayer identification number|103~; and, {2} the $500 penalty for improper endorsement or negotiation of a client's refund check|104~. The penalty for not retaining a copy of the client's return, or a list, is excused if it is due to reasonable cause and not willful neglect.

For a preparer who aids or assists in, procures or advises with respect to, the preparation or presentation of any portion of a return, affidavit, claim or other document, a penalty applies if the preparer knows or has reason to believe that the return or other document will be used in connection with any material matter arising under the tax laws and the preparer knows that if the portion of the return or other document were so used, an understatement of the tax liability of another person would result. The penalty normally is $1,000,|105~ but it is $10,000 if the document relates to a corporation's tax liability.|106~

In addition to being coordinated with the return preparer penalties for understatements due to unrealistic positions and willful or reckless conduct, the aiding and abetting penalty also is coordinated with the penalty for promoting abusive tax shelters.|107~ In other words, if the aiding and abetting penalty is imposed on a preparer, the other penalties will not be imposed. However, both the aiding and abetting penalty and the penalty for promoting abusive tax shelters may be imposed with respect to separate documents.|108~ As an example, if a promoter furnishes promotional material at the time of sale and subsequently provides partnership schedules such as a K-1 to investors, both penalties could apply.

If a preparer discloses or uses information furnished to him by a taxpayer for reasons other than to prepare the tax return, a $250 civil penalty may be imposed for each improper disclosure or use. The aggregate amount that may be imposed for any calendar year is $10,000.|109~ The penalty is not imposed if the disclosure or use of the return information is made pursuant to a court order, one of the other provisions of the Code that permits disclosure under specified circumstances, or in connection with preparing state and local tax returns and declarations of estimated tax.|110~

Establishing Reasonable Cause

Although the language in the various statutes is not consistent, a penalty waiver can be obtained in various circumstances by a showing of reasonable cause, reasonable cause and good faith,|111~ or "reasonable cause and not due to willful neglect."|112~ The courts have tended to define reasonable cause as the exercise of prudent care that a reasonable man would use in managing his own affairs.

Simply proving a lack of willful neglect on the part of the taxpayer is not sufficient.|113~ Prudent care generally implies a taxpayer's good faith as well. Furthermore, the terms reasonable cause and good faith are to be interpreted the same as under prior law.|114~ This issue usually is determined on a case by case approach after considering all the facts and circumstances, including the taxpayer's education and background. Reliance on competent counsel may constitute due care if the advisor is given all necessary information.|115~ Most of the criteria established by the IRS and the courts require the taxpayer to demonstrate the exercise of ordinary business care and prudence.

The committee reports for the 1989 legislation authorize judicial review of IRS determinations involving the accuracy penalty. The reports state "it is appropriate for the courts to review the determination of the accuracy-related penalties by the same general standard applicable to their review of the additional taxes that the IRS determines are owed".|116~

The committee reports also specify that the IRS should:

* Develop policy statements.

* Develop a handbook on penalties for all IRS employees and make it available to tax advisors also.

* Upgrade training procedures.

* Improve communications with taxpayers on the subject of penalties.

* Develop and maintain a master file data base on penalties.

* Cease to mechanically assess penalties, thus more carefully considering whether penalties apply in the first instance.|117~


The 1989 Revenue Reconciliation Act's massive penalty overhaul culminated years of discussion about the complexity and lack of coordination of the Code's penalty structure. Congressional intent in the committee reports also reflects years of growing concern over thoughtless, mechanical application of penalties by the IRS.

Congress has taken a significant stride in achieving coordination in the penalty structure and increasing fairness. However, various penalty increases reflect a Congressional tone that violators should receive stronger and appropriate punishment.


1 Internal Revenue Code {IRC} Chapter 68, Subchapter B, Sections 6671 through 6724.

2 IRC Chapter 68, Subchapter A, Sections 6651 through 6665.

3 IRC Chapter 68, Subchapter B, Sections 6694 through 6696.

4 IRC Sections 6212 and 6671.

5 Treasury Regulation Section 301.6721-1(a)(2).

6 Treasury Regulation Section 301.6721-1(c).

7 Treasury Regulation Section 301.6721-1(c)(2).

8 IRC Section 6721(a) and 6721(b).

9 Treasury Regulation Section 301.6721-1(b)(3).

10 Treasury Regulation Section 301.6721-1(b)(6).

11 IRC Sections 6721(c) and 6721(d).

12 Treasury Regulation Section 301.6721-1(d)(2).

13 Treasury Regulation Section 301.6721-1(f).

14 Treasury Regulation Section 301.6721-1(f)(4).

15 Treasury Regulation Section 301.6721-1(f)(4) and 301.6721-1(f)(5).

16 IRC Section 6724(a).

17 Treasury Regulation Section 301.6724-1(a)(2).

18 Treasury Regulation Section 301.6724-1(b).

19 Treasury Regulation Section 301.6724-1(c)(1).

20 Treasury Regulation Section 301.6724-1(d).

21 Treasury Regulation Sections 301.6724-1(e) and 301.6724-1(f).

22 Treasury Regulation Section 301.6722-1(a).

23 Treasury Regulation Section 301.6722-1(c).

24 IRC Section 6722(c).

25 IRC Section 6723.

26 Treasury Regulation Section 301.6723-1(a)(4).

27 IRC Section 6652(l) {should read(k)}.

28 IRC Section 6673(a).

29 Committee Reports, P.L. 101-239, 12-19-89, Act Section 7731(a), Revenue Reconciliation Act of 1989 (RRA).

30 IRC Section 6673(b).

31 IRC Section 6702(a).

32 IRC Sections 6651(a)(1) and 6651(b).

33 IRC Section 6651(f).

34 IRC Sections 6651(a)(2), 6651(b), and 6651(d).

35 IRC Section 6651(a)(3).

36 See IRC Sections 6654 and 6665, and the section "Estimated Taxes" below for more information on this requirement.

37 IRC Section 6651(c).

38 IRC Section 6651(c)(1).

39 IRC Section 6651(a).

40 Acker v. Comm., 26 TC 107 (1956), modified 258 F.2d 568 (6th Cir., 1958), aff'd 361 U.S. 87 (1959).

41 Internal Revenue Code {IRC} Section 6662.

42 The National Public Accountant, October, 1991, pp.24, "The State of Accuracy Related Penalties", by Timothy Mills and Matthew Monippallil.

43 IRC Section 6664(b). This change overrides Technical Advice Memorandum 8802003 which held the substantial underpayment penalty applied even though no return had been filed.

44 IRC Section 6664(c). Treasury Regulation Section 1.6664-4.

45 IRC Section 6662(c).

46 IRC Section 6662(c). Treasury Regulation Section 1.6662-3(b) states that negligence occurs where a taxpayer fails "to make a reasonable attempt to comply with the internal revenue laws or to exercise ordinary and reasonable care in the preparation of a tax return." This includes failure to maintain proper books and records or to properly substantiate items. Disregard "includes careless, reckless or intentional disregard of the code, temporary or final treasury regulations, or revenue rulings."

47 Treasury Regulation Section 1.6662-3 as set forth in T.D. 8381 (December 31,1991). See also Rev. Rul. 80-28, 1980-1 CB 304 and Marcello, T.C. Memo, 1988-46.

48 Ibid.

49 Treasury Regulation Section 1.6662-3(c).

50 IRC Sections 6662(d) and 6662(h).

51 Treasury Regulation Section 1.6662-4.

52 IRC Section 6662(d)(1)(B)(ii).

53 Treasury Regulations Section 1.6662-4. Also, see Revenue Procedure 90-16, 1990-1 CB 477, as updated by Revenue Procedure 91-19, 1991-1 CB 523, and Revenue Procedure 92-23, IRB 1992-13 for information-specific requirements for certain tax return schedules.

54 Ibid.

55 Treasury Regulation Section 1.6662-4(f). Also, see footnote 53 above.

56 IRC Section 6662(d)(1)(B)(i).

57 Treasury Regulations Section 1.6662-4(d). Also. see footnote 74 below.

58 IRC Section 6662(e).

59 Treasury Regulation Section 1.6662-5.

60 IRC Section 6662(h).

61 IRC Section 6664(c)(2)(a).

62 IRC Section 6662(f).

63 IRC Section 6662(g).

64 Davis vs. Comm'r, 184 F2nd 86 (10th circuit, 1950). Parks vs. Comm'r, 94 TC No.38 (1990). See also 37 C.J.S. Fraud, Section 1.

65 IRC Section 6663.

66 IRC Section 6663(b).

67 IRC Section 7454(a).

68 IRC Section 6663(b).

69 IRC Section 6662(b).

70 IRC Section 6654(l)(2)(B)(ii).

71 Internal Revenue News Release IR-92-18, issued on February 28, 1992. The Internal Revenue Service has revised its Publication 505, "Tax Withholding and Estimated Tax," to reflect these new rules. If you want to order the revised publication, call 1-800-TAX-FORM.

72 IRC Section 6656.

73 Ibid.

74 Committee Reports, P.L. 101-239, 12-19-89.

75 Rev. Proc. 90-58 1990-52 I.R.B.1.

76 IRC Section 6694(a).

77 The language of the committee reports specifies the similarity in the Code Section 6694(a) standard and the ethical standard for CPA's. In this regard, Statement #1 of the AICPA's Statements on Responsibilities in Tax Practice (SRTP) should be consulted. Also, in December 1990, SRTP Interpretation 1-1 on the "realistic possibility standard" was issued. It provides further guidance on the level of assurance a CPA in tax practice should have regarding a client's return position. It is interesting to note that the level of assurance under Statement #1, which can be reached, for example, by relying on well-reasoned articles and treatises, may be something less than the level required to avoid the taxpayer penalty because of "substantial authority." "Substantial authority" does not include such secondary tax law as articles and treatises. See the section entitled "Substantial Understatement of Income Tax" above.

78 IRC Section 6694(a). The IRS states in Treasury Regulation Section 1.6694-2 that disclosure is adequate if made on a properly completed and filed Form 8275.

79 Goulding v. U.S., 89-2 USTC Paragraph 9498 (D.Ct.,Il.).

80 Treasury Regulation Section 1.6694-2(b)(1).

81 Treasury Regulation Section 1.6694-2(b)(3), Example 5.

82 Treasury Regulation Section 1.6694-1(b)(1).

83 Treasury Regulation Section 1.6694-2(c)(3). Also, see the revenue procedures set forth in footnote 53 above.

84 Treasury Regulations Section 1.6694-2(d).

85 Treasury Regulation Section 1.6694-3.

86 Treasury Regulation Section 1.6694-3(c)(1).

87 Treasury Regulation Section 1.6694-3(e)(1).

88 Treasury Regulation Section 1.6694-3(b).
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Author:Cash, L. Stephen; Dickens, Thomas L.; Hagan, Joseph M.
Publication:The National Public Accountant
Date:Jan 1, 1993
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