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Final regulations relating to the accuracy-related penalty.

I. INTRODUCTION

On December 31, 1991, the Internal Revenue Service published final regulations (1*) on the accuracy-related penalty imposed by section 6662 of the Internal Revenue Code. (2) Section 6662 was enacted by the Omnibus Budget Reconciliation Act of 1989 (the "1989" Act") (3) as part of a broad-based reform of the penalty provisions. This article (i) reviews the historical underpinnings of section 6662 and the congressional intent underlying the changes effected in 1989, (ii) describes the final regulations, and (iii) comments on the manner in which those final regulations implement the congressional intent underlying section 6662.

II. BACKGROUND OF SECTION 6662

For many years, the penalties imposed by the Code were easy to understand. Penalties for negligence, fraud, late payment of tax, and late filing of returns were authorized under even the early formulations of the federal income tax law. For example, the Revenue Act of 1918 provided for a 5-percent penalty on the total amount of a deficiency if any part was due to negligence. No penalty was imposed if the return was made in "good faith" and the understatement was not due "to any fault of the taxpayer." (4) Subsequent regulations defined negligence as "the absence of reasonable care under the circumstances." (5) The Internal Code of 1954 imposed a penalty equal to 5 percent of the amount of any underpayment due to "negligence or international disregard of rules and regulations." (6) These general provisions remained relatively unchanged for many years.

Beginning in 1981, the penalty scheme became increasingly more complicated. In that year, an interest component was added to the negligence penalty, (7) and a valuation overstatement penalty for purposes of the income tax was added. (8) In 1982, a new penalty for substantial understatement of tax was added to the Code. (9) A valuation understatement penalty for purposes of estate and gift taxes was added in 1984. (10) In 1986, yet another penalty -- for overstatement of pension liabilities -- was added. (11)

These various modifications to the penalty scheme led to complex and sometimes harsh results. Stacked or overlapping penalties often were imposed for the same conduct, or on the same underpayment.

In an effort to remedy these problems, Congress enacted the Improved Penalty Administration and Tax Compliance Act as part of the 1989 Act. The 1989 Act consolidated the penalties for negligence, substantial understatement, and valuation misstatements in a new section 6662 and imposed a single 20 percent (12) penalty on the portion of any underpayment (13) attributable to any of the proscribed conduct. (14) Further, standardized exception criteria were made applicable to all accuracy-related penalties: No penalty is imposed if it is shown that (i) the taxpayer had reasonable cause for an underpayment, and (ii) the taxpayer acted in good faith. (15)

The legislative history to the 1989 Act makes clear that the enactment of standardized exception criteria represented a key component of the overall legislative effort to both simplify the penalty scheme and improve fairness for taxpayers:

The enactment of this standardized exception criterion is designed to permit the courts to review the assertion of penalties under the same standards that apply in reviewing additional tax that the Internal Revenue Service asserts is due. By applying this unified exception criterion to all the accuracy-related penalties, the committee believes that taxpayers will more easily understand the standard of behavior that is required. The committee also believes that this unified exception criterion will simplify the administration of these penalties by the IRS.

The committee is concerned that the present-law accuracy-related penalties (particularly the penalty for substantial understatements of tax liability) have been determined too routinely and automatically by the IRS. The committee expects that enactment of standardized exception criterion will lead the IRS to consider fully whether imposition of these penalties is appropriate before determining these penalties. (16)

The 1989 Act also made a number of other reforms to the penalty provisions in order to further the goals of simplification and fairness. Four key reforms warrant special emphasis. First, the prior law negligence penalty applied to the entire underpayment if any part of the underpayment was attributable to negligence. Thus, if an audit revealed a negligently reported deduction of $1 and if other audit adjustments not attributable to negligence resulted in a total underpayment of $1,001, the 5-percent negligence penalty applied to the entire $1,001. (17) Although the 1989 Act increased the penalty rate from 5 percent to 20 percent, the penalty is imposed only on the amount of the underpayment attributable to negligence (or to other conduct proscribed by section 6662).

Second, a taxpayer's failure to include on an income tax return an amount shown on an informal return was presumed to be negligent prior to the 1989 Act. This presumption was eliminated. The legislative history cautions, however, that "[a]s a practical matter, even in the absence of a statutory presumption, evidence of such a failure is still strong evidence of negligence." (18)

Third, the 1989 Act modified the substantial understatement penalty by (i) lowering the rate to 20 percent, (ii) requiring the IRS to publish annually a list of positions for which it contends no substantial authority exists, and (iii) expanding the list of authorities that constitute substantial authority to include proposed regulations, private letter rulings, technical advice memoranda, actions on decisions (AODs), general counsel memoranda (GCMs), information or press releases, notices, and any other similar documents published in the Internation Revenue Bulletin, and General Explanations of tax legislation prepared by the Joint Committee on Taxation ("Blue Books"). With respect to item (ii), the legislative history notes:

The committee believes that this list will be useful to taxpayers, in that it will assist taxpayers in determining whether substantial authority exists with respect to a particularly issue on the list. Although the list is not exclusive, the committee intends that the IRS make the list as comprehensive as practical, which will make it more useful to taxpayers and their advisors. (19)

Consistent with this general objective, the legislative history gave Treasury express (but narrow) authority to restrict the list of authorities:

The committee's intent is to broaden the list of authorities upon which taxpayers may rely. The committee would, however, permit the Treasury to issue regulations providing that specific items on the committee's list of additional authorities (except for proposed regulations not yet superseded or "Blue Books") that were issued prior to the date of enactment of this bill may not be considered to be substantial authority. For example, Treasury regulations could provide that private letter rulings issued prior to the date they began to be publicly disseminated are not substantial authority. Any such limitation should, however, be as narrow as practicable, in order to further the committee's general intent that the list of authorities on which taxpayers may rely should be broadened. (20)

Fourth, the 1989 Act revised the valuation overstatement penalty by (i) extending the penalty to all taxpayers, (ii) providing for the application of the penalty only if the value or adjusted basis of property claimed on a return is 200 percent or more of the correct amount, (iii) limiting the penalty to cases overstatement exceeds $5,000 ($10,000 for C corporations other than personal holding companies), and (iv) increasing the penalty rate from 20 percent to 40 percent in the case of "gross valuation misstatements." (21) The intent of these changes was to exempt from the penalty "a number of instances of good-faith valuation disputes that may be subject to penalty under present law." (22)

III. THE FINAL REGULATIONS

UNDER

SECTION 6662

A. Overview

The final regulations under section 6662 reflect extensive public comments on the proposed regulations published on March 4, 1991. (23) The regulations address only three of the five components of the accuracy-related penalty: (i) negligence or disregard of rules or regulations, (ii) substantial understatements of income tax, and (iii) substantial (and gross0 income tax valuation misstatements. The provisions of section 6662 relating to substantial overstatements of pension liabilities and substantial estate or gift tax valuation understatements are not addressed.

The regulations specifically prohibit the stacking of penalties, making clear that only one penalty may be imposed even if the underpayment is attributable to more than one of the accuracy-related penalty components (e.g., negligence and valuation misstatements). (24)

The regulations generally are effective for income tax returns due (without regard to extensions) after December 31, 1989. (25) The rules relating to adequate disclosure, however, are effective for income tax returns due (without regard to extensions) after December 31, 1991. Transitional relief is provided under certain circumstances for returns filed prior to January 1, 1992. (26)

B. Negligence or Disregard of Rules

or Regulations

1. Negligence

Under the regulations, "negligence" includes the failure (i) to make a reasonable attempt to comply with the tax law, (ii) to exercise ordinary and reasonable care in preparing a tax return, and (iii) to keep adequate books and records (or to properly substantiate items). A return position is negligent "if it lacks a reasonable basis." (27)

The regulations also describe specific cases in which negligence is "strongly indicated." First, negligence is strongly indicated if the taxpayer fails to include in its return an amount of income shown on an information return (e.g., Form 1099). Second, negligence is strongly indicated if the taxpayer "fails to make a reasonable attempt to ascertain the correctless of a deduction, credit, or exlusion on a return which would seem to a reasonable and prudent person to be 'too good to be true.'" (28) Third, negligence is strongly indicated if items are treated inconsistently as between the returns of (i) a partner and the partnership, or (ii) an S corporation shareholder and the S corporation. (29)

2. Disregard of Rules and Regulations

The "disregard of rules or regulations" prong of the negligence penalty applies to careless, reckless, or intentional disregard of rules or regulations. (30) "Careless" disregard is shown if the taxpayer "does not exercise reasonable diligence to determine the correctness of a return position that is contrary to a rule or regulation." (31) "Reckless" disregard is shown if the taxpayer makes little or no effort to determine whether a rule or regulation exists, under circumstances in which the taxpayer's conduct "demonstrates a substantial deviation from the standard of conduct that a reasonable person would observe." (32) Finally, "intentional" disregard is shown if the taxpayer acts with knowledge of the rule or regulation that is disregarded. A taxpayer is not consider to have disregarded a "revenue ruling or a notice," however, if the taxpayer's position contrary to that ruling or notice "has a realistic possibility of being sustained on its merits." (23)

3. Exceptions

A penalty for negligence or international disregard will not be imposed to the extent that (i) the taxpayer complied with the regulatory requirements for adequate disclosure, or (ii) the taxpayer had reasonable cause for the position taken and acted in good faith. These exceptions are discussed in Part III. F.

C. Substantial Understatement

of Income Tax

1. General Rule

For purposes of the "substantial understatement" component of the accuracy-related penalty, an understatement" is defined as the excess of (i) the amount of tax required to be shown on the taxpayer's return for the taxable year, over (ii) the amount of tax actually shown on that return (reduced by certain credits, refunds, or other repayments). (34) An understatement is "substantial" if it exceeds the greater of 10 percent of the tax required to be shown on the taxpayer's return for the taxable year or $5,000 ($10,000 in the case of certain corporations). (35)

2. Application of the "Subtantial Authority"

Exception

Except for tax shelter items, an understatement may be reduced by the portion thereof that is attributable to an item supported by substantial authority. (36) In the case of tax shelter items, (37) it also must be shown that the taxpayer reasonably believed, at the time the return was filed, that the treatment claimed for that item "was more likely than not the proper treatment." (38)

Under the regulations, the "substantial authority" standard is less stringent than a "more likely than not" standard (i.e., a greater than 50 percent likelihood of success if litigated), but more stringent than the "reasonable basis" standard applied to the negligence penalty. The regulations state that a position that is "arguable, but fairly unlikely to prevail in court" complies with the "reasonable basis" standard but not the "substantial authority" standard. (39)

Substantial authority exists if the weight of authorities supporting the tax treatment of an item "is substantial in relation to the weight of authorities supporting contrary tax treatment." (40) The weight of an authority depends on its relevance, persuasiveness, and source. (41) Substantial authority may exist for more than one position on an item. In addition, substantial authority may exist despite the absence of certain types of authority. Accordingly, a taxpayer may have substantial authority for a position tht is "supported only by a well-reasoned construction of the applicable statutory provision." (42)

The regulations broaden the list of authorities upon which taxpayers may rely to include the authorities described in the legislative history of the 1989 Act. Private letter rulings, however, constitute authority only if issued after October 31, 1976, whereas AODs and GCMs constitute authority only if issued after March 12, 1981. (43) For returns due (without regard to extensions) after December 31, 1982, and before January 1, 1990, taxpayers may rely on either the new, expanded list of authorities or the prior, narrower list. (44)

In response to several comments, the regulations clarify that an authority ceases to be an authority to the extent it is overruled or modified, explicitly or implicitly, by a body with the power to overrule or modify that authority. (45) The regulations note that a Tax Court opinion generally is not considered overruled or modified by a court of appeals decisions to which the taxpayer does not have a right of appeal unless the Tax Court specifically adopts the decision. A private letter ruling ceases to be authority if it is revoked or is "inconsistent with a subsequent proposed regulation, revenue ruling or other administrative pronouncement published in the Internal Revenue Bulletin." (46)

Finally, the regulations provide that, in the absence of certain enumerated events (e.g., the ommission of material facts), a taxpayer has substantial authority for the tax treatment of an item if such treatment is supported by a ruling or determination letter issued directly to the taxpayer, a technical advice memorandum in which the taxpayer is named, or an affirmative statement in a revenue agent's report for a prior taxable year of the taxpayer. (47)

No penalty is imposed if substantial authority exists either at the time the taxpayer's return is filed or on the last day of the taxpayer's taxable year. (48) Thus, a taxpayer might have substantial authority if its return position is based on a case decided prior to the close of the taxable year at issue even if that case is overruled after the close of the taxable year but before the taxpayer files its return.

With respect to tax shelter items, a taxpayer is considered to reasonably believe that the tax treatment of an item is more likely than not the proper treatment if, after analyzing the pertinent facts and authorities, the taxpayer (or the taxpayer's professional tax advisory) concludes that there is a greater than 50-percent likehood of success if challenged by the IRS. (49) The test is imposed at the entity level in the case of pass-through entities. (50)

3. Other Exceptions to the Substantial

Understatement Penalty

Except for tax shelter items, the penalty for substantial understatement generally does not apply to the extent the taxpayer makes adequate disclosure. In addition, the penalty does not apply (including with respect to tax shelter items) to the extent the taxpayer had reasonable cause for the position taken and acted in good faith. Both of these exceptions are discussed in Part III. F.

D. Substantial and Gross Valuation Misstatements

1. General Rule

A valuation misstatement is "substantial" if the value or adjusted basis of any tangible or intangible property claimed on a return is 200 percent or more of the correct amount. (51) A "gross" valuation misstatement (subject to the 40-percent penalty rule) exists if the valuation is 400 percent or more of the correct amount. (52) If property has an actual value or adjusted basis of zero, any different amount reported on the return is deemed to constitute a gross valuation misstatement. (53) No penalty will be imposed unless the underpayment attributable to both substantial and gross valuation misstatements exceeds $5,000 ($10,000 for C corporations other than personal holding companies).

The regulations provide that the determination whether a substantial or gross valuation misstatement exists is made on a property-by-property basis. (54) Nevertheless, the determination whether the applicable dollar limitation (i.e., $5,000 or $10,000) applies is made on an aggregate basis, by combining all portions of an underpayment for the year that are attributable to substantial or gross valuation misstatements. (55) In the case of a pass-through entity, the determination whether there is a substantial or gross valuation misstatement is made at the entity level, but the dollar limitation is applied at the taxpayer (e.g., partner) level. (56)

The regulations provide that the penalty applies to returns due after December 31, 1989, even though the original valuation misstatement was made on an earlier return due (without regard to extensions) before January 1, 1990. (57)

2. Exceptions

The penalty for valuation misstatements does not apply to the extent the taxpayer had reasonable cause for the position taken and acted in good faith. See Part III. F. No disclosure exception applies to this penalty. (58)

E. Application of the Accuracy-Related Penalties

in the Context of Carrybacks and Carryovers

The regulations provide tough rules for the application of the three previously described accuracy-related penalties in the context or carrybacks and carryovers. (59) The penalty for negligence or disregard or rules or regulations may be imposed on any underpayment for a year to which a loss, deduction or credit is carried, to the extent such underpayment is attributable to negligence or disregard of rules or regulations in the year in which the carryback or carryover item arose (the "loss or credit year"). (60)

Similarly, the penalty attributable to a substantial understatement may be imposed on any underpayment for a year to which a loss, deduction or credit is carried, to the extent such underpayment is attributable to a "tainted item" in the loss or credit year. A "tainted item" generally is any item with respect to a loss or credit year that lacks substantial authority or adequate disclosure. (61) In the case of a tax shelter authority and a reasonable belief that the tax treatment is more likely than not the proper treatment. (62) Whether an understatement is substantial is determined by references to the return for the carryback year. (63)

Finally, the penalty attributable to a substantial or gross valuation misstatement may be imposed on any underpayment for a year to which a loss, deduction or credit is carried, to the extent that (i) such underpayment is attributable to a substantial or gross valuation misstatement in the loss or credit year, and (ii) the applicable dollar limitation is satisfied in the carryback or carryover year. (64)

Transitional rules are provided under each of the three penalty provisions for carrybacks to pre-1990 years. (65) These rules make clear that the applicable penalty applies to any part of an underpayment for a carryback year for which the return is due (without regard to extensions) before January 1, 1990, provided that such part is attributable to proscribed conduct (i.e., negligence, a substantial understatement, or a valuation misstatement) in a loss or credit year for which the return is due (without regard to extensions) after December 31, 1989.

F. Avoiding the Accuracy-Related Penalty

1. Reasonable Cause and Good Faith

The negligence, substantial understatement, and substantial (or gross) valuation misstatement penalties do not apply to any portion of an underpayment with respect to which the taxpayer had reasonable cause and acted in good faith. (66) This exception is applied on a case-by-case basis and requires a review of "all pertinent facts and circumstances." (67) According to the regulations, the most important consideration "is the extent of the taxpayer's effort to assess the taxpayer's proper tax liability." (68) In addition, the regulations provide the following guidance:

Circumstances that may indicate reasonable cause and good faith include an honest misunderstanding of fact or law that is reasonable in light of the experience, knowledge and education of the taxpayer. An isolated computational or transcriptional error generally is not inconsistent with reasonable cause and good faith. Reliance on an information return or on the advice of a professional (such as a appraiser, attorney or accountant) does not necessarily demonstrate reasonable cause and good faith. Similarly, reasonable cause and good faith is not necessarily indicated by reliance on facts that, unknown to the taxpayer, are incorrect. Reliance on an information return, professional advice or other facts, however, constitutes reasonable cause and good faith if, under all the circumstances, such reliance was reasonable and the taxpayer acted in good faith. (69)

2. Adequate Disclosure

The negligence and substantial understatement penalties -- but not the substantial (or gross) valuation misstatement penalty -- generally may be avoided by adequate disclosure on the taxpayer's return. In several cases, however, the adequate disclosure exception will not be available. First, the adequate disclosure exception does not apply if the taxpayer's position is frivolous. (70) A position is frivolous if it is "patently improper." (71) Second, the exception does not apply if the taxpayer fails to keep adequate books and records or does not properly substantiate items. (73) Third, with respect to the penalty for negligence or disregard of rules or regulations, the disclosure exception does not apply if the taxpayer's position is contrary to a regulation and does not represent "a good faith challenge to the validity of the regulation." (73) Fourth, with respect to the substantial understatement penalty, the exception does not apply to items or positions attributable to a tax shelter. (74)

A taxpayer's position is adequately disclosed if made on Form 8275 (or, in the case of a position contrary to a regulation, on Form 8275-R (75)) and attached to the taxpayer's return or qualified amended return. (76) If the taxpayer's position is contrary to a rule or regulation, the rule or regulation must be adequately identified. (77) Special disclosure rules apply with respect to recurring items, carrybacks and carryovers, and pass-through entities. (78)

IV. THE FINAL REGULATIONS AS A

REFLECTION OF CONGRESSIONAL

INTENT

For the most part, the regulations implement the statutory provisions enacted in 1989 in a manner consistent with the congressional intent. In several areas in which the regulations could have turned in the direction of simplicity, fairness or clarity, however, a different choice was made. The preamble to the final regulations explains the rationale underlying these choices, and addresses point-by-point many of the public comments on these issues. A few examples are set forth below.

First, both the 1989 Act and its legislative history emphasize the importance of standardized exception criteria. The primary purpose of these criteria is clear: Congress wished to ensure that taxpayers could easily understand the standards required to avoid a penalty. The standards of reasonable care and good faith that are embodied in the standardized criteria have been present in the Code for more than 70 years.

The regulations generally comply with the concept of standardized exception criteria, but unique standards are applied in certain circumstances. For example, the regulations implementing the new negligence penalty provide a special rule for return positions contrary to a revenue ruling or notice -- such positions must have a "realistic possibility of success" in order to avoid the penalty. (79) Similarly, a taxpayer taking a position contrary to a regulation can avoid the negligence penalty through disclosure only if the taxpayer's position constitutes a "good faith challenge" to the regulation. This apparently is intended to be a higher standard than the general requirement that the position not be frivolous. (80)

Second, the regulations contain four limited examples of circumstances in which negligence is "strongly indicated." Once a decision was made to offer specific regulatory examples, a broader, more widely applicable set of examples (as was urged by commentators) would have been desirable. (81)

Third, the statutory presumption of negligence in the case of a failure to report amounts shown on information returns was repealed by the 1989 Act, albeit with a qualification in the legislative history. The regulations effectively replace the statutory presumption with a regulatory pressumption -- negligence is "strongly indicated" by such a failure. Although this rule was authorized by the legislative history, it is questionable whether tax administration is best served by the regulation. Granted, the integrity and effectiveness of the information matching program is vital to sound tax administration, and the regulatory presumption could be viewed as furthering those goals. An aggressive regulatory provision such as this one, however, could provoke an equally aggressive legislative response, the net effect of which could be an impairment of the integrity and effectiveness of the matching system. For example, a provision in the recently proposed Taxpayer Bill of Rights would require the IRS to corroborate any failure to report an amount on an information return before determining a tax deficiency. (82)

Fourth, the regulations restrict the use of IRS written determinations for purposes of the substantial authority exception to the maximum extent permitted by the legislative history. For example, the legislative history states that Treasury regulations may (but are not required to) provide that private letter rulings issued prior to the date they became publicly disseminated are not substantial authority. (83) Immediately after authorizing such a restriction, however, the legislative history states:

Any such limitation should, however, be as narrow as practicable, in order to further the committee's general intent that the list of authorities on which taxpayers may rely should be broadened. (84)

The regulations implement the restriction specifically authorized by the legislative history and go further. Only private letter rulings issued after October 31, 1976, and AODs and GCMs issued after March 12, 1981, may be cited as substantial authority, (85) and a written determination "more than 10 years old generally is accorded very little weight." (86) Further, the regulations provide that a private letter ruling constitutes no authority whatsoever if it is "inconsistent with a subsequent proposed regulation, revenue ruling or other administrative pronouncement published in the Internal Revenue Bulletin." (87)

These restrictions on the status of private letter rulings as authority are unfortunate, since such rulings often are the only guidance on point. If the only authority is a well-reasoned private letter ruling issued on October 31, 1976, it should count for something, and a ruling issued more than 10 years ago should not suffer demerits solely for that reason. The rule that private letter rulings do not constitute authority if inconsistent with subsequent IRS guidance is similarly ill-advised. Determinations of consistency may be highly subjective, and should not constitute an independent basis for disregarding a ruling. (88) This rule is particularly harsh where the ruling merely is inconsistent with a notice of proposed rulemaking. A proposed regulation is not law, and while it may reflect changes in the law since the private letter ruling was issued (thereby perhaps affecting the weight accorded the ruling), it should not, of itself, cause the prior ruling to be struck from the list of authorities. (89) Taken together, the restrictions on the use of IRS determinations as authority are inconsistent with the spirit of the 1989 Act.

Finally, the penalty for valuation misstatements applies -- at the 40 percent rate -- if property with a zero value or basis is reported as having any value (assuming that the applicable $5,000 or $10,000 limitation is exceeded). As a consequence of this rule, the formidable penalty for gross valuation misstatements will apply in many cases in which the 400 percent requirement is satisfied only because zero value or basis property is involved. The preamble explains this rule, as follows:

Some commentators argued that treating all valuation misstatements with respect to zero value or basis property as gross valuation misstatements is too harsh. However, this approach is consistent with the principle inherent in the statute that relatively greater misstatements are subject to penalty at a higher rate, as well as with the statutory language, and is, therefore, retained in the final regulations. (90)

An exception for zero value or basis property could have been crafted and, although not specifically mandated by the Act, would have been a sensible and prudent rule.

V. CONCLUSION

The penalty regulations generally are faithful to the principles of penalty reform as described in the 1989 Act and its legislative history. In certain cases, however, the regulations could have provided more specific guidance or adopted more liberal rules in furtherance of the underlying legislative objectives of simplifying the penalty scheme, improving administration of the penalties, and discouraging routine and automatic assessment of penalties by the IRS.

Notes

(1) T.D. 8381, 56 Fed. Reg. 67,942 (1991).

(2) Unless otherwise indicated, all section references herein are to the Internal Revenue Code of 1986, as amended (the "Code"), or to the Treasury regulations promulgated thereunder.

(3) Pub. L. No. 239, 101st Cong., 1st Sess. (1989).

(4) Revenue Act of 1918, [subsection] 250(b).

(5) Regulations 62, Art. 1005(2), Revenue Act of 1921.

(6) I.R.C. [subsection] 6653(a) (prior to amendment); Treas. Reg. [subsection] 301.6653-1(a) (prior to amendment).

(7) Economic Recovery Tax Act of 1981 (ERTA), Pub. L. No. 97-34, [subsection] 722(b)(1).

(8) ERTA [subsection] 722(a)(1).

(9) Tax Equity and Fiscal Responsibility Act of 1982, Pub. L. No. 97-248, [subsection] 323(a).

(10) Deficit Reduction Act of 1984, Pub. L. No. 98-369, [subsection] 145(c)(2)(A).

(11) Tax Reform Act of 1986, Pub. L. No. 99-514, [subsection] 1138(c).

(12) In some cases, however, the penalty for valuation misstatements is increased to 40 percent. See notes 52-53 and accompanying text.

(13) An "underpayment" is the amount by which any tax exceeds the excess of (i) the amount of tax shown on the taxpayer's return, plus (ii) amounts not shown as tax that were previously assessed (or collected without assessment), over (iii) the amount of any rebates. I.R.C. [subsection] 6664(a).

(14) If the fraud penalty under section 6663 is imposed on any portion of an underpayment, the accuracy-related penalty will not also apply to that portion.

(15) I.R.C. [subsection] 6664(c).

(16) H.R. Rep. No. 247, 101st Cong., 1st Sess. 1392-93 (1989) (1989 House Report).

(17) Despite the apparent unfairness, this result was upheld by the courts. Commissioner v. Asphalt Products Co., 482 U.S. 117 (1987).

(18) 1989 House Report at 1389.

(19) Id. at 1390 (emphasis supplied).

(20) Id. at 1390 n.79 (emphasis supplied).

(21) In 1990, the substantial valuation misstatement penalty was extended to certain "net section 482 transfer price adjustments," as defined in section 6662(e)(3). The regulations reserve guidance on this provision.

(22) 1989 House Report at 1391.

(23) See, e.g., Tax Executives Institute, Comments on Proposed Regulations Under Sections 6662 and 6664 of the Internal Revenue Code (May 13, 1991); American Bar Association Civil Penalties Task Force of the Section of Taxation, Comments Concerning Proposed Regulations Under Code Sections 6662, 6664 and 6694 of the Internal Revenue Code of 1986 (June 3, 1991); New York State Bar Association Tax Section Committee on Compliance and Penalties, Report on Proposed Regulations Relating to the Accuracy-Related Penalty (September 10, 1991).

(24) Treas. Reg. [subsection] 1.6662-2(c). The regulations properly provide, however, that both the accuracy-related penalty and the penalty for failure to file a return (section 6651) may be imposed on the same portion of an underpayment. Treas. Reg. [subsection] 1.6662-2(a). As previously noted, however, the same portion of an underpayment cannot be subject to both the accuracy-related penalty and the fraud penalty. The accurary-related penalty applies only if a return has been filed. I.R.C. [subsection] 6664(b); 1989 House Report at 1393-94.

(25) Treas. Reg. [subsection] 1.6662-2(d).

(26) Specifically, the regulations will not be applied adversely to such returns to the extent that the provisions of such regulations "were not reflected in" the 1989 Act, Notice 90-20, 1990-1 C.B. 328, or rules and regulations consistent with the 1989 Act that were in effect before March 4, 1991 (i.e., before the proposed regulations under section 6662 were published).

(27) Treas. Reg. [subsection] 1.6662-3(b)(1).

(28) Treas. Reg. [subsection] 1.6662-3(b)(1)(ii). Although several comments objected to the "too good to be true" formulation, the regulations retain the formulation on the grounds that it represents a typical form of negligent behavior and has been used by courts to describe negligence.

(29) Treas. Reg. [subsection] 1.6662-3(b)(1)(iii), (iv).

(30) Treas. Reg. [subsection] 1.6662-3(b)(2).

(31) Id.

(32) Id.

(33) Id. The realistic possibility of success standard is defined, by reference to Treas. Reg. [subsection] 1.6694-2(b)(1) (relating to the return preparer penalty):

A position 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 (realistic possibility standard).

Neither the "negligence" nor the "disregard" prong of the penalty applies if the taxpayer complies with this "realistic possibility" exception. See Treas. Reg. [subsection] 1.6662-3(a). The IRS specifically considered, but rejected, the suggestion that the penalty should be waived if the taxpayer's position contrary to a revenue ruling or notice has a "reasonable basis" (a formulation utilized for purposes of the negligence prong of the penalty). Preamble, T.D. 8381, 56 Fed. Reg. 67,492, 67,494 (1991).

(34) Treas. Reg. [subsection] 1.6662-4(b)(2).

(35) Treas. Reg. [subsection] 1.6662-4(b)(1).

(36) Treas. Reg. [subsection] 1.6662-4(a).

(37) A "tax shelter" is defined as any plan or arrangement the principal purpose of which is to avoid or evade federal income tax. Treas. Reg. [subsection] 1.6662-4(g)(2)(i). An item is a "tax shelter item" if it is directly or indirectly attributable to that principal purpose. Treas. Reg. [subsection] 1.6662-4(g)(3). A "principal purpose" is a purpose that exceeds any other purpose. Treas. Reg. [subsection] 1.6662-4(g)(2)(i). The regulations provide, however, that a purpose to obtain a tax benefit "in a manner consistent with the statute and Congressional purpose" is not considered a tax avoidance or evasion purpose. Treas. Reg. [subsection] 1.6662-4(g)(2)(ii).

(38) Reas. Reg. [subsection] 1.6662-4(g)(1) (emphasis added).

(39) Treas. Reg. [subsection] 1.6662-4(d)(2).

(40) Treas. Reg. [subsection] 1.6662-4(d)(3)(i).

(41) Treas. Reg. [subsection] 1.6662-4(d)(3)(ii).

(42) Id.

(43) Treas. Reg. [subsection] 1.6662-4(d)(3)(iii). GCMs published in pre-1955 volumes of the Cumulative Bulletin, however, constitute authority under the final regulations.

The regulations provide that a private letter ruling, technical advice memorandum, GCM, or AOd "generally is accorded very little weight" if it is over 10 years old. Treas. Reg. [subsection] 1.6662-4(d)(3)(ii). In response to criticism of this rule, the final regulations provide that "the persuasiveness and relevance of a document, viewed in light of subsequent developments, should be taken into account along with the age of the document." Id. (emphasis supplied).

(44) Treas. Reg. [subsection] 1.6662-4(d)(v).

(45) Treas. Reg. [subsection] 1.6662-4(d)(3)(iii).

(46) Id.

(47) Treas. Reg. [subsection] 1.6662-4(d)(3)(iv)(A).

(48) Treas. Reg. [subsection] 1.6662-4(d)(3)(iv)(C).

(49) Treas. Reg. [subsection] 1.6662-4(g)(4).

(50) Treas. Reg. [subsection] 1.6662-4(g)(5).

(51) Treas. Reg. [subsection] 1.6662-5(e)(1).

(52) Treas. Reg. [subsection] 1.6662-5(e)(2).

(53) Treas. Reg. [subsection] 1.6662-5(g).

(54) Treas. Reg. [subsection] 1.6662-5(f)(1).

(55) Treas. Reg. [subsection] 1.6662-5(f)(2).

(56) Treas. Reg. [subsection] 1.6662-5(h).

(57) Treas. Reg. [subsection] 1.6662-5(k).

(58) Treas. Reg. [subsection] 1.6662-5(a).

(59) Treas. Reg. [subsection[ 1.6662-3(d), 1.6662-4(c), 1.6662-5(c).

(60) Treas. Reg. [subsection] 1.6662-3(d)(1).

(61) Treas. Reg. [subsection] 1.6662-4(c)(3)(i).

(62) Treas. Reg. [subsection] 1.6662-4(c)(3)(ii).

(63) Treas. Reg. [subsection] 1.6662-4(c)(1). The regulations also make clear that the amount of an understatement in a carryback year is not reduced by the carryback of a loss, deduction, or credit to such year. Treas. Reg. [subsection] 1.6662-4(c)(2).

(64) Treas. Reg. [subsection] 1.6662-5(c)(1).

(65) Treas. Reg. [subsection] 1.6662-3(d)(2), 1.6662-4(c)(4), 1.6662-5(c)(2).

(66) Treas. Reg. [subsection] 1.6664-4(a).

(67) Treas. Reg. [subsection] 1.6664-4(b).

(68) Id.

(69) Id.

(70) Treas. Reg. [subsection] 1.6662-3(c)(1), 1.6662-4(e)(2)(i).

(71) Treas. Reg. [subsection] 1.6662-3(b)(3).

(72) Treas. Reg. [subsection] 1.6662-3(c)(1), 1.6662-4(e)(2)(iii). It is not clear how this rule interrelates with the record maintenance requirements of sections 6038A and 6038C. See Treas. Reg. [subsection] 1.6038A-3.

(73) Treas. Reg. [subsection] 1.6662-3(c)(1). It is not clear why this provision was made applicable only to the negligence penalty. Of course, a position contrary to a regulation that is not taken in good faith may be frivolous as well, and therefore expressly excluded from the adequate disclosure exception for purposes of the substantial understatement penalty.

(74) Treas. Reg. [subsection] 1.6662-4(e)(2)(ii).

(75) The preamble specifies that Form 8275 (with appropriate modification) is to be used for this purpose until Form 8275-R is made available. 56 Fed. Reg. at 67,494. It is anticipated that Form 8275-R will be made available at the end of May 1992.

(76) Treas. Reg. [subsection] 1.6662-3(c)(2), 1.6662-4(f)(1). See Treas. Reg. [subsection] 1.6664-2(c)(3) (defining qualified amended return).

(77) Treas. Reg. [subsection] 1.6662-3(c)(2). Although this rule presumably applies for purposes of both the negligence and substantial understatement penalties, it is expressly stated only in the context of the negligence penalty.

(78) Treas. Reg. [subsection] 1.6662-3(c)(2), 1.6662-4(f)(3)-(5).

(79) Treas. Reg. [subsection] 1.6662-3(a). The IRS justified this rule on the grounds that it was beneficial to taxpayers, and that the statute did not require any such exception to the penalty for disregard of a revenue ruling. 56 Fed. Reg. at 67,494. It is questionable how beneficial this rule is, given that the less stringent reasonable cause and good faith exception is available to prevent the imposition of the penalty for disregard of any rule or regulation. Presumably, the IRS considered the special rule for revenue rulings helpful to taxpayers since, if it applied, the threshold requirement of "disregard" would not be satisfied and there would be no ned to resort to the reasonable cause (or disclosure) exception. In practice, however, the "realistic possibility" standard likely will lead to interpretational disputes. An examining agent or court could easily question whether the general exception for reasonable cause was inteded to apply where a taxpayer's position contrary to a revenue ruling failed to satisfy the specific "realistic possibility" exception.

(80) The preamble states that this special ule for disclosure of positions contrary to regulatiosn was added because such disclosure is important to "the self-assessment system" and because the legislative history contemplated a good faith limitation on the disclosure exception. Id. Actually, the legislative history is ambiguous on this point, and reasonably could be construed to equate a "good faith challenge" to a "non-frivolous challenge." See 1989 House Report at 1393. Simplicity would have been gained a little loss to the self-assessment system or to the dictates of the legislative history by simply relying on the "non-frivolous" limitation for this purpose.

(81) For example, the New York State Bar suggested: "Examples should be derived from the multitude of cases which deal with the negligence penalty in the context of a failure to report income, the overstatement of a deduction, large discrepancies between actual and reported income, a failure to keep adequate records, and the burden of proof necessary for a taxpayer to overcome the assertion of negligence." New York State Bar Association Tax Section Committee on Compliance and Penalties, Report on Proposed Regulations Relating to the Accuracy-Related Penalty (September 10, 1991).

(82) H.R. 4287, 102d Cong., 2d Sess., [subsection] 5153 (1992). See Portillo v. Commissioner, 932 F.2d 1128, 1134 (5th cir. 1991) (IRS deficiency notice based on taxpayer failure to report an item shown on a Form 1099 held clearly arbitrary and capricious where the filer of the Form 1099 was unable to document cash payments allegedly made to the taxpayer; the IRS held to have a duty to investigate the "bald assertion of payment" under these circumstances).

(83) 1989 House Report at 1390 n.79.

(84) Id.

(85) Treas. Reg. [subsection] 1.6662-4(d)(3)(iii).

(86) Treas. Reg. [subsection] 1.6662-4(d)(3)(ii). Of course, taxpayers also may benefit from the exclusion of private rulings issued before November 1, 1976, since that huge volume of material -- which is virtually impossible for taxpayers to research without computer assistance -- also cannot be used by IRS to challenge a taxpayer's claim of substantial authority.

(87) Treas. Reg. [subsection] 1.6662-4(d)(3)(iii).

(88) A similar concern arises in the context of the exception, under the tax shelter rules, for cases in which the taxpayer's purpose is to secure a benefit "in a manner consistent with the state and Congressional purpose." Treas. Reg. [subsection] 1.6662-4(g)(2)(ii) (emphasis supplied). Whether a result authorized by a statute also is consistent with the congressional purpose underlying the statute may be extremely difficult to determine and, at least generally, should be irrelevant. A common rule of statutory construction is that a review of the legislative history is unwarranted if the result is clear on the face of the statute.

(89) The preamble is somewhat disingenuous in explaining the rule on proposed regulations, stating that "[i]t is not appropriate to retain as an authority a document that does not accurately reflect the current status of the law and position of the Service." 56 Fed. Reg. at 67,495-96. A proposed regulation may or may not reflect current law; one reason for issuing proposed regulations is to obtain public comment in order to ensure that the proposal is consistent with the Code. Furthermore, a proposed regulation is, by definition, only a proposed position of the IRS.

(90) Id. at 67,496.

ALLAN W. GRANWELL is a tax partner at Cadwalader, Wickersham & Taft, and specializes in international taxation. From 1981 to 1984, Mr. Granwell was with the U.S. Treasury Department serving as International Tax Counsel and Director of the Office of International Tax Affairs.

DUANE H. PELLERVO is a tax partner at Cadwalader, Wickersham & Taft. Mr. Pellervo practices primarily in the corporate and insurance tax areas. From 1981 to 1985, he was an attorney in the corporate tax branch of the former Legislation and Regulations Division, Office of Chief Counsel, Internal Revenue Service.

MICHAEL QUIGLEY is an associate with Cadwalader, Wickersham & Taft. He specializes in tax controversy work, including civil tax litigation. Mr. Quigley was a trial attorney with the Tax Division of the U.S. Department of Justice from 1983 at 1987.

EDWIN P. GEILS has been an associate with Cadwalader, Wickersham & Taft since 1988.
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Date:Mar 1, 1992
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