Impact of IRM change on disclosure to avoid sec. 6662(d) penalty.
Disclosure may be made on Form 8275, Disclosure Statement, or Form 8275-R, Regulation Disclosure Statement; alternatively, in certain circumstances disclosure is considered to have been made on the return with respect to items specifically listed in Rev. Proc. 95-55. Rev. Proc. 95-55 updates Rev. Proc. 94-74 in identifying circumstances when disclosure of an item on a taxpayer's return will avoid the substantial understatement penalty under Sec. 6662 (d). Disclosure under Rev. Proc. 95-55 may be preferred by many taxpayers, particularly in light of revisions to the Internal Revenue Manual (IRM) (dated July 24, 1995). The revisions provide for new internal processing procedures for individual returns with Forms 8275 attached (see Tax Clinic, "Form 8275 Disclosure May Lead to Additional Scrutiny," TTA, Jan. 1996, p. 10).
A substantial understatement of income tax under Sec. 6662 (d) results if the understatement of tax exceeds the greater of 10% of the tax required to be shown on the return for the tax year or $5,000 ($10,000 for a corporation other than an S corporation or a personal holding company). If the tax return position meets the substantial authority standard and is not in disregard of Treasury rules or regulations, the substantial understatement penalty will not apply. Substantial authority is defined under Regs. Sec. 1.66624 (d) (2) as less stringent than a "more likely than not" standard (which is a greater-than-50% likelihood of being upheld in litigation), but stricter than a reasonable basis standard. If the tax return position lacks substantial authority, disclosure of the relevant facts affecting the tax treatment of that item must be made in order to avoid the 20% substantial understatement penalty.
In order for the taxpayer to be protected from penalty by disclosure, the position must at least meet the reasonable basis standard. The Omnibus Budget Reconciliation Act of 1993 (OBRA) replaced the "not frivolous" disclosure standard under prior law with the reasonable basis standard. Reasonable basis was previously defined under Regs. Sec. 1.6661-3 (a) (2) as a return position that is "arguable, but fairly unlikely to prevail in court." Notwith-standing this prior Treasury definition, the legislative history of the OBRA disclosure standard indicates that Congress intended that "reasonable basis" should be viewed as "a relatively high standard of tax reporting." Thus, recently amended Regs. Sec. 1.66623 (b) (3), while reserving a general definition of reasonable basis, has described its relationship to other standards as significantly higher than the not frivolous standard applicable to preparers under Sec. 6694 and defined in Regs. Sec. 1.6694-2 (c) (2) as "not patently improper." Furthermore, the OBRA Conference Report provided that the "reasonable basis" standard is not satisfied "by a return position that is merely arguable or that is merely a colorable claim."
As mentioned, a new IRS processing procedure is now in place for individual returns with Forms 8275 or 8275-R attached. More specifically, IRM 4164.2 provides that individual returns with attached Forms 8275 (or 8275-R) will be identified as "Specials" and screened by the IRS Center where filed for the potential audit significance of the disclosure statement. "Specials" are returns containing certain features identified by the Service in the initial data inputting process for manual screening and review of all return items. Returns selected as a result of this process are forwarded to the district examination function for possible audit selection.
Note: Although the IRM provides guidance only for individual returns with Forms 8275, many practitioners believe that similar procedures eventually will be issued for C and S corporation returns.
Therefore, in light of IRM 4164.2, disclosure of positions having reasonable basis but lacking substantial authority may be more prudently made in accordance with Rev. Proc. 95-55. Under Rev. Proc. 95-55, disclosure is considered adequate if (1) the forms and attachments are completed in a clear manner and in accordance with the instructions, (2) the money amounts entered on the forms are verifiable (i.e., the taxpayer, on audit, can demonstrate the origin of the numbers) and (3) the taxpayer can show good faith in entering that number on the applicable form.
For returns filed on 1995 forms for a tax year beginning in 1995, and for any return filed on 1995 forms in 1996 for short tax years beginning in 1996, disclosure of the following information is considered adequate:
Individual itemized deductions: For individual taxpayers, disclosure on the return is considered adequate for the following 1995 Schedule A itemized deductions:
* Medical and dental expenses.
* State and local income, real estate and other taxes.
* Interest expense.
* Casualty and theft losses.
Certain trade or business expenses: Disclosure is considered adequate for the following trade or business expenses (including these expenses as they relate to the rental of property):
* Casualty and theft losses.
* Legal expenses.
* Specific bad debt charge-off.
* Reasonableness of officers' compensation (except "golden parachute" compensation).
* Repair expenses.
* Taxes (other than foreign taxes).
Corporation book/tax differences: An item clearly identified on Form 1120 Schedule M-1, Reconciliation of Income (Loss) per Books With Income per Return, is adequately disclosed if:
* The amount of the deviation from the financial books and records is not the result of a computation that includes the netting of items, and
* The information provided may reasonably be expected to apprise the IRS of the nature of the potential controversy concerning the tax treatment of the item.
Other items: The following additional items are considered adequately disclosed if the appropriate form is completed and attached to the return:
* Sale or exchange of home (Form 2119).
* Employee business expenses (Form 2106).
* Fuels credit (Form 4136).
* Investment credit (e.g., rehabilitation credit) (Form 3468).
* Moving expenses (Form 3903).
Foreign tax items: The following foreign tax items are covered in Rev. Proc. 95-55:
* International boycott transactions disclosed on Form 5713.
* Certain intercompany transactions shown on Schedule M (Form 5471), Transaction Between Controlled Foreign Corporation and Shareholders or Other Related Persons, and on Form 5472, Part IV, Monetary Transactions Between Reporting Corporations and Foreign Related Party.
Note: Rev. Proc. 95-55 applies only to disclosure of an item or a position taken on a return for purposes of eliminating the substantial understatement penalty or avoiding the preparer penalty for understatements due to unrealistic positions. Such disclosure will not constitute adequate disclosure to avoid imposition of the penalty for disregard of the rules or regulations (such disclosure must be made on either Form 8275 or Form 8275-R) or substantial valuation misstatements. (Discussion of both the preparer penalty of Sec. 6694 and the penalty for negligence or disregard of the rules is beyond the scope of this item.)
Finally, Regs. Sec. 1.6664-2 (c) (3) provides that a qualified amended return may be filed solely to make disclosure to avoid substantial understatement and disregard of rules or regulations penalties. Therefore, in limited situations taxpayers may wish to delay disclosure. For example, generally, coordinated examination program (CEP) taxpayers may file "a qualified amended return" with disclosure within 15 days after written notice from the IRS requesting that a qualified amended return be furnished (see Rev. Proc. 94-69 for further details). Caution: If a non-CEP taxpayer is contacted by the Service for an examination before the taxpayer discloses a given position, it is too late to disclose on a qualified amended return.
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|Title Annotation:||Internal Revenue Manual|
|Author:||Tutoki, Christopher R.|
|Publication:||The Tax Adviser|
|Date:||Jul 1, 1996|
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