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Proposed accuracy-related penalty regulations.

On February 28, 1991, the Internal Revenue Service issued proposed regulations under sections 6662 and 6664 of the Internal Revenue Code, concerning the accuracy-related penalty for substantial understatements of income tax, for negligence or disregard of rules and regulations, and for substantial valuation misstatements. The proposed regulations (IA-015-90) were published in the Federal Register on March 4, 1991 (56 Fed. Reg. 8959), and in the April 1, 1991, issue of the Internal Revenue Bulletin (1991-13 I.R.B. 24). (1)


Tax Executives Institute is the principal association of corporate tax executives in North America. Our more than 4,700 members represent approximately 2,000 of the leading corporations in the United States and Canada. TEI represents a cross=section of the business community, and is dedicated to the development and effective implementation of sound tax policy, to promoting the uniform and equitable enforcement of the tax laws, and to reducing the cost and burden of administration and compliance to the benefit of taxpayers and government alike. As a professional association, TEI is firmly committed to maintaining a tax system that works -- one that is administrable and with which tax-payers can comply.

TEI members are responsible for managing the tax affairs fo their companies and must contend daily with the provisions of the tax law relating to the operation of business enterprises. We believe that the diversity and professional training of our members enable us to bring an important, balanced, and practical perspective to the issues raised by the proposed regulations sections 6662 and 6664 of the Code.


As part of the Omnibus Budget Reconciliation Act of 1989, Congress enacted the Improved Penalty and Compliance Tax Act. The 1989 Act revised and streamlined several penalty provisions of the Internal Revenue Code, consolidating them into a new section 6662. The changes were made because Congress believed that the Code's myriad penalties caused confusion among taxpayers and led to difficulties in administration by the IRS. H.R. Rep. No. 101-247, 101st Cong., 1st Sess. 1388 (1989) (hereinafter cited as the "House Report").

Tax Executives Institute was pleased to have participated in the process that gave rise to the penalty reform legislation and sincerely believes that the 1989 Act, even with its flaws, represents a marked improvement over prior law. As Congress and the IRS itself acknowledged during the legislative process, however, the proof of penalty reform is in its implementation: the richest-looking pudding must be rejected if its taste is so bitter that it is impossible to eat. In other words, the statutory provisions must be interpreted in balanced and reasonable regulations, and then those regulations must be applied fairly and evenhandledly by the IRS in a manner consistent with legislative intent.

TEI believes that the proposed regulations represent a good first step in the penalty-reform implementation process. We submit, however, that the regulations require modification in several respects. In the following comments, we address our recommended changes to the regulations relating to (i) the reasonable cause and good faith provision of section 6664(c); (ii) the prescribed form of disclosure under section 6662(d)(2)(B); (iii) the definition of authority for purposes of the substantial authority provision of section 6662(d)(2)(B); (iv) the special rules under section 6664(c)(2), relating to the assertion of penalties in respect of charitable deduction property; and (v) the scope of the revised negligence penalty under section 6662(c). In addition, we address certain issues not covered by the proposed regulations: the requirement that the IRS issue a "Secretarial list" of positions not enjoying substantial support; the inchoate implementation of the "administrative recommendations" set forth in the legislative history; and the need to issue regulations under section 6662(e), relating to the penalty for net section 482 transfer pricing adjustments.

Prop. Reg. [section] 1.6664-4(b): The

Scope and Purpose of the

Reasonable Cause Exception

1. Background. New section 6662(b) imposes a 20-percent penalty on an underpayment that is attributable to (1) negligence, (2) any substantial understatement of income tax, (3) any substantial valuation overstatement, (4) any substantial overstatement of pension liabilities, and (5) any substantial estate or gift tax valuation understatement. The accuracy-related penalty does not apply to understatements of tax for which there is substantial authority or to which the relevant facts affecting an item's tax treatment are adequately disclosed in the return or in a statement attached to the return. I.R.C. $S 6662(d)(2)(B). In addition, under section 6664(c) of the Code, no penalty will be imposed with respect to an underpayment if there was reasonable cause and the taxpayer acted in good faith.

2. Context of New Section 6664(c). The importance of a properly construed section 6664(c) to penalty reform should not be devalued. Under prior law, the IRS had authority to waive the substantial understatement penalty where reasonable cause existed, but a taxpayer had no statutory right to such a waiver. As a result, taxpayers were not infrequently confronted with the argument that an IRS refusal to grant a waiver could be overturned only where the IRS's decision was arbitrary and capricious. (2) New section 554(c) seeks to remedy this situation by according taxpayers a statutory right not to have the penalty asserted where the reasonable cause and good faith standards are satisfied.

Specifically, the reasonable cause exception was enacted as part of the 1989 Act because of Congress's concern that the prior penalties (especially the substantial understatement penalty) were being unevenly and unfairly asserted by the IRS. The House Report on the bill provides in pertinent part:

The committee is concerned that the present-law accuracy-related penalties (particularly the penalty for substantial under-statement 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.

In addition, the committee has designed this standardized exception criterion to provide greater scope for judicial review of IRS determinations of these penalties. . . . The committee believes that providing greater scope for judicial review of IRS determinations of these penalties will lead to greater fairness of the penalty structure and minimize inappropriate determinations of these penalties.

House Report at 1393. In addition, in its administrative recommendations to the IRS, Congress enjoined the IRS to change its approach in applying the penalty provisions: "In the application of penalties, the IRS should make a correct substantive decision in the first instance rather than mechanically assert penalties with the idea they will be] corrected later." House Report at 1405.

Thus, Congress concluded that the IRS had under prior law asserted penalties too routinely and automatically. By statutorily requiring the IRS to consider whether reasonable cause and good faith existed before asserting a penalty, Congress signalled its desire for the IRS to avoid a "gotcha" mentality and to apply the reasonable cause exception in a flesible, rational, and balanced manner. It is critical that the regulations forthrightly acknowledge this signal; otherwise, IRS field personnel may assume that, notwithstanding the statutory reconfiguration of the accuracy-related penalty, they can continue with "business as usual." Regrettably, we believe the proposed regulations are inadequate to achieve this purpose. Indeed, at best, they send a mixed message to taxpayers and IRS field personnel.

3. The Shortcomings of the Proposed Regulations. The proposed regulations properly recognize that the reasonable cause exception must be made on a case-by-case basis taking into account all pertinent facts and circumstances. For this purpose, the regulations provide that the most important factor to be considered is the extent of the taxpayer's effort to self-assess his proper tax liability. Circumstances that may indicate reasonable cause include an honest misunderstanding of fact or law taking into account the taxpayer's experience, knowledge, and education. The regulations also recognize that an "isolated computational or transcriptional error" is generally not a basis for imposition of the penalty. Prop. Reg. $S 1.6664-4(b).

With respect to the application of the reasonable cause exception in a corporate setting, Prop. Reg. $S 1.6664-4(b) provides:

For example, reliance on erroneous information (such as an error relating to the cost or a djusted basis [1] of property, the date property was placed in service, or the amount of opening or closing inventory) inadvertently included in data compiled by various divisions of a multidivisional corporation or in financial books and records prepared by those divisions generally indicates [2] reasonable cause and good faith, provided the corporation employed [3] internal controls and procedures, reasonable under the circumstances, that were designed to identify such [4] factual errors.

The quoted language is taken virtually verbatim from the old regulations under section 6661 of the Code. (3) See Treas. Reg. $S 1.6661-6(b). We submit that the mere parroting of prior regulatory language is insufficient to effectuate Congress's desire to expand the reasonable cause exception. (4)

On its face, the example in the old section 6661 regulations suggested that the IRS recognized that there is no way that a large corporation's tax personnel can review each and every one of the literally millions of transactions to determine whether its treatment is accurate. Regrettably, there is evidence that the sentiment was not effectively communicated to, or at least emulated by, IRS field personnel in respect of pre-1989 Act law. Thus, in respect of the old regulations, our members report that revenue agents have construed the books-and-records example quite narrowly. For example, some agents have seized upon the word "generally" in the regulations; have argued that the tax department did not "rely" on the information or that the intended relief for erroneous entries in the financial books extended only to records maintained by a corporate division (in contrast to the financial accounting records maintained at corporate headquarters); or have asserted that the operative internal controls cited by the taxpayer were not "reasonable under the circumstances" simply because the error occurred. In light of taxpayer experiences with the field's interpretation of the example in the old section 6661 regulations, we submit that more is needed than merely transporting the example, without any material change, to the proposed regulations.

4. TEI Recommendations. To effectuate legislative intent, the regulations should provide that, in determining whether a taxpayer is entitled to relief under the reasonable cause exception, due weight shall be accorded to the complexity of the rules with which the taxpayer must grapple, as well as to the operational constraints under which taxpayers -- striving in good faith to comply with the tax laws -- must operate. The regulations should expressly confirm that the reasonable cause and good faith standards can be met without requiring the taxpayer to discover all the tax law issues that may exist in respect of its return. The purpose of this clarification is not to immunize a corporate taxpayer from the consequences of the actions of its non-tax-oriented employees, or to encourage a corporate tax department to adopt a Sergeat Schultz-approach ("I see nothing, I know nothing") to its oversight of such employees. Rather, it is to recognize that not every taxpayer error should give rise to a penalty. Thus, a finding of good faith and reasonable cause will never excuse the taxpayer from its liability for the additional' tax and interest with respect to its error; it would simply preclude the assertion of a penalty for non-volitional, non-culpable activity. To our mind's eye, section 6662 remains an essentially behavior=based provision and, consequently, the non-assertion of the penalty (by the operation of section 6664(c)) would be proper where the standards set forth in the text are satisfied.

In determining whether the reasonable cause and good faith standards have been satisfied, the inquiry should focus on whether the taxpayer establishes reasonable business procedures (i.e., acceptable internal controls) to ensure compliance with its obligation and then makes a good faith effort to ensure those procedures are followed. With particular regard to corporate taxpayers, the regulations should acknowledge both that the tax return of a large company will frequently be several thousand pages in length and will encompass literally millions of transactions involving myriad subsidiaries and partnerships (including those not operated by the taxpayer); they should further acknowledge that the financial books and records of the company (on which the tax staff must of necessity rely) are generally reviewed by independent auditors and, in respect of publicly traded companies, prepared pursuant to the Securities Exchange Act of 1934 and the Foreign Corrupt Practices Act. We specifically recommend that the corporate tax example in Prop. Reg. $S 1.6664-4(b) be expanded to provide that the taxpayer will be presumed to have acted with reasonable cause and in good faith. We make this suggestion because of previously cited reports that some IRS field personnel under old section 6661 too quickly decided that the word "generally" gave them broad discretion to conclude that the penalty should be asserted.

Finally, we recommend that the regulations provide that an evaluation of the taxpayer's good faith should be based on the actions (or inactions) of those corporate employees and outside advisers who have responsibility for the corporation's tax affairs. For example, no penalty should be imposed where (i) the corporation establishes reasonable business procedures designed to ensure compliance with the tax laws and takes reasonable steps to ensure that those procedures are followed, but (ii) a non-tax employee fails to implement and adhere to those procedures. Such a clarification in the regulations would serve to effectuate congressional intent that the reasonable cause exception be applied in an evenhanded and fair manner. As the staff of the Joint Committee on Taxation put it in explaining old section 6661:

Congress did not adopt an absolute standard that a taxpayer may take a position on a return only if, in fact, the position reflects the correct treatment of the item because, in some circumstances, tax advisors may be unable to reach so definitive a conclusion. Rather, Congress adopted a more flexible standard under which the courts may assure that taxpayers who take non-disclosed highly aggressive filing positions are subject to the penalty while those whose endeavor in good faith to fairly self-assess are not penalized.

Staff of Joint Committee on Taxation, General Explanation of the Revenue Provisions of the Tax Equity and Fiscal Responsibility Act of 1982 (H.R. 4961, 97th Congress; Public Law 97-248), 97th Cong., 2d Sess. 217-18 (1982) (hereinafter referred to as "1982 General Explanation").

In accordance with the foregoing recommendations, TEI submits that the following language should be added to Prop. Reg. $S 1.6664-4(b):

In the case of a corporation, reasonable cause and good faith is ordinarily present where the tax return is prepared in reliance on the company's independently audited financial books and records prepared pursuant to the Securities Exchange Act of 1934 and the Foreign Corrupt Practices Act, as long as the taxpayer has established reasonable business procedures to ensure compliance with the tax laws and make a good faith effort to comply with those procedures.

Example (8). X is a publicly traded corporation that is subject to the Securities Exchange Act of 1934 and the Foreign Corrupt Practices Act. In compliance with SEC rules, independent accountants audit X's books and records on a annual basis and certify the results; X also consults with the auditors with respect to the financial reporting of all of its material transactions. In conjunction with X's tax staff and its independent auditors, X has established and maintains internal accounting systems designed to accurately track its fixed assets, to report its income and expense items, and to retain those records in the event of an IRS audit. In reliance on X's books and records, X prepared its tax return. Subsequently, certain records cannot be located and X is unable to substantiate deductions on its tax return. Because of the establishment of reasonable business procedures and X's good faith efforts to ensure compliance with those procedures, X has established reasonable cause and good faith that would prevent the application of the negligence penalty for failing to keep adequate books and records or to substantiate items properly.

Example (9). Assume the same facts as in Example (8). One of X's divisions completes the sale of some of X's fixed assets in the ordinary course of business. A divisional employee fails to remove the sold asset from X's fixed asset accounting system. X's tax staff prepares the tax return in reliance on X's books and records, and the return claims a deduction for a full year of depreciation with respect to the sold asset. The excess depreciation deduction results in the underpayment of tax for the year. Because of the establishment of reasonable business procedures and X's good faith efforts to ensure compliance with those procedures, X is deemed to have reasonable cause and to have acted in good faith with respect to the underpayment of tax relating to the excess depreciation deduction.

Prop. Reg. $S 1.6662-4(f):

Adequate Disclosure

Under section 6662(d)(2)(B)(ii), the amount of any understatement is to be reduced by that portion of the understatement attributable to any item with respect to which the relevant facts are adequately disclosed "in the return or in a statement attached to the return." The proposed regulations adopt a highly restrictive interpretation of the adequate disclosure provision. Specifically, Prop. Reg. $S 1.662-4(f) provides that disclosure is adequate for purposes of section 6662(d)(2)(B)(ii) if it is made on a Form 8275 (Disclosure Statement) attached to the return. The regulations continue that the Commissioner may by annual revenue procedure prescribe the circumstances under which disclosure of information on a return is adequate; if the annual procedure does not include an item (or if the Commissioner decides not to even issue the annual revenue procedure), then under the regulations disclosure is adequate only if it is made on the Form 8275.

The adequate disclosure provision of section 6662(d)(2)(B)(ii) was intended to provide taxpayers with a "safe harbor" from the operation of the accuracy-related penalty: if a taxpayer discloses the relevant facts relating to an item, the penalty will not be asserted with respect to that item. The Institute has long believed that, since the provision was intended to provide relief to taxpayers, it should not be construed in a begrudging or unreasonably narrow fashion. As the staff of the Joint Committee on Taxation stated in describing the original substantial understatement penalty in 1982, disclosure will be deemed adequate "if the taxpayer discloses facts sufficient to enable the Internal Revenue Service to identify the potential controversy, if it analyzed that information." 1982 General Explanation at 218 (emphasis added).

TEI has longed believed that items properly reported on government-prescribed forms or schedules should be deemed to be adequately disclosed for purposes of the substantial understatement penalty. If the IRS concludes that its current forms do not seek sufficient information "to enable the Internal Revenue Service to identify the potential controversy, if it analyzed that information," then the forms should be revised.

More fundamentally, TEI believes the proposed regulations are at odds with the statute which clearly prescribes two means of satisfying the adequate disclosure provision: (i) disclosure in the return or (ii) disclosure in an attachment to the return. Although the IRS;s general rulemaking authority may empower the IRS to prescribe the format and contents of an attachment to the return (Form 8275), we submit that the IRS has no authority to read the "in the return" disclosure avenue out of the Code. Consequently,
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Publication:Tax Executive
Date:May 1, 1991
Previous Article:Resolving transfer-pricing disputes through the revised competent authority process.
Next Article:Temporary and proposed "hot interest" regulations under section 6621(c).

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