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The state of accuracy-related penalties.

The State of Accuracy-Related Penalties

Prior to the enactment of the Improved Penalty Administration and Compliance Act (IMPACT)(1) of 1989, the civil penalty provisions of the Internal Revenue Code were often confusing, overlapping and subject to inconsistent and inequitable application by the Service. IMPACT completely overhauled and consolidated the previous penalty provisions contained in numerous Code sections into a single unified system. One of the principal features of the new system is the elimination of "stacking"(2) of multiple penalties by the Service on the same taxpayer misconduct.

The new penalty system consists of three provisions: Section 6662 on accuracy-related penalties; Section 6663 on the civil fraud penalty; and Section 6664, which provides the definitional and regulatory framework for the application of the previous two sections. On March 4, 1991, the Service issued the long-awaited proposed regulations on the accuracy-related penalties and coordinated them with definitions and rules in Section 6664. An in-depth understanding of the proposed regulations is important to taxpayers and their advisers to avoid the new penalty provisions.

The proposed regulations deal only with three types(3) of misconduct by taxpayers: 1. Negligence or disregard of rules

or regulations, 2. A substantial understatement of

income tax, and 3. Substantial (or gross) valuation


Accuracy-Related Penalty

The penalty is 20% on the portion of an underpayment of tax that is attributable to negligence, a substantial understatement of tax or a substantial valuation misstatement.(4) The penalty increases to 40% of an underpayment due to a gross valuation misstatement. An accuracy-related penalty may be imposed only in cases where a tax return has been filed by taxpayer.(5) Also, if a fraud penalty is imposed, the accuracy-related penalty is automatically abated for the same offense.(6)

Effective Dates

The new penalty provisions are generally effective for returns due after December 31, 1989. However, the proposed regulations will not be applied adversely to taxpayers who took positions based on rules or regulations in effect prior to March 4, 1991.(7)

Negligence or Disregard of

Rules or Regulations

The proposed regulations define the term "negligence" as any failure to make a reasonable attempt to comply with tax provisions or to exercise ordinary and reasonable care in the preparation of a tax return.(8) Two types of taxpayer activities are automatically negligent. The first is to take a frivolous position which, by definition, is one that is patently improper.(9) The second is the taxpayer's failure to keep proper books and records or to substantiate any item reported on the tax return.(10)

Indications of Negligence

The following situations by themselves do not prove negligence, but they strongly indicate(11) the taxpayer's lack of due care. 1. An amount of income stated on

an information return is not included

in the tax return. 2. A deduction, credit or exclusion

which would appear to a reasonable

person as "too good to be

true" is claimed by the taxpayer

without further inquiry into its

correctness. 3. A partner treats an item on his

tax return in a manner that is

inconsistent with the way it is

treated on the partnership's information

return or fails to notify

the Service of the inconsistency. 4. The treatment of an item by a

shareholder of an S corporation is

different from the manner it is

treated by the same corporation.

Disregard of Rules or Regulations

Closely related to negligence is disregard or rules or regulations. A taxpayer's disregard of the provisions of the Internal Revenue Code, temporary or final Treasury regulations and revenue rulings may be careless, reckless or intentional.(12) A careless disregard of rules or regulations is exhibited when the taxpayer fails to exercise reasonable diligence in ascertaining the correctness of the position he has taken on the tax return when such a position is contrary to a rule or regulation. A reckless disregard is present where the taxpayer makes little or no effort to determine the existence of a rule or regulation, under circumstances which would induce a reasonable person to investigate. A taxpayer who knowingly disregards a rule or regulation is guilty of intentional disregard.(13)

Substantial Understatement

of Income Tax

A 20% penalty is imposed on any portion of an underpayment of tax attributable to a substantial understatement of income tax. A substantial understatement exists when the amount of the underpayment exceeds the greater of: (a) 10% of the correct tax or (b) $5,000 ($10,000 for a corporation other than an S corporation or a personal holding company).(14)

The term "underpayment" may generally be described as the amount of the correct tax less the amount of tax shown by the taxpayer on the return. Any overstated withholding credits and estimated tax payments will increase the amount of an underpayment.(15) In contrast, any amounts previously assessed or collected before the return is filed but not shown on the return includes any amount of an underpayment. Finally, the amount of tax shown by the taxpayer on the return includes any amount shown as additional tax on a qualified amended return. This additional tax also will reduce the amount of underpayment.

For example, Abel's 1990 tax return reported a tax liability of $25,000. He had neglected to claim on his return $2,000 of back-up withholding. Upon audit by the Service, the correct amount of the tax liability was found to be $35,000. The amount of Abel's underpayment of tax is calculated as follows:
 Amount of tax imposed $ 35,000
 Tax reported by taxpayer (25,000)
 Previously assessed tax (2,000)
 Amount of underpayment $ 8,000

Special Rules for Carryback

and Carryover Years

In determining whether an understatement of tax is substantial for a year in which a carryback or carryover arises (the loss or credit year), the total underpayments in the carryback or carryover years are treated as an underpayment in the loss or credit year. The "10% or $5,000 ($10,000)" test is then applied to the correct tax in the loss or credit year.

For example, Ace Inc., a C corporation, filed returns on a calendar year basis as follows:

Table : Taxable Income Tax Liability
1987 $ 30,000 $ 4,500
1988 $ 40,000 $ 6,000
1989 ( $100,000 ) -0-
1990 $ 30,000* $ 4,500*

*Before NOL Carryover

The NOL of $100,000 in 1989 was carried back to 1987 and 1988 and carried forward to 1990, thus reducing the tax liability in each year to zero. After examination by the Service in 1991 of the 1989 return, the taxable income for 1989 was determined to be $30,000 due to unreported income. The NOL carrybacks and carryovers were therefore disallowed. Therefore there were tax understatements of $4,500 for 1987; $6,000 for 1988; $4,500 for 1989; and $4,500 for 1990. The underpayments are aggregated to determine if the understatement for 1989 is substantial. The total amount of underpayments, $19,500, is substantial since it exceeds (a) 10% of the correct tax for 1989 or (b) $10,000. Therefore, the total amount of underpayment is subject to the 20% penalty.

Substantial or Gross

Valuation Misstatements

The third offense which triggers a 20% penalty on any portion of underpaid tax is substantial valuation misstatement. A 40% penalty is applied in the case of a gross valuation misstatement of property, which may be tangible or intangible.

A substantial valuation misstatement exists if the fair market value or adjusted basis of property claimed on a return is 200% or more of the correct amount.(16) The valuation misstatement is treated as gross if the value or adjusted basis claimed on a return is 400% or more of the correct amount. Regardless of the amount involved, a valuation misstatement is gross when the correct value of the property or its adjusted basis is zero.(17)

The penalty is imposed only when the portion of an underpayment that is attributable to either a substantial or gross valuation misstatement exceeds $5,000 ($10,000 for a corporation other than an S corporation or a personal holding company).(18) This dollar limitation is applied separately to each tax year for which there is a substantial or gross valuation misstatement.(19)

Multiple Valuation Misstatements

On returns with multiple valuation misstatements, the determination of whether the misstatement is substantial or gross is made on each item of property.(20) For example, Baker claims a value of $70,000 on Property A when its correct value is only $40,000. He also places a value of $35,000 on property B, although its fair market value is $10,000. The aggregate value claimed by Baker is $105,000, which is more than 200% of its correct value of $50,000. However, only property B is subject to the penalty if the underpayment of tax exceeds $5,000.

Pass-through Entities

In the case of tax returns of pass-through entities (such as partnerships, S corporations, estates and trusts) the 200% or 400% test is made at the entity level, while the $5,000 (or $10,000) limitation test is applied at the taxpayer level.(21) Thus, while a partnership may show a substantial or gross valuation misstatement, the $5,000 test at the taxpayer level may protect the individual partners from the penalty.

Exceptions to Penalty


Based on statutory provisions and legislative history, the proposed regulations prescribe three exceptions to abate accuracy-related penalties: (1) reasonable cause and good faith, (2) adequate disclosure and (3) substantial authority. (See Table 1.)

Table : Table 1

Exceptions for Avoiding

Accuracy-Related Penalties

 Reasonable Cause Adequate Substantial
 and Good Faith Disclosure Authority
Negligence YES YES, Form 8275 YES
or Disregard required

of Rules
Substantial YES YES, Form 8275 YES
Understatement or disclosure
of Tax on the tax return
Substantial YES NO NO

or Gross Valuation Misstatement

Reasonable Cause and Good Faith

Under Section 6664-4(c)(1), all accuracy-related penalties may be avoided if the taxpayer can show that he had a reasonable cause and that he acted in good faith(22) regarding the portion of the underpaid tax. The proposed regulations provide that this exception is allowed on a case-by-case basis, after an examination of all facts and circumstances. The most important factor which indicates that the taxpayer's reasonable cause and good faith is the extent of the taxpayer's efforts in assessing his proper tax liability.(23)

Also, the taxpayer's experience, knowledge and education are other circumstances that may be considered.(24) As a general rule, an isolated computational or transcriptional error will not automatically trigger the penalty.(25) In addition, the taxpayer's reliance on erroneous information reported on a W-2 or Form 1099 may indicate that he was acting in good faith, unless he knew or had reason to believe that the information furnished was incorrect.(26)

By itself, the taxpayer's reliance on the advice of a professional (such as an appraiser, attorney or accountant) will not shield him from penalty. However, such reliance may constitute reasonable cause and good faith if, under the facts and circumstances of the case, the reliance was reasonable and the taxpayer acted in good faith.(27)

Adequate Disclosure

Except in the case of a frivolous position or unsubstantiated item,(28) the penalty for negligence or disregard of rules or regulations may be avoided if the position is adequately disclosed on a properly completed and filed Form 8275, Disclosure Statement. The taxpayer will have to identify specific provisions and rulings on the Form 8275 if a position is contrary to a rule or regulation. Disclosure on the tax return itself will no longer abate a penalty imposed for negligence or disregard of rules or regulation.(29) Also, the disclosure exception will not protect the taxpayer from penalty for substantial or gross valuation misstatements or substantial understatement of tax resulting from tax shelter items.(30)

Substantial Authority

The penalty for substantial understatement of tax and negligence or disregard of rules or regulations may be avoided if the taxpayer can show substantial authority for his position. The proposed regulations expand the list of substantial authorities to include proposed regulations; private letter rulings and technical advice memoranda; actions on decisions and general counsel memoranda; general explanations of tax legislation prepared by the Joint Committee on Taxation; and IRS notices, information or press releases and announcements published in the Internal Revenue Bulletin.(31)

Indetermining whether substantial authority exists for the tax treatment of an item, the weight of the authorities supporting the treatment must be substantial in relation to the weight of authorities supporting a contrary treatment. The weight given an authority depends on the relevance and persuasiveness as well as the type of authority. As a general rule, the more recent an authoritative statement, the greater its weight. Documents such as private letter rulings, general counsel memoranda and technical advice memoranda that are more than ten years old will be given very little weight.(32)


The new unified penalty system and the proposed regulations based on it have brought much clarity, certainty and fairness to a very confusing area of tax laws. The new penalties are not harsh enough to deter those taxpayers who are determined to play the "audit lottery." But for most taxpayers and their advisers, the new system is a welcome and overdue improvement.


(1) Subtitle G, Omnibus Budget Reconciliation Act of 1989.

(2) H. Rept. No. 247 at 1388-89.

(3) The Service has announced that it will provide shortly the necessary guidance on the two remaining accuracy-related offenses: (1) substantial or gross overstatement of pension liabilities and (2) substantial or gross undervaluations under estate or gift tax provisions.

(4) Section 6662(a).

(5) Section 6664(b).

(6) Section 6662(b).

(7) Prop. Reg. 1.6662-2(d).

(8) Prop. Reg. 1.6662-3(b)(1).

(9) Prop. Reg. 1.6662-3(b)(3).

(10) Prop. Reg. 1.6662-3(c)(1).

(11) Prop. Reg. 1.6662-3(b)(1).

(12) Prop. Reg. 1.6662-3(b)(2).

(13) Id.

(14) Prop. Reg. 1.6662-4(b)(1)(ii)

(15) Prop. Reg. 1.6662-4(b)(4).

(16) Prop. Reg. 1.6662-5(e)(1).

(17) Prop. Reg. 1.6662-5(g).

(18) Prop. Reg. 1.6662-5(b).

(19) Id.

(20) Prop. Reg. 1.6662-5(f)(1).

(21) Prop. Reg. 1.6662-5(h)(1).

(22) Prop. Reg. 1.6664-4(a).

(23) Prop. Reg. 1.6664-4(b)(1).

(24) Id.

(25) Id.

(26) Id.

(27) Id.

(28) Prop. Reg. 1.6662-3(c)(1).

(29) Prop. Reg. 1.6662-3(c)(2).

(30) Prop. Reg. 1.6662-4(e)(2)(ii).

(31) Prop. Reg. 1.6662-4(d)(3)(iii).

(32) Prop. Reg. 1.6662-4(d)(3)(ii).

Timothy H. Mills, DBA, is an assistnat professor of accountancy at Eastern Illinois University. He received his doctoral degree from Louisiana Tech University in 1989. He has written previously for the Journal of Business and Economic Perspectives.

Matthew M. Monippallil, JD, CPA, is an associate professor of accountancy at Eastern Illinois University. His articles have appeared in numerous professional and scholarly publications inclusing the Tax Adviser, Taxation for Accountants, CPA Journal, Journal of Behavioral Economics, Taxation for Lawyers, and Journal of Small Business Management.
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Title Annotation:Improved Penalty Administration and Compliance Act's new penalty system
Author:Mills, Timothy H.; Monippallil, Matthew M.
Publication:The National Public Accountant
Date:Oct 1, 1991
Previous Article:Robert L. Gordon named NSPA Accountant of the Year.
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