Procedure & Administration
The Internal Revenue Code imposes an accuracy-related penalty on understatements of tax. In many cases, the basic formula for calculating this penalty is relatively straightforward; however, calculating a penalty can quickly become a complex and sometimes daunting task that requires careful consideration and insight.
When calculating the accuracy-related penalty, one must determine the correct amount of tax and whether any penalty defenses apply. If multiple adjustments are made to a taxpayer’s return, then multiple penalties may need to be coordinated. The penalty calculation can become even more complex when multiple years are involved. Net operating loss (NOL) carrybacks and carryovers further complicate the calculation.
Sec. 6662: The Basics:
A 20% accuracy-related penalty will be imposed on any portion of an underpayment to which Sec. 6662 applies. There are a number of Sec. 6662 accuracy-related penalties, including:• Negligence or disregard of rules or regulations (Sec. 6662(b)(1)); • A substantial understatement of income tax (Sec. 6662(b)(2)); • A substantial valuation misstatement under chapter 1 of the Code (normal taxes and surtaxes) (Sec. 6662(b)(3)); • A substantial overstatement of pension liabilities (Sec. 6662(b)(4)); and • A substantial estate or gift tax valuation understatement (Sec. 6662(b)(5)).
In certain circumstances, the accuracy-related penalty rate is 40%. These circumstances include:• A gross valuation misstatement (Sec. 6662(h)); • An underpayment attributable to one or more undisclosed transactions lacking economic substance (Sec. 6662(i)); or • An understatement attributable to a transaction involving an undisclosed foreign financial asset (Sec. 6662(j)).
Each of the above penalties applies only to the portion of an underpayment attributable to the particular type of misconduct. Imposing multiple accuracy-related penalties with respect to the same underpayment—commonly referred to as “stacking”—is not permitted. The maximum accuracy-related penalty imposed on any portion of an underpayment is 20% (40% if one of the circumstances listed above exists) even if more than one penalty applies to that portion. For example, if a portion of an underpayment of tax is attributable to both a substantial understatement and a gross valuation misstatement, the maximum accuracy-related penalty is 40% of the underpayment, rather than a combined 60%.
Although there are a number of separate penalties contained in Sec. 6662, this item focuses primarily on the substantial understatement of income tax in Sec. 6662(d). Essentially, a substantial-understatement penalty is imposed when a taxpayer fails to report the correct amount of tax on its return and the resulting understatement exceeds a threshold amount.
Calculating Substantial-Understatement Penalty
Sec. 6662(b)(2) imposes a 20% penalty on any portion of an underpayment of income tax required to be shown on a tax return that is attributable to a substantial understatement of income tax. An understatement of tax is defined in Sec. 6662(d) as the difference between the amount of tax the taxpayer was required to report on the tax return for the year and the amount of tax actually reported by the taxpayer on the tax return (minus any rebates). In other words: Understatement = X − (Y − Z), where X is the amount of tax required to be shown on the return, Y is the amount of tax shown on the return, and Z is any rebate. The amount of the understatement can be reduced by the defenses described below.
For corporate taxpayers, other than S corporations or personal holding companies, an understatement of income tax is substantial if its amount for the tax year exceeds the lesser of (1) 10% of the tax required to be shown on the return for the tax year (or, if greater, $10,000) or (2) $10 million. For other taxpayers, an understatement of income tax is substantial if its amount for the tax year exceeds the greater of (1) 10% of the tax required to be shown on the return for the tax year or (2) $5,000.
Sec. 6662(d) Defenses
Under Secs. 6662(d)(2)(B)(i) and (ii), taxpayers can avoid the substantial-understatement penalty for non–tax shelter items by either (1) establishing that substantial authority exists for the treatment of the item or (2) adequately disclosing the relevant facts affecting the item’s tax treatment in the return or in a statement attached to the return (i.e., Form 8275, Disclosure Statement) and establishing that there is a reasonable basis for the tax treatment of the item.
Substantial authority is an objective standard that requires an analysis and application of the law to the relevant facts. The substantial-authority standard is less stringent than the more-likely-than-not standard (a greater than 50% likelihood that the position will be upheld) but more stringent than the reasonable-basis standard (defined in Regs. Sec. 1.6662-3(b)(3)). The tax treatment of an item has substantial authority only if the weight of the authorities supporting the treatment is substantial in relation to the weight of the authorities supporting contrary treatment. To avoid the substantial-understatement penalty, substantial authority must exist either at the time the return containing the applicable item is filed or on the last day of the tax year to which the return relates (Regs. Sec. 1.6662-4(d)).
Disclosure is deemed adequate if it is made on a properly completed form attached to the return or to a qualified amended return for the tax year. In the case of an item or position that is not contrary to a regulation, disclosure must be made on Form 8275; however, a position or item contrary to a regulation must be disclosed on Form 8275-R, Regulation Disclosure Statement (Regs. Sec. 1.6662-4(f)).
Note that with the introduction of the uncertain tax position (UTP) disclosure requirement, for affected corporations, a complete and accurate disclosure of a tax position on the appropriate year’s Schedule UTP, Uncertain Tax Position Statement, is treated as if the corporation had filed a Form 8275 or 8275-R regarding the position. A separate Form 8275 or 8275-R does not need to be filed to avoid certain accuracy-related penalties with respect to that tax position (see Announcement 2010-75 and Schedule UTP instructions). As noted above, disclosure of a return position is not sufficient by itself to avoid a substantial-understatement penalty. The taxpayer must establish there is a reasonable basis for the tax treatment of the item. A tax return position will generally satisfy the reasonable-basis standard if the return position is reasonably based on one or more of the authorities set forth in Regs. Sec. 1.6662-4(d)(3)(iii), even though it might not satisfy the substantial-authority standard.
Adequate disclosure can also be made on a qualified amended return. A qualified amended return is an amended return, or a timely request for an administrative adjustment, filed after the due date of the return and before the earliest of certain dates (including the date the taxpayer is first contacted by the IRS about an examination, including a criminal investigation, of the return) (Regs. Sec. 1.6664-2(c)(3)).
As this article discusses in Part III, carrybacks and carryovers can complicate the computation of penalties. Note that the disclosure requirement for an item included in any loss, deduction, or credit that is carried to another year must be met in the year the carryback or carryover arises. Disclosure is not required in the year the carryback or carryover is used (Regs. Sec. 1.6662-4(f)(4)).
Rev. Proc. 94-69 allows Coordinated Industry Case (CIC, formerly Coordinated Examination Program) taxpayers to make a disclosure at the beginning of an audit cycle. Specifically, a written statement provided by a CIC taxpayer to the IRS is treated as a qualified amended return if the statement is provided after the tax return has been filed but no later than 15 days (or any later date agreed to in writing by the appropriate district official upon a showing of reasonable cause) from the date of written notice from the IRS to the taxpayer requesting the statement to be furnished with respect to the tax year(s) involved.
In addition, the reasonable-cause and good-faith exception of Sec. 6664 can provide additional relief from an accuracy-related penalty even if a return position does not satisfy the reasonable-basis standard. Sec. 6664(c) provides that no penalty will be imposed under Sec. 6662 for any portion of an underpayment of tax (other than by a transaction lacking economic substance under Sec. 7701(o) or certain valuation overstatements) for which the taxpayer shows that there was reasonable cause and the taxpayer acted in good faith. That conclusion is made on a case-by-case basis, taking into account all pertinent facts and circumstances. Generally, the most important factor is the taxpayer’s efforts to assess the proper tax liability. Reliance on professional tax advice constitutes reasonable cause and good faith if, under all the circumstances, the reliance was reasonable and made in good faith (Regs. Sec. 1.6664-4(c)).
by John Keenan, J.D., Washington, D.C., and Whitney Lessman, J.D., Chicago. Rona Hummel, CPA, an adjunct professor with the College of Business at Bloomsburg University in Bloomsburg, Pa., contributed to this item. “Tax Clinic” The Tax Adviser, March 01, 2013
Edited and posted by Harold Goedde CPA, CMA, Ph.D. (taxation and accounting)