WHAT ARE DEFENSES TO “ACCURACY-RELATED PENALTY”?
INTRODUCTION – ACCURACY RELATED PENALTY
Internal Revenue Code (IRC) Section 6662(b)(2) authorizes the Internal Revenue Service (IRS) to impose a penalty if an underpayment exceeds a computational threshold called a “substantial understatement”.
Pursuant to IRC Section 6662(d)(1)(A), for Individuals, the “understatement” of tax is “substantial” if it exceeds the greater of $5,000 or Ten percent (10%) of the tax that must be shown on the return.
Pursuant to IRC Section 6662(d)(1)B), for Corporations (other than S corporations or personal holding companies), an “understatement” is “substantial” if it exceeds the lesser of Ten percent (10%) of the tax required to be shown on the return (or, if greater, $10,000), or $10,000,000.
INTERNAL REVENUE MANUAL Section 18.104.22.168.5 (01-24-2012)
Examination Penalty Assertion
In proposing the penalty to the taxpayer or taxpayer’s representative, the examiner will:
- Fully explain the proposed penalty.
- Document the reasons why the penalty assertion is appropriate.
- Consider and document any possible exceptions to the penalty provided by the taxpayer or the taxpayer’s representative whether or not they are accepted.
The level of taxpayer cooperation is not grounds for asserting or not asserting a penalty.
BURDEN OF PROOF – Pursuant to IRC Section 7491(c), in court proceedings, the IRS bears the initial burden of production regarding the accuracy-related penalty. The IRS must first present sufficient evidence to establish that the penalty is warranted. The burden of proof then shifts to the taxpayer to establish any exception to the penalty, such as reasonable cause.
PENALTY DEFENSE #1 – SUBSTANTIAL AUTHORITY
Pursuant to IRC Section 6662(a), the amount of an accuracy-related penalty equals Twenty percent (20%) of the portion of the underpayment attributable to a substantial “understatement”. An “understatement” is the difference between (1) the correct amount of tax and (2) the tax reported on the return, reduced by any rebate.
Pursuant to IRC Section 6662(d)(2)B) and Treasury Regulation Section 1.6662-4, understatements are reduced by the portion attributable to an item for which the taxpayer had “substantial authority” for the tax treatment of the item.
TREASURY REGULATION Section 1.6662-4(d) – Substantial authority—
(1) Effect of having substantial authority. If there is substantial authority for the tax treatment of an item, the item is treated as if it were shown properly on the return for the taxable year in computing the amount of the tax shown on the return. Thus, for purposes of section 6662(d), the tax attributable to the item is not included in the understatement for that year.
(2) Substantial authority standard. The substantial authority standard is an objective standard involving an analysis of the law and application of the law to relevant facts. The substantial authority standard is less stringent than the more likely than not standard (the standard that is met when there is a greater than 50-percent likelihood of the position being upheld), but more stringent than the reasonable basis standard as defined in § 1.6662-3(b)(3). The possibility that a return will not be audited or, if audited, that an item will not be raised on audit, is not relevant in determining whether the substantial authority standard (or the reasonable basis standard) is satisfied.
(3) Determination of whether substantial authority is present—
(i) Evaluation of authorities. There is substantial authority for the tax treatment of an item only if the weight of the authorities supporting the treatment is substantial in relation to the weight of authorities supporting contrary treatment. All authorities relevant to the tax treatment of an item, including the authorities contrary to the treatment, are taken into account in determining whether substantial authority exists. The weight of authorities is determined in light of the pertinent facts and circumstances in the manner prescribed by paragraph (d)(3)(ii) of this section. There may be substantial authority for more than one position with respect to the same item. Because the substantial authority standard is an objective standard, the taxpayer’s belief that there is substantial authority for the tax treatment of an item is not relevant in determining whether there is substantial authority for that treatment.
(ii) Nature of analysis. The weight accorded an authority depends on its relevance and persuasiveness, and the type of document providing the authority. For example, a case or revenue ruling having some facts in common with the tax treatment at issue is not particularly relevant if the authority is materially distinguishable on its facts, or is otherwise inapplicable to the tax treatment at issue. An authority that merely states a conclusion ordinarily is less persuasive than one that reaches its conclusion by cogently relating the applicable law to pertinent facts. The weight of an authority from which information has been deleted, such as a private letter ruling, is diminished to the extent that the deleted information may have affected the authority’s conclusions. The type of document also must be considered. For example, a revenue ruling is accorded greater weight than a private letter ruling addressing the same issue. An older private letter ruling, technical advice memorandum, general counsel memorandum or action on decision generally must be accorded less weight than a more recent one. Any document described in the preceding sentence that is more than 10 years old generally is accorded very little weight. However, 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. There may be substantial authority for the tax treatment of an item despite the absence of certain types of authority. Thus, a taxpayer may have substantial authority for a position that is supported only by a well-reasoned construction of the applicable statutory provision.
(iii) Types of authority. Except in cases described in paragraph (d)(3)(iv) of this section concerning written determinations, only the following are authority for purposes of determining whether there is substantial authority for the tax treatment of an item: Applicable provisions of the Internal Revenue Code and other statutory provisions; proposed, temporary and final regulations construing such statutes; revenue rulings and revenue procedures; tax treaties and regulations thereunder, and Treasury Department and other official explanations of such treaties; court cases; congressional intent as reflected in committee reports, joint explanatory statements of managers included in conference committee reports, and floor statements made prior to enactment by one of a bill’s managers; General Explanations of tax legislation prepared by the Joint Committee on Taxation (the Blue Book); private letter rulings and technical advice memoranda issued after October 31, 1976; actions on decisions and general counsel memoranda issued after March 12, 1981 (as well as general counsel memoranda published in pre-1955 volumes of the Cumulative Bulletin); Internal Revenue Service information or press releases; and notices, announcements and other administrative pronouncements published by the Service in the Internal Revenue Bulletin. Conclusions reached in treatises, legal periodicals, legal opinions or opinions rendered by tax professionals are not authority. The authorities underlying such expressions of opinion where applicable to the facts of a particular case, however, may give rise to substantial authority for the tax treatment of an item. Notwithstanding the preceding list of authorities, an authority does not continue to be an authority to the extent it is overruled or modified, implicitly or explicitly, by a body with the power to overrule or modify the earlier authority. In the case of court decisions, for example, a district court opinion on an issue is not an authority if overruled or reversed by the United States Court of Appeals for such district. However, a Tax Court opinion is not considered to be overruled or modified by a court of appeals to which a taxpayer does not have a right of appeal, unless the Tax Court adopts the holding of the court of appeals. Similarly, a private letter ruling is not authority if revoked or if inconsistent with a subsequent proposed regulation, revenue ruling or other administrative pronouncement published in the Internal Revenue Bulletin.
PENALTY DEFENSE #2 – REASONABLE CAUSE
Pursuant to IRC Section 6664(c)(1) and Treasury Regulation Section 1.6664-4, the accuracy-related penalty does not apply to any portion of an underpayment where the taxpayer acted with “reasonable cause and in good faith”. A “reasonable cause” determination takes into account all of the pertinent facts and circumstances. The most important factor is the extent to which the taxpayer made an effort to determine the proper tax liability.
INTERNAL REVENUE MANUAL (IRM) Section 22.214.171.124.1 (01-24-2012)
- No accuracy-related penalty under IRC 6662 is imposed if it is shown that the taxpayer had reasonable cause for the position taken and that the taxpayer acted in good faith.
- IRC 6664(c) provides an exception to the imposition of any accuracy-related penalty if the taxpayer shows that there was reasonable cause and the taxpayer acted in good faith.
- The determination of whether the taxpayer acted with reasonable cause and in good faith is made on a case-by-case basis, taking into account all the relevant facts and circumstances.
- Generally, the most important factor in determining reasonable cause is the taxpayer’s effort to report the proper tax liability. Other factors to consider are the taxpayer’s experience, knowledge, education, and the taxpayer’s reliance on the advice of a tax advisor.
- All relevant facts, including the nature of the tax investment, the complexity of the tax issues, the competence of the tax advisor, the education of the taxpayer, and the quality of the opinion relied upon must be developed to determine whether the taxpayer was reasonable and acted in good faith.
INTERNAL REVENUE MANUAL (IRM) Section 126.96.36.199.2 (07-01-2008)
Taxpayer’s Effort to Report the Proper Tax Liability
- Generally, the most important factor in determining whether the taxpayer has reasonable cause and acted in good faith is the extent of the taxpayer’s effort to report the proper tax liability.
COURT FINDINGS – The courts abate the accuracy-related penalties, partially or in full, where the taxpayer showed a reasonable and good faith attempt to ascertain the correct amount of tax due. The courts most commonly find reasonable cause on the bases of maintenance of adequate records to substantiate deductions and reasonable reliance on a competent tax professional.