Sec. 6662 imposes an accuracy-related penalty equal to 20% of any underpayment of federal tax resulting from certain specified taxpayer behaviors (e.g., negligence, disregard of rules or regulations, substantial understatement of income tax, and certain valuation misstatements).
Negligence includes any failure to make a reasonable attempt to comply with the provisions of the internal revenue laws, to exercise ordinary and reasonable care in the preparation of a tax return, or to keep adequate books and records or to substantiate items properly. However, a return position that has a reasonable basis will not be held to be attributable to negligence.
The IRS can impose the accuracy-related penalty for careless, reckless, or intentional disregard of the rules or regulations, but a taxpayer may be able to avoid the penalty for taking a position on a return that is contrary to a rule or regulation if the taxpayer properly discloses the position.
A taxpayer may be able to avoid a penalty due to a substantial underpayment of tax if the taxpayer can show substantial authority for the position causing the understatement or has a reasonable basis for the tax treatment of an item and adequately discloses the facts regarding the item’s treatment.
Sec. 6662 imposes an accuracy-related penalty equal to 20% of any underpayment of federal tax resulting from certain specified taxpayer behaviors (e.g., negligence, disregard of rules or regulations, substantial understatement of income tax, and certain over-and undervaluations).1 This two-part article addresses the Sec. 6662 accuracy-related penalty and the defenses available to taxpayers. Part I provides an overview of the various bases upon which a Sec. 6662 penalty can be imposed. Part II, in the May issue, will discuss in detail the Sec. 6664 reasonable cause and good-faith defense to the Sec. 6662 penalty. Both parts discuss key considerations for practitioners tasked with helping clients contest an asserted application of the Sec. 6662 penalty.
Current IRS examination procedures effectively direct examining agents to assert the Sec. 6662 penalty whenever a taxpayer understates its tax liability. For example, the Internal Revenue Manual (IRM) states that “[t]he substantial understatement penalty will be automatically asserted on Wage & Investment (W&I) and SB/SE campus cases when mathematically applicable under the correspondence examination batch program.”.”2 The direction to IRS examiners is to apply the substantial understatement (Sec. 6662(b)(2)) penalty in all cases in which there is a prima facie case (i.e., a mathematical trigger) for application thereof. Nonetheless, the authors’ experience, and the experience of many tax professionals, is that some IRS agents have broadly (and improperly) interpreted this direction to require automatic assertion of not only the substantial understatement but also the negligence and disregard (Sec. 6662(b)(1)) penalties with respect to all underpayments. Given these procedures, there is a de facto administrative presumption that the Sec. 6662 penalty applies to any understatement of tax.3 In practice, then, taxpayers must justify the nonapplication of, or affirmative defense to, the Sec. 6662 penalty for every item the IRS adjusts on audit.
This administrative approach (the automatic assertion of accuracy-related penalties) is contrary to congressional intent.4 Nonetheless, given the current tax enforcement environment, it is the situation taxpayers and practitioners are likely to confront for the foreseeable future. In addition, examining IRS agents will often have little, if any, practical real-world business experience. This means that such agents have no practical frame of reference for judging the reasonableness of taxpayer conduct (an essential determination, either directly or indirectly, for all the Sec. 6662 penalties), especially in a business environment. Similarly, such agents often assume that taxpayers have unlimited resources and time, and unfairly judge the reasonableness of the taxpayer’s conduct on that basis. Moreover, whether the agents have such experience or not, they often assume for penalty purposes that a taxpayer is per se negligent (or worse) if the taxpayer happens to disagree with the government about the interpretation or application of federal tax law.In these circumstances, it is especially important for practitioners to thoroughly understand both the circumstances under which the IRS may properly apply a Sec. 6662 penalty and the potential defenses thereto.
Sec. 6662(a) imposes an addition to tax of 20% of the portion of the “underpayment to which [Sec. 6662] applies,” which is any underpayment attributable to certain conditions or taxpayer conduct identified in Sec. 6662 itself. Thus, for the Sec. 6662 penalty to apply, a taxpayer must have an underpayment of tax, and the underpayment must be attributable to one of the specific conditions or behaviors (referred to herein as “triggers”) identified in Sec. 6662, including:
- Negligence or disregard of rules or regulations;
- Any substantial understatement of income tax;
- Any substantial valuation misstatement under chapter 1 (i.e., Secs. 1–1400U-3, dealing with normal taxes and surtaxes);
- Any substantial overstatement of pension liabilities; and
- Any substantial estate or gift tax valuation understatement.5
Before discussing the specific Sec. 6662 triggers, several general points should be made. First, it is helpful to divide the triggers into conduct-based and mechanical triggers. The conduct-based triggers (negligence and disregard) apply as a function of the taxpayer’s conduct. The mechanical triggers are, at least as an initial matter, mathematical in nature and are imposed either because an under-or overstatement exceeds a certain threshold or because the taxpayer has significantly over-or undervalued an item on the taxpayer’s return.
Second, the purpose of tax penalties is to “encourage voluntary compliance by supporting the standards of behavior expected by the Internal Revenue Code.”6 Thus, only behavior that falls below the relevant standards of care should properly be subject to penalty. As discussed below, the proper focus of the statutory regime is ultimately on the taxpayer’s behavior in most cases because if the taxpayer can demonstrate the reasonableness of its conduct or return position, the Sec. 6662 penalty should generally not apply even under a mechanical trigger. As the Supreme Court has recognized, “the [tax] law is complicated, accounting treatment of various items raises problems of great complexity, and innocent errors are numerous. . . . It is not the purpose of the law to penalize frank difference of opinion or innocent errors made despite the exercise of reasonable care.”7
Third, the reference to the “portion” of any underpayment in Sec. 6662(a) means that the penalty applies only to that portion of the underpayment that is attributable to a specific trigger. Any portion of the underpayment that is not attributable to a trigger is not subject to the Sec. 6662 penalty. This is in contrast to prior law under which the penalty applied on the entire underpayment if any portion thereof was attributable to negligence. For similar reasons, there is no “stacking” of Sec. 6662 penalties. That is, even if a portion of an underpayment is attributable to more than one trigger, only one trigger will apply to that portion. Thus, the maximum accuracy-related penalty that can apply to any portion of an underpayment is 20% (or 40% if the Sec. 6662(h) gross valuation misstatement rules apply). Similarly, any portion of an underpayment that is attributable to civil fraud (Sec. 6663) is not subject to the Sec. 6662 penalty.8
Fourth, in this context practitioners should be aware of Sec. 6662A, which generally imposes a similar accuracy-related penalty on understatements attributable to “reportable transactions.” Reportable transactions are generally those taxpayers are required to disclose under the Sec. 6011 regulations finalized in2003.9A full discussion of Sec. 6662A is beyond the scope of this article, but practitioners should be aware that if a taxpayer’s understatement is attributable to a reportable transaction, a whole different set of rules applies, with respect to both the application of the penalty in the first instance and the potential reasonable cause/goodfaith exception under Sec. 6664.
Fifth, it is important to note that despite the statutory nomenclature, Sec. 6662 actually imposes an “addition to tax.” This characterization has important administrative and procedural significance. Perhaps most notably, additions to tax are assessed in the same manner as the underlying taxes, and the IRS’s assertion thereof is presumed correct.10 In addition, because the Sec. 6662 penalty is an addition to tax, underpayment interest accrues on the penalty in the same manner as on the tax itself.11
Finally, Sec. 6664 provides an affirmative defense to the proposed application of any of the Sec. 6662 triggers. Specifically, “[n]o penalty shall be imposed under section 6662 . . . with respect to any portion of an underpayment if it is shown that there was a reasonable cause for such portion and that the taxpayer acted in good faith with respect to such portion.”12 The interaction of the Sec. 6662 penalty provisions and the Sec. 6664 defense raises some interesting issues, which will be addressed more fully in Part II. Nonetheless, it will be helpful for readers, as they consider the application of specific Sec. 6662 triggers below, to be aware of the potential availability of Sec. 6664’s reasonable cause/good-faith defense.
The first Sec. 6662 penalty trigger is negligence.13 The term “negligence” is not defined in the Code or the regulations. Nevertheless, courts have generally applied the common law tort definition of the term, holding that negligence means failing to do what a reasonable and ordinarily prudent person would do under the same or similar circumstances.14 In addition, the regulations, while not defining negligence, do provide examples of negligent behavior. These examples include failing to keep adequate books and records and failing to substantiate items properly.15
Practice tip: In all cases, however, it is important to remember (and to remind IRS agents) that the taxpayer’s negligence is objectively measured. This requires a determination of what is reasonable under the circumstances and necessarily involves a comparison of the taxpayer’s conduct with that of other similarly situated taxpayers. In this regard, both courts and the regulations recognize that the taxpayer’s experience, knowledge, and education are relevant in determining the reasonableness of his or her conduct.16 Of course, this is a two-edged sword. For example, if taxpayers are relatively unsophisticated and inexperienced, they are generally held to a lower standard. But such lack of sophistication could also support a conclusion that the taxpayer’s failure to consult a tax adviser was itself negligent. On the other hand, relatively sophisticated and experienced taxpayers are routinely held to a higher standard by courts.17
As discussed below, the negligence determination mandated by Sec. 6662 appears to focus on two related but distinct taxpayer activities: (1) complying with the Code itself (presumably both substantive and procedural rules) and (2) preparing returns (including documentation and substantiation of items shown thereon).
Complying with the Code
Taxpayer conduct: According to the Code, the term “negligence” includes any “failure to make a reasonable attempt to comply” with the Code.18 This standard applies to both taxpayer conduct and taxpayer return positions. The two are interrelated, however, and are difficult to separate in practice. For example, given the Code’s well-recognized (and equally well-bemoaned) complexity and the complexity of federal tax law in general, one might argue that a taxpayer (other than perhaps a tax professional) that attempts to prepare anything other than a very routine return is negligent per se.19 This was probably not Congress’s intent, but in any event many taxpayers do rely on tax professionals to advise on, and more often to prepare, their returns. In many such instances, a taxpayer has only the slightest understanding of the technical positions taken on the return. Nonetheless, if the taxpayer has reasonably relied on a tax professional’s advice in determining and reporting those positions, the taxpayer should be viewed as having met the “reasonable attempt to comply” standard and therefore should not properly be characterized as negligent with respect to such positions, even if the substantive position is erroneous.20
The Supreme Court in Boyle recognized that “[c]ourts have frequently held that ‘reasonable cause’ is established when a taxpayer shows that he reasonably relied on the advice of an accountant or attorney . . . even when such advice turned out to have been mistaken.”21 Boyle itself dealt with the question of whether a taxpayer demonstrated reasonable cause for his failure to timely file a return, technically a defense to the penalty in question in that case. Nonetheless, the Court’s reasonable cause determination in that case was essentially the same as the determination required by the Sec. 6662 “reasonable attempt to comply” negligence standard: whether the taxpayer “exercised ordinary business care and prudence” and was nevertheless unable to file the return when due.22
Practice tip: As can readily be seen, the Sec. 6662 negligence penalty, with its focus on the reasonableness of taxpayer behavior and positions, overlaps and can easily be confused with the Sec. 6664 reasonable cause/good-faith defense. Negligence on the one hand and reasonable cause and good faith on the other are really two sides of the same coin. Nonetheless, if taxpayers can demonstrate that they made a reasonable attempt to comply with the Code (either by their own actions or vicariously through reasonable reliance on a tax professional), they should not be viewed as negligent and should not need to resort to Sec. 6664.
Taxpayer positions: In addition to taxpayer behavior, the statutory “reasonable attempt to comply” standard can also apply to taxpayer return positions. In this regard, the regulations recognize that a return position that has a reasonable basis “is not attributable to negligence.”23 The term “reasonable basis” is not defined, but the regulations indicate that it describes a position less robust than one supported by substantial authority but more robust than one that is merely arguable or colorable.24
A taxpayer has the burden of establishing the reasonable basis for any return position. The existence of a reasonable basis for any position is determined by reference to the authorities identified in the regulations, including, among others, the Code, legislative history, treasury regulations, court decisions, and IRS rulings and announcements.25 According to the regulations, if a return position is “reasonably based” on one or more such authority, the return position will generally satisfy the reasonable basis standard even though it may not satisfy the substantial authority standard.26 This determination is generally based on authorities existing at the time the return is filed. Importantly, the reasonable basis standard is objective, so the taxpayer’s belief that a reasonable basis exists is irrelevant to determining whether a reasonable basis actually exists.27 But this also means that a position’s reasonable basis can be articulated after the fact.
Heightened Scrutiny of “Too Good to Be True” Positions
According to the regulations, negligence is strongly indicated where “[a] taxpayer fails to make a reasonable attempt to ascertain the correctness of a deduction, credit or exclusion on a return which would seem to a reasonable and prudent person to be ‘too good to be true’ under the circumstances.”28 While this “strong indication” may have some intuitive appeal, it is difficult to justify. It appears that the regulations essentially require a taxpayer to judge the merit of the positions recommended by the taxpayer’s tax adviser, something the taxpayer often lacks the ability to do and an activity that, under Boyle, he or she is not required to do.
If interpreted to apply only to positions that a layperson with no special knowledge of tax law would view as too good to be true, the regulations seem to add little to the reasonable attempt to comply standard. And if interpreted more broadly, so as to implicitly require the taxpayer to review his or her adviser’s advice (or to obtain a second opinion), the regulations seem inconsistent with Supreme Court authority.
Nonetheless, the regulatory presumption (strong indication) exists, and the taxpayer must address it if the IRS raises it on audit. In determining whether a transaction is too good to be true, practitioners should remind agents that the determination of whether a position is too good to be true for this purpose is expressly situational: “under the circumstances.” Thus, practitioners should consider the context of the item or treatment. That is, if the taxpayer’s return position or treatment of an item is generally consistent with the applicable statutory or regulatory regime, the position would seem not to be too good to be true under the circumstances. Similarly, if the taxpayer reasonably relied on a tax adviser, positions recommended by that adviser should not normally be too good to be true because the taxpayer is not independently expert in tax matters and would not be expected to be in a position to make that determination.
Practice tip: In this regard, while a too good to be true item is not expressly equivalent to a tax shelter item, the regulations defining a tax shelter are instructive in identifying a too good to be true item. For example, the regulations acknowledge that the principal purpose of a transaction is not to avoid or evade federal income tax (read “not too good to be true”) if such position has as its purpose claiming exclusions from income, accelerated deductions, or other tax benefits in a manner consistent with the statute and congressional purpose.29
The regulations identify several common activities that are not tax shelter activities, such as holding tax-exempt bonds, taking cost recovery, deferring income in tax-sheltered retirement vehicles, and electing foreign sales corporation status.30 Thus, the regulations acknowledge that certain statutory provisions are inherently taxpayer favorable, and taxpayers may avail themselves of the benefits thereof without being characterized as being improperly “tax motivated.” Similar reasoning should help distinguish positions that really are too good to be true from those that are consistent with statutory regimes (albeit arguably applying such provisions in a manner or extent perhaps not anticipated by Congress or Treasury).
Preparation of Returns
In addition to the statutory reasonable attempt standard, the regulations state that negligence includes any failure “to exercise ordinary and reasonable care in the preparation of a tax return.”31 Presumably, this language is intended to apply to the taxpayer’s actual preparation of the return itself, rather than the taxpayer’s conduct in determining return positions. Otherwise, it would be redundant with the general reasonable attempt to comply standard discussed above. Thus, this standard requires an evaluation of how the taxpayer prepares and assembles the return itself (e.g., the mechanical process of filling out the return). In this regard, the regulations state that negligence is strongly indicated where a taxpayer “fails to include on an income tax return an amount of income shown on an information return” (e.g., a Form W-2 or 1099).32
This aspect of the negligence penalty also seems to implicate the reasonableness of the taxpayer’s recordkeeping, docu-mentation and substantiation of expenses, and care taken to ensure that items are properly reported on returns.33 The Sec. 6664 regulations illustrate this point. According to the regulations, when a taxpayer procrastinates until April 15 to prepare a return, hurriedly gathers his or her tax records and prepares the return, and files a return containing numerous errors, the taxpayer is not considered to have reasonable cause for the underpayment or to have acted in good faith in attempting to file an accurate return.34 Again, the lack of reasonable cause and good faith should be generally equivalent to negligence for purposes of Sec. 6662.
Negligence: Effect of Disclosure
The regulations state that taxpayers may not avoid the penalty for negligence by disclosing their positions.35 This is logical, given that negligence is generally defined under the regulations as a failure to act reasonably with respect to determining a return position or preparing a return. It would be illogical to forgive taxpayers’ negligence merely because they have disclosed it. If taxpayers are aware of their negligence, they should correct the negligent error, not disclose it.
The second Sec. 6662 penalty trigger is disregard of rules or regulations. For purposes of the disregard trigger, the term “rules or regulations” includes the Code, temporary or final Treasury regulations, and revenue rulings or notices (other than notices of proposed rulemaking) issued by the IRS.36 As is the case with the negligence trigger, the focus here is almost exclusively on the taxpayer’s conduct. Again, the statute does not define the term but instead identifies three types of disregard: careless, reckless, and intentional disregard.
Careless Disregard and Reckless Disregard
Disregard of rules or regulations is careless if the taxpayer does not exercise reasonable diligence to determine the correctness of a return position that is contrary to the rule or regulation.37 Disregard is reckless if the taxpayer makes little or no effort to determine whether a rule or regulation exists, under circumstances that demonstrate a substantial deviation from the standard of conduct that a reasonable person would observe.38 In light of these definitions, it appears that careless and reckless disregard, as defined in the regulations, largely overlap and are virtually the same as negligence. Both a “failure to exercise reasonable diligence” and making “little or no effort” seem literally synonymous with the negligence standard discussed above. Thus, in practice it would be difficult to distinguish between negligence and careless or reckless disregard because the same facts would generally support either characterization. To this extent, the negligence rules discussed above are generally relevant to the question of whether the taxpayer carelessly or recklessly disregarded a rule or regulation.
Disregard is intentional if the taxpayer knows of the rule or regulation that is disregarded.39 Only intentional disregard comports with what most taxpayers would consider disregard in the ordinary sense: a taxpayer is aware of the rule or regulation and understands its application to his or her return, but nevertheless fails to follow the rule. This type of taxpayer conduct, characterized as it is by an intentional and willful disregard of a known obligation, should be relatively rare.
It is important to note that a taxpayer is not negligent, nor does he or she disregard a rule or regulation, merely because the taxpayer takes a position with which the government disagrees, even if the taxpayer’s position is ultimately found to be erroneous. Such a “mistake of law,” if made in good faith, is not negligent as long as the taxpayer’s conduct (e.g., engagement of a tax adviser) or return position satisfy the negligence standard (i.e., reasonable attempt or reasonable basis, respectively).40 The regulations support this position: “[A]n honest misunderstanding of fact or law that is reasonable in light of all the facts and circumstances, including the experience, knowledge and education of the taxpayer” demonstrates reasonable cause and good faith.41
Practice tip: As any reader with even a passing familiarity with the Code and regulations can attest, federal tax law can be extraordinarily complex. Indeed, items whose treatment is clear-cut and unambiguous are probably the exception rather than the norm. Obviously, the proper treatment of routine items and transactions is often easily determined. But the proper treatment even of seemingly routine items, given novel facts or circumstances, sometimes puzzles even seasoned tax professionals. The proper federal tax treatment of an item requires interpreting the applicable statutory, regulatory, and judicial authority and applying that authority to often myriad facts. The regulations explicitly recognize that there may be substantial authority for more than one position for the same item.42 In this environment, it would be patently unreasonable to take the position that merely being “wrong” about an item makes a taxpayer negligent. Similarly, the fact that a taxpayer carefully considers an ambiguous rule or regulation, but in good faith applies it in a manner with which the government disagrees, should be sufficient to fend off a charge that the taxpayer disregarded the rule. Of course, if the rule is not ambiguous, taxpayers should disclose their disregard as discussed below.
Disregard: Effect of Disclosure
The regulations provide that the IRS may not impose a Sec. 6662 disregard penalty on any portion of an underpayment attributable to a position contrary to a rule or regulation if the position is adequately disclosed.43 This rule logically seems to apply only to intentional disregard. If taxpayers carelessly or recklessly disregard a rule or regulation, they presumably are not aware of the rule or regulation and consequently could not disclose their disregard of it. In any event, disclosure is adequate for this purpose if made on a properly completed and filed Form 8275, Disclosure Statement, or 8275-R, Regulation Disclosure Statement, as appropriate.44 In certain circumstances, a disclosure made generally prior to IRS contact but after the filing of the original return (a “qualified amended return”) can also satisfy the disclosure requirement.45 The disclosure exception does not apply to negligence, however, and also does not apply in the case of a position that does not have a reasonable basis or where the taxpayer fails to keep adequate books and records or to properly substantiate items.46
The third Sec. 6662 penalty trigger is the existence of a substantial understatement of tax.47 This is the first mechanical trigger. This penalty applies, logically, only if the taxpayer’s return contains an understatement and that understatement is substantial. Notwithstanding this trigger’s seemingly mechanical nature, there are two independent ways a taxpayer can avoid the penalty: (1) substantial authority and (2) reasonable basis and disclosure.48
The term “understatement” is defined as the excess of (1) the amount of the tax required to be shown on the return for the tax year over (2) the amount of the tax imposed that is shown on the return, reduced by any rebate.49
Reduction of Understatement for Substantial Authority
The amount of any understatement is reduced by the portion of the understatement that is attributable to the taxpayer’s treatment of any item if there is or was substantial authority for the taxpayer’s treatment.50 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.51 Thus, a nontax-shelter item for which there is substantial authority is excluded from the taxpayer’s understatement for the year.
The question of whether there is substantial authority for a taxpayer’s position requires an objective analysis of the law and its application to the relevant facts.52 This exception applies where there are authorities supporting the taxpayer’s per-return treatment of an item and those authorities are substantial in relation to authorities, if any, supporting a contrary position.53
Authorities that may be consulted in determining whether substantial authority exists include, among others, the Code and other statutory provisions; proposed, temporary, and final regulations construing such statutes; revenue rulings and procedures; tax treaties and corresponding regulations, and Treasury and other official explanations of such treaties; court cases; and congressional intent as reflected in committee reports.54 All relevant authorities must be considered, and the regulations recognize that there may be substantial authority for more than one position.55 The substantial authority standard is less stringent than the more-likely-than-not standard but is more stringent than the reasonable basis standard.56
Practice tip: It is important to recognize that the substantial authority exception to the substantial understatement penalty does not depend on the reasonableness of the taxpayer’s conduct. This is essentially a mechanical exception to a mechanical trigger. That is, this trigger is not “fault-based,” and the exception similarly applies regardless of the taxpayer’s conduct. The statute requires that any understatement be reduced by any portion of the understatement for which substantial authority existed. There either was or was not substantial authority for the taxpayer’s position. Thus, the existence of substantial authority can be determined and demonstrated after the fact (upon audit, for example) regardless of the taxpayer’s conduct and regardless of whether the taxpayer was even aware of such authority at the time the return was prepared.57
Understatement: Effect of Disclosure
The amount of any understatement is also reduced by the portion of the understatement for which:
- The relevant facts affecting the item’s tax treatment are adequately disclosed (either on the return itself or in a statement attached thereto); and
- There is a reasonable basis for the tax treatment of that item by the taxpayer.58
Thus, if an item has a reasonable basis and the taxpayer properly discloses it, the item is treated as if it were shown properly on the return for the tax year in computing the amount of the tax shown on the return.59 Whether a reasonable basis exists for any taxpayer position is determined by reference to the same authorities used for substantial authority determination discussed above.60 However, the reasonable basis standard requires a lower level of authority than the substantial authority standard. The taxpayer must generally make the required disclosure on a completed Form 8275 or 8275-R.61
Understatement: Tax Shelters
For tax shelters (defined below), the foregoing rules do not apply. That is, the amount of a taxpayer’s understatement related to a tax shelter item is not reduced as described above, even if there was substantial authority for the taxpayer’s treatment of the item or there was a reasonable basis and the taxpayer disclosed the position.62
The term “tax shelter” for this purpose means a partnership or other entity, any investment plan or arrangement, or any other plan or arrangement, if a significant purpose of such partnership, entity, plan, or arrangement is the avoidance or evasion of federal income tax.63 Under the regulations, however, tax shelter is defined (arguably more leniently) as a partnership, entity plan, or arrangement the principal purpose of which is to avoid or evade federal income tax.64 In the authors’ experience, given how the IRS administers the Sec. 6662 penalty, this distinction seems to make little practical difference. In any event, for substantial understatements attributable to tax shelters, only the Sec. 6664 reasonable cause/ good-faith exception avoids the substantial understatement trigger.
An understatement (after any appropriate reduction as described above) is substantial if it exceeds certain statutory thresholds. For individual taxpayers, an understatement is substantial if it exceeds the greater of (1) 10% of the tax required to be shown on the return for the tax year or (2) $5,000.65 For corporate taxpayers, an understatement is substantial if it 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.66
For this purpose, the term “amount of the tax required to be shown on the return for the tax year” has the same meaning as “amount of income tax imposed” as defined in Regs. Sec. 1.6664-2(b). That term, in turn, is defined as the amount of tax imposed on the taxpayer under subtitle A (income taxes) for the tax year, determined without regard to certain items, most commonly the credits for tax withheld (tax withheld on wages and tax withheld at source on nonresident aliens and foreign corporations) and payments of tax or estimated tax by the taxpayer.67
As the foregoing discussion indicates, the determination of a substantial understatement involves a seemingly mechanical analysis—a comparison of the amount of the taxpayer’s understatement for the tax year to the relevant statutory thresholds. However, at least with respect to nontaxshelter items, the amount of an understatement is reduced if the authority supporting the taxpayer’s treatment of any portion of the understatement is substantial or if the taxpayer has a reasonable basis for that portion and it was disclosed as required in the regulations. Moreover, as is the case for all Sec. 6662 penalty triggers, the substantial understatement trigger is avoidable if the Sec. 6664 reasonable cause/ good-faith defense can be satisfied.
Three types of valuation misstatements can also trigger Sec. 6662. These include any “substantial valuation misstatement,” any “substantial overstatement of pension liabilities,” and “substantial estate or gift tax valuation understatements.”68 Because these triggers are somewhat less common than the others, they are addressed here collectively and more summarily.
Substantial Valuation Misstatement
Effectively, there are two distinct substantial valuation misstatement standards: one for Sec. 482 transactions and one for non–Sec. 482 transactions.69
Sec. 482 transactions: For Sec. 482 transactions (generally related-party transactions), the substantial valuation misstatement trigger operates as both an overstatement and an understatement trigger. This trigger applies if:
- The price for the sale or use of any property or services claimed on a return in connection with any transaction between persons described in Sec. 482 (commonly referred to as related parties) is 200% or more (or 50% or less) of the amount determined under Sec. 482 to be the correct amount of the price; or
- The net Sec. 482 transfer price adjustment for the tax year exceeds the lesser of $5 million or 10% of the taxpayer’s gross receipts.70 A net Sec. 482 transfer price adjustment is generally the net increase in taxable income for the tax year resulting from adjustments under
Sec. 482 in the price for the sale or use of any property or services.
Non–Sec. 482 transactions: For non– Sec. 482 transactions, the substantial valuation misstatement trigger is effectively a substantial overstatement trigger. That is, a substantial valuation misstatement exists for such transactions if the value (or the adjusted basis) of any property claimed on a return is 150% or more of the amount ultimately determined to be the correct amount of such value or adjusted basis.71 The term “property” as used here appears to be consistent with its everyday (tax) meaning. Perhaps the most common example of this occurs when a taxpayer misstates the value of property contributed to a charitable organization for purposes of the charitable contribution deduction under Sec. 170.
Substantial Overstatement of Pension Liabilities
A substantial overstatement of pension liabilities occurs if the actuarial determination of the liabilities taken into account for purposes of computing the deduction under paragraph (1) or (2) of Sec. 404(a) is 200% or more of the amount determined to be the correct amount of such liabilities.72
Substantial Estate or Gift Tax Valuation Understatement
The substantial estate or gift tax valuation understatement penalty applies if the value of any property claimed on any return imposed by subtitle B is 65% or less of the amount determined to be the correct amount of the valuation.73
Rules Generally Applicable to Valuation Misstatements
Valuation penalty not conduct based: The valuation triggers are not conduct based, focusing instead fairly mechanically on the taxpayer’s reported value for property. Thus, the reasonableness of a taxpayer’s conduct in determining the reported value is not directly a consideration in applying these triggers. Consequently, if the taxpayer’s reported value for property exceeds the relevant over-or undervaluation thresholds, the penalty applies and the taxpayer’s only recourse is to establish a reasonable cause/good-faith defense under Sec. 6664. As will be discussed in Part II of this article, that defense is particularly difficult to prove in cases of valuation misstatement, with many technical requirements for the underlying appraisals upon which taxpayers rely.
Penalty thresholds: The substantial valuation misstatement triggers are not applicable unless the misvaluations exceed certain thresholds. For example, no substantial valuation misstatement trigger applies unless the valuation misstatement under chapter 1 exceeds $5,000 ($10,000 in the case of a corporation other than an S corporation or a personal holding company).74 Similarly, no penalty is imposed unless the portion of the underpayment attributable to a substantial estate or gift tax valuation understatement exceeds $5,000.75
Heightened penalty for gross valua tion misstatements: The normal penalty rate of 20% is doubled to 40% for any gross valuation misstatement.76
Property-by-property determination: The determination of whether there is a substantial or gross valuation misstatement on a return is made on a propertyby-property basis.77
No disclosure exception: Somewhat logically, taxpayers may not avoid the valuation misstatement triggers by disclosing the valuation misstatement.78
Practice tip: Attentive readers have likely noticed that the valuation penalties have fairly loose tolerances. That is, the penalties do not apply unless the underpayments attributable to the valuation misstatements exceed certain de minimis thresholds and unless the misstatements are fairly substantial (e.g., reported value is 50% more than the actual value with respect to the substantial valuation misstatement for a non–Sec. 482 transaction). These loose tolerances were intentional: “[T]he committee believes that raising both the threshold and the minimum percentage will eliminate from the penalty’s scope a number of instances of good-faith valuation disputes that may be subject to penalty under present law.”79 This may lead readers to conclude that there is considerable room for error in valuation matters, but this would be an incorrect and dangerous conclusion, because any valuation misstatement that causes an underpayment of tax is still subject to penalty under the other triggers (e.g., negligence or substantial understatement), even if it is not subject to penalty as a valuation misstatement.80
As the foregoing discussion illustrates, the Sec. 6662 penalty rules are numerous and complicated. A central issue, directly or indirectly, in the proper application of the Sec. 6662 penalty is the extent to which taxpayers acted reasonably in preparing their returns or determining return positions. Unfortunately, in many circumstances IRS agents often lack the real-world business experience necessary to fairly and objectively judge the reasonableness of taxpayer behavior. In an environment where IRS agents are being encouraged, if not required, to apply the Sec. 6662 penalty for all asserted underpayments of tax, it is especially important for tax practitioners to fully understand the rules if they are to successfully assist and defend their clients on audit.
John Cook is an assistant professor of accountancy in the Raj Soin College of Business at Wright State University in Dayton, OH. Alan Ocheltree is director, Tax Controversy, at Cardinal Health, Inc., in Dublin, OH. For more about this article, contact Prof. Cook at email@example.com.
1 The term “tax” for this purpose means any tax imposed by the Internal Revenue Code (Sec. 6664(a)). Thus, the Sec. 6662 penalty can apply to, among others, underpayments of income tax, gift tax, estate tax, or employment tax.
2 IRM §126.96.36.199(8) (emphasis added).
4 The committee report states that “[t]he committee is concerned that the present-law accuracy-related penalties (particularly the penalty for substantial understatements of tax liability) have been determined too routinely and auto matically 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.” H.R. Rep’t No. 247, 101st Cong., 1st Sess. 1392 (1989) (emphasis added).
5 Sec. 6662(b). Tax professionals often refer to the accuracy-related penalties (e.g., the negligence penalty or the substantial understatement penalty); this is a common and practical shorthand terminology. Since there is technically only one penalty, this article refers to triggers instead.
6 IRM §188.8.131.52(1).
7 Spies, 317 U.S. 492, 496 (1943).
8 Sec. 6662(b) (flush language)
9 Regs. Sec. 1.6011-4(a).
10 Sec. 6665(a); but see Sec. 7491(c).
11 See, e.g., Sec. 6601.
12 Sec. 6664(c)(1).
13 Sec. 6662(b)(1).
14 See, e.g., Neely, 85 T.C. 934 (1985).
15 Regs. Sec. 1.6662-3(b)(1).
16 Regs. Sec. 1.6664-4(b)(1).
17 See, e.g., Pelton & Gunther, P.C., T.C. Memo. 1999-339 (attorney taxpayers held to higher standard: “[W]e take into account the legal background and years of legal experience possessed by petitioner’s owner(s)”); Tippin, 104 T.C. 518 (1995) (“[A]n attorney specializing in taxation and bankruptcy law . . . is held to a higher standard of care”).
18 Sec. 6662(c).
19 Indeed, in some cases courts have held that the taxpayer’s failure to consult with a qualified tax adviser in the face of complicated tax issues constituted negligence. See, e.g., Wesel, T.C. Memo. 1980-438 (holding that “a prudent man would have consulted one knowledgeable in the tax laws prior to entering such complex arrangements”); Zmuda, 731 F.2d 1417 (9th Cir. 1984) (failure to seek “independent legal advice” in the face of a complicated tax avoidance transaction supported a negligence determination).
20 Of course, this conclusion assumes that the taxpayer has given the adviser all the pertinent return information.
21 Boyle, 469 U.S. 241, 250 (1985) (emphasis added).
22 Id. at 243.
23 Regs. Sec. 1.6662-3(b)(1).
24 Regs. Sec. 1.6662-3(b)(3).
25 Regs. Sec. 1.6662-4(d)(3)(iii).
26 Regs. Sec. 1.6662- 3(b)(3).
27 See also Regs. Sec. 1.6662-4(d)(3)(i) (“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”).
28 Regs. Sec. 1.6662-3(b)(1)(ii).
29 Regs. Sec. 1.6662-4(g)(2)(ii).
31 Regs. Sec. 1.6662-3(b)(1).
34 Regs. Sec. 1.6664-4(b)(2), Example (4).
35 Regs. Sec. 1.6662-7(b).
36 Regs. Sec. 1.6662-3(b)(2).
40 See, e.g., Freeland, T.C. Memo. 1986-10 (where the law is subject to disagreement, no negligence or intentional disregard of rules and regulations has been found); Lansdown, 73 F.3d 373 (10th Cir. 1995) (taxpayer erroneously believed he was entitled to foreign earned income exclusion, but the negligence penalty was not imposed because “the tax laws are exceedingly complex and difficult to apply. . . . To find petitioner negligent for not knowing in advance how these rules ultimately would be applied to his situation is unfair”).
41 Regs. Sec. 1.6664-4(b)(1). This regulation specifically deals with the existence of reasonable cause and good faith. Nonetheless, as discussed above, given the overlap of the reasonable cause/good-faith concept with the negligence concept, the result is the same: No Sec. 6662 penalty should apply.
42 Regs. Sec. 1.6662-4(d)(3)(i).
43 Regs. Sec. 1.6662-3(c)(1).
44 Regs. Sec. 1.6662-3(c)(2). The provisions of Regs. Sec. 1.6662-4(f)(2), which permit disclosure in accordance with an annual revenue procedure for purposes of the substantial understatement penalty, do not apply for purposes of this section.
45 See Rev. Rul. 94-69, 1994-2 C.B. 804, and Regs. Sec. 1.6662-4(f)(2).
46 Regs. Secs. 1.6662-1 and 1.6662-3(c)(1).
47 Sec. 6662(b)(2).
48 Sec. 6662(d)(2)(B). As discussed above, the Sec. 6664 reasonable cause/ good-faith exception can also apply.
49 Sec. 6662(d)(2)(A). An understatement is determined without regard to items to which Sec. 6662A applies.
50 Sec. 6662(d)(2)(B). Substantial authority exists for this purpose if that authority existed either at the time the return was filed or on the last day of the tax year to which the return relates (Regs. Sec. 1.6662-4(d)(3)(iv)(C)).
51 Regs. Sec. 1.6662-4(d)(1).
52 Regs. Sec. 1.6662-4(d)(2). For more on the substantial authority standard, see Nash and Parker, “Establishing Substantial Authority for Undisclosed Tax Positions,” 40 The Tax Adviser 380 (June 2009).
53 Regs. Sec. 1.6662-4(d)(3)(i).
54 Regs. Sec. 1.6662-4(d)(3)(iii).
55 Regs. Sec. 1.6662-4(d)(3)(i).
56 Regs. Sec. 1.6662-4(d)(2). The reasonable basis standard indicates a standard “significantly higher” than not frivolous but lower than substantial authority (Regs. Sec. 1.6662-3(b)(3)). For the numerically inclined, the reasonable basis standard falls above colorable (around 10%) but below the realistic possibility of success standard (one in three, or 33%). The substantial authority standard falls above the realistic possibility of success standard but below the more-likely-than-not standard (greater than 50%).
57 Of course, the authorities a taxpayer can use for this purpose are only those that existed as of the time the return was filed or on the last day of the taxpayer’s tax year.
58 Sec. 6662(d)(2)(B).
59 Regs. Sec. 1.6662-4(e)(1).
60 Regs. Sec. 1.6662-3(b)(3).
61 Regs. Sec. 1.6662-4(f)(1).
62 Sec. 6662(d)(2)(B).
63 Sec. 6662(d)(2)(C).
64Regs. Sec. 1.6662-4(g)(2)(i).
65 Sec. 6662(d)(1)(A).
66 Sec. 6662(d)(1)(B).
67 Regs. Sec. 1.6664-2(b).
68 Secs. 6662(b)(3), 6662(b)(4), and 6662(b)(5), respectively.
69 Sec. 6662(e)(1).
70 Sec. 6662(e)(1)(B).
71 Sec. 6662(e)(1)(A).
72 Sec. 6662(f)(1).
73 Sec. 6662(g)(1).
74 Sec. 6662(e)(2).
75 Sec. 6662(g)(2).
76 Sec. 6662(h).
77 Regs. Sec. 1.6662-5(f)(1).
78 Regs. Sec. 1.6662-1.
79 H.R. Rep’t No. 247, 101st Cong., 2d Sess. 1391 (1989).