Sec. 6694 was amended in 2007 to extend application of the income tax return preparer penalties to all tax return preparers. The new law also raised the preparer standards of conduct and increased the applicable penalties. However, the penalty will not apply if (1) the preparer has a reasonable belief that the position would more likely than not be sustained on its merits or (2) there is a reasonable basis for the position and the position is adequately disclosed. Except in the case of tax shelters, taxpayers can avoid the Sec. 6662 accuracy-related penalty if the position has substantial authority or the taxpayer adequately discloses an item or position that has a reasonable basis.
For these purposes, disclosure generally is made on Form 8275, Disclosure Statement, or Form 8275-R, Regulation Disclosure Statement. Although seemingly straightforward, completing the forms can be difficult because there is little guidance on when a disclosure will be treated as “adequate.” The regulations and instructions contain little in the way of specific examples or standards. Disclosures that are made but that are not treated as adequate will attract IRS attention but will not provide penalty protection. Thus, the challenge is to disclose the appropriate amount of information to satisfy the IRS that disclosure is adequate.
Defining Adequacy
The instructions to both disclosure forms are similar with respect to the information required in Parts I and II, except that Form 8275-R contains more specific instructions and requires an explanation of the regulation’s invalidity. Both forms require:
- A citation of the rule for which a contrary position is taken;
- The name of the item; and
- A complete description of the item being disclosed.
One example in the instructions to both forms provides that if entertainment expenses are reported, then a description such as “theater tickets, catering expenses, and banquet hall rentals” should be listed.
For Part II of the forms, little guidance is provided other than a warning similar to that set forth in the Internal Revenue Manual (IRM) that the disclosure must provide sufficient information to apprise the IRS of the controversy (see below). An example in Part II of the instructions to both forms shows that disclosure is not adequate if Form 8275 or Form 8275-R is not attached, even if an underlying document at the source of the controversy is attached to the return. Regs. Sec. 1.6662-4(f) provides some helpful guidance with respect to recurring items, carrybacks and carryovers, and passthrough entities but refers only to “properly completed” Forms 8275 and 8275-R.
The IRM relies on case law in stating that taxpayers must disclose sufficient information so that the IRS can identify the potential controversy that may be involved (Schirmer,89 TC 277 (1987), acq. 1989-2 CB 1) and that the disclosure must provide the IRS with more than simply a clue (Horwich, TC Memo 1991-465). Similarly, the IRM lists some of the essential items for an adequate disclosure, including a reference to “the facts affecting the tax treatment of the item sufficient to apprise the Ser-vice of the nature of the potential controversy” (IRM Section 20.1.5.8.1.2). However, the IRM also states that if the disclosure statement is too general to “reasonably apprise” the IRS of the nature and amount of the potential controversy, the disclosure exception to Secs. 6662 and 6694 will not apply.
Completing the Form
The purpose of the disclosure forms is to put the IRS on notice of a potential controversy. These forms are not intended to be, and should not be treated as, a rebuttal to an IRS challenge. The taxpayer risks foreclosing additional arguments if, before the IRS even determines that the issue is worthy of challenge, the taxpayer relies on particular arguments to support the position or item in the disclosure form. In addition, attempts to draft legal arguments in anticipation of an IRS challenge could create an audit issue where one otherwise might not exist.
Thus, the detailed explanation in Part II generally should not include contrary authorities or arguments supporting the position taken on the return. However, there are situations in which citing contrary authority may be helpful in avoiding examination of the issue (e.g., citing a case in which the court did not follow a revenue ruling). Likewise, it is not necessary to state the level of confidence with respect to the position (e.g., that the position has a reasonable basis). Rather, the detailed explanation should identify the item or position, the amount of the item, the statute, ruling, notice, or other guidance that is the source of the controversy, and a description of the nature of the controversy.
When to Use Form 8275-R
The IRS uses Form 8275-R as a means to identify taxpayer claims that a regulation is invalid. Courts sometimes may agree that a regulation is invalid, but only in exceptional cases (e.g., Rite Aid Corp., 255 F3d 1357 (Fed. Cir. 2001)). Thus, Form 8275-R should be used only when the taxpayer is challenging the validity of an IRS regulation. When making this kind of challenge, the taxpayer is arguing that the government issued the regulation contrary to its statutory authority.
Taxpayer positions that involve interpretations of a regulation, or determinations that a particular regulation does not apply, should not be treated as a challenge to the validity of a regulation. In these cases, Form 8275, rather than Form 8275-R, should be used. Use of Form 8275-R almost certainly will result in an IRS challenge to the taxpayer’s position. Therefore, it is prudent to use this form only when required.
Conclusion
Adequate disclosure can protect the preparer and taxpayer from penalties in certain cases. However, preparing a disclosure that is adequate to apprise the IRS of the controversy without prejudicing the taxpayer is not a simple task. Care should be taken to provide only the appropriate information. Save the detailed analysis and arguments to respond to an actual government challenge and use the disclosure form to notify, rather than to advocate.
EditorNotes
Annette B. Smith is with Washington National Tax Services PricewaterhouseCoopers LLP in Washington, DC
Unless otherwise noted, contributors are members of or associated with PricewaterhouseCoopers LLP.
If you would like additional information about these items, contact Ms. Smith at (202) 414-1048 or annette.smith@us.pwc.com.
