IRS Modifies Position on Frozen Refundable Credits and the Substantial Understatement Penalty

From the IRS

The IRS announced, in Program Manager Technical Advice (PMTA) 2012-16, that it would no longer impose a penalty under Sec. 6662 for a substantial understatement of tax when a taxpayer claims a refundable tax credit he or she is not entitled to, but the IRS does not pay the refund or approve the credit (which the IRS calls a frozen refundable credit). In that case, there is no “underpayment” as defined in Sec. 6664, and, without an underpayment, the penalty does not apply.

Sec. 6662(d)(1) defines a substantial understatement of income tax as an understatement that exceeds the greater of 10% of the tax required to be shown on the return for the tax year or $5,000. In earlier guidance, the IRS concluded that the Sec. 6662 penalty applied to situations in which the taxpayers erroneously claimed the first-time homebuyer credit (Sec. 36), the earned income tax credit (EITC) (Sec. 32), and the additional child tax credit (Sec. 24).

Examples in the earlier guidance involved situations where the IRS determined the taxpayers were not entitled to the claimed refundable credits, it did not refund any of the incorrect amounts, and it calculated the underpayments as including the incorrect refund claims. This led to the imposition of the penalty for substantial understatement of tax.

In PMTA 2012-16, the IRS recalculated the underpayments in each of the four examples from the earlier guidance to subtract the frozen refundable credit amounts from the amount of tax imposed, treating the frozen credit as a sum collected without assessment, like withheld amounts and estimated tax payments. This would reduce the amount of underpayment under the IRS’s calculation. Under the prior guidance (PMTAs 2010-001 and 2011-003), the frozen refundable credits were treated as reducing the amount shown as due by the taxpayer on his or her return, which would increase the underpayment.

However, while the IRS now states that Sec. 6662 does not apply in the restated examples from the earlier PMTAs, it has introduced the possibility that Sec. 6676, which applies a 20% penalty for making an excessive refund claim, could apply to those fact patterns not involving the EITC. (Note that the Sec. 6676 penalty specifically does not apply to an erroneous EITC claim.)

The IRS is continuing to impose the Sec. 6662 penalty in cases in which the IRS actually paid the erroneous refunds (which the IRS calls “non-frozen refunds”), and the PMTA cited a case currently before the Tax Court in which the IRS is pursuing the penalty (Rand, Tax Ct. Dkt. 2633-11).