PATH Brings Changes to Federal Penalty Computations

Editor: Valrie Chambers, Ph.D., CPA

The Protecting Americans From Tax Hikes Act of 2015 (PATH), part of the Consolidated Appropriations Act, 2016, P.L. 114-113, which was signed by President Barack Obama on Dec. 18, 2015, contains numerous far-reaching procedural and administrative provisions (in addition to the many temporary and permanent individual and business income tax extensions it included). This item discusses the PATH legislation’s immediate impact on certain federal penalty computations and the guidance issued on Dec. 30, 2015, by the IRS Chief Counsel’s Office that reversed the government’s application of the accuracy-related and fraud penalties in cases involving disallowed refundable tax credits.

Amended Sec. 6664

PATH Section 209 contains administrative provisions pertaining to penalty application. Section 209(a) amends Sec. 6664(a) defining underpayment of income tax by adding the following language: “A rule similar to the rule of Sec. 6211(b)(4) shall apply for purposes of this subsection.” Under Sec. 6664, as amended by PATH, disallowed refundable credits must be taken into account when determining the tax shown on the income tax return. Therefore, if it applies, Sec. 6664 will now serve to reduce the tax shown on a return below zero for purposes of calculating the underpayment of tax subject to penalty under Sec. 6662 and Sec. 6663. Sec. 6662 applies to the imposition of the 20% accuracy-related penalty on the specified underpayment of tax, while Sec. 6663 applies to the imposition of the 75% fraud penalty.

For these purposes, under Sec. 6664(a), the term “underpayment” means the excess of the amount of tax actually due over the amount of tax shown on the return (and/or previously assessed or collected). To determine a taxpayer’s deficiency, Sec. 6211(b)(4) now provides that refundable credits are taken into account as a negative amount of tax. Before the PATH amendments, no such rule applied when calculating what an underpayment was for accuracy-related or fraud penalty purposes.

Upon the passage of PATH, penalties for erroneous refund claims may now apply to disallowed refundable portions of tax credits. PATH Section 209(d)(1) provides that this provision applies to income tax returns filed after Dec. 18, 2015, as well as retroactively for tax years open for assessment as of Dec. 18, 2015, under Sec. 6501.

Reversal of Tax Court’s Rand Decision

PATH Section 209 also effectively reverses the Tax Court’s decision in Rand,141 T.C. 376 (2013), by specifying that refundable tax credits are taken into account as a negative amount of tax when calculating the penalty. In Rand, the Tax Court held that disallowed refundable tax credits must be taken into account when determining a 20% accuracy-related penalty under Sec. 6662, but the credits could not be used to reduce the tax shown on a return below zero. Thus, under Rand, disallowed refundable tax credits could generate underpayments under Sec. 6664(a), but only to the extent the credits reduced the taxpayer’s tax liability to zero. Any additional disallowed refunds claimed due to refundable tax credits were to be disregarded when applying the penalty.

Chief Counsel Guidance

Chief Counsel (CC) notices are directives the IRS issues that provide interim guidance, furnish temporary procedures, describe changes in litigating positions, and/or announce administrative information to IRS staff to provide immediate notification of important policy or procedural changes. Consistent with the Rand decision, on July 31, 2014, the IRS issued CC-2014-007, instructing IRS attorneys to calculate any accuracy-related or fraud penalty involving disallowed refundable credits in accordance with Rand and to concede penalties in excess of the amount provided for byRand.

In response to PATH’s enactment, CC-2016-004 was issued on Dec. 30, 2015. The notice indicates that IRS attorneys should no longer follow Rand and CC-2014-007 and should not concede accuracy-related or fraud penalties going forward or based upon disallowed refund claims for erroneous refund credits when the statute of limitation has not expired or a statutory notice of deficiency asserts these penalties. CC-2016-004 ends by stating, “Pending further guidance on procedures for handling pending and future Tax Court cases, [IRS] attorneys should contact [IRS] Procedure and Administration.”

Because clients may be exposed to much larger filing penalties for federal refundable tax credit claims, tax practitioners must be aware of the reversal of the Rand decision and the issuance of CC-2016-004. These expanded filing penalties may apply to tax returns filed after Dec. 18, 2015, as well as tax returns previously filed that may be selected for examination within the applicable statute of limitation. It is unusual that a legislative change, such as the one contained in Section 209 of the PATH Act of 2015 pertaining to penalties and refundable tax credits, would be applied both prospectively and retroactively to open tax years. This retroactive application is a change from previous law that the Tax Court ruled on in Rand and the IRS subsequently conceded in CC-2014-007. Consequently, additional legislative or judicial activity in this area is likely to occur.