A review of adequate disclosure rules

Editor: Valrie Chambers, CPA, Ph.D.   Federal and state tax return rules are more complex than ever, and differences of opinion on certain rules among tax ­authorities, tax professionals, and/or taxpayers are not unusual. In avoiding the Sec. 6694 preparer penalty for taking a position on a taxpayer’s return that the IRS disagrees with, “adequate disclosure,” in IRS parlance, is the guiding principle for every tax professional preparing returns. While states may have similar rules, this discussion focuses on how this term is used for federal tax purposes. (Adequate disclosure may also allow taxpayers to avoid the Sec. 6662 penalty for a substantial understatement of tax; however, this discussion focuses on the practitioner aspect of adequate disclosure.)

Since adequate disclosure is a critical component of a CPA’s tax return deliverables, tax return preparers need to be familiar with these rules and concepts. If a tax return preparer prepares a return and any part of an understatement of liability on the return is due to an unreasonable position, and the preparer knew (or reasonably should have known) of the position, the preparer can be subject to penalties under Sec. 6694.

A position (other than a position with respect to a tax shelter or a reportable transaction to which Sec. 6662A applies) is unreasonable unless there is or was substantial authority for the position, or the position was disclosed as provided in Sec. 6662(d)(2)(B)(ii)(I) and there is a reasonable basis for the position. A position with “substantial authority” is one that has approximately a 40% chance of success. A position with a “reasonable basis” on a return is one that has at least a 20% chance of success based on its merits.

A tax shelter or a reportable transaction to which Sec. 6662A applies is unreasonable unless it is reasonable to believe that the position is more likely than not (50% or more chance of success) to be sustained on its merits. Disclosure of a position with respect to a tax shelter or reportable transaction will have no effect on the application of a Sec. 6694 preparer penalty.

A practitioner cannot take an unreasonable position on a return and may not prepare or sign a return with an unreasonable position under the Code’s preparer and taxpayer penalty rules; the practitioner rules of Circular 230, Regulations Governing Practice Before the Internal Revenue Service (31 C.F.R. Part 10.34);and the AICPA’s Statement on Standards for Tax Services No. 1, Tax Return Positions.

Adequate disclosure guide

Typically, merely completing the required forms as directed by the form-specific instructions achieves adequate disclosure. However, this minimal type of disclosure applies only if it is certain that every position represented on a return is either (1) a position that is “more likely than not” to succeed on its merits, in the case of a position considered a tax shelter or an “avoidance-type” reportable transaction (i.e., to which Sec. 6662A applies); or (2) in all other cases, the position has substantial authority. Additionally, all reportable transactions must be disclosed on Form 8886, Reportable Transaction Disclosure Statement, and, if applicable, on the correct line of Schedule M-3, Net Income (Loss) Reconciliation. For all other reasonable positions, additional disclosure is required. This additional disclosure is achieved only by completing Form 8275, Disclosure Statement; Form 8275-R, Regulation Disclosure Statement; or Schedule UTP, Uncertain Tax Position Statement, which must be attached to the return.

However, to reduce this disclosure burden, the IRS has provided a revenue procedure that details the items for which reporting in accordance with the form instructions will suffice for positions having a reasonable basis but not substantial authority. On Jan. 29, 2018, the IRS issued Rev. Proc. 2018-11, which specifies circumstances of adequate return disclosure for purposes of avoiding both accuracy-related taxpayer penalties and preparer penalties with respect to an understatement related to a reasonable position. Unless the position relates to one of the items specifically enumerated in Rev. Proc. 2018-11, the relevant disclosure form must be attached to the return to disclose the position if it fails to reach the standard of substantial authority, although it reaches the minimal standard of a ­reasonable basis.

Rev. Proc. 2018-11 does not apply to foreign financial transactions that must be disclosed on their appropriate forms; tax shelters; transactions lacking economic substance; avoidance-type reportable transactions, which must be disclosed on Form 8886and on the proper line of a required Schedule M-3; and related-party transactions.

Rev. Proc. 2018-11 does cover the following items:

1. Form 1040, U.S. Individual Income Tax Return, Schedule A, Itemized Deductions:
   1. Medical and dental expenses.
   2. Taxes. Line 8 of Schedule A must list each type of tax and the amount paid.
   3. Interest expenses. Form 4952, Investment Interest Expense Deduction, may be required. Sec. 265 nondeductible, tax-exempt-related amounts are not directly covered by this revenue procedure. Hence, if an allocation between deductible and nondeductible investment interest expense is needed, then Form 8275 is required unless there is substantial authority for the allocation.
   4. Contribution deductions. Return attachments may be required. Particular substantiation rules must be met.
   5. Casualty and theft losses. Form 4684, Casualties and Thefts,must be attachedlisting each loss.
   6. Employee business expenses. Either Form 2106, Employee Business Expenses, or 2106-EZ, Unreimbursed Employee Business Expenses,must be completed. This item also covers the deductible amounts to be entered directly onto an individual’s income tax return, as in the case of those entered on Form 1040, line 24, “Certain Business Expenses of Reservists, Performing Artists, and Fee-Basis Government Officials.”
2. Certain trade or business expenses, including those relating to rental property:
   1. Casualty and theft losses, as above.
   2. Legal expenses as valid business expensed amounts, but not for amounts required to be amortized or characterized as capital expenditures.
   3. Specific bad-debt charge-offs, but not for amounts added to the allowance for doubtful accounts.
   4. Officers’ compensation. If required, Form 1125-E, Compensation of Officers, must be completed. However, the revenue procedure does not cover nondeductible amounts under Sec. 162(m) and Sec. 280G “excess parachute payments.”
   5. Repair expenses, for valid business expensed amounts, but not for amounts properly characterized as capital expenditures.
   6. Taxes, not including foreign taxes.
3. Differences in book and income tax reporting (Schedules M-1 and M-3):
   1. Items with differences must be disclosed, correctly characterizing them as temporary or permanent differences (if filing a required Schedule M-3), and the correct amounts of book and tax income must be completed for those items as well as in total.
   2. This disclosure must reasonably apprise the IRS of the potential controversy concerning the tax treatment of the item, unless Form 8275 or Form 8275-R (or Schedule UTP) is properly completed. The IRS will not consider itself to be “reasonably apprised” of a potentially controversial amount if the amount is aggregated into a larger number of like or unlike items on the schedule.
   3. When applicable, the additional information for Schedule M-1 or M-3 (for example, Schedule B (Form 1120) or Schedule C (Form 1065)) must be completed.
4. Foreign items:
   1. International boycott transactions, as long as the return is accompanied by a properly completed Form 5713, International Boycott Report, and, where required by their instructions, Schedules A, B, and C of Form 5713 are properly completed.
   2. Treaty-based return positions, as long as the return is accompanied by Form 8833, Treaty-Based Return Position Disclosure Under Section 6114 or 7701(b), when required by its instructions.
5. Other:
   1. Moving expenses, as long as the return is accompanied by Form 3903, Moving Expenses.
   2. Fuel credits, as long as the return is accompanied by Form 4136, Credit for Federal Tax Paid on Fuels.
   3. Investment credits, as long as the return is accompanied by Form 3468, Investment Credit.

The revenue procedure in action

If there is a reasonable basis for the tax treatment of the item, the amount of the understatement subject to penalty is reduced by the portion of the understatement attributable to the item with respect to which the relevant facts affecting the item’s tax treatment are adequately disclosed in the return or in a statement attached to the return. All required information must be furnished in accordance with the applicable forms and instructions, including using the correct boxes/lines on the return. The dollar amounts entered on these forms must be verifiable, good-faith numbers, representing properly substantiated amounts (when required) and sourcing from a taxpayer’s adequately kept books and records. Items listed only as “other,” such as “other expense,” must have an additional description on the applicable line of the form or an attached statement.

Following Rev. Proc. 2018-11 could save preparers a substantial amount of time and anxiety and simultaneously reduce the risk of penalties. The revenue procedure is also a guidepost for discussions with clients about both the records they need to maintain and the disclosures they need to make. This revenue procedure only applies to 2017 returns but is intended to be reissued annually (although no revenue procedure was ever issued to cover 2016 returns). For 2018 returns, it stands to reason that practitioners may continue to use Rev. Proc. 2018-11 as a guide until a new revenue procedure is issued for 2018.