Does substantial authority provide penalty protection?

By Michael A. Urban, J.D., MLT, and Mark A. Bond, J.D., LL.M., Washington, D.C.

Editor: Annette B. Smith, CPA

This discussion explores a question prompted by language in IRS Chief Counsel Field Service Advice (FSA) 200009002: Does substantial authority protect against a penalty for a return position that is contrary to a regulation? While FSA 200009002 is ambiguous on that point, the existence of substantial authority will not necessarily protect a taxpayer from a penalty for an undisclosed return position that is contrary to a regulation.

Accuracy-related penalties

Sec. 6662 imposes an accuracy-related penalty equal to 20% of the portion of an underpayment of tax attributable to, among other things:

  • Negligence or disregard of rules or regulations; or
  • Any substantial understatement of income tax.

The term "negligence" includes any failure to make a reasonable attempt to comply with the provisions of the internal revenue laws or to exercise ordinary and reasonable care in the preparation of a tax return and also includes any failure by the taxpayer to keep adequate books and records or to substantiate items properly (Regs. Sec. 1.6662-3(b)(1)).

The term "disregard" includes any careless, reckless, or intentional disregard of rules or regulations. A disregard is "careless" if the taxpayer does not exercise reasonable diligence to determine the correctness of a return position. A 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. A disregard is "intentional" if the taxpayer knows of the rule or regulation that is disregarded (Regs. Sec. 1.6662-3(b)(2)).

The term "rules or regulations" includes the provisions of the Internal Revenue Code, temporary or final Treasury regulations, and revenue rulings or notices (not including notices of proposed rulemaking) published in the Internal Revenue Bulletin (Regs. Sec. 1.6662-3(b)(2)).

Most importantly here, the penalty does not apply to a position that is contrary to a revenue ruling or notice if the position has "a realistic possibility of being sustained on its merits" (Regs. Sec. 1.6662-3(b)(2)). Realistic possibility is generally considered to be a lower standard than "substantial authority." It follows that substantial authority should provide penalty protection for a return position that is contrary to a revenue ruling or notice. But what if the return position is contrary to a regulation? On this question, Regs. Sec. 1.6662-3(b)(2) provides no clear guidance.

Other exceptions

Perhaps an answer can be found by exploring the substantial-understatement component of the Sec. 6662 penalty. An understatement generally is reduced by the portion of the understatement attributable to:

  • The tax treatment of any item for which there is or was "substantial authority" for the treatment; and
  • Any item if the relevant facts affecting the item's tax treatment were adequately disclosed in the return or a statement attached to the return, and there is a reasonable basis for the taxpayer's tax treatment of the item (Secs. 6662(d)(2)(B) and (C)) (these exceptions do not apply to tax shelters items).

"Substantial authority" is an objective standard that is higher than a "reasonable basis" and is satisfied "only if the weight of the authorities supporting the treatment is substantial in relation to the weight of authorities supporting contrary treatment." All authorities relevant to the tax treatment of an item, including the authorities contrary to the treatment, are taken into account in determining whether substantial authority exists (Regs. Secs. 1.6662-4(d)(2) and (3)(i)).

The proper method of disclosing the tax treatment of an item for purposes of avoiding the penalty for disregarding rules or regulations depends on whether the return position is only contrary to a rule, or instead is contrary to a regulation. If the position is only contrary to a rule, it must be disclosed on a properly completed and filed Form 8275, Disclosure Statement, that adequately identifies the rule in question. If the position is contrary to a regulation, disclosure must be made on a properly completed and filed Form 8275-R, Regulation Disclosure Statement, that adequately identifies the regulatory provision in question, and the position must represent a good-faith challenge to the validity of the regulation. In both cases, disclosure provides penalty protection only if there is a reasonable basis for the position (Regs. Sec. 1.6662-3(c)).

Disclosing a return position attributable to negligence, by the way, would not avoid an accuracy-related penalty. The disclosure provision requires a reasonable basis, and a position that has a reasonable basis is per se not negligent (Regs. Sec. 1.6662-3(b)(1)).

Internal Revenue Manual

Another place to look for clues about whether substantial authority shields from penalties a return position that is contrary to a regulation is the Internal Revenue Manual. IRM Section 20.1.5.8.2.1(3) provides that a good-faith challenge to the validity of a regulation generally requires a showing that the taxpayer conducted a careful analysis of reasonably available authorities relating to the issue, including: (1) statutory language; (2) legislative history; (3) the underlying Treasury Decision; and (4) relevant case law (including case law pertaining to the presumption of validity to which regulations are entitled). That IRM section further states that "[t]he persuasiveness of the rationale supporting the contrary position should also be taken into account in determining whether the taxpayer's position represents a good faith challenge to the validity of a regulation." However, as noted above, the "good faith challenge" requirement is in addition to, not in lieu of, the adequate disclosure requirement.

Because all relevant authorities must be evaluated and weighed, in theory there could be substantial authority for a position that is contrary to a regulation. In that regard, Regs. Sec. 1.6662-4(d)(3)(i) recognizes that there may be substantial authority for more than one position with respect to the same item. Nonetheless, these sources leave unclear whether the existence of substantial authority provides protection from the disregard-of-regulations penalty.

FSA 200009002

An intriguing statement is found in FSA 200009002. There, the IRS Chief Counsel's Office determined that the taxpayer "had substantial authority for its return position, relieving it of liability for penalties based on negligence or disregard of rules and regulations." Although it does not appear that the return position in question was contrary to a regulation, the reference to substantial authority as a safe harbor against the disregard-of-regulations penalty is notable because, based on the structure of Sec. 6662, substantial authority is only relevant to the substantial-understatement component of the accuracy-related penalty. One possible explanation is that the author of the memorandum may have been focused only on negligence, and a return position supported by substantial authority is not negligent.

Comparison with the tax return preparer penalty

Perhaps additional insight into whether substantial authority will preclude a penalty for disregarding a regulation can be gained by comparing the Sec. 6694 tax return preparer penalty for conduct giving rise to understatements of a liability on a return. The regulations provide a procedure for a signing tax return preparer to disclose a return position contrary to either a rule or a regulation "for which there is a reasonable basis but for which there is not substantial authority." The disclosure is adequate if made on a properly completed and filed Form 8275 (for rules) or Form 8275-R (for regulations) (Regs. Secs. 1.6694-2(d)(3)(i) and (i)(A)). The same language is used in describing the disclosure rules applicable to nonsigning tax return preparers (Regs. Sec. 1.6694-2(d)(3)(ii)). The plain implication is that, for tax return preparers, a position for which there is substantial provide a procedure for a signing tax return preparer to disclose a return position contrary to either a rule or a regulation "for which there is a reasonable basis but for which there is not substantial authority." The disclosure is adequate if made on a properly completed and filed Form 8275 (for rules) or Form 8275-R (for regulations) (Regs. Secs. 1.6694-2(d)(3)(i) and (i)(A)). The same language is used in describing the disclosure rules applicable to nonsigning tax return preparers (Regs. Sec. 1.6694-2(d)(3)(ii)). The plain implication is that, for tax return preparers, a position for which there is substantial authority does not have to be disclosed even if it is contrary to a regulation. Bolstering this idea, Sec. 6694 makes clear that the tax return preparer penalty only applies to an "unreasonable position," a term that excludes a position for which there is substantial authority.

Notably, however, no comparable provisions are contained in either Sec. 6662(c) or the related regulations on accuracy-related penalties.

Where does that leave the situation? It appears that if a return position is contrary to a regulation, the only way to be assured of protection from the disregard of rules or regulations component of the Sec. 6662 accuracy-related penalty is adequate disclosure, even if the position is supported by substantial authority. In short, relying on the language in FSA 200009002 would be unwise.

EditorNotes

Annette B. Smith, CPA, is a partner with PricewaterhouseCoopers LLP, Washington National Tax Services, in Washington, D.C.

For additional information about these items, contact Ms. Smith at 202-414-1048 or annette.smith@pwc.com.

Unless otherwise noted, contributors are members of or associated with PricewaterhouseCoopers LLP.

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