Accuracy-related penalty tested in five recent cases.

• Author: Anderson, Kevin D.

In five recent cases, the Tax Court tested the defenses of various taxpayers to the imposition by the IRS of accuracy-related penalties for substantial understatements of income tax. In each case, the court weighed the facts to decide whether a 20% accuracy-related penalty applied, considering the taxpayers' efforts to properly determine their correct income tax liability. A review of these cases provides relevant and timely insight into the defenses available against an accuracy-related penalty.

Background

Secs. 6662(a) and (b)(2) impose a 20% penalty on an underpayment attributable to a substantial understatement of income tax. For an individual, an understatement is considered substantial if it exceeds the greater of $5,000 or 10% of the tax required to be shown on the return (Sec. 6662(d)(1)(A)). For a corporation, an understatement is considered substantial if it exceeds the lesser of $10 million or 10% of the tax required to be shown on the return (or, if greater, $10,000) (Sec. 6662(d) (1)(B)).

Before applying the mechanical test for determining whether an underpayment is deemed substantial, the taxpayer excludes any portion of the underpayment for which (1) there is substantial authority for the treatment of the position, or (2) the position was adequately disclosed in the tax return and there is a reasonable basis for the treatment of the item (Sec. 6662(d) (2)(B)).

For underpayments arising from circumstances for which there is neither substantial authority nor adequate disclosure, taxpayers are forced to rely on the more subjective standard in Sec. 6664(c), i.e., the reasonable-cause and good-faith exception. Generally, a penalty under Sec. 6662 will not be imposed for the portion of an underpayment for which it is adequately demonstrated that there is reasonable cause and that the taxpayer acted in good faith. Regs. Sec. 1.6664-4 provides guidance on whether taxpayers acted with reasonable cause and in good faith. It requires assessing taxpayers' efforts to determine the proper tax liability as well as their experience, knowledge, and education, and whether they relied on the advice of a professional tax adviser.

Seven IN. Enterprises, Inc.

In Seven W. Enterprises, Inc., 136 T.C. 539 (2011), the IRS assessed substantial underpayment penalties on two commonly controlled corporations that failed to self-assess the personal holding company tax. The Tax Court allowed a reasonable-cause exception to overcome the penalties for tax...