10th Circuit reverses Tax Court on IRS failure to waive penalty.

• Author: Barton, Peter C.

In Fisher, 45 F3d 396 (1995), rev'g TC Memo 1992-740, the Tenth Circuit ruled that the IRS abused its discretion in refusing to waive the Sec. 6661 substantial understatement penalty. The Court of Appeals based its decision on the Service's failure to respond to the taxpayers' request for a waiver and failure to give reasons for denying the waiver.

Sec. 6661, which applies to tax returns due prior to Jan. 1, 1990, imposes a 25% penalty for any underpayment due to a substantial understatement of income tax. For individuals, an understatement is substantial if it exceeds 10% of the correct tax liability or $5,000, whichever is greater. For any item not involving a tax shelter, an understatement shall be reduced under Sec. 6661(b)(2)(B) when the taxpayer's treatment of the item was either based on substantial authority or the taxpayer adequately disclosed the relevant facts affecting the item's tax treatment on the return or in an attached statement.

Sec. 6661(c) allows the IRS to waive the penalty if the taxpayer shows both that there was reasonable cause for the understatement and that he acted in good faith. In Mailman, 91 TC 1079 (1988), the Tax Court ruled that the denial of a waiver by the Service is reviewable by the court on an "abuse of discretion" basis. Under this standard, it is not enough for the taxpayer to convince the court that the court would have waived the penalty. Instead, the court will defer to the IRS's judgment unless the taxpayer convinces the court that the Service denied the waiver "arbitrarily, capriciously, or without sound basis in fact."

For returns due after Dec. 31, 1989, Congress repealed Sec. 6661 and replaced it with Secs. 6662 and 6664. Sec. 6662, the accuracy-related penalty, imposes a 20% penalty for any underpayment of tax due to one or more of the following: negligence, substantial understatement of income tax, substantial valuation overstatement, substantial overstatement of pension liabilities, or substantial estate or gift tax valuation understatement. Sec. 6662 prevents the stacking of these penalties. The substantial authority and the adequate disclosure exceptions to the substantial understatement penalty continue to apply, with the additional requirement that, for adequate disclosure, there must be a reasonable basis for the treatment of the item.

Sec. 6664(c) specifies that no penalties shall be imposed under Sec. 6662 or 6663 (relating to fraud) if the taxpayer had reasonable cause for the...