Establishing substantial authority for undisclosed tax positions.

AuthorNash, Claire Y.


* To avoid the imposition of a penalty for an understatement of tax due to an unreasonable position for an understatement related to an undisclosed position, a practitioner must meet the substantial authority standard with respect to the position.

* Regs. Sec. 1.6662(d)(3)(iii) lists the authorities that may be cited to support that there is substantial authority for the tax treatment of an item. The weight accorded an authority depends on its relevance, its persuasiveness, and its source.

* In analyzing the weight that an authority carries, a practitioner must look to the decisions of the federal appellate circuit in which the taxpayer resides. While there is a distinct hierarchy of authorities observed by all the circuits, there is considerable variance among the circuits on the deference given to the various forms of authority within that hierarchy.



When CPAs and attorneys engage in tax consulting services, they are advocates for their clients. However, they do not have the luxury afforded other consultants of adopting the attitude that "the client is always right." CPAs and attorneys commonly consult with clients or prospective clients who would like to take an aggressive approach with respect to an undisclosed tax position on a tax return. It is not appropriate to comply with the client's request merely because the taxpayer is willing to run the risk of incurring tax penalties if the IRS audits the return and challenges the tax position.

CPAs and attorneys must meet the ethical standards of their professions when recommending undisclosed tax positions to clients. In addition to professional practice standards, they must also comply with statutory standards of conduct that apply to tax return preparers to avoid the imposition of accuracy-related penalties when there is an understatement of tax liability. When advising on undisclosed positions, practitioners must conduct an analysis of the various tax authorities to determine the likelihood that a position will be sustained on its merits. This article examines:

* The requirement to support undisclosed tax positions in accordance with the applicable statutory standard to avoid accuracy-related penalties;

* The authorities in the regulations that can be cited to support that the statutory standards have been met; and

* The deference given each authority in judicial decisions to the extent that the court has determined its precedential value.

Standards of Conduct

The Internal Revenue Code and related regulations set forth rules on the authority of CPAs, attorneys, enrolled agents, and others representing taxpayers to practice before the IRS. Statutory and administrative authorities set forth the standards of conduct for advising clients about federal tax issues and issuing written opinions with respect to the advice given to clients. Generally, if a return includes adequate disclosure of a position taken on the return and the justification for that position, there will be no accuracy-related penalty imposed for that position on either the taxpayer or the tax return preparer as long as there is a reasonable basis for the position.

Since disclosure of unsettled tax issues will undoubtedly draw the attention of the Service, taxpayers often strongly prefer that their tax return preparers file their returns without disclosing unsettled issues on the face of their returns. Due to this natural tendency of taxpayers to avoid disclosure of questionable tax positions, Congress and the IRS are constantly concerned about taxpayers filing returns with such positions. In order to discourage the filing of tax returns with undisclosed aggressive tax positions, Congress has raised the standards tax return preparers must meet with respect to a return to avoid the imposition of an accuracy-related penalty for an understatement of tax due to an unreasonable position (i.e., a preparer penalty). Under Sec. 6694, as amended by the Emergency Economic Stabilization Act of 2008 (EESA), (1) to avoid a preparer penalty for an undisclosed position, a tax return preparer must be able to show that there is substantial authority for the position.

Substantial Authority in Support of an Undisclosed Tax Position

Regs. Sec. 1.6662-4(d)(3)(i) explains when there is substantial authority in support of a tax position. The regulation provides in part:

There is substantial authority for the tax treatment of an item 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. The weight of authorities is determined in light of the pertinent facts and circumstances in the manner prescribed by paragraph (d)(3)(ii) of this section. There may be substantial authority for more than one position with respect to the same item. Because the substantial authority standard is an objective standard, the taxpayer's belief that there is substantial authority for the tax treatment of an item is not relevant in determining whether there is substantial authority for that treatment. Regs. Sec. 1.6694-2 requires the prescribed analysis in Regs. Sec. 1.6662-4(d)(3)(ii) for purposes of determining whether substantial authority is present. A tax return preparer may not rely on unreasonable assumptions, and the authorities contained in Regs. Sec. 1.6662-4(d) (3)(iii) must be considered in determining whether a position satisfies the substantial authority standard of conduct.

Regs. Sec. 1.6662(d)(3)(iii) indicates that only the following are acceptable authorities to determine whether there is substantial authority for the tax treatment of an item:

* Internal Revenue Code and other statutory provisions;

* Proposed, temporary, and final regulations;

* Revenue rulings and revenue procedures;

* Tax treaties and regulations thereunder and Treasury and other official explanations of such treaties;

* Court cases;

* Congressional intent as reflected in committee reports;

* General explanations of tax legislation prepared by the Joint Committee on Taxation (the Blue Book);

* Private letter rulings and technical advice memoranda issued after October 31, 1976;

* Actions on decisions and general counsel memoranda issued after March 12, 1981;

* IRS information or press releases; and

* Notices, announcements, and other administrative pronouncements published by the Service in the Internal Revenue Bulletin.

An authority no longer remains an authority if it is overruled or modified, implicitly or explicitly, by a body with the power to overrule or modify it. There is substantial authority for a tax position if there is substantial authority at the time the taxpayer files the return containing the position, or if there was substantial authority on the last day of the tax year to which the return relates.

Outside of the hypothetical illustrations found in Regs. Sec. 1.6694-2, there is little guidance for tax return preparers on how to navigate through the rules requiring the use of substantial authorities in the analysis needed to comply with the standards of conduct and ensure that an undisclosed tax position will be sustained on its merits. To conduct an informed analysis, preparers should be familiar with the deference the courts have afforded a particular authority. The discussion that follows reviews the authorities set forth in Regs. Sec. 1.6662(d)(3)(iii) that tax return preparers may rely on to provide evidence that there is substantial authority in support of a tax position.

Assessing the Weight of an Authority

As noted above, there is substantial authority for the tax treatment of an item when the weight of authorities supporting the treatment is substantial in relation to the weight of authorities supporting contrary treatment. The weight accorded an authority depends on its relevance, persuasiveness, and the source of the authority.

Whether a taxpayer or tax return preparer can avoid accuracy-related penalties associated with a substantial understatement of tax often depends on the adequacy of the preparer's analysis and the weight accorded the authorities used to support that there is substantial authority for a position. Even if a preparer's interpretation of an authority is faulty, the preparer may be able to avoid the accuracy-related penalty as long as it was reasonable to construe the authority as he or she did.

For example, in Crouch, (2) the Tax Court ruled against the imposition of the accuracy penalty when Crouch, a tax return preparer, relying on Sec. 174, Rev. Rul. 73-395, and [section]2119 of the Tax Reform Act of 1976 (TRA 76), (3) understated his income by taking an improper deduction for prepublication expenses associated with tax guides that he intended to market. The substantial authorities on the issue were inconsistent. Sec. 174 permitted a deduction for research and experimental expenditures, but case law on the issue had held that prepublication expenses did not qualify as research and experimental expenses. Rev. Rul. 73-395 stated that a taxpayer must capitalize expenditures referred to in Sec. 174 over time rather than deducting them in full in the year in which the taxpayer incurred them. However, TRA 76 [section]2119 provided that such expenditures could be expensed under Sec. 174 in disregard of Rev. Rul. 73-395 as long as the party taking the deduction was engaged in a trade or business associated with the deduction.

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