Final regulations relating to the accuracy-related penalty.

• Author: Granwell, Alan Winston

1. INTRODUCTION

   On December 31, 1991, the Internal Revenue Service published final regulations (1*) on the accuracy-related penalty imposed by section 6662 of the Internal Revenue Code. (2) Section 6662 was enacted by the Omnibus Budget Reconciliation Act of 1989 (the "1989" Act") (3) as part of a broad-based reform of the penalty provisions. This article (i) reviews the historical underpinnings of section 6662 and the congressional intent underlying the changes effected in 1989, (ii) describes the final regulations, and (iii) comments on the manner in which those final regulations implement the congressional intent underlying section 6662.

2. BACKGROUND OF SECTION 6662

   For many years, the penalties imposed by the Code were easy to understand. Penalties for negligence, fraud, late payment of tax, and late filing of returns were authorized under even the early formulations of the federal income tax law. For example, the Revenue Act of 1918 provided for a 5-percent penalty on the total amount of a deficiency if any part was due to negligence. No penalty was imposed if the return was made in "good faith" and the understatement was not due "to any fault of the taxpayer." (4) Subsequent regulations defined negligence as "the absence of reasonable care under the circumstances." (5) The Internal Code of 1954 imposed a penalty equal to 5 percent of the amount of any underpayment due to "negligence or international disregard of rules and regulations." (6) These general provisions remained relatively unchanged for many years.

   Beginning in 1981, the penalty scheme became increasingly more complicated. In that year, an interest component was added to the negligence penalty, (7) and a valuation overstatement penalty for purposes of the income tax was added. (8) In 1982, a new penalty for substantial understatement of tax was added to the Code. (9) A valuation understatement penalty for purposes of estate and gift taxes was added in 1984. (10) In 1986, yet another penalty -- for overstatement of pension liabilities -- was added. (11)

   These various modifications to the penalty scheme led to complex and sometimes harsh results. Stacked or overlapping penalties often were imposed for the same conduct, or on the same underpayment.

   In an effort to remedy these problems, Congress enacted the Improved Penalty Administration and Tax Compliance Act as part of the 1989 Act. The 1989 Act consolidated the penalties for negligence, substantial understatement, and valuation misstatements in a new section 6662 and imposed a single 20 percent (12) penalty on the portion of any underpayment (13) attributable to any of the proscribed conduct. (14) Further, standardized exception criteria were made applicable to all accuracy-related penalties: No penalty is imposed if it is shown that (i) the taxpayer had reasonable cause for an underpayment, and (ii) the taxpayer acted in good faith. (15)

   The legislative history to the 1989 Act makes clear that the enactment of standardized exception criteria represented a key component of the overall legislative effort to both simplify the penalty scheme and improve fairness for taxpayers:

   The enactment of this standardized exception criterion is designed to permit the courts to review the assertion of penalties under the same standards that apply in reviewing additional tax that the Internal Revenue Service asserts is due. By applying this unified exception criterion to all the accuracy-related penalties, the committee believes that taxpayers will more easily understand the standard of behavior that is required. The committee also believes that this unified exception criterion will simplify the administration of these penalties by the IRS.

   The committee is concerned that the present-law accuracy-related penalties (particularly the penalty for substantial understatements of tax liability) have been determined too routinely and automatically by the IRS. The committee expects that enactment of standardized exception criterion will lead the IRS to consider fully whether imposition of these penalties is appropriate before determining these penalties. (16)

   The 1989 Act also made a number of other reforms to the penalty provisions in order to further the goals of simplification and fairness. Four key reforms warrant special emphasis. First, the prior law negligence penalty applied to the entire underpayment if any part of the underpayment was attributable to negligence. Thus, if an audit revealed a negligently reported deduction of $1 and if other audit adjustments not attributable to negligence resulted in a total underpayment of $1,001, the 5-percent negligence penalty applied to the entire $1,001. (17) Although the 1989 Act increased the penalty rate from 5 percent to 20 percent, the penalty is imposed only on the amount of the underpayment attributable to negligence (or to other conduct proscribed by section 6662).

   Second, a taxpayer's failure to include on an income tax return an amount shown on an informal return was presumed to be negligent prior to the 1989 Act. This presumption was eliminated. The legislative history cautions, however, that "[a]s a practical matter, even in the absence of a statutory presumption, evidence of such a failure is still strong evidence of negligence." (18)

   Third, the 1989 Act modified the substantial understatement penalty by (i) lowering the rate to 20 percent, (ii) requiring the IRS to publish annually a list of positions for which it contends no substantial authority exists, and (iii) expanding the list of authorities that constitute substantial authority to include proposed regulations, private letter rulings, technical advice memoranda, actions on decisions (AODs), general counsel memoranda (GCMs), information or press releases, notices, and any other similar documents published in the Internation Revenue Bulletin, and General Explanations of tax legislation prepared by the Joint Committee on Taxation ("Blue Books"). With respect to item (ii), the legislative history notes:

   The committee believes that this list will be useful to taxpayers, in that it will assist taxpayers in determining whether substantial authority exists with respect to a particularly issue on the list. Although the list is not exclusive, the committee intends that the IRS make the list as comprehensive as practical, which will make it more useful to taxpayers and their advisors. (19)

   Consistent with this general objective, the legislative history gave Treasury express (but narrow) authority to restrict the list of authorities:

   The committee's intent is to broaden the list of authorities upon which taxpayers may rely. The committee would, however, permit the Treasury to issue regulations providing that specific items on the committee's list of additional authorities (except for proposed regulations not yet superseded or "Blue Books") that were issued prior to the date of enactment of this bill may not be considered to be substantial authority. For example, Treasury regulations could provide that private letter rulings issued prior to the date they began to be publicly disseminated are not substantial authority. Any such limitation should, however, be as narrow as practicable, in order to further the committee's general intent that the list of authorities on which taxpayers may rely should be broadened. (20)

   Fourth, the 1989 Act revised the valuation overstatement penalty by (i) extending the penalty to all taxpayers, (ii) providing for the application of the penalty only if the value or adjusted basis of property claimed on a return is 200 percent or more of the correct amount, (iii) limiting the penalty to cases overstatement exceeds $5,000 ($10,000 for C corporations other than personal holding companies), and (iv) increasing the penalty rate from 20 percent to 40 percent in the case of "gross valuation misstatements." (21) The intent of these changes was to exempt from the penalty "a number of instances of good-faith valuation disputes that may be subject to penalty under present law." (22)

3. THE FINAL REGULATIONS

   UNDER

   SECTION 6662

   1. Overview

      The final regulations under section 6662 reflect extensive public comments on the proposed regulations published on March 4, 1991. (23) The regulations address only three of the five components of the accuracy-related penalty: (i) negligence or disregard of rules or regulations, (ii) substantial understatements of income tax, and (iii) substantial (and gross0 income tax valuation misstatements. The provisions of section 6662 relating to substantial overstatements of pension liabilities and substantial estate or gift tax valuation understatements are not addressed.

      The regulations specifically prohibit the stacking of penalties, making clear that only one penalty may be imposed even if the underpayment is attributable to more than one of the accuracy-related penalty components (e.g., negligence and valuation misstatements). (24)

      The regulations generally are effective for income tax returns due (without regard to extensions) after December 31, 1989. (25) The rules relating to adequate disclosure, however, are effective for income tax returns due (without regard to extensions) after December 31, 1991. Transitional relief is provided under certain circumstances for returns filed prior to January 1, 1992. (26)

   2. Negligence or Disregard of Rules

      or Regulations

      1. Negligence

         Under the regulations, "negligence" includes the failure (i) to make a reasonable attempt to comply with the tax law, (ii) to exercise ordinary and reasonable care in preparing a tax return, and (iii) to keep adequate books and records (or to properly substantiate items). A return position is negligent "if it lacks a reasonable basis." (27)

         The regulations also describe specific cases in which negligence is "strongly indicated." First, negligence is strongly indicated if the taxpayer fails to include in its return an amount of income shown on an information return (e.g., Form...