Highlights of the new taxpayer accuracy-related penalty rules.

• Author: Bischoff, William R.

Practitioners Will Now Face Increased Compliance Burdens and Conflicts Between Their Clients' Interests and Their Own

On Dec. 30, 1991, the Treasury Department released final regulations on the taxpayer accuracy-related penalty under Sec. 6662. The new rules apply to tax returns due after Dec. 31, 1991 (without regard to extensions), and thus affect the preparation of returns for calendar year 1991. This article will summarize the key points in the new regulations, which replace the proposed regulations issued in March 1991, and will focus on defenses against imposition of the accuracy-related penalty and the new rules regarding disclosures to avoid the accuracy-related penalty.

(For a discussion of the new preparer penalty final regulations, see "The Final Return Preparer Regulations," in the April issue.(1))

Combined Accuracy-related

Penalty - the Basics

Sec. 6662 imposes a 20% penalty on (1) substantial understatements of income tax and (2) underpayments attributable to negligence or disregard of rules or regulations. Sec. 6662 also includes penalties on valuation misstatements, pension liability overstatements, and gift or estate tax undervaluations. However, these provisions are beyond the scope of this article. Together, the five parts of the 20% taxpayer penalty under Sec. 6662 are referred to as the combined accuracy-related penalty. (The final regulations cover only the substantial understatement, negligence or disregard, and valuation misstatement parts of the combined accuracy-related penalty.)

The new regulations confirm that both the failure to file and accuracy-related penalties can apply to late filed returns. However, the accuracy-related penalty applies only if a return is filed, and late filing will not be taken into account by the IRS in determining if the accuracy-related penalty should be imposed.(2) The components of the 20% accuracy-related penalty cannot be stacked. For example, if both the substantial understatement and negligence parts of the accuracy-related penalty apply to the same item, the total accuracy-related penalty will be 20% of the underpayment caused by the item.(3)

The two accuracy-related provisions of greatest concern to most taxpayers are (1) the substantial understatement component and (2) the two-pronged component for negligence or disregard of the tax rules or regulations. Even though both the substantial understatement and negligence or disregard penalties are technically components of the combined accuracy-related penalty, they are, in reality, two separate penalties for all practical purposes. Thus, they will be discussed separately. Fortunately, both can be avoided if the taxpayer takes reasonable precautions.

Observation: In most cases, the best defense will involve making tax return disclosures. Taxpayers and practitioners will need to be careful to make disclosures that are sufficient to avoid both the substantial understatement penalty and the negligence or disregard penalty. Generally, disclosures that are sufficient to avoid the taxpayer substantial understatement penalty will also be sufficient to avoid the $250 per return preparer penalty imposed by Sec. 6694(a). Similarly, disclosures that are sufficient to avoid the taxpayer negligence or disregard penalty will generally also be sufficient to avoid the $1,000 per return preparer penalty under Sec. 6694(b). As will be discussed later, special disclosure rules apply to positions that are contrary to regulations.

Defenses Against Assessment

of the Taxpayer Substantial

Understatement Penalty

While Sec. 6662(b)(2) imposes a 20% penalty on any substantial understatement of income tax, all of the following defenses are potentially available to the taxpayer.

Insubstantial understatement defense: Sec. 6662(d) (1) defines a substantial understatement of income tax as exceeding the greater of (1) 10% of the tax required to be shown on the return or (2) $5,000 ($10,000 for corporations that are not S corporations or personal holding companies (PHCs)). Understatements that fall below these parameters are not subject to the substantial understatement penalty. The final regulations include a definition of "understatement" and special rules for determining the amount of an understatement when carrybacks or carryovers are involved.(4)

Substantial authority defense: Sec. 6662(d)(2)(B) provides that no penalty can be assessed for a substantial understatement if the taxpayer can show that there was "substantial authority" for the tax treatment of the item causing the understatement. However, if a "tax shelter" is involved, the taxpayer must reasonably believe that the tax treatment was "more likely than not" the proper treatment.(5) More likely than not...