The accuracy-related penalty.

• Author: Cook, John
• Position: Part 1

Sec. 6662 imposes an accuracy-related penalty equal to 20% of any underpayment of federal tax resulting from certain specified taxpayer behaviors (e.g., negligence, disregard of rules or regulations, substantial understatement of income tax, and certain over-and undervaluations). (1) This two-part article addresses the Sec. 6662 accuracy-related penalty and the defenses available to taxpayers. Part I provides an overview of the various bases upon which a Sec. 6662 penalty can be imposed. Part II, in the May issue, will discuss in detail the Sec. 6664 reasonable cause and good-faith defense to the Sec. 6662 penalty. Both parts discuss key considerations for practitioners tasked with helping clients contest an asserted application of the Sec. 6662 penalty.

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Current IRS examination procedures effectively direct examining agents to assert the Sec. 6662 penalty whenever a taxpayer understates its tax liability. For example, the Internal Revenue Manual (IRM) states that "[t]he substantial understatement penalty will be automatically asserted on Wage & Investment (W&I) and SB/SE campus cases when mathematically applicable under the correspondence examination batch program." (2) The direction to IRS examiners is to apply the substantial understatement (Sec. 6662(b)(2)) penalty in all cases in which there is a prima facie case (i.e., a mathematical trigger) for application thereof. Nonetheless, the authors' experience, and the experience of many tax professionals, is that some IRS agents have broadly (and improperly) interpreted this direction to require automatic assertion of not only the substantial understatement but also the negligence and disregard (Sec. 6662(b)(1) penalties with respect to all underpayments. Given these procedures, there is a de facto administrative presumption that the Sec. 6662 penalty applies to any understatement of tax. (3) In practice, then, taxpayers must justify the nonapplication of, or affirmative defense to, the Sec. 6662 penalty for every item the IRS adjusts on audit.

This administrative approach (the automatic assertion of accuracy-related penalties) is contrary to congressional intent. (4) Nonetheless, given the current tax enforcement environment, it is the situation taxpayers and practitioners are likely to confront for the foreseeable future. In addition, examining IRS agents will often have little, if any, practical real-world business experience. This means that such agents have no practical frame of reference for judging the reasonableness of taxpayer conduct (an essential determination, either directly or indirectly, for all the Sec. 6662 penalties), especially in a business environment. Similarly, such agents often assume that taxpayers have unlimited resources and time, and unfairly judge the reasonableness of the taxpayer's conduct on that basis. Moreover, whether the agents have such experience or not, they often assume for penalty purposes that a taxpayer is per se negligent (or worse) if the Taxpayer happens to disagree with the government about the interpretation or application of federal tax law.

In these circumstances, it is especially important for practitioners to thoroughly understand both the circumstances under which the IRS may properly apply a Sec. 6662 penalty and the potential defenses thereto.

Overview

Sec. 6662(a) imposes an addition to tax of 20% of the portion of the "underpayment to which [Sec. 6662] applies," which is any underpayment attributable to certain conditions or taxpayer conduct identified in Sec. 6662 itself. Thus, for the Sec. 6662 penalty to apply, a taxpayer must have an underpayment of tax, and the underpayment must be attributable to one of the specific conditions or behaviors (referred to herein as "triggers") identified in Sec. 6662, including:

* Negligence or disregard of rules or regulations;

* Any substantial understatement of income tax;

* Any substantial valuation misstatement under chapter 1 (i.e., Secs. 1-1400U-3, dealing with normal taxes and surtaxes);

* Any substantial overstatement of pension liabilities; and

* And substantial estate or gift tax valuation understatement. (5)

Before discussing the specific Sec. 6662 triggers, several general points should be made. First, it is helpful to divide the triggers into conduct-based and mechanical triggers. The conduct-based triggers (negligence and disregard) apply as a function of the taxpayer's conduct. The mechanical triggers are, at least as an initial matter, mathematical in nature and are imposed either because an under-or overstatement exceeds a certain threshold or because the taxpayer has significantly over-or undervalued an item on the taxpayer's return.

Second, the purpose of tax penalties is to "encourage voluntary compliance by supporting the standards of behavior expected by the Internal Revenue Code." (6) Thus, only behavior that falls below the relevant standards of care should properly be subject to penalty. As discussed below, the proper focus of the statutory regime is ultimately on the taxpayer's behavior in most cases because if the taxpayer can demonstrate the reasonableness of its conduct or return position, the Sec. 6662 penalty should generally not apply even under a mechanical trigger. As the Supreme Court has recognized, "the [tax] law is complicated, accounting treatment of various items raises problems of great complexity, and innocent errors are numerous. ... It is not the purpose of the law to penalize frank difference of opinion or innocent errors made despite the exercise of reasonable care." (7)

Third, the reference to the "portion" of any underpayment in Sec. 6662(a) means that the penalty applies only to that portion of the underpayment that is attributable to a specific trigger. Any portion of the underpayment that is not attributable to a trigger is not subject to the Sec. 6662 penalty. This is in contrast to prior law under which the penalty applied on the entire underpayment if any portion thereof was attributable to negligence. For similar reasons, there is no "stacking" of Sec. 6662 penalties. That is, even if a portion of an underpayment is attributable to more than one trigger, only one trigger will apply to that portion. Thus, the maximum accuracy-related penalty that can apply to any portion of an underpayment is 20% (or 40% if the Sec. 6662(h) gross valuation misstatement rules apply). Similarly, any portion of an underpayment that is attributable to civil fraud (Sec. 6663), is not subject to the Sec. 6662 penalty. (8)

Fourth, in this context practitioners should be aware of Sec. 6662A, which generally imposes a similar accuracy-related penalty on understatements attributable to "reportable transactions." Reportable transactions are generally those taxpayers are required to disclose under the Sec. 6011 regulations finalized in 2003. (9) A full discussion of Sec. 6662A is beyond the scope of this article, but practitioners should be aware that if a taxpayer's understatement is attributable to a reportable transaction, a whole different set of rules applies, with respect to both the application of the penalty in the first instance and the potential reasonable cause/good-faith exception under Sec. 6664.

Fifth, it is important to note that despite the statutory nomenclature, Sec. 6662 actually imposes an "addition to tax." This characterization has important administrative and procedural significance. Perhaps most notably, additions to tax are assessed in the same manner as the underlying taxes, and the IRS's assertion thereof is presumed correct. (10) In addition, because the Sec. 6662 penalty is an addition to tax, underpayment interest accrues on the penalty in the same manner as on the tax itself. (11)

Finally, Sec. 6664 provides an affirmative defense to the proposed application of any of the Sec. 6662 triggers. Specifically, "[n]o penalty shall be imposed under section 6662 ... with respect to any portion of an underpayment if it is shown that there was a reasonable cause for such portion and that the taxpayer acted in good faith with respect to such portion." (12) The interaction of the Sec. 6662 penalty provisions and the Sec. 6664 defense raises some interesting issues, which will be addressed more fully in Part II. Nonetheless, it will be helpful for readers, as they consider the application of specific Sec. 6662 triggers below, to be aware of the potential availability of Sec. 6664's reasonable cause/good-faith defense.

Negligence

The first Sec. 6662 penalty trigger is negligence. (13) The term "negligence" is not defined in the Code or the regulations. Nevertheless, courts have generally applied the common law tort definition of the term, holding that negligence means failing to do what a reasonable and ordinarily prudent person would do under the same or similar circumstances. (14) In addition, the regulations, while not defining negligence, do provide examples of negligent behavior. These examples include failing to keep adequate books and records and failing to substantiate items properly. (15)

Practice tip: In all cases, however, it is important to remember (and to remind IRS agents) that the taxpayer's negligence is objectively measured. This requires a determination of what is reasonable under the circumstances and necessarily involves a comparison of the taxpayer's conduct with that of other similarly situated taxpayers. In this regard, both courts and the regulations recognize that the taxpayer's experience, knowledge, and education are relevant in determining the reasonableness of his or her conduct. (16) Of course, this is a two-edged sword. For example, if taxpayers are relatively unsophisticated and inexperienced, they are generally held to a lower standard. But such lack of sophistication could also support a conclusion that the taxpayer's failure to consult a tax adviser was itself negligent. On the other hand, relatively sophisticated and experienced taxpayers are...