The complexities of calculating the accuracy-related penalty.

• Author: Keenan, John

The Internal Revenue Code imposes an accuracy-related penalty on understatements of tax. In many cases, the basic formula for calculating this penalty is relatively straightforward; however, calculating a penalty can quickly become a complex and sometimes daunting task that requires careful consideration and insight.

When calculating the accuracy-related penalty, one must determine the correct amount of tax and whether any penalty defenses apply. If multiple adjustments are made to a taxpayer's return, then multiple penalties may need to be coordinated. The penalty calculation can become even more complex when multiple years are involved. Net operating loss (NOL) carrybacks and carryovers further complicate the calculation.

This item offers insight into some of the complexities of calculating the accuracy-related penalty.

Sec. 6662: The Basics

A 20% accuracy-related penalty will be imposed on any portion of an underpayment to which Sec. 6662 applies. There are a number of Sec. 6662 accuracy-related penalties, including:

* Negligence or disregard of rules or regulations (Sec. 6662(b)(1));

* A substantial understatement of income tax (Sec. 6662(b)(2));

* A substantial valuation misstatement under chapter 1 of the Code (normal taxes and surtaxes) (Sec. 6662(b)(3));

* A substantial overstatement of pension liabilities (Sec. 6662(b)(4)); and

* A substantial estate or gift tax valuation understatement (Sec. 6662(b)(5)).

In certain circumstances, the accuracy-related penalty rate is 40%. These circumstances include:

* A gross valuation misstatement (Sec. 6662(h));

* An underpayment attributable to one or more undisclosed transactions lacking economic substance (Sec. 6662(1)); or

* An understatement attributable to a transaction involving an undisclosed foreign financial asset (Sec. 6662(j)).

Each of the above penalties applies only to the portion of an underpayment attributable to the particular type of misconduct. Imposing multiple accuracy-related penalties with respect to the same underpayment--commonly referred to as "stacking"--is not permitted. The maximum accuracy-related penalty imposed on any portion of an underpayment is 20% (40% if one of the circumstances listed above exists) even if more than one penalty applies to that portion. For example, if a portion of an underpayment of tax is attributable to both a substantial understatement and a gross valuation misstatement, the maximum accuracy-related penalty is 40% of the underpayment, rather than a combined 60%.

Although there are a number of separate penalties contained in Sec. 6662, this item focuses primarily on the substantial understatement of income tax in Sec. 6662(d). Essentially, a substantial-understatement penalty is imposed when a taxpayer fails to report the correct amount of tax on its return and the resulting understatement exceeds a threshold amount.

Calculating the Substantial-Understatement Penalty

Sec. 6662(b)(2) imposes a 20% penalty on any portion of an underpayment of income tax required to be shown on a tax return that is attributable to a substantial understatement of income tax. An understatement of tax is defined in Sec. 6662(d) as the difference between the amount of tax the taxpayer was required to report on the tax return for the year and the amount of tax actually reported by the taxpayer on the tax return (minus any rebates). In other words: Understatement = X - (Y - Z), where X is the amount of tax required to be shown on the return, Y is the amount of tax shown on the return, and Z is any rebate. The amount of the understatement can be reduced by the defenses described below.

For corporate taxpayers, other than S corporations or personal holding companies, an understatement of income tax is substantial if its amount for the tax year exceeds the lesser of (1) 10% of the tax required to be shown on the return for the tax year (or, if greater, $10,000) or (2) $10 million. For other taxpayers, an understatement of income tax is substantial if its amount for the tax year exceeds the greater of (1) 10% of the tax required to be shown on the return for the tax year or (2) $5,000.

Sec. 6662(d) Defenses

Under Secs. 6662(d). (2)(B)(i) and (ii), taxpayers can avoid the substantial-understatement penalty for non-tax shelter items by either (1) establishing that substantial authority exists for the treatment of the item or (2) adequately disclosing the relevant facts affecting the item's tax treatment in the return or in a statement attached to the return (i.e., Form 8275, Disclosure Statement) and establishing that there is a reasonable basis for the tax treatment of the item.

Substantial authority is an objective standard that requires an analysis and application of the law to the relevant facts. The substantial-authority standard is less stringent than the morelikely-than-not standard (a...