20.1.5  Return Related Penalties (Cont. 1)

20.1.5.9 
IRC 6662(e), Substantial Valuation Misstatement

20.1.5.9.3  (01-24-2012)
IRC 6662(e)(1)(B), Valuation Misstatement Penalties for Transfer Pricing Transactions Under IRC 482

  1. IRC 6662(e)(1)(B) imposes transfer pricing penalties on any underpayment attributable to a substantial valuation misstatement pertaining to transfer pricing under IRC 482. These penalties are identified as the transactional penalty and the net adjustment penalty.

  2. The Transactional Penalty. This penalty applies when the price reported for any property or services is 200 percent or more (or 50 percent or less) of the amount determined under IRC 482 to be the correct price.

  3. The Net Adjustment Penalty. This penalty applies when the net IRC 482 adjustment exceeds the lesser of $5 million or 10 percent of the taxpayer’s gross receipts.

  4. The term "price for any property or services" encompasses all kinds of adjustments under IRC 482, including purchase prices, fees, services, rents, interest, and advances.

  5. For the net IRC 482 adjustments that are excluded from the penalty, see IRC 6662(e)(3)(B). For calculation examples see Treas. Reg. 1.6662-6(c)(7).

  6. See Exhibit 20.1.5-4 flow chart for the IRC 6662(e) Transfer Pricing Penalty.

20.1.5.9.4  (01-24-2012)
IRC 6662(h), Gross Valuation Misstatement

  1. A gross valuation misstatement exists:

    1. If the value or adjusted basis of any property claimed on a return is 200 percent or more of the corrected amount,

    2. If the price for any property or service (or for the use of property) claimed on a return is 400 percent or more (or 25 percent or less) of the amount determined under IRC 482 to be the correct price, or

    3. If the net IRC 482 adjustment exceeds the lesser of $20,000,000 or 20 percent of the taxpayer’s gross receipts.

20.1.5.9.5  (01-24-2012)
Penalty Calculation

  1. In the example below the substantial valuation misstatement penalty applies to the individual income tax return because both conditions for assertion are met (no exceptions to the penalty apply and the amount of the understatement and underpayment are equal):

    Example:

    Reference Items Conditions Amounts
    a) Price of property (or adjusted basis) as reported on the return $46,000
    b) Price as adjusted by examination $20,000
    c) 150 percent times the amount in (b) $30,000
    d) Note: Condition #1 is met. The value reported on the return of $46,000 is more than 150 percent of the adjusted amount of $20,000 ($46,000 divided by $20,000 = 230 percent).  
    e) Amount adjusted (line "a" less line "b" ) $26,000
    f) Underpayment on $26,000 $ 7,000
    g) Penalty (20 percent times $7,000) $ 1,400
    h) Note: Condition #2 is met. The underpayment of $7,000 attributable to the misstatement of $26,000 exceeds the required $5,000.  

  2. If the adjusted value in (b) above were $10,000, the amount reported of $46,000 would then exceed the adjusted amount ($10,000) by more than 200 percent ($46,000 divided by $10,000 = 460 percent). The gross valuation misstatement penalty would then apply at 40 percent of the applicable underpayment.

  3. For calculation examples, involving carryovers and flow through entities, see IRM 20.1.5.2.3.

  4. The penalty is considered separately for each property adjusted. To distinguish between a substantial and a gross valuation misstatement requires a property-by-property calculation.

  5. With regard to the transfer pricing penalty under IRC 6662(e), please refer to the rules for coordinating between the transactional penalty and the net adjustment penalty illustrated by examples in Treas. Reg. 1.6662-6(f).

20.1.5.9.6  (01-24-2012)
Penalty Assessments and Abatements

  1. See IRM 20.1.5.3.2 for purposes of the IRC 6662(h) penalty.

20.1.5.9.7  (01-24-2012)
Penalty Relief

  1. See IRM 20.1.5.6 for purposes of the IRC 6662(h) penalty.

20.1.5.9.7.1  (01-24-2012)
Reasonable Cause

  1. IRC 6662(c) provides an exception to the penalty if the taxpayer has reasonable cause and acted in good faith.

  2. The reasonable cause exception applies to the transfer pricing penalties only under certain circumstances. See IRC 6662(e).

    1. For the transactional penalty, see IRM 20.1.5.9.3 and IRC 6662(e)(1)(B)(i). A taxpayer must meet the reasonable cause requirements to avoid the penalty.

    2. For the net adjustment penalty, see IRM 20.1.5.9.3.

  3. In instances where a taxpayer has relied on a professional analysis in determining transfer pricing, the relationship of the professional is not determinative in evaluating whether the taxpayer reasonably relied in good faith on advice.

20.1.5.9.7.2  (01-24-2012)
Charitable Deduction Property

  1. No penalty may be imposed under IRC 6662 with respect to any portion of an underpayment upon a showing by the taxpayer that there was a reasonable cause for, and the taxpayer acted in good faith with respect to, such portion.

  2. The taxpayer will not satisfy the good faith test by merely relying on an appraisal. The taxpayer will not be considered to have reasonably relied in good faith on advice unless the requirements of Treas. Reg. 1.6664-4(b) and (c) are met.

  3. In addition, the taxpayer must meet the specific requirements in Treas. Reg. 1.6664-4(h) where charitable deduction property is involved.

  4. When there is an underpayment due to overstated charitable deduction property, the reasonable cause exception under IRC 6662(c)(2) applies only if the following two conditions are first met:

    1. The claimed value of the property was based on a "qualified appraisal" made by a "qualified appraiser," and

    2. The taxpayer made a good faith investigation of the value of the contributed property.

  5. The Pension Protect Act of 2006 added a penalty provision under IRC 6695A. If the claimed value of property based on an appraisal results in a substantial or gross valuation misstatement under IRC 6662, and IRC 6695A penalty is imposed on any person who prepared the appraisal and who knew, or reasonably should have known, the appraisal would be used in connection with a return or claim for refund. See IRM 20.1.12, Penalties Applicable to Incorrect Appraisals.

20.1.5.10  (01-24-2012)
IRC 6662(f), Substantial Overstatement of Pension Liabilities

  1. The amount of the substantial overstatement of pension liabilities penalty is 20 percent of the underpayment attributable to a substantial overstatement of pension liabilities and 40 percent of the underpayment attributable to a gross valuation misstatement.

  2. An overstatement of pension liabilities occurs when the actuarial determination of the liabilities taken into account for purposes of computing the employer contribution deduction under IRC 404(a) is 200 percent or more of the correct amount (400 percent or more in the case of a gross valuation misstatement).

  3. The penalty does not apply unless the underpayment attributable to the substantial overstatement of pension liabilities (or gross valuation misstatement, if applicable) exceeds $1,000.

20.1.5.10.1  (01-24-2012)
Penalty Calculation

  1. The following example illustrates the penalty criteria and calculation:

    1. The taxpayer’s 2008 return had taxable income of $300,000 and tax of $98,000.

    2. In determining the amount of taxable income, the taxpayer deducted $80,000 for contributions to a defined benefit pension plan maintained for its employees.

    3. Upon examination of the taxpayer’s return, the IRS adjusted the interest assumption in valuing the pension liabilities for calculating the deduction.

    4. The taxpayer’s maximum deduction for contributions to its plan was accordingly adjusted from $80,000 to $35,000.

    Note:

    The 200 percent requirement is met when the amount deducted on the return ($80,000) exceeds the correct amount ($35,000) by more than 200 percent ($80,000 divided by $35,000 = 229 percent). The penalty is calculated as follows:

    Reference Items Calculation Conditions Amounts
    a) Taxable income as adjusted ($300,000 + $45,000) $345,000
    b) Tax liability as adjusted $111,500
    c) Tax liability as filed $98,000
    d) Underpayment ("b" less "c" ) $13,500
    e) Penalty rate 20%
    f) Penalty ("d" times "e" ) $2,700

  2. Since the deduction claimed exceeds the corrected amount by more than 200 percent, but is less than 400 percent, the penalty applies at the 20 percent rate. If the corrected deduction were $18,000, the percentage of the overstatement would be 444 percent ($80,000 divided by $18,000) and the penalty would apply at the 40 percent rate.

20.1.5.10.2  (01-24-2012)
Penalty Relief

  1. The penalty will not apply if the taxpayer shows that there was a reasonable cause for the valuation or assumptions used in deriving at the deduction on the return and that the taxpayer acted in good faith.

  2. See IRM 20.1.5.6 for additional penalty relief criteria.

20.1.5.11  (01-24-2012)
IRC 6662(g), Substantial Estate or Gift Tax Valuation Understatement

  1. The amount of the substantial estate or gift tax valuation understatement penalty is 20 percent of the underpayment attributable to a substantial estate or gift tax valuation understatement or 40 percent of the underpayment attributable to a gross valuation misstatement.

  2. This penalty applies only to returns of tax imposed for estate or gift taxes.

20.1.5.11.1  (07-01-2008)
Penalty Assertion

  1. There is a substantial estate or gift tax valuation understatement if the value of the property claimed on an estate or gift tax return is 65 percent or less of the corrected amount (or 40 percent or less in the case of a gross valuation misstatement). See IRC 6662(g)(1) and IRC 6662(h)(2)(C) respectively.

  2. The penalty does not apply unless the underpayment attributable to the substantial estate or gift tax valuation understatement (or gross valuation misstatement, if applicable) exceeds $5,000.

20.1.5.11.2  (01-24-2012)
Penalty Calculation

  1. The determination of whether the percentage threshold for a substantial or gross valuation misstatement is reached is made on a property-by-property basis.

  2. To calculate the valuation understatement percentage:

    1. Divide the value of the property reported on the return, by

    2. The corrected value of the property.

  3. The following example illustrates the calculation of the understatement percentage for three adjustments (assuming the $5,000 requirement is met and no exceptions to the penalty apply).

    Example:

    The decedent’s estate tax return included stock in three closely held corporations: A, B, and C. On the return, the stock in each corporation was valued at $80,000. On examination, the corrected stock values were determined to be $120,000 for A, $190,000 for B, and $330,000 for C. The following determinations were made:

    1. Stock A: The amount on the return ($80,000), divided by the corrected amount ($120,000) is 67 percent. The penalty does not apply to this adjustment because the value of the stock is not 65 percent or less of the corrected amount.

    2. Stock B: The amount on the return ($80,000), divided by the corrected amount ($190,000) is 42 percent. The accuracy-related penalty attributable to a substantial estate or gift tax valuation understatement applies to this adjustment because the value of Stock B is 65 percent or less (but more than 40 percent) of the corrected amount. The penalty amount is 20 percent of the underpayment attributable to the adjustment for Stock B.

    3. Stock C: The amount on the return ($80,000), divided by the corrected amount ($330,000) is 24 percent. The accuracy-related penalty attributable to a gross valuation misstatement applies to this adjustment because the value of Stock C is 40 percent or less of the corrected amount. The penalty amount is 40 percent of the underpayment attributable to the adjustment for Stock C.

  4. For calculation examples that relate to the above adjustments, see Exhibit 20.1.5-5.

20.1.5.11.3  (07-01-2008)
Penalty Assessments and Abatements

  1. See IRM 20.1.5.3.2 for purposes of the IRC 6662(g) penalty.

20.1.5.11.4  (01-24-2012)
Penalty Relief

  1. Penalty relief may be available under certain circumstances if a taxpayer acquired property from a decedent who died in 2010.

  2. Special rules may apply in determining tax items including basis, gain, loss, holding period, and character of the acquired property. Section 301(c) of the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010, P. L. 111-312, allows the executor of the estate of any decedent who died in 2010 to elect not to have the estate tax rules apply and instead to have modified carryover basis rules apply. This election could impact the amount of tax owed. See Pub 4895, Tax Treatment of Property Acquired From a Decedent Dying in 2010.

  3. A taxpayer acquiring property from a decedent may not know whether the executor will elect not to have the estate tax rules apply to the decedent’s estate. Thus, a taxpayer may be entitled to penalty relief, for example, suppose a taxpayer acquired property from a decedent who died in 2010 and sold the same property in 2010. If the taxpayer filed a timely extension to file their income tax return, estimated the gain or loss from such a sale, and made any other estimates for the acquired property necessary to compute the tax, and it is later determined that the taxpayer owes additional tax because the estimate is incorrect, penalty relief will be considered if the estimate was based on a reasonable interpretation of the law.

  4. See IRM 20.1.5.6 for additional information on penalty relief.

20.1.5.12  (01-24-2012)
IRC 6662(b)(6), Penalty for Underpayments Attributable to Transactions Lacking Economic Substance

  1. An accuracy-related penalty is imposed on any transactions lacking economic substance as defined under IRC 6662(b)(6). The penalty applies on any disallowed tax benefits failing to meet the requirements of IRC 7701(o), Clarification of Economic Substance Doctrine or any similar rule of law.

  2. Guidance is provided in IRB 2010-40, http://www.irs.gov/irb/2010-40_IRB/ar09.html, IRB 2010-40, Interim Guidance Under the Codification of the Economic Substance Doctrine and Related Provisions in the Education Reconciliation Act of 2010, dated October 4, 2010.

  3. The penalty for underpayments attributable to transactions lacking economic substance is equal to 20 percent of the underpayment.

  4. The penalty is effective and applies to transactions entered into on or after March 31, 2010.

  5. Contact the Office of Servicewide Penalties or your local technical advisor prior to assertion of this penalty pending additional written guidance.

20.1.5.12.1  (01-24-2012)
IRC 6662(i), Increase in Penalty in Case of Nondisclosed Noneconomic Substance Transactions

  1. If any portion of an underpayment is attributable to one or more nondisclosed noneconomic substance transactions, the penalty increases to 40 percent as defined under IRC 6662(i).

  2. Nondisclosed noneconomic substance transaction means any portion of a transaction described in IRC 6662(b)(6), where the relevant facts affecting the tax treatment are not adequately disclosed in the return or in a statement attached to the return. A taxpayer will be deemed to have adequately disclosed only if it provides the required information on Form 8275, Disclosure Statement or Form 8275-R, Regulation Disclosure Statement, or on Schedule UTP, if required to file such schedule (see Announcement 2010-75 for information on when a taxpayer must file Schedule UTP), or consistent with the instructions to any other subsequently issued form or schedule.

  3. If the transaction is also a reportable transaction pursuant to Treas. Reg. 1.6011-4, the taxpayer has not adequately disclosed the transaction unless it is reported both in accordance with the reportable transaction reporting rules and on Form 8275, Form 8275-R, or Schedule UTP (or any subsequently issued form or schedule), as appropriate. A taxpayer will be deemed to have adequately disclosed if it makes a disclosure consistent with the terms of Rev. Proc. 94-69.

  4. The penalty is effective and applies to transactions entered into on or after March 31, 2010.

  5. Contact the Office of Servicewide Penalties or your local technical advisor prior to assertion of this penalty pending additional written guidance.

  6. LB&I examiners must obtain the approval of the Director of Field Operations before raising the IRC 6662(i) penalty in any case.

20.1.5.12.1.1  (01-24-2012)
Special Rules for Amended Return

  1. Do not take into account amendments or supplements to a tax return filed after the date the taxpayer is first contacted by the IRS.

20.1.5.12.1.1.1  (01-24-2012)
Penalty Relief

  1. Reasonable cause does not apply to any transactions lacking economic substance.

20.1.5.13  (01-24-2012)
IRC 6662(b)(7) and IRC 6662(j), Undisclosed Foreign Financial Asset Understatement

  1. The undisclosed foreign financial asset understatement penalty is 20 percent of the portion of the understatement attributable to any transaction involving an undisclosed foreign financial asset.

  2. An undisclosed foreign financial asset is any asset with respect to which information is required to be provided under IRC 6038, IRC 6038B, IRC 6038D, IRC 6046A or IRC 6048, but was not reported on the return or on a statement as required under the provisions of these IRC sections.

  3. The penalty is increased to 40 percent, if any portion of an underpayment is attributable to any undisclosed foreign financial asset.

  4. The penalty is effective and apply to taxable year returns filed after March 18, 2010.

  5. Contact the Office of Servicewide Penalties or your local technical advisor prior to assertion of this penalty pending additional written guidance.

20.1.5.14  (01-24-2012)
IRC 6663, Civil Fraud Penalty

  1. IRC 6663(a) provides that if any underpayment of tax is due to fraud, a penalty is imposed equal to 75 percent of the portion of the underpayment due to fraud.

  2. For purposes of IRC 6663, a portion of the underpayment will be considered due to fraud when the intent is to evade tax.

  3. For common features of the civil fraud penalty and the accuracy-related penalties, see IRM 20.1.5.2.

20.1.5.14.1  (01-24-2012)
Indications of Fraud

  1. IRC 6663 does not define "fraud." Courts have long recognized that the essence of the fraud penalty is the state of mind. The state of mind has been described in various ways, but most definitions require "intent to evade tax." Intent is distinguished from inadvertence, reliance on incorrect professional advice, honest difference of opinion, negligence, or carelessness.

  2. Because direct proof of a taxpayer’s fraudulent intent is rarely available, fraud must be proven by circumstantial evidence and reasonable inferences. Fraud will generally involve one or more of the following elements:

    • Deception

    • Misrepresentation of material facts

    • False or altered documents

    • Evasion (e.g., diversion or omission)

    • Conspiracy

  3. Some common "badges of fraud" include:

    1. Understatement of income (e.g., by omissions of specific items or entire sources of income, failure to report substantial amounts of income received);

    2. Fictitious or improper deductions (e.g., overstatement of deductions, personal items deducted as business expenses);

    3. Accounting irregularities (e.g., two sets of books, false entries on documents);

    4. Acts of the taxpayer evidencing an intention to evade tax (e.g., false statements, destruction of records, transfer of assets);

    5. A consistent pattern over several years of underreporting taxable income;

    6. Implausible or inconsistent explanations of behavior;

    7. Failure to cooperate with the examining agent;

    8. Concealment of assets;

    9. Engaging in illegal activities (e.g., drug dealing), or attempting to conceal illegal activities;

    10. Inadequate records; and

    11. Dealing in cash.

  4. Recommendations for asserting the civil fraud penalty should be carefully reviewed to fully establish that the evidence supports the assertion. Fraud must be proven by clear and convincing evidence.

  5. All statutory notices of deficiency asserting the civil fraud penalty must be reviewed by Area Counsel.

20.1.5.14.2  (01-24-2012)
Penalty Assertion

  1. Civil fraud penalty will be asserted when there is clear and convincing evidence to prove that some part of the underpayment of tax was due to civil fraud. Such evidence must show the taxpayer’s intent to evade tax which the taxpayer believed to be owing.

  2. To assert the civil fraud penalty in a tax case, it is necessary to establish that a part of the deficiency is due to a knowingly false representation of facts by the taxpayer. The IRS bears the burden of proving civil fraud by clear and convincing evidence. See IRC 7454(a). The IRS must show that the taxpayer:

    • Knew the content of the return was false, and

    • Filed the return with the intent to evade tax.

  3. The civil fraud penalty should be asserted on a case-by-case basis giving consideration to all factors which have a bearing on the taxpayer’s fraudulent intent.

  4. If a taxpayer submits an amended return, it does not cure the defects on the previously filed fraudulent return and the civil fraud penalty would apply.

  5. The civil fraud penalty cannot be asserted on the same underpayment (or portion of an underpayment) on which accuracy-related penalties are asserted. Only one penalty can be applied to any portion of an underpayment of tax. See IRC 6662 and IRC 6663.

  6. The criteria for proving fraudulent failure to file under IRC 6651(f) and civil fraud under IRC 6663 are the same. Generally, if a fraudulent return is filed late, IRC 6651(f) is the appropriate penalty to assert. Although there is no specific prohibition against asserting penalties under both IRC 6651(f) and IRC 6663, the examiner should exercise caution. The court is not likely to sustain the assertion of both penalties unless compelling facts support the IRS’s position. Area Counsel should be consulted before asserting both penalties on the same return. See IRM 20.1.2.2.7.5, Fraudulent Failure to File — IRC 6651(f), for additional information regarding restrictions on the assertion of the civil fraud penalty with respect to the fraudulent failure to file penalty.

  7. On a joint return, the civil fraud penalty does not apply to a spouse unless some part of the underpayment is due to civil fraud on the part of that spouse. See IRC 6663(c).

    1. For taxpayers filing a joint return after having filed separate returns, see IRC 6013(b)(5).

    2. The civil fraud penalty follows the IRC provision that allows a married couple to file a joint return after separate returns have been filed.

    3. If the sum of the amounts shown as tax on the two separate returns (for example, $150 plus $100 = $250) is less than the amount shown as tax on the joint return (for example, $300), then for the purpose of computing the civil fraud penalty, the sum of the amounts shown on the separate returns is treated as the amount shown on the joint return.

    4. Any fraud on a separate return will be deemed to be fraud on the joint return.

  8. As a general rule, examination employees in SB/SE, TEGE, W&I, and LB&I are authorized to assess civil fraud penalties. To the contrary, employees in other functions and non-examination employees are generally not authorized to assess the civil fraud penalty. When fraud is identified by functions outside of Examination, the case must be discussed with the employee's manager and the fraud technical advisor (FTA) for referral consideration. See IRM 25.1.11, Campus Collection Fraud Procedures and IRM 25.1.14, Campus Examination Fraud Procedures.

  9. In cases closed as unagreed with the civil fraud penalty, the report must include any alternative penalty positions that are applicable. Closing an unagreed case without including an explanation of the alternative penalty positions in the report may hamper the government’s litigation because the basis for the alternative penalty positions may be unclear to either Appeals or Counsel.

  10. The examiner’s report will reflect the civil fraud penalty under IRC 6663 and identify the adjustments attributable to fraud.

  11. Determination of the civil fraud penalty is a shared responsibility of the examiner, the examiner’s group manager, and the fraud technical advisor.

  12. For additional information see IRM 25.1, Fraud Handbook.

20.1.5.14.3  (01-24-2012)
Penalty Referral

  1. If an examiner determines there are affirmative acts (firm indications) of fraud/willfulness exist and criminal criteria are met, the examiner will discuss with their group manager and the FTA for referral to CI. Referral guidelines to CI are listed in IRM 25.1.3, Criminal Referrals.

  2. When an examiner determines that only the civil fraud penalty applies, a referral to Criminal Investigation (CI) is not required. See IRM 25.1.2, Recognizing and Developing Fraud, and IRM 25.1.6, Civil Fraud.

20.1.5.14.4  (01-24-2012)
Civil and Criminal Fraud

  1. The major difference between civil and criminal fraud is the degree of proof required to establish fraud on the part of the taxpayer.

    1. Criminal fraud requires sufficient evidence to prove guilt beyond a reasonable doubt.

    2. Civil fraud requires clear and convincing evidence of fraud with intent to evade tax.

  2. Due to the lower standard of proof in civil cases, the civil fraud penalty may be imposed upon a taxpayer who was not convicted of criminal tax evasion. If the taxpayer is convicted of criminal tax evasion under IRC 7201, the civil fraud penalty should be asserted for the same tax year.

  3. Criminal conviction does not mean the civil penalty will be automatically sustained.

  4. Examiners and managers should be aware of collateral estoppel and the important distinction it can have in civil tax fraud penalty cases. Collateral estoppel is a legal doctrine that prevents a taxpayer, who has been previously convicted of criminal tax evasion under IRC 7201, from asserting a defense to the civil fraud penalty. See IRM 25.1.6.4, Collateral Estoppel.

  5. Examiners should coordinate closely with the group manager, fraud technical advisor, CI, and Counsel on cases involving potential fraud.

20.1.5.14.5  (01-24-2012)
Penalty Calculation

  1. The civil fraud penalty is derived by multiplying the 75 percent penalty rate times the underpayment attributable to civil fraud.

  2. If any part of an underpayment is due to civil fraud, then the entire underpayment shall be treated as attributable to civil fraud unless the taxpayer establishes otherwise. The examiner will make a good faith effort to objectively weigh the evidence provided and eliminate those items that are inaccurate, but not fraudulent from the penalty calculation. See IRC 6663(b).

  3. For a calculation example involving the accuracy-related penalty and the civil fraud penalty, see Exhibit 20.1.5-1.

  4. For a calculation example involving civil fraud when Form 1040 Schedule C, gross receipts cause an adjustment to self-employment tax under IRC 1401, with a related change in the income tax deduction allowed under IRC 164(f). See Exhibit 20.1.5-6.

20.1.5.14.6  (01-24-2012)
Civil Fraud Development

  1. If it is determined that a case has firm indications of fraud, but does not meet criminal criteria, Form 11661, Fraud Development Recommendation - Examination, must be prepared. See IRM 25.1.2, Recognizing and Developing Fraud, for procedures on developing and processing a civil fraud case.

20.1.5.14.7  (01-24-2012)
Penalty Assessments and Abatements

  1. The examiner will compute the penalty and provide any special closing instructions for CCP on Form 3198 or Form 3198-A.

  2. The total civil fraud penalty amount will be assessed to the Master File with transaction code (TC) 320 using one of the following forms:

    • Form 5344, Examination Closing Record

    • Form 5403, Appeals Closing Record

    • Form 5599, TE/GE Examined Closing Record

  3. Under certain conditions the fraud penalty is assessed to the Non-Master File with TC 320:

    • Form 4720, Return of Certain Excise Taxes on Charities and Other Persons Under Chapters 41 and 42 of the IRC; or

    • Form 5734, Non-Master File Assessment Voucher.

  4. The Form 5734 will be processed with the tax return.

20.1.5.14.8  (01-24-2012)
Penalty Relief

  1. In general, no fraud penalty is imposed on 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.

  2. Reasonable cause with respect to transactions entered into on or after March 31, 2010, will not apply to any transaction lacking economic substance. See IRC 6664(c)(2) and IRC 6662(b)(6).

20.1.5.15  (01-24-2012)
IRC 6662A, Accuracy-Related Penalty on Understatements with Respect to Reportable Transactions

  1. IRC 6662A generally imposes an accuracy-related penalty on any reportable transaction understatement for tax years ending after October 22, 2004. The penalty applies to:

    1. Any listed transaction (which is one category of reportable transactions); and

    2. Any other reportable transaction if a significant purpose of the transaction is the avoidance or evasion of federal income tax.

  2. A reportable transaction understatement under IRC 6662A differs from an underpayment for IRC 6662(a) and IRC 6662(b), accuracy-related penalties. The IRC 6662A penalty does not apply to reportable transaction understatements attributable to transactions settled under IRB 2005-80.

  3. The computation of the IRC 6662A penalty is 20 percent of the reportable transaction understatement where the reportable transaction was properly disclosed, and 30 percent of the reportable transaction understatement where the transaction was not properly disclosed. The disclosure requirements are explained in the section below.

20.1.5.15.1  (01-24-2012)
Adequate Disclosure and Rescission of IRC 6707A Impact on IRC 6662A

  1. A taxpayer uses Form 8886, Reportable Transaction Disclosure Statement, to make the disclosure required under IRC 6011 and the regulations. Under Treas. Reg. 1.6011-4(e), the Form 8886 must be attached to the taxpayer's tax return (or amended return) for each taxable year for which a taxpayer participates in a reportable transaction. In addition, when the first Form 8886 is filed by the taxpayer, a duplicate Form 8886 must be sent to the Office of Tax Shelter Analysis (OTSA).

  2. Generally, a taxpayer should first file a Form 8886 beginning with the first year that it has participated in the reportable transaction. Thus, the requirement to file a duplicate Form 8886 should arise during the first year of participation in the reportable transaction.

  3. If, however, the taxpayer fails to file any Form 8886 in its first year of participation, the requirement to send a duplicate Form 8886 to OTSA will arise whenever the taxpayer first submits a Form 8886, regardless of how many years it has been engaged in the reportable transaction at issue.

  4. A failure to submit either filing is a failure to satisfy the disclosure requirements. If a taxpayer has entered into more than one reportable transaction, the taxpayer is required to meet the disclosure requirements with respect to each transaction.

  5. A taxpayer is treated as meeting the disclosure requirements of IRC 6011 and the associated regulations if the Commissioner (or the Commissioner’s delegate) rescinds the penalty under IRC 6707A.

  6. IRC 6707A provides a monetary penalty for the failure to include on any return or statement any information required to be disclosed under IRC 6011 with respect to a reportable transaction.

  7. IRC 6707A authorizes the Commissioner to rescind the imposition of the penalty with respect to reportable non-listed transactions if it would promote compliance with the tax laws and effective tax administration. The penalty cannot be rescinded with respect to a listed transaction.

  8. The Commissioner’s refusal to rescind the penalty may not be reviewed by Appeals or in any court proceeding.

  9. The examiner should question the taxpayer or otherwise determine whether the taxpayer successfully sought rescission of an IRC 6707A penalty with respect to the reportable transaction at issue, because such rescission could directly impact the application of IRC 6662A.

  10. If the transaction at issue is a listed transaction, however, IRC 6707A does not permit rescission and, therefore, the potential rescission of an IRC 6707A penalty and its impact on IRC 6662A is not an issue.

20.1.5.15.2  (01-24-2012)
Penalty Calculation

  1. The reportable transaction understatement is defined in IRM 20.1.5.2.4 (6).

  2. The example below provides a calculation of a reportable transaction understatement

    • Corporation Z is a C corporation. In Tax year (TY) 2005, Z had a net operating loss of $300,000. During TY 2005, Z participated in a reportable transaction that had a significant purpose of tax avoidance and generated a $250,000 loss. As required under Treas. Reg. 1.6011-4, Z filed a completed Form 8886 with its timely filed TY 2005 tax return and also filed a copy with the Office of Tax Shelter Analysis (OTSA).

    • Upon audit, the IRS disallowed Z’s $300,000 net operating loss, but determined that Z’s tax liability for TY 2005 remains $0. The adjustments consist of: disallowance of the $250,000 loss attributable to the reportable transaction and disallowance of a $50,000 deduction. The IRS determines that the disallowed $50,000 deduction was taken by Z in disregard of the rules or regulations. In addition, Z’s position did not have a realistic possibility of being sustained on its merits and was not adequately disclosed on Form 8275 pursuant to Treas. Reg. 1.6662-3(c).

    • Although Z disregarded the rules or regulations, Z will not owe an accuracy-related penalty on the underpayments under IRC 6662 because Z’s corrected tax liability for TY 2005 is $0 and no underpayment exists. Without an underpayment, there is no liability for a penalty under IRC 6662. Z, however, is subject to the penalty on a reportable transaction understatement under IRC 6662A for TY 2005 because Z participated in a reportable transaction with a significant purpose of tax avoidance and there is a reportable transaction understatement resulting from the taxpayer’s tax treatment of that transaction. The penalty rate is 20 percent because Z properly disclosed participation in the reportable transaction. Z’s penalty is calculated as follows:

    • The reportable transaction understatement = ($250,000 x .35) + (0) = $87,500

      Reference Explanation
      Amount - $250,000 Increase in taxable income resulting from the difference between the proper tax treatment and the taxpayer's treatment of the loss attributable to the reportable transaction.
      Percentage - 35% Highest corporate income tax rate imposed by IRC 11.
      Credit - $0 Decrease in aggregate amount of credits that results from the difference between the taxpayer's treatment of the reportable transaction and the proper tax treatment of that transaction.

    • Z’s reportable transaction understatement is $87,500, upon which a 20 percent penalty is applied because Z's properly disclosed the transaction under Treas. Reg 1.6011-4. Z’s accuracy-related penalty on the reportable transaction understatement under IRC 6662A is $17,500 for TY 2005 ($87,500 x .20).

  3. If the taxpayer files an amended return after the IRS first contacts the taxpayer regarding an examination of the return or any other dates specified by the IRS, the tax treatment of an item on the amended return is not taken into account in determining the reportable transaction understatement.

    Note:

    Due to the definition of "reportable transaction understatement," the IRC 6662A penalty, unlike the IRC 6662 penalty, will apply even if there is no underpayment of tax on the taxpayer’s return, as shown in the example above.

  4. In the case of a reportable transaction, the IRC 6662A penalty will not be imposed if the taxpayer:

    1. Adequately disclosed its reportable transaction as required under IRC 6011 and the associated regulations, and

    2. Meets other criteria set out in IRC 6664(d) to establish reasonable cause and good faith.

20.1.5.15.3  (01-24-2012)
Coordination with Other Penalties

  1. Generally, the IRC 6662A penalty is in addition to any other accuracy-related penalty that may be imposed. However, the IRC 6662A penalty does not apply to any portion of an understatement on which the fraud penalty is imposed. Additionally, the IRC 6662A penalty does not apply to any portion of an understatement on which a IRC 6662 penalty is imposed at the increased rates determined under IRC 6662(h) for gross valuation misstatements or under IRC 6662(i) for nondisclosed, noneconomic substance transactions. If the IRC 6662A penalty is applied, the penalty under IRC 6676 (erroneous claim for refund or credit) does not apply.

  2. For purposes of determining whether the taxpayer has a substantial understatement of income tax under IRC 6662(d), determine whether the taxpayer has an understatement in excess of the greater of:

    1. 10 percent of tax required to be shown on the return, or

    2. $5,000.

  3. The understatement attributable to the IRC 6662A reportable transaction is included in the IRC 6662(d) understatement calculation. However, the reportable transaction understatement upon which the IRC 6662A penalty is asserted, is not included in the amount of the understatement used to determine the underpayment upon which the 20 percent under IRC 6662(d) penalty is asserted. These calculations are illustrated in the following example.

  4. Example:

    • A and B, husband and wife, filed a joint federal income tax return for Tax Year (TY) 2005, reporting taxable income of $15,800 and a tax liability of $1,644. A and B participated in a reportable transaction of which a significant purpose was the avoidance or evasion of federal income tax, which was not disclosed pursuant to IRC 6011. A and B had no amounts previously assessed (or collected without assessment) and no rebates had been made. Subsequently, the return was examined and the following adjustments and penalties were agreed to:

      Adjustments and Conditions Additional Conditions Amounts
      Adjustment 1 (no penalty)   $1,000
      Adjustment 2 (subject to IRC 6662(d))   40,000
      Adjustment 3 (subject to IRC 6663)   45,000
      Adjustment 4 (subject to IRC 6662A)   34,000
      Total Adjustments   $120,000
      Taxable income shown on return   15,800
      Taxable income as corrected, including adjustment 4   $135,800
      Taxable income as corrected, excluding adjustment 4   $101,800
      Computation of underpayment, excluding the underpayment attributable to the reportable transaction understatement:    
      Income taxes, excluding tax attributable to reportable transaction   $18,780
      Tax shown on return $1,644  
      Previous assessments None  
      Rebates None  
      Balance   $1,644
      Underpayment, excluding the underpayment attributable to the reportable transaction understatement   $17,136
      Step 1: Determine the portion, if any, of the underpayment on which no accuracy-related or fraud penalty is imposed:    
      Taxable income as shown on return   $15,800
      Adjustment #1 (No penalty imposed)   1,000
      "Adjusted" taxable income   $16,800
      Tax on "adjusted" taxable income   $1,794
      Tax shown on return   $1,644
      Portion of underpayment on which no penalty is imposed   $150
      Step 2: Determine the portion, if any, of the underpayment on which a substantial understatement of income tax penalty of 20 percent is imposed:    
      "Adjusted" taxable income from Step 1   $16,800
      Adjustment #2   40,000
      "Adjusted" taxable income   $56,800
      Tax on "adjusted" taxable income   $7,794
      Tax on "adjusted" taxable income from Step 1   1,794
      Portion of underpayment on which 20 percent penalty is imposed   $6,000
      IRC 6662(d) penalty = $1,200 ($6,000 x 20%)    
      Step 3: Determine the portion, if any, of the underpayment on which a fraud penalty of 75 percent is imposed:    
      Total underpayment   $17,136
      Less the sum of the portions of such underpayment determined in:    
      Step 1 $150  
      Step 2 6,000  
      Total   $6,150
      Portion of underpayment on which 75 percent penalty is imposed   $10,986
      IRC 6663 penalty = $8,240 ($10,986 x 75%)    
      Step 4: Determine the portion of the understatement on which a 30 percent is imposed:    
      Amount of increase in taxable income resulting from reportable transaction   $34,000
      Highest rate of tax imposed by IRC 1   35%
      Reportable transaction understatement and portion of understatement on which 30 percent penalty is imposed   $11,900
      IRC 6662A penalty = $3,570 ($11,900 x 30%)    
           

    • For purposes of determining whether there was a substantial understatement on A and B’s joint income tax return, the reportable transaction understatement of $11,900 is included in the total understatement for purposes of calculating whether the understatement is substantial, e.g., exceeds the greater of $5,000 or 10% of the tax required to be shown on the return.

    • A and B’s tax required to be shown on the return was ten percent of which is $2,775.

    • A and B’s understatement subject to the penalty under IRC 6662(d) was $6,000, to which the $11,900 reportable transaction understatement is added in calculating the amount of the understatement to determine whether it is substantial.

    • The total of $17,900 is substantial because it exceeds the greater of $5,000 or $2,775.

    • The 20 percent substantial understatement penalty under IRC 6662(d), however, will only be applied to the $6,000 underpayment attributable to the understatement of tax resulting from the $40,000 adjustment.

    • IRC 6662A applies to tax years ending after October 24, 2004.

20.1.5.15.4  (01-24-2012)
Penalty Assessments and Abatements

  1. Because IRC 6662A penalty is computed on the reportable transaction understatement with respect to certain reportable transactions, the penalty cannot be asserted until the completion of the examination of the underlying tax liability.

  2. Because there is no expedited or stand-alone assessment, there are generally no special procedures for case development or penalty approval for the IRC 6662A penalty. Instead, the existing procedures for developing and approving an IRC 6662 penalty can be used for the IRC 6662A penalty. See IRM 20.1.5.3, IRM 20.1.5.3.2, and IRM 20.1.5.1.6. Also, when closing the case from the group, the examiner will:

    1. Identify the adjustment in the report relating to the IRC 6662A penalty and provide the penalty computation in the workpapers.

    2. Complete and attach Form 3198 or Form 3198-A to identify the IRC section and penalty amount for CCP.

    3. Use the appropriate closing record and enter the PRN 681 and the positive penalty amount to assess the penalty See IRM 20.1.5.3.2 (7).

  3. The PRN 681 and penalty assessment amount will automatically post to the Master File with TC 240.

  4. The examiner should also check to determine whether the taxpayer successfully sought rescission of an IRC 6707A penalty with respect to the same transaction, as rescission may impact the application of the IRC 6662A penalty. See IRM 20.1.5.15.1. (Because rescission is not available for a listed transaction, this consideration does not apply to those transactions).

  5. Taxpayers are entitled to pre-assessment Appeals consideration and statutory notice of deficiency procedures for the IRC 6662A penalty. When forwarding a case to Appeals, the examiner should ensure the IRC 6662A case file transmitted to Appeals through Technical Services includes an alternative penalty position and information, if available, on any prior Appeals decisions pertaining to this issue, including the Appeals officer’s name.

20.1.5.15.5  (01-24-2012)
Penalty Relief

  1. Reasonable cause with respect to transactions entered into on or after March 31, 2010, will not apply to any transaction lacking economic substance.

  2. The accuracy-related penalty under IRC 6662A does not apply with respect to any portion of a reportable transaction understatement if, pursuant to IRC 6664(d), it is shown that there was reasonable cause and the taxpayer acted in good faith with respect to that portion of the understatement. A taxpayer does not have reasonable cause and did not act in good faith unless:

    1. The relevant facts affecting the tax treatment of the item are adequately disclosed in accordance with the regulations prescribed under IRC 6011 (or the IRC 6707A penalty for failure to disclose is rescinded in full) ;

    2. There is or was substantial authority for the treatment of the item; and

    3. The taxpayer reasonably believed that its treatment of the item was more likely than not the proper treatment.

20.1.5.16  (01-24-2012)
IRC 6676, Erroneous Claim for Refund or Credit Penalty

  1. The IRC 6676 penalty was enacted in the Small Business and Work Opportunity Tax Act of 2007 to complement and close a gap left by the following penalties which apply to underpayment of tax:

    • IRC 6662, Accuracy-Related Penalty

    • IRC 6662A, Accuracy-Related Penalty on Understatements with Respect to Reportable Transactions

    • IRC 6663, Fraud Penalty

  2. The IRC 6676 does not apply to any portion of the disallowed amount of the claim for refund or credit that is subject to the penalties listed above.

  3. An IRC 6676 penalty may be imposed on a taxpayer who files an erroneous claim for refund or credit with respect to federal income tax (other than a claim relating to the earned income credit) that is excessive in amount and for which there is no reasonable basis for the claimed tax treatment. The penalty applies to all claims, formal and informal, relating to federal income taxes. This penalty can be asserted on claims for refund filed after the enactment date of May 25, 2007.

  4. The taxpayer making such a claim shall be liable for the penalty in the amount of 20 percent of the excessive amount claimed. The "excessive amount" is the amount of the claim for refund or credit that exceeds the amount allowed.

  5. Any excessive amount with respect to IRC 6662(b)(6), noneconomic substance transactions, shall be treated as lacking reasonable basis.

20.1.5.16.1  (01-24-2012)
Penalty Assertion

  1. When examining federal income tax claims and amended tax returns if there is a question as to whether there is a reasonable basis for the claim, the IRC 6676 penalty should be considered.

  2. The erroneous claim for refund or credit penalty is equal to 20 percent of the disallowed portion of the claim for refund or credit for which there is no reasonable basis for the claimed tax treatment.

  3. The penalty may be asserted on any return where the amount of the claim for refund or credit for any taxable year exceeds the allowable amount.

  4. The penalty for filing an erroneous refund claim for refund or credit is asserted on the "excessive amount" of the claim for refund or credit.

  5. Example of "excessive amount:"

    1. If a $5,000 credit is claimed and only $1,500 is allowable, $3,500 is the excessive amount. The IRC 6676 penalty = $700 (3,500 x 20%).

  6. A separate IRC 6676 penalty case file should be created and this case file is referred to as the "related" case. The income tax file is the "key" case.

  7. During examination of the "key" case, the examiner reviews documentation to determine whether facts exist to propose an IRC 6676 penalty. The examiner documents this determination in the "key" case workpapers, (include copies of workpapers in "related" penalty case file).

  8. Generally, the penalty will not be proposed until the disallowed amount of the claim for refund or credit is determined. See IRM 4.10.8.9, Claims.

  9. Special procedures apply when asserting the penalty on married filing joint (MFJ) cases. See IRM 20.1.5.16.3, "Related" Case File.

20.1.5.16.1.1  (01-24-2012)
Coordination with Other Penalties

  1. Pursuant to IRC 6676(d) the penalty shall not apply to any portion of the disallowed portion of the claim for refund or credit that is subject to:

    1. Any component of IRC 6662,

    2. IRC 6662A, or

    3. IRC 6663.

  2. The IRS can impose the IRC 6676 penalty in addition to other penalties, except those listed in (1) above, and can impose the penalty on multiple claims lacking reasonable basis. On a case by case basis, the Service shall apply a rule of equity and good conscience in determine whether to impose the IRC 6676 penalty in addition to other penalties or on multiple claims.

20.1.5.16.2  (01-24-2012)
Case Procedures

  1. These examination procedures apply to all functions working IRC 6676 cases. The procedures involving Form 5345-D, Examination Request−ERCS (Examination Returns Control System) Users, (paragraph 3 below) do not apply to TE/GE.

  2. Do not establish or control the IRC 6676 penalty case on the Audit Information Management System (AIMS).

  3. Control the IRC 6676 penalty, "related" case, on ERCS. If the SB/SE or LB&I examiner determines a penalty examination is warranted, the examiner prepares Form 5345-D, and secures the group manager’s approval.

  4. TE/GE functions does not use ERCS. The five business units of TE/GE have their own processing functions. If the TE/GE examiner determines the penalty is warranted, group manager approval should be secured.

  5. After securing managerial approval, the examiner advises the taxpayer of the opening of the IRC 6676 penalty "related" case.

  6. After consideration of all the facts and circumstances, if the examiner determines an IRC 6676 penalty applies, then the examiner prepares Form 886-A, Explanation of Items.

  7. Prior to preparing Letter 4143-C, IRC Section 6676 Erroneous Claims Penalty Assessment Notification Letter, the examiner offers the taxpayer and/or taxpayer’s representative a meeting with the examiner’s manager to discuss the unagreed issue.

  8. If the managerial conference results in non-assertion of the penalty, document the conversation in the penalty case file workpapers and close the ERCS control. Then the "related" case file can be associated with the claim for refund or credit "key" case and closed under normal claim procedures.

  9. If the managerial conference results in a determination that the penalty is warranted, the examiner prepares and issues Letter 4143-C. This letter advises the taxpayer of the proposed penalty, solicits payment, offers an Appeals conference, and provides an explanation of the dispute process. Include a copy of Form 5838-EC, Agreement to Assessment and Collection-Section 6676 Erroneous Claim for Refund or Credit Penalty,Form 886-A, and other pertinent documents or workpapers with the letter.

  10. Associate the IRC 6676"related" case file with the "key" case (the claim for refund or credit) until it is resolved.

  11. Close unagreed cases together as a package.

  12. Important Reminder: The IRC 6676 penalty is not subject to deficiency procedures. The penalty should not be included on an examination report, on the examination 30−day letter, or on the statutory notice of deficiency.

  13. When claims are disallowed and the IRC 6676 penalty is not applicable, the examiner documents the basis for non−assertion of the IRC 6676 penalty in the "related" case file workpapers. Treas. Reg. 1.6662-3(b)(3) provides the definition of reasonable basis. A standard statement such as "Erroneous claims penalty deemed not applicable" is not sufficient. The reason(s) for applicability or non-applicability of the penalty must be clearly stated. The examiner's manager signs off on the decision not to apply the penalty when a substantial portion of the claim for refund or credit is disallowed.

  14. IRC 6751(b) requires managerial approval of penalty assessments. The manager signs on line 10b and 11b of Form 8278, Assessment and Abatement of Miscellaneous Civil Penalties.Form 8278 is used for all IRC 6676 penalty cases except for MFJ claims for refund or credit. For MFJ penalty cases, the manager's signature of approval is required on line 14 of Form 3870, Request for Adjustment. Examiners should complete the appropriate IRC 6676 penalty lead sheet and include it in the penalty case file. Managerial approval can also be documented on the penalty lead sheet and/or related workpapers.

  15. Consult the group manager for assistance in developing the IRC 6676 penalty and evaluating a taxpayer’s reasonable basis defense. If after consulting with the group manager, it is determined that involvement by Area Counsel is appropriate contact should be initiated. If Area Counsel is involved, Area Counsel will coordinate its advice with the Office of the Associate Chief Counsel (Procedure and Administration), as appropriate, to ensure that the application of IRC 6676 is fair and consistent.

  16. The examiner identifies the IRC 6676 penalty in the examination report (the examination report for this penalty consists of the Form 5838-EC, and Form 886-A). Examiners will show the IRC section, penalty name, and penalty computation in the report and workpapers.

  17. The examiner's time for the penalty "related" case is applied to the "key" case onForm 5344 or other similar closing document.

  18. If a paid tax return preparer prepared the claim for refund or credit return, it is the examiner’s responsibility to investigate and coordinate with his/her respective business unit’s Return Preparer Coordinator (RPC) to ensure no return preparer violations exist. Civil Penalty Approval, leadsheet has a preparer penalty section that should be completed to document that return preparer penalties were considered.

20.1.5.16.3  (01-24-2012)
"Related" Case File

  1. The examiner creates a penalty case file(s) with a separate assessment Form 8278 or Form 3870 for married filing joint (MFJ) for each penalty tax year.

    1. Form 8278, Assessment and Abatement of Miscellaneous Civil Penalties, is used for IRC 6676 penalty cases except for a MFJ income tax return claims The IRC 6676 penalty is assessed on MFT 55 for IMF and MFT 13 for BMF with PRN 565 using Form 8278.

    2. Form 3870, Request for Adjustment, is used when asserting the IRC 6676 penalty on MFJ income tax returns. The penalty "related" case, for MFJ income tax return claims, must be assessed on MFT 30 with PRN 687. Do not use Form 8278 for MFJ penalty cases.

  2. The applicable "Special Handling Notice" is placed on the outside front cover of each case file.

    1. LB&I and SB/SE - The examiner completes Form 3198 by checking the "Civil Penalties (Form 8278)" box under "Special Features."

    2. TE/GE - The examiner completes Form 3198-A by entering similar information as indicated above for the "Special Features" section.

  3. The following documents are also included in the "related" penalty case file and placed in the location typical for the operating division:

    1. Form 9984, Examining Officer’s Activity Record.

    2. Form 4318, Examination Workpapers Index (Field Examinations), Form 4318-OA, Examination Workpapers Index, orForm 4700, Examination Workpapers.

    3. IRC 6676 Penalty Lead Sheet.

    4. Civil Penalty Approval.

    5. Form 5345-D, ERCS Users (SB/SE or LB&I).

    6. Form 5838-EC, Agreement to Assessment and Collection of IRC section 6676 Erroneous Claim for Refund or Credit Penalty.

    7. Form 886-A, Explanation of Items for the penalty.

    8. Copy of Letter 4143-C.

    9. Taxpayer’s protest (response to Letter 4143-C), if applicable.

    10. Examiner’s rebuttal to taxpayer’s protest, if applicable.

    11. Copies of all correspondence to and from the taxpayer or taxpayer's power of attorney relating to the erroneous claim or the IRC 6676 penalty.

    12. The following information and documentation from the income tax case file (if applicable) and the claim for refund or credit "key" case file is included in the IRC 6676"related" case file and placed in the location typical for the operating division.
      •Copy of the first four pages of the income tax return and any schedules related to income or expense items for which the erroneous claim for refund or credit was subsequently filed.
      •Copy of the original claim for refund or credit determined to be erroneous and lacking a reasonable basis, plus Form 872-EC if applicable.
      •Copy of the portions of the income tax report relating to the partial or full disallowance of the excessive amount of the erroneous claim for refund or credit, including Form 886-A and supporting schedules.
      •Copy of forms and letters issued and/or secured relating to the partial or full disallowance of the erroneous claim, including, but not limited to, Form 2297, Waiver of Statutory Notice of Claim Disallowance, Form 3363, Acceptance of Proposed Disallowance of Claim for Refund or Credit, and Letter 569, Letter of Claim Disallowance, and the examination 30-day letter.
      •Copy of reports from IRS engineers, economists, international specialists, outside fee experts, etc. relating to the erroneous claim for refund or credit.

      Note:

      The examiner should make a copy of relevant documents from the penalty "related" case file to place in the penalty section of the income tax return examination case file (if applicable) and the claim for refund or credit "key" case file. This ensures documentation relating to IRC 6676 penalty will be available if processed and closed separately because of issues with the period of limitations for assessment.

20.1.5.16.4  (01-24-2012)
Appeal Rights

  1. IRC 6676 penalty cases are generally subject to pre-assessment Appeal Rights procedures.

  2. If the taxpayer does not request Appeals consideration, the penalty case file is closed for assessment of the penalty by updating to Status Code 51 and sending it to CCP in accordance with functional procedures.

  3. If the taxpayer timely requests Appeals consideration and provides a protest, the penalty case file will be updated to Status Code 21 and sent to Technical Services to be forwarded to Appeals in accordance with functional procedures. The IRS's position should be clearly outlined with any alternative positions prior to forwarding to Appeals. Appeals will contact the taxpayer to schedule an appointment.

  4. Taxpayers may seek review of their liability for the IRC 6676 penalty in a United States District Court or the United States Court of Federal Claims. However, to seek court review of the liability for the IRC 6676 penalty, the taxpayer must first fully pay the liability and file a claim for refund with the IRS. Refund claims are usually filed on Form 843, Claim For Refund and Request for Abatement.

20.1.5.16.5  (01-24-2012)
Penalty Relief

  1. IRC 6676 shall not apply if there is reasonable basis for the claimed tax treatment.

  2. Section 1409 Codification of Economic Substance Doctrine and Penalty amendments provided that any excessive amount which is attributable to any transaction (with respect to transactions entered into on or after March 31, 2010), described in IRC 6662(b)(6) will not be treated as having a reasonable basis.

  3. Reasonable cause criteria does not apply to an IRC 6676 penalty.

20.1.5.16.6  (01-24-2012)
Group Processing and Penalty Assessment Instructions

  1. The IRC 6676penalty case is not established or controlled on AIMS.

  2. The group clerk/secretary inputs the IRC 6676 penalty "related" case on ERCS using Activity Code 554. The Activity Code 554 automatically establishes MFT "PD" and Source Code 99. The claim for refund or credit "key" case is also updated on ERCS. Additionally, the clerk/secretary will make the income tax case the "key" case and the penalty case the "related" case (using Form 5345-D prepared by examiner). The input information for the penalty case "related" and the claim for refund or credit "key" case can be secured from the data completed by the examiner at the bottom of the first page of Form 3198 (SB/SE and LB&I) or Form 3198-A (TE/GE).

  3. IRC 6676 penalty case is not subject to mandatory review.

  4. For fully agreed penalty cases, the groups will close the penalty case and "key" case to the appropriate CCP campus in accordance with functional procedures and updated to Status Code 51.

  5. All unagreed and partially unagreed portions of the income tax "key" case and/or IRC 6676 penalty case that are sent to Appeals are updated to Status Code 21 and closed to the appropriate Technical Services office to be processed in accordance with functional procedures.

  6. The "related" IRC 6676 separate penalty case file must be associated with the "key" case file whenever possible.

Exhibit 20.1.5-1 
Calculation of Underpayment Penalty

Reference: IRM 20.1.5.2.2 (3), IRM 20.1.5.2.4 (8), and IRM 20.1.5.14.5 (3)
         
The following example illustrates how an underpayment is computed:
  (a) Corrected tax $10,000
  (b) Less: Tax per return 7,000
  (c) Plus any amounts not previously assessed or collected without assessment 0
  (d) Plus any amount of rebates made   0
  (e) Underpayment ($10,000 less $7,000) $ 3,000
         
The following example illustrates a calculation of the underpayment with multiple adjustments:
Adjustment A (no penalty imposed) $1,000
Adjustment B (subject to 6662)  40,000
Adjustment C (subject to 6663)  45,000
Total adjustments (A + B + C)  86,000
Plus: Taxable income shown on the return  15,800
Taxable income as corrected $101,800
         
Computation of underpayment:  
Corrected tax $ 25,828
  Less: Tax shown on return 2,374
  Less: Previous assessments 0
  Less: Rebates 0
Underpayment $23,454
         
The following example illustrates the computation of the portions of the underpayment on which accuracy and fraud penalties are separately asserted:
Step 1:
Determine the portion of the underpayment on which no accuracy-related or civil fraud penalty is imposed:
Taxable income shown on return $15,800
Plus: Adjustment A  1,000
Adjusted taxable income 16,800
         
Tax on adjusted taxable income 2,524
  Less: Tax shown on return 2,374
Portion of underpayment on which no penalty is imposed $150
Step 2:
Determine the portion of the underpayment on which the accuracy-related penalty attributable to a substantial underpayment penalty under IRC 6662(d) of 20 percent is imposed:
Adjusted taxable income from Step 1 $ 16,800
Plus: Adjustment B  40,000
Adjusted taxable income 56,800
         
Tax on adjusted taxable income 11,880
  Less: Tax on adjusted taxable income from Step 1  2,524
Portion of underpayment on which the 20% penalty is imposed $9,356
 
IRC 6662(d) penalty = $1,871 ($9,356 x 20%)    
Step 3:  
Determine the portion of the underpayment on which a civil fraud penalty (IRC 6663) of 75 percent is imposed:  
Total underpayment $23,454  
  Less: The underpayment determined in Step 1 150  
  Less: The underpayment determined in Step 2 9,356  
Portion of underpayment on which the 75 percent penalty is imposed $13,948  
IRC 6663 penalty = $10,461 ($13,948 x 75%)    

Exhibit 20.1.5-2 
Calculation of the Accuracy-Related Penalty Attributable to a Substantial Understatement

Reference: IRM 20.1.5.8.3 (2)
(1) The amount of the IRC 6662(d) understatement is derived as follows:
         
  (a) Corrected tax $8,500
  (b) Less: tax on return 2,000
  (c) Less: rebates 100
  (d) Less: tax on adjustments with no penalty 600
  (e) Understatement $5,800
(2) For the penalty to apply in the above example, the understatement of $5,800 must be more than the greater of $5,000 or $850 (e.g., 10 percent of the $8,500 corrected tax required to be shown on the return). The understatement of $5,800 meets the requirement for penalty assertion.
(3) In calculating the understatement in (2) above the following definitions apply:  
Rebates: An amount not showing on the return which is assessed or collected as a deficiency prior to the filing of the return.  
Exceptions: Substantial authority, adequate disclosure, and reasonable cause are exceptions to the penalty. See IRM 20.1.5.8.1.1 for discussion of substantial authority, and IRM 20.1.5.7.2.1, for adequate disclosure. Each return adjustment is reviewed separately to determine if any exceptions apply. When an exception applies to any adjustment, the tax on that adjustment is not used in determining the amount of the understatement or the amount of the underpayment to which the penalty applies.  
(4) To establish the amount of the penalty when not all adjustments are subject to the penalty:  
  (a) Calculate the total underpayment,  
  (b) Calculate the underpayment subject to an exception,  
  (c) Subtract (b) from (a), and  
  (d) Multiply the applicable penalty rate times (c).  
(5) The following calculations establish if an understatement is substantial (no rebates or exceptions to the penalty apply):  
  (a) The taxpayer failed to report income of $25,000 on his tax return:  
  Corrected tax $20,000
    Less: tax as reported on return 12,000
  Understatement 8,000
  Ten percent of corrected tax 2,000
  (10% of $20,000 = $2,000)  
  The greater of $5,000 or $2,000 $5,000
Since the $8,000 understatement exceeds $5,000, the understatement is substantial and meets the requirement for assertion under IRC 6662(d).  
         
  (b) The taxpayer failed to report $247,000 of Schedule C income:  
  Corrected tax: $67,000
  (Note: This includes any adjustment to self-employment tax.)  
    Less: tax as reported on return 61,000
  Understatement 6,000
  The greater of $5,000 or $6,700 $6,700
  (Note: $6,700 is 10 percent of corrected tax of $67,000.)  
  The understatement of $6,000 does not exceed the greater of $5,000 or 10 percent of the corrected tax, e.g., $6,700. The underpayment is therefore not substantial and the penalty cannot be asserted under IRC 6662(d).  
The accuracy-related penalty attributable to a substantial understatement will not be asserted on the same portion of the underpayment attributable to adjustments for which another accuracy-related penalty under IRC 6662 or the civil fraud penalty under IRC 6663 is asserted.  

Exhibit 20.1.5-3 
Calculation of the Accuracy-Related Penalty Attributable to a Substantial Understatement with Multiple Adjustments

Reference: IRM 20.1.5.8
The taxpayer has substantial authority for adjustment A. The accuracy-related penalty attributable to a substantial understatement under IRC 6662(d) applies to adjustments B and C. The taxpayer has uncredited withholding of $1,500.
Taxable income per return   $18,200
Adjustments per examination:    
   Adjustment A (non-tax shelter item) 5,300  
   Adjustment B 10,000  
   Adjustment C 18,000  
Total (A + B + C)   33,300
Corrected taxable income   51,500
Corrected tax   17,000
  Less: Tax on return 2,500
Understatement   $14,500
       
Taxable income per return   $18,200
  Plus: Adjustment A (no penalty) 5,300
Corrected taxable income:   23,500
Corrected tax on $23,500   3,300
  Less: Tax per return 2,500
Tax on Adjustment A   $800
       
Corrected tax liability   $17,000
  Less: Tax on return 2,500
  Less: Tax on Adjustment A (no penalty)   800
Understatement (for penalty purposes)   13,700
  Less: Adjustment to increased withholding credits 1,500
Underpayment   $12,200

Exhibit 20.1.5-4 
IRC 6662(e), Transfer Pricing Penalty

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Reference IRM 20.1.5.9.3 (6)

Exhibit 20.1.5-5 
Substantial and Gross Valuation Misstatement Penalties

Reference: IRM 20.1.5.11.2 (4)
The penalties are calculated on the amount of the underpayment attributable to each valuation understatement. The penalties are calculated as follows:
  (a) The following adjustments and penalties apply:
    1. Stock A adjustment (no penalty applies)
$120,000 less 80,000
$40,000
    2. Stock B adjustment (substantial valuation misstatement penalty applies)
$190,000 less 80,000

$110,000
    3. Stock C adjustment (gross valuation misstatement penalty applies) $330,000 less 80,000
$250,000
  (b) Calculation of the underpayment for adjustments on which no penalty is applicable:
    1. Taxable income as filed $1,200,000
    2. Adjustment without penalty $70,000
    3. Adjusted taxable amount (line 1 plus 2) $1,270,000
    4. Tax on line 3 $707,000
    5. Tax on return $675,000
    6. Underpayment attributable to $70,000 adjustment $32,000
  (c) Calculation of the underpayment for a substantial valuation misstatement penalty:
    1. Amount from line (b)3 $1,270,000
    2. Adjustment having substantial valuation misstatement penalty $110,000
    3. Adjusted taxable amount (line 1 plus 2) $1,380,000
    4. Tax on line 3 $757,000
    5. Amount from line (b)4 $707,000
    6. Underpayment attributable to $110,000 (line 4 less 5) $50,000
    7. Substantial valuation misstatement penalty (20% of line 6) $10,000
  (d) Calculation of underpayment for a gross valuation misstatement penalty:
    1. Amount from (c)3 $1,380,000
    2. Adjustment having gross valuation misstatement penalty $250,000
    3. Adjusted taxable amount (line 1 plus 2) $1,630,000
    4. Tax on line 3 $869,000
    5. Amount from line (c)4 $757,000
    6. Underpayment attributable to $250,000 (line 4 less 5) $112,000
    7. Gross Valuation Misstatement Penalty (40% × $112,000) $44,800

Exhibit 20.1.5-6 
Calculation of the Underpayment Amount Attributable to Fraud based on Self-Employment Tax Adjustment

Reference IRM 20.1.5.14.5 (4)

Calculation of the Adjusted Taxable Income:
Unreported Schedule C gross receipts subject to fraud penalty $50,000
Plus: Taxable income shown on the return 70,000
  Less: One-half of self-employment ($3000 less $1500) 1,500
Adjusted taxable income $118,500
Calculation of the Underpayment:
Tax on adjusted taxable Income $34,900
  Less: Tax per return 15,000
Plus: Self-employment tax increase 3,000
Underpayment subject to fraud $22,900

Exhibit 20.1.5-7 
Determining Reasonable Cause and Good Faith

Reference IRM 20.1.5.6.1 (9)

To determine reasonable cause and good faith take into consideration the taxpayer’s effort to assert the proper tax liability.

Taxpayers are required to exercise ordinary business care and prudence, e.g., taking that degree of care that a reasonable prudent person would exercise. Below are some circumstances that may or may not indicate reasonable cause and good faith.

Circumstances that may indicate reasonable cause and good faith: Circumstances that may not indicate reasonable cause and good faith:
Honest misunderstanding of fact or law that is reasonable given the experience, knowledge, sophistication and education of taxpayer. Lack of significant business purpose.
An isolated computational or transcription error. Reliance on advice of a tax advisor or appraiser who the taxpayer knows or should have known lacked sufficient expertise or lacked independence.
Reliance on erroneous information reported on Forms W-2, 1099, etc., provided that the taxpayer did not know or have reason to know that the information was incorrect. Taxpayer agreed with the organizer or promoter of the tax shelter that the taxpayer would protect the confidentiality of the tax aspects of the structure of the tax shelter.
Reliance on advice of a tax advisor or appraiser who does not suffer from a conflict of interest or lack of expertise. Claimed tax benefits are unreasonable in comparison to the taxpayer’s investment in the tax shelter.
A corporation’s legal justification. Nondisclosure of a reportable transaction.

Exhibit 20.1.5-8 
Substantial Authority List

Reference IRM 20.1.5.8.1.1 (4)

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. Treas. Reg. 1.6662-4(d)(3)(i). The weight accorded an authority depends on its relevance, persuasiveness and the type of document providing the authority. Treas. Reg. 1.6662-4(d)(3)(ii).

Except in cases described in Treas. Reg. 1.6662-4 (d)(3)(iv) concerning written determinations, only the following are authority for purposes of determining whether there is substantial authority for the tax treatment of an item:

  • Applicable provisions of the IRC sections and other statutory provisions;

  • Proposed, temporary, and final regulations construing such statutes,

  • Revenue rulings and revenue procedures;

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

  • Court cases;,

  • Congressional intent as reflected in committee reports, joint explanatory statements of managers included in conference committee reports, and floor statements made prior to enactment by one of a bill's managers;

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

  • Private letter rulings and technical advice memoranda;

  • Actions on decisions and general Counsel memoranda;

  • IRS information or press releases; and

  • Notices, announcements and other administrative pronouncements published by the IRS in the Internal Revenue Bulletin.

Conclusions reached in treatises, legal periodicals, legal opinions, or opinions rendered by tax professionals are not authority. The authorities underlying such expressions of opinion where applicable to the facts of a particular case, however, may give rise to substantial authority for the tax treatment of an item.

There also is substantial authority if the treatment of an item is supported by:

  • The conclusion of a ruling or a determination letter issued to the taxpayer,

  • The conclusion of a technical advice memorandum in which the taxpayer is named, or

  • An affirmative statement in a revenue agent’s report with respect to a prior taxable year of the taxpayer.

Such a written determination does not, however, demonstrate substantial authority if there was a misstatement or omission of a material fact or the facts that subsequently develop are materially different from the facts on which the written determination was based or if the written determination is modified or revoked after the date of issuance. See Treas. Reg. 1.6662-4(d)(3)(iv)(A).


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