20.1.5  Return Related Penalties

Manual Transmittal

January 24, 2012

Purpose

(1) This transmits revised IRM 20.1.5, Penalty Handbook, Return Related Penalties.

Background

This section provides policies and procedures for penalty applications for IRC 6662, IRC 6662A, IRC 6663, and IRC 6676.

Material Changes

(1) Minor editorial changes have been made throughout this IRM. Web site addresses, legal references, IRM references, and tables were reviewed and updated as necessary.

(2) Other significant changes to this IRM include the following:

Reference Description
IRM 20.1.5.1 Updated text for clarity. Added Erroneous Claims for Refund or Credit language.
IRM 20.1.5.1.1 Added penalty legislative provisions - Section 1409, Codification of Economic Substance Doctrine and Penalties, and Section 512, Hiring Incentives to Restore Employment Tax Act penalties.
IRM 20.1.5.1.2 Revised title for LB&I new name. Removed Announcement 2002-2 and related information.
IRM 20.1.5.1.3 Revised title to include "SB/SE."
IRM 20.1.5.1.4 Added penalty legislative provisions; Small Business Work Opportunity Tax Act, Erroneous Claim for Refund or Credit IRC 6676 Penalty, Section 1409 Codification of Economic Substance Doctrine and Penalties, and Section 512, Hiring Incentives to Restore Employment Tax Act penalties.
IRM 20.1.5.1.5 Revised title. Updated text. Added 2011 Offshore Voluntary Disclosure Initiative (OVDI) for the accuracy-related penalty policy.
IRM 20.1.5.1.6 Updated text for clarify for Small Business Self/Employed (SB/SE), Large Business and International (LB&I), Tax Exempt and Government Entities (TE/GE), and Wage and Investment (W&I).
IRM 20.1.5.1.7 Removed.
IRM 20.1.5.2.1 Removed last two sentences in paragraph 4.
IRM 20.1.5.2.2 20.1.5.2.2 Revised title and updated text for clarity.
IRM 20.1.5.2.3 Updated text for clarity.
IRM 20.1.5.2.4 Added definitions for economic substance doctrine and reasonable basis.
IRM 20.1.5.2.5 Updated text for clarity.
IRM 20.1.5.3 Updated text for clarity and removed duplicate text. Revised alpha list. Added SB/SE and W&I Campus Exam non-use of Form 3198, Special Handling Notice for Examination Case Processing, for Report Generation Software (RGS)/Correspondence Examination Automation Support (CEAS).
IRM 20.1.5.3.1 Revised title. Updated text for clarity for the Automated Underreporter Penalty Program.
IRM 20.1.5.3.2 Updated text for clarity. Added SB/SE and W&I Campus Exam non-use of Form 3198 for RGS/CEAS. Added recently penalty legislation for Section 1409 Codification of Economic Substance Doctrine penalties for IRC 6662(b)(6), and IRC 6662(i) and Section 512, Hiring Incentives to Restore Employment Tax Act penalties for IRC 6662(b)(7) and IRC 6662(j)(3).
IRM 20.1.5.5 Updated text for clarity.
IRM 20.1.5.6 Added Erroneous Claims for Refund or Credit penalty text.
IRM 20.1.5.6.1 Updated text for clarity.
IRM 20.1.5.6.7 Removed previous title "Advisor Independence" . Now titled Special Rules for Corporate Tax Shelter Items which was IRM 20.1.5.6.8, this subsection no longer exist.
IRM 20.1.5.7.2.1 Updated text for clarity.
IRM 20.1.5.8 Updated paragraph 8 text for clarify for SB/SE and W&I Campuses.
IRM 20.1.5.8.1.2 Added Rev. Proc. 2008-14, Rev. Proc. 2009-15 and Rev. Proc. 2010-13. Removed Rev. Proc. 2001-52, Rev. Proc. 2002-66 and Rev. Proc. 2003-77.
IRM 20.1.5.8.1.3.2 Removed.
IRM 20.1.5.8.2 Removed text on "patently suspect." Updated preparer penalty paragraph 7 text for clarity.
IRM 20.1.5.11.2 Updated example amounts and percentages.
IRM 20.1.5.11.4 Added penalty relief text for estate decedent who died in 2010 under IRC 301(c) of the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010, P.L 111-312.
IRM 20.1.5.12 Added new subsection for Section 1409 Codification of Economic Substance Doctrine IRC 6662(b)(6) penalty. This subsection was previously titled IRC Section 6663: Civil Penalty which has been moved to IRM 20.1.5.14.
IRM 20.1.5.12.1 Added new subsection for Section 1409 Codification of Economic Substance Doctrine IRC 6662(i) penalty. This subsection was previously titled Indications of Fraud which has been moved to IRM 20.1.5.14.1.
IRM 20.1.5.12.1.1 Added new subsection, Special Rules for Amended Return.
IRM 20.1.5.12.1.1.1 Added new subsection, Penalty Relief.
IRM 20.1.5.13 Added new subsection for Section 512, Hiring Incentives to Restore Employment for IRC 6662(b)(7) and IRC 6662(j)(3). This subsection was previously titled IRC Section 6662A: Accuracy-Related Penalty on Understatements with Respect to Reportable Transactions which has been moved to IRM 20.1.5.15.
IRM 20.1.5.14 IRC 6663: Civil Fraud Penalty moved from IRM 20.1.5.12.
IRM 20.1.5.14.1 Updated and moved text from IRM 20.1.5.12.1.
IRM 20.1.5.14.2 Updated and moved text from IRM 20.1.5.12.2.
IRM 20.1.5.14.3 Moved text from IRM 20.1.5.12.3.
IRM 20.1.5.14.4 Updated and moved text from IRM 20.1.5.12.4.
IRM 20.1.5.14.5 Moved text from IRM 20.1.5.12.5.
IRM 20.1.5.14.6 Moved text from IRM 20.1.5.12.6.
IRM 20.1.5.14.7 Moved text from IRM 20.1.5.12.7.
IRM 20.1.5.14.8 Added new subsection and penalty relief text for IRC 6663.
IRM 20.1.5.15 IRC 6662A: Accuracy-Related Penalty on Understatements with Respect to Reportable Transactions moved from IRM 20.1.5.13.
IRM 20.1.5.15.1 Revised titled and updated text moved from IRM 20.1.5.13.1.
IRM 20.1.5.15.2 Updated and moved text from IRM 20.1.5.13.2.
IRM 20.1.5.15.3 Updated and moved from text IRM 20.1.5.13.3.
IRM 20.1.5.15.4 Revised titled, updated and moved text from IRM 20.1.5.13.4, previously titled Penalty Assessment.
IRM 20.1.5.15.5 Changed title, updated and moved text from IRM 20.1.5.13.5, previously titled Reasonable Cause and Good Faith.
IRM 20.1.5.16 IRC 6676, Erroneous Claim for Refund or Credit Penalty updated title and added IRC 6676 Interim Guidance (IG) memo SB/SE 20-0111-001. This text was moved from IRM 20.1.5.14.
IRM 20.1.5.16.1 Added IG information and moved text from IRM 20.1.5.14.1.
IRM 20.1.5.16.1.1 Added new subsection and IG text.
IRM 20.1.5.16.2 Changed title, added IG information and moved text from IRM 20.1.14.2, previously titled Coordination with Other Penalties.
IRM 20.1.5.16.3 Changed title, added IG information, and moved text from IRM 20.1.14.3, previously titled Penalty Relief.
IRM 20.1.5.16.4 Changed title, added IG information and moved text from IRM 20.1.5.14.4, previously titled Penalty Assessment.
IRM 20.1.5.16.5 Added new subsection, IG text and Interim Procedural Update (IPU) 090706.
IRM 20.1.5.16.6 Added new subsection and IG text.
Exhibit 20.1.5-5 Updated amounts and percentages to agree with IRM 20.1.5.11.2 (4) updates.

Effect on Other Documents

IRM 20.1.5, dated 07-01-2008, is superseded. This IRM incorporates Interim Guidance SBSE 20-0111-001, IRC 6676, Erroneous Claim for Refund or Credit Penalty Examination Procedures, dated December 31, 2010, and IPU 090706, IRC 6676, dated July 29, 2009.

Audience

Small Business/Self-Employed (SB/SE), Large Business and International (LB&I), Tax Exempt and Government Entities (TE/GE), Appeals, Wage and Investment (W&I), and other employees who address accuracy-related penalties, fraud penalty, and the erroneous claim for refund or credit penalty.

Effective Date

(01-24-2012)

Duane Gillen
Director, Examination Policy, SE:S:EP:EP
Small Business/Self-Employed Division

20.1.5.1  (01-24-2012)
Penalty Policy

  1. The Office of Servicewide Penalties (OSP), part of Examination Policy, oversees the implementation of servicewide policies and strategies for all penalties servicewide. OSP provides instructions to staff in IRM 20.1, Penalty Handbook, applicable to all operating divisions to ensure consistent and accurate treatment of all taxpayers.

  2. Penalties should be considered and developed simultaneously with the examination of the returns and not at the conclusion of the audit. Proper consideration and application of penalties will:

    • Encourage voluntary compliance;

    • Conserve IRS resources due to early disposition of tax shelter issues;

    • Provide clear guidance to taxpayers and practitioners;

    • Ensure consistent and fair treatment of the issues; and

    • Ensure that noncompliant behavior is penalized.

  3. Consideration of penalties must be documented in all taxpayer examinations, including those involving tax shelters and erroneous claims for refund or credit. The applicability of penalties should be consider during the examination, and if warranted developed as the examination progress. Only after all facts and circumstances surrounding an examination have been developed, can a determination be made as to the application of appropriate penalties.

  4. The consideration and assertion of penalties in audits involving tax shelters is vital to the IRS efforts in addressing the proliferation of tax shelters. Appropriate administration of penalties seeks to ensure fairness and consistency in the administration of the tax law and seeks to effectively discourage noncompliant behavior.

  5. All penalties including the accuracy-related penalties, the fraud penalty, and the erroneous claims for refund or credit penalty are important deterrents to non-compliance.

  6. Examiners and managers should not use penalties as a bargaining point in the development or processing of cases. See IRM 1.2.20.1.1, Policy Statement 20-1 (Formerly P-1-18). The relevant guidance on not "trading penalties" is located in IRM 8.6.4.1.2 (6), Split-Issue Settlements.

20.1.5.1.1  (01-24-2012)
Background

  1. The return-related penalties covered in this IRM include:

    1. IRC 6662, Imposition of Accuracy-Related Penalty on Underpayments,

    2. IRC 6663, Imposition of Fraud Penalty,

    3. IRC 6662A, Imposition of Accuracy-Related Penalty on Understatements with Respect to Reportable Transactions,

    4. IRC 6707A, Penalty for Failure to include Reportable Transaction Information with Return, and

    5. IRC 6676, Erroneous Claim for Refund or Credit penalty.

  2. IRC 6662 imposes an accuracy-related penalty on any portion of an underpayment attributable to one or more of the following:

    1. Negligence or disregard of the rules or regulations. See IRM 20.1.5.7 and IRC 6662(c).

    2. Substantial understatement of income tax. See IRM 20.1.5.8 and IRC 6662(d).

    3. Substantial valuation misstatement. See IRM 20.1.5.9 and IRC 6662(e).

    4. Substantial overstatement of pension liability. See IRM 20.1.5.10 and IRC 6662(f).

    5. Substantial estate or gift tax valuation understatement. See IRM 20.1.5.11 and IRC 6662(g).

    6. Gross valuation misstatement. See IRM 20.1.5.9.4 and IRC 6662(h).

    7. Disallowance of claimed tax benefits by reason of a transaction lacking economic substance (within the meaning of IRC 7701(o)) or failing to meet the requirements of any similar rule of law. See IRC 6662(b)(6) and IRM 20.1.5.12.

    8. Nondisclosed noneconomic substance transactions. See IRC 6662(j) and IRM 20.1.5.12.1.

    9. Undisclosed foreign financial asset understatement. See IRC 6662(b)(7), IRC 6662(i), and IRM 20.1.5.13.

  3. IRC 6663 imposes a penalty on any portion of an underpayment attributable to fraud. See IRM 20.1.5.14.

  4. IRC 6662A imposes an accuracy-related penalty on a reportable transaction understatement. See IRM 20.1.5.15.

  5. IRC 6707A imposes a penalty for failure to include reportable transaction information with return. Information for this penalty is included in IRM 20.1.5.15.1.

  6. IRC 6676 imposes a penalty for erroneous claim for refund or credit with respect to income tax. See IRM 20.1.5.16.

  7. See IRC 6664, Definitions and Special Rules, for the accuracy-related penalties and IRM 20.1.5.6, Penalty Relief.

20.1.5.1.2  (01-24-2012)
Large Business and International (LB&I)

  1. LB&I examiners must consider the accuracy-related penalty during their examinations. Examiners are required to consider, and then, if appropriate, develop the accuracy-related penalty in all cases in which there is an underpayment of tax attributable to a listed transaction.

  2. If an underpayment of tax is attributable to a taxpayer’s participation in a listed transaction, the examiner must develop the accuracy-related penalty issues and prepare a written report supporting the recommendation to impose or not to impose the penalty.

  3. For a tax shelter case involving a listed transaction, the decision to impose or not impose an accuracy-related penalty must be approved by the respective Director of Field Operations (DFO).

  4. When an examiner identifies a new potentially abusive tax shelter transaction or promoter information, the examiner must contact LB&I field Counsel as well as the Office of Tax Shelter Analysis (OTSA).

20.1.5.1.3  (01-24-2012)
Small Business/Self-Employed Examination (SB/SE)

  1. SB/SE examiners should follow procedures outlined in IRM 20.1.5.1.6 regarding managerial approval for imposing penalties in a tax shelter case involving a listed transaction.

  2. Examiners should send promoter information to the Lead Development Center (LDC), and also involve the employee designated by their business unit responsible for coordinating and assisting in the identification of abusive tax shelters.

20.1.5.1.4  (01-24-2012)
Statutory Changes

  1. This section reflects the current law unless otherwise stated. Below is a list of the relevant statutory changes for the accuracy-related penalties. Also listed are other penalty statutory changes that may have an effect on the accuracy-related penalties. If the examiner has questions relating to previous years or relating to the effect of these statutory changes, the examiner should research the code section applicable to that year.

  2. The American Jobs Creation Act of 2004 (AJCA) added IRC 6662A, Imposition of Accuracy-Related Penalty on Understatements with Respect to Reportable Transactions and reasonable cause exception for reportable transaction understatements.

  3. AJCA amended IRC 6662(d) by changing the definition of "substantial" as it relates to corporations (other than S-Corporations or personal holding companies) and eliminating the exception for tax shelter items as it relates to all taxpayers.

  4. The AJCA also added IRC 6707A, Penalty for Failure to Include Reportable Transaction Information with Return, and IRC 6664(d).

  5. The Pension Protection Act of 2006 added a penalty under IRC 6695A, Substantial and Gross Valuation Misstatements Attributable to Incorrect Appraisals.

  6. The Small Business and Work Opportunity Tax Act of 2007 added IRC 6676, Erroneous Claim for Refund or Credit penalty.

  7. Health Care and Reconciliation Act of 2010 codified the Economic Substance Doctrine, added IRC 7701(o) and amended IRC 6662, IRC 6662A, IRC 6664 and IRC 6676.

  8. The Hiring Incentives to Restore Employment (HIRE) Act of 2010 added IRC 6662(j) and IRC 6662(b)(6).

20.1.5.1.5  (01-24-2012)
IRS Voluntary Disclosure Initiatives

  1. IRS voluntary disclosure initiatives provides excellent opportunities to quickly bring more taxpayers into compliance in a cost effective manner.

  2. On February 8, 2011, IRS announced the 2011 Offshore Voluntary Disclosure Initiative (OVDI) designed to bring offshore money back into the U.S. tax system and help taxpayers get current with their taxes. See IRM 20.1.9.1.4, Voluntary Disclosure Special Process, and IR 2011-14, Second Special Voluntary Disclosure Initiative Opens; Those Hiding Assets Offshore Face Aug. 31 Deadline, at http://www.irs.gov/newsroom/article/0,,id=235695,00.html.

  3. On October 27, 2005, the IRS issued IRB 2005-46, Settlement Initiative (commonly referred to as Announcement 2005-80, Global Settlement Initiative or GSI). Taxpayers who undertook these arrangements had until January 23, 2006, to submit their settlement papers with the IRS. In general, the initiative requires the taxpayer to concede all of the claimed tax benefits associated with the transaction. Transaction costs were allowed as an ordinary loss and an accuracy-related penalty under IRC 6662 ranging from 5 percent to 20 percent was asserted based upon the specific information. Since this was purely an administrative offer (limited time) there were no provisions for penalty relief for reasonable cause. In very limited circumstances, as set forth in IRB 2005-46, the taxpayer may have qualified for penalty relief. If the taxpayer asserted reliance upon an independent written tax opinion, special servicewide procedures were developed for reviewing penalty relief claims. To ensure consistent treatment, a penalty panel subcommittee reviewed all cases where relief was proposed. The Technical Advisors assigned the specific issues were available for assistance on the settlement terms and penalty relief provision.

20.1.5.1.6  (01-24-2012)
Managerial Approval of Penalties

  1. IRC 6751(b)(1) states, in general, that no penalty under the IRC shall be assessed unless the initial determination of such assessment is personally approved (in writing) by the immediate supervisor of the individual making such determination or such higher level official as the Secretary may designate.

  2. The employee initially proposing the penalty should indicate the name of the penalty, the IRC section, and the amount of the penalty on Form 4318-OA, Examination Workpapers Index, Form 4318, Examination Workpapers Index, Form 4700, Examination Workpapers or Form 5772, EP/EO Workpaper Summary. The penalty computation should also be documented in the case file.

  3. The IRS also requires managerial review on the non-assertion of penalties when there is a substantial understatement of tax under IRC 6662(d).

  4. For SB/SE exam cases, written managerial approval and non-assertions should be documented on the Civil Penalty Approval, leadsheet.

  5. For LB&I cases, managerial approval and non-assertions should be documented on the penalty leadsheets. The LB&I Information Management System provides leadsheets based on the Standard Audit Index Number (SAIN) entry for the penalty issue. SAIN 011 is used to approve penalties in LB&I.

  6. For Wage and Investment (W&I) and SB/SE campus cases, written managerial approval and non-assertions may be documented on Form 4700. On Correspondence Examination Automation Support (CEAS) cases, the manager must input a Report Generation Software (RGS)/CEAS non-action notation to indicate concurrence with the penalty assertion.

  7. For TE/GE, managerial approval and non assertions may be documented on Form 5772 or similar workpaper summary.

  8. Any function not listed above that has examiners asserting penalties must obtain written managerial approval as required by IRC 6751(b). This written approval must be documented in the workpapers.

  9. Any penalties automatically calculated through electronic means are excluded from IRC 6751(b)(1) requirement.

    1. When IRC 6662 accuracy-related penalties for negligence and substantial understatement are assessed under the Automated Underreporter (AUR) program without an employee independently determining the appropriateness of the penalty, then the penalty is one that is automatically calculated through electronic means and may be assessed without written supervisory approval.

    2. However, if a taxpayer responds either to the initial letter proposing a penalty or to the notice of deficiency that the program automatically issues, an IRS employee will have to consider the taxpayer’s response. Therefore, the IRS employee will have to make an independent determination as to whether the response provides a basis upon which the taxpayer may avoid the penalty. The employee’s independent determination of whether the penalty is appropriate means the penalty is not automatically calculated through electronic means. Accordingly, IRC 6751(b)(1) requires managerial written approval of an employee’s determination to assert the penalty.

20.1.5.2  (01-24-2012)
Common Features of Accuracy-Related and Civil Fraud Penalties

  1. The accuracy-related and civil fraud penalties apply only if a return is filed.

  2. The accuracy-related and civil fraud penalties do not apply in the case of a return prepared by the IRS under IRC 6020(b).

  3. The accuracy-related and civil fraud penalty issues are developed separately from the tax law issues that gave rise to the tax understatement. Penalty issues require review and managerial approval prior to being asserted.

  4. Generally, requests for penalty abatements should be addressed by the office that initially conducted the examination. See IRM 20.1.5.3.2 (13) and IRM 20.1.5.6.

  5. Claims for refund on assessed accuracy-related and civil fraud penalties are handled like other claims.

  6. Return Filing Requirements: The accuracy-related penalties and the civil fraud penalty apply when a return is filed. These penalties cannot be asserted on a substitute-for-return (SFR) filed under IRC 6020(b). See IRC 6664(b). The accuracy-related and fraud penalties can be asserted on a secured delinquent return, e.g., an original return obtained after the taxpayer is contacted by the IRS; however, examiners cannot apply the accuracy-related penalties to a delinquent return after an assessment (TC 290/300) is made under SFR procedures. Examiners should review available IRS CFOL information when making penalty determinations to establish payment patterns and any history of non-compliance.

  7. Uniform Definition of Underpayment:IRC 6664(a) provides a common definition of underpayment. See IRM 20.1.5.2.4 (8) for underpayment calculation. The accuracy-related and civil fraud penalties are calculated only on the underpayment (or portion of the underpayment) of tax attributable to the misconduct or fraud.

  8. Coordination of Accuracy-Related and Civil Fraud Penalties: The accuracy-related and civil fraud penalties cannot be asserted on the same portion of the same underpayment, except as an alternative penalty position. However, the accuracy-related penalty and the civil fraud penalty may be asserted on the same return when civil fraud applies to one portion of the underpayment and the accuracy-related penalty applies to another portion of the underpayment.

  9. Coordination of the Accuracy-Related Penalty Attributable to a Reportable Transaction Understatement and the Civil Fraud Penalty: The accuracy-related penalty attributable to a reportable transaction understatement and the civil fraud penalty cannot be asserted on the same portion of the same understatement (a reportable transaction understatement is treated as an underpayment for purposes of determining the fraud penalty). However, the accuracy-related penalty attributable to a reportable transaction understatement and the civil fraud penalty may be asserted on the same return when civil fraud applies to one portion of the underpayment and the accuracy-related penalty attributable to a reportable transaction understatement applies to another portion. See IRC 6662A(e).

  10. Interest: Under IRC 6601(e)(c)(B), interest on civil fraud and accuracy-related penalties is imposed from the due date of the return, including extensions, until the date of payment. IRC 6601(e)(3) provides, however, that if payment is made within 21 calendar days after notice and demand (10 business days if the amount for which the notice and demand is equal or exceeds $100,000), interest on the amount paid is not imposed for the period after the date of the notice and demand.

  11. Deficiency Procedures May Apply: If the underlying tax is subject to deficiency procedures, the penalty is as well; in such a case, the accuracy-related and fraud penalties follow the guidelines for examination 30-day letters and statutory notices of deficiency.

20.1.5.2.1  (01-24-2012)
Two and Ten Year Bans on Claiming the Earned Income Tax Credit (EITC)

  1. The two-year ban under IRC 32(k)(1)(B)(ii) applies when it is determined that a taxpayer recklessly or intentionally disregarded the EITC rules when claiming the EITC.

  2. The ten-year ban under IRC 32(k)(1)(B)(i) applies when it is determined that a taxpayer fraudulently claimed the EITC.

  3. The two and ten-year bans are in addition to any other penalty imposed under present law. The law does not require that an accuracy-related penalty under IRC 6662(c) for negligence or disregard be asserted in order to impose the EITC two-year ban.

  4. Follow IRM 20.1.5.7 guidelines when asserting the accuracy-related penalty under IRC 6662(c).

  5. The ten-year ban for fraudulently claiming the EITC essentially follows criteria for assertion of civil fraud under IRC 6663. See IRM 20.1.5.14.2.

    Note:

    The ten-year ban can be asserted when it is applicable, even if the fraud penalty is not (or cannot be) applied.

20.1.5.2.2  (01-24-2012)
Allocation of an Underpayment

  1. An allocation is necessary when both the accuracy-related and the civil fraud penalties apply. For example, when there are three return adjustments, and one penalty applies to just one of the three, apply the penalty rate times the amount of that underpayment. This is the amount of the penalty.

  2. In computing the portions of an underpayment subject to penalties imposed under IRC 6662 and IRC 6663, adjustments to a return are considered made in the following order:

    1. Those for which no penalties are imposed.

    2. Those for which a penalty has been imposed at a 20 percent rate (e.g., a penalty for negligence or disregard of rules or regulations, substantial understatement of income tax or substantial valuation misstatement, under IRC 6662(b)(1) through IRC 6662(b)(3), respectively).

    3. Those for which a penalty is imposed at a 40 percent rate (e.g., a penalty for a gross valuation misstatement under IRC 6662(b)(3) and IRC 6662(h).

    4. Those for which a penalty has been imposed at a 75 percent rate (e.g., a penalty for fraud under IRC 6663).

    See Treas. Reg. 1.6664-3.

  3. See Exhibit 20.1.5-1, Calculation of Underpayment Penalty, for an example:

    1. The first adjustment with no penalty.

    2. The second with the accuracy-related penalty attributable to a substantial understatement.

    3. The third with the civil fraud penalty.

  4. See IRM 20.1.5.15.3 (4) for an example of a calculation involving IRC 6662(d), IRC 6663, and IRC 6662A.

  5. Only one penalty rate applies to any portion of an underpayment. When two penalties could apply, the penalty at the higher rate is asserted. If two penalties at the same rate would apply, assert the penalty that is more comprehensively applicable. In unagreed cases, include the other penalty in the report as an alternative penalty position.

  6. The following illustrates the "no stacking" provision in Treas. Reg. 1.6662-2(c):

    1. If a portion of the underpayment of tax required to be shown on a return is attributable to both negligence and a substantial understatement, the accuracy-related penalty would apply only once at the 20 percent rate to this portion of the underpayment. The examiner should assert the penalty that is most strongly supported by the facts and circumstances and write up the other as an alternative penalty position.

    2. The penalty is applied at the 40 percent rate on any portion of the underpayment attributable to a gross valuation misstatement. Any penalty at the 20 percent rate that could have applied to this portion is not asserted except as an alternative penalty position.

    3. A penalty is applied at the 75 percent rate on any portion of the underpayment attributable to civil fraud. Any penalty that could have applied to this portion at the 20 or 40 percent rate is not asserted except as an alternative penalty position.

  7. Any income tax withholding, estimated tax payments, or other payment made before a return was filed, that was not claimed on the return or previously allowed as a credit against the tax liability for the taxable year is allocated as follows:

    1. If the unclaimed prepayment credit is allocable to a particular adjustment, e.g., withholding on unreported W–2 income, the credit is used to reduce the amount of the underpayment resulting from the adjustment.

    2. If the unclaimed prepayment credit is not allocable to a particular adjustment, the credit is applied in accordance with the ordering rules set forth in Treas. Reg. 1.6664-3.

    3. See Treas. Reg. 1.6664-3(d) for examples illustrating the manner in which unclaimed prepayment credits are to be allocated.

20.1.5.2.3  (01-24-2012)
Carrybacks and Carryovers

  1. The amount of an underpayment subject to IRC 6662 or IRC 6663 will not be reduced by any carryback of a loss, deduction, or credit to that year.

    Example:


    A tax year (TY) 2009 examination adjustment results in an underpayment of $3,000, which is subject to the accuracy-related penalty attributable to negligence.
    A $12,000 net operating loss (NOL) carryback from TY 2010 to TY 2009 offsets the $3,000 underpayment for income tax purposes, but the $3,000 underpayment is subject to the penalty because the NOL is not taken into account in determining the underpayment for TY 2009.
    The amount of the negligence penalty imposed for TY 2009 is $600 (20% x $3,000).

  2. If an underpayment in a loss year is subject to IRC 6662 or IRC 6663 and that loss is carried back to an earlier year or carried forward to a later year, any underpayment resulting from the disallowance of the loss in the earlier or later year will also be subject to IRC 6662 or IRC 6663. See Treas. Reg. 1.6662-3(d) and Treas Reg. 1.6662-4(c).

    Example:


    The taxpayer filed a TY 2009 return with an NOL of $45,000.
    The taxpayer carried forward $20,000 of the NOL to TY 2010.
    An examination of the TY 2009 return results in an adjustment of $60,000 due to the negligent omission of income.
    The $45,000 NOL is disallowed in full and there is an underpayment of $3,000 for TY 2009.
    The $20,000 amount carried over from TY 2009 to TY 2010 is disallowed. This produces a TY 2010 underpayment of $2,000.
    The TY 2009 underpayment of $3,000 and the FY 2010 underpayment of $2,000 are subject to IRC 6663 fraud penalty.

    Note:

    If the NOL disallowance for TY 2009 did not result in an underpayment, but did create an underpayment for TY 2010 (due to the disallowed carryover from TY 2009), then the fraud penalty would apply to the underpayment in TY 2010 only.

  3. When the penalty assertion requires a dollar threshold (e.g., $5,000 for substantial understatements and valuation misstatements), this threshold must be met for each year in which the penalty will be asserted (including a carryback or carryover year).

  4. For special rules regarding carrybacks and carryovers in the area of transfer pricing, see Treas. Reg. 1.6662-6(e).

  5. In the case of carrybacks and carryovers, adequate disclosure is made on the return for the taxable year in which the carryback or carryover originates. See IRM 20.1.5.7.2.1 for more information relating to adequate disclosure.

20.1.5.2.4  (01-24-2012)
Definitions

  1. Amount of Tax Imposed: This is the corrected tax including any statutory adjustments based on adjusted gross income (AGI). For example:

    1. Medical, casualty loss, and miscellaneous deductions;

    2. Changes to the tax as a result of the examination; or

    3. Changes to any credit, prepayment credit, or refundable credit as a result of the examination (this includes any prepayment credits that were paid for the year under examination but were not credited).

  2. Listed Transaction: A listed transaction is a reportable transaction, which is the same as, or substantially similar to, a transaction specifically identified by the IRS as a tax avoidance transaction for purposes of IRC 6011. See IRC 6707A(c)(2) and Treas. Reg. 1.6011-4(b)(2).

  3. Qualified Amended Return: A qualified amended return is an amended return or a timely request for administrative adjustment under IRC 6227, filed after the due date of the return (determined with regard to extensions), but before:

    1. The receipt of an audit notification letter,

    2. Contact concerning an activity described in IRC 6700,

    3. The date a pass-through entity is first contacted by the IRS,

    4. The date the IRS serves a John Doe summons relating to the tax liability of a person, group or class that includes that taxpayer or pass-through entity in which the taxpayer may have an interest,

    5. The date on which the IRS announces a settlement initiative to compromise or waive penalties with respect to a listed transaction, or

    6. With respect to an undisclosed listed transaction, contact concerning activity described in IRC 6707(a) or contact concerning a list described in IRC 6112.

  4. Rebate: A rebate is the amount of an abatement, credit, refund, or other repayment made on the basis that the tax imposed was less than the excess of the sum of:

    1. The amount shown as a tax by the taxpayer on the return, plus

    2. Amounts not shown previously assessed, (or collected without assessment) over rebates previously made.

  5. Reportable Transaction: Any transaction with respect to which information is required to be included with a return or statement because, as determined under regulations prescribed under IRC 6011, such transaction is of a type which the IRS determines as having a potential for tax avoidance or evasion. See IRC 6707A(c)(1) and Treas. Reg. 1.6011-4(b)(1).

  6. Reportable Transaction Understatement: The reportable transaction understatement is the sum of:

    1. The increase in taxable income that results from a difference between the proper tax treatment of the item related to the transaction and the taxpayer’s treatment of the item multiplied by the highest tax rate imposed by IRC 1 for individuals or IRC 11 for corporations, and

    2. The decrease in the aggregate amount of credits which results from the difference between the credits the taxpayer claimed and the proper amount. See IRM 20.1.5.15.2 for a calculation example.

  7. Tax Per Return: Tax per the return includes:

    • Math error corrections,

    • Changes made by a qualified amended return posted to the account as a credit or debit, and

    • Any amounts not shown on the return, but previously assessed or collected without assessment (e.g., jeopardy assessments). See Treas. Reg. 1.6664-2(d).

  8. Underpayment: An underpayment is defined as the amount by which any tax imposed, exceeds the excess of:

    1. The sum of the amount shown on the return, plus

    2. Amounts not shown that were previously assessed (or collected without assessment), over

    3. The amount of rebates made.

      Note:

      In calculating the amount of the underpayment, adjustments to refundable credits, prepayment credits for withholding, or estimated tax payments are included.

    4. See Exhibit 20.1.5-1, Calculation of Underpayment Penalty, for an example.

  9. Economic Substance Doctrine: The economic substance doctrine is defined as the common law doctrine under which income tax benefits with respect to a transaction are not allowable if the transaction does not have economic substance or lacks a business purpose.

  10. Reasonable Basis: Reasonable basis is a relatively high standard of tax reporting, that is, significantly higher than not frivolous or not patently improper. See Treas. Reg. 1.6662-3(b)(3).

20.1.5.2.5  (01-24-2012)
Notice of Inconsistent Treatment

  1. A partner, S-Corporation shareholder, beneficiary of an estate or trust, owner of a foreign trust, or residual interest holder in a real estate mortgage investment conduit (REMIC) generally must report items consistent with the way they were reported on Schedule K-1, Schedule Q, or a foreign trust statement.

  2. Form 8082, Notice of Inconsistent Treatment or Administrative Adjustment Request (AAR), is used to notify the IRS of any inconsistency between the tax treatment of an item by an impacted person and the way the pass-through entity treated and reported such item.

  3. Form 8082 is also used to notify the IRS if an impacted person did not receive a Schedule K-1, Schedule Q, or foreign trust statement.

  4. If the Form 8082 is not filed as required, the taxpayer may be subject to the accuracy-related penalty under IRC 6662 or the fraud penalty under IRC 6663.

  5. See IRC 6227 and IRM 4.31.4, Administrative Adjustment Request (AAR), for additional information.

20.1.5.3  (01-24-2012)
Examination Penalty Assertion

  1. The examiner is responsible for the assertion of the accuracy-related penalties, erroneous claim for refund penalty, erroneous claim for credit penalty, and the fraud penalty.

  2. The applicable accuracy-related penalty and the fraud penalty are to be addressed in all examinations and the workpapers should be prepared under the following guidelines:

    1. For examination adjustments that clearly do not involve penalties, a brief statement to that effect is sufficient.

    2. All examiners are required to document the procedures used, information obtained, and conclusions reached in deciding to recommend or not recommend applicable penalties during examinations.

    3. Penalties should not be asserted without an explanation. Standard statements such as "negligence penalty deemed not to be applicable" are not sufficient.

    4. An alternative penalty positions should be documented in the workpapers when applicable.

    5. The IRS requires managerial review on the non-assertion of penalties when there is a substantial understatement of tax. See IRM 20.1.5.8 for substantial understatement criteria.

    6. As part of the examiner's workload review, managers should review the non-assertion of penalties when there is a substantial understatement of tax under IRC 6662(d).

    7. SB/SE area office examiners should document managerial involvement on Civil Penalty Approval, leadsheet. The substantial understatement penalty leadsheet may also be used for the development of the IRM 6662(d) penalty.

    8. LB&I team members should document managerial involvement on the SAIN Leadsheet 011.

    9. W&I and SB/SE campus cases, documentation and managerial involvement can be made on Form 4700. On Report Generation Software (RGS), Correspondence Examination Automation Support (CEAS) cases, the manager must input a RGS/CEAS non-action notation to indicate concurrence with the penalty assertion.

    10. When a penalty appears warranted, but it is not asserted, the applicable exceptions to the penalty will be documented in the workpapers. See IRM 20.1.5.8.1 and IRM 20.1.5.8.1.1 for exceptions to the substantial understatement penalty.

    11. Taxpayer claims for penalty relief under IRC 6664 must be evaluated and, if a taxpayer cannot meet the standards for penalty relief, the penalty should be applied.

    12. With managerial approval, Area Counsel can be contacted to assist the examiner with penalty development when evaluating a taxpayer's reasonable basis, reasonable cause, and substantial authority defenses.

  3. Form 3198, Special Handling Notice for Examination Case Processing, or Form 3198-A, TE/GE Special Handling Notice, should be attached to each penalty case except for campus RGS/CEAS cases. The examiner will identify the applicable IRC section on the form for the Centralized Case Processing (CCP) function.

  4. Examiners will identify the adjustments related to each penalty in the report, and they will identify each penalty separately by name, IRC section, and penalty computation.

  5. In proposing the penalty to the taxpayer or taxpayer’s representative, the examiner will:

    1. Fully explain the proposed penalty.

    2. Document the reasons why the penalty assertion is appropriate.

    3. Consider and document any possible exceptions to the penalty provided by the taxpayer or the taxpayer’s representative whether or not they are accepted.

      Note:

      The level of taxpayer cooperation is not grounds for asserting or not asserting a penalty.

  6. When more than one component of the accuracy-related penalty may apply to the same portion of an underpayment (e.g., negligence and substantial understatement):

    1. On agreed cases - assert the penalty with the strongest position in the report.

    2. On unagreed cases - assert the penalty with the strongest position in the report and list any other applicable penalties as alternative positions.

    Reminder:

    The alternative penalty position(s) is included in the examination 30-day letter and in the statutory notice of deficiency.

  7. The requirements for managerial approval of penalties are explained in IRM 20.1.5.1.6.

20.1.5.3.1  (01-24-2012)
Automated Underreporter Penalty Assertion

  1. The Automated Underreporter (AUR) Program matches information returns against individual income tax returns to verify that income is reported and deductions taken correctly.

  2. AUR computer-generated notices are for Individual Master File (IMF). If the accuracy-related penalty is applicable, the AUR system generates the appropriate penalty paragraph for CP 2501, Initial Inquiry Letter, or the CP 2000, Notice of Proposed Adjustment. In the absence of a taxpayer response to the letter or notice, the penalty determination will be made on the basis of return information and the significance of the amounts omitted.

  3. On AUR cases involving taxpayer contacts, the assertion of the accuracy-related penalty requires managerial approval. See IRM 20.1.5.1.6.

  4. Notices and reports will fully identify the names, IRC sections, and the computation of the penalty amounts being asserted.

  5. All penalty determinations involving a reasonable cause exception will be documented in the workpapers. This will be done by identification on the AUR system and will remain with the case file.

  6. In unagreed cases, the IRS will provide the taxpayer or representative with a complete explanation of the penalty.

  7. See IRM 4.19.3.16.5, Accuracy-Related Penalty Due to Substantial Understatement of Tax for penalties related to AUR cases.

20.1.5.3.2  (01-24-2012)
Penalty Assessments and Abatements

  1. The examiner will compute the accuracy-related penalty for CCP.

  2. The amount of the IRC 6662 penalty is 20 percent of the portion of the underpayment resulting from the misconduct. The penalty rate increases to 40 percent in certain circumstances involving gross valuation misstatements, nondisclosed noneconomic substance transactions, and undisclosed foreign financial asset understatements.

  3. The amount of the IRC 6663 penalty is 75 percent of the underpayment due to fraud. See IRM 20.1.5.14.

  4. The amount of the IRC 6662A penalty is 20 percent of the reportable transaction understatement. The penalty rate increases to 30 percent of the reportable transaction understatement where the transaction was not properly disclosed. See IRM 20.1.5.15.4.

  5. The amount of the IRC 6676 penalty is 20 percent of the "excessive amount." See IRM 20.1.5.16.

  6. Stacking of IRC 6662, IRC 6663, IRC 6662A, and IRC 6676 penalties is not permitted. The maximum amount of the IRC 6662 penalty imposed on a portion of an underpayment of tax is 20 percent (or 40 percent in certain circumstances) of that portion of the underpayment, even if that portion of the underpayment is attributable to more than one type of misconduct under IRC 6662.

  7. For assessment, compute the penalty amount and enter it and the penalty reference number (PRN) on Form 5344, Examination Closing Record, Form 5403, Appeals Closing Record, or Form 5599, TE/GE Examined Closing Record.

    Note:

    The penalty amount and PRN will automatically flow to the Form 5344 on cases worked through RGS

    .

  8. Using the appropriate closing record, enter the PRN 680 with a positive dollar amount to assess the following components of the accuracy-related penalty:

    • IRC 6662(c), negligence or disregard of the rules and regulations

    • IRC 6662(d), substantial understatement

    • IRC 6662(e), substantial valuation misstatement

    • IRC 6662(f), substantial overstatement of pension liabilities

    • IRC 6662(g), substantial estate or gift tax valuation understatement

    • IRC 6662(h), increase in penalty in case of gross valuation misstatement

  9. The following accuracy-related penalty components should not be assessed with PRN 680. Contact the Office of Servicewide Penalties for further guidance at http://sbseservicewide.web.irs.gov/penalty/default.aspx.

    • IRC 6662(b)(6) and IRC 6662(i) nondisclosed noneconomic substance transactions.

    • IRC 6662(b)(7) and IRC 6662(j)(3) undisclosed foreign financial asset understatements.

  10. Use PRN 681 and the computed penalty amount to assess a reportable transaction understatement penalty under IRC 6662A. See IRM 20.1.5.15.4.

  11. Transaction Code (TC) 240 will automatically post to the Master File (MF) account that relates to the assessment of an accuracy-related penalty.

  12. MF will systemically compute interest on an accuracy-related penalty from the due date or extended due date of the return (whichever is later) to the earlier of:

    1. The date of payment,

    2. Waiver date plus 30 days, or

    3. 23C date of assessment.

  13. When abating an assessed IRC 6662 penalty, use PRN 680 with a negative dollar amount. Use PRN 681 with a negative dollar amount to abate the IRC 6662A penalty. TC 241 will automatically post to the MF account that relates to an abatement of an accuracy-related penalty. A penalty abatement amount can be in part or in full of the assessed penalty amount. A penalty reason code (PRC) must always be entered for penalty abatements. See IRM 20.1.1.5.1, Master File Penalty Reasonable Codes.

20.1.5.4  (01-24-2012)
Post-Assessment Abatement Consideration of Accuracy-Related Penalties

  1. If a taxpayer is afforded an opportunity to provide information to explain why the penalty should not be asserted, but does not, the statutory notice of deficiency showing additional tax and penalties should be issued.

  2. If the notice defaults without taxpayer contact, the tax, penalties, and interest are assessed.

  3. If a taxpayer receives notice and demand for tax and penalty payment and then makes his/her first response to the IRS requesting abatement of the accuracy-related penalty, the penalty abatement request will be considered based on the evidence provided.

  4. The function responsible for the penalty assessment should decide whether the penalty should be abated.

  5. If the evidence is not sufficient to support a reasonable cause claim for the penalty abatement, the taxpayer should be issued the appropriate letter to indicate that the abatement request is denied and the remaining recourse is to pay the tax, penalties, and interest and file a claim for refund on Form 843, Claim for Refund and Request for Abatement.

  6. Post-assessment consideration of IRC 6662 and IRC 6662A accuracy-related penalty abatement requests are not forwarded to Appeals.

20.1.5.5  (01-24-2012)
Statute of Limitations

  1. All managers and examiners are responsible for protecting the statute of limitations on penalty assessments. See IRM 25.6, Statute of Limitations.

20.1.5.6  (01-24-2012)
Penalty Relief

  1. General penalty relief is discussed in IRM 20.1.1.3, Criteria for Relief From Penalties. Reasonable cause and good faith exception to IRC 6662 and IRC 6662A penalties are discussed below and in IRC 6664.

  2. Exceptions specific to each accuracy-related penalty, civil fraud penalty, and the erroneous claim for refund or credit penalty are discussed in their respective sections of this manual; for example, see IRM 20.1.5.15.5, Penalty Relief, for IRC 6662A.

20.1.5.6.1  (01-24-2012)
Reasonable Cause

  1. No accuracy-related penalty under IRC 6662 is imposed if it is shown that the taxpayer had reasonable cause for the position taken and that the taxpayer acted in good faith.

  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 reportable transaction understatement. However, if IRC 6707A applies for a Listed Transaction, there is no reasonable cause exception and the penalty must be applied.

    1. The reasonable cause provision in IRC 6664(c) applies to all of the components of the accuracy-related penalty on underpayments and the fraud penalty.

    2. The reasonable cause provision in IRC 6664(d) applies only to the accuracy-related penalty on reportable transaction understatements.

  3. IRC 6664(c) provides an exception to the imposition of any accuracy-related penalty if the taxpayer shows that there was reasonable cause and the taxpayer acted in good faith.

  4. The determination of whether the taxpayer acted with reasonable cause and in good faith is made on a case-by-case basis, taking into account all the relevant facts and circumstances.

  5. Special rules apply to items of a corporation attributable to a tax shelter resulting in a substantial understatement. See IRM 20.1.5.6.7.

  6. Generally, the most important factor in determining reasonable cause is the taxpayer’s effort to report the proper tax liability. Other factors to consider are the taxpayer’s experience, knowledge, education, and the taxpayer’s reliance on the advice of a tax advisor.

  7. All relevant facts, including the nature of the tax investment, the complexity of the tax issues, the competence of the tax advisor, the education of the taxpayer, and the quality of the opinion relied upon must be developed to determine whether the taxpayer was reasonable and acted in good faith.

  8. Treas. Reg. 1.6664-4(d) provides that the failure to disclose a reportable transaction on Form 8886, Reportable Transaction Disclosure Statement, is an indication that the taxpayer did not act in good faith with respect to the portion of an underpayment attributable to a reportable transaction, as defined under IRC 6011.

  9. Examples of types of conduct that may or may not constitute reasonable cause are described in Exhibit 20.1.5-7.

  10. Treas. Reg. 1.6664-4(g) provides guidelines for applying the reasonable cause and good faith exception to IRC 6662(e) penalties for transactions between persons described in IRC 482, Allocation of Income and Deductions Among Taxpayers, and net adjustment in IRC 485, Transfer Pricing Adjustments. For specific reasonable cause criteria on transfer pricing adjustments, see IRM 20.1.5.9.7.1.

20.1.5.6.2  (07-01-2008)
Taxpayer’s Effort to Report the Proper Tax Liability

  1. Generally, the most important factor in determining whether the taxpayer has reasonable cause and acted in good faith is the extent of the taxpayer’s effort to report the proper tax liability. For example, reliance on erroneous information reported on an information return indicates reasonable cause and good faith, provided that the taxpayer did not know or have reason to know that the information was incorrect. Similarly, an isolated computational or transcription error may indicate reasonable cause and good faith.

  2. Generally, there is reasonable cause and good faith if the taxpayer relies on erroneous information inadvertently included in data compiled by various divisions of a multidivisional corporation or in financial books and records prepared by those divisions. The corporation, however, must have employed internal controls and procedures, reasonable under the circumstances, which were designed to identify factual errors.

20.1.5.6.3  (07-01-2008)
Experience, Knowledge, Sophistication, and Education of Taxpayer

  1. Circumstances that may suggest reasonable cause and good faith include an honest misunderstanding of fact or law that is reasonable in light of the facts, including the experience, knowledge, sophistication and education of the taxpayer. The taxpayer’s mental and physical condition, as well as sophistication with respect to the tax laws at the time the return was filed, are relevant in deciding whether the taxpayer acted with reasonable cause.

  2. If the taxpayer is misguided and unsophisticated in tax law, but acts in good faith, a penalty is not warranted.

20.1.5.6.4  (01-24-2012)
Reliance on Advice

  1. Reliance upon a tax opinion provided by a tax advisor may serve as a basis for the reasonable cause and good faith exception to the accuracy-related penalty. The reliance, however, must be objectively reasonable. For example, the taxpayer must supply the advisor with all the necessary information to assess the tax matter. Similarly, if the advisor suffers from a conflict of interest or lack of expertise that the taxpayer knew about or should have known, the taxpayer might not have acted reasonably in relying on that advisor. The advice also must be based on all pertinent facts, circumstances and the law as it relates to those facts and circumstances.

  2. The advice must not be based on unreasonable factual or legal assumptions (including assumptions as to future events) and must not unreasonably rely on the representations, statements, findings, or agreements of the taxpayer or any other person. For example, the advice must not be based on a representation or assumption which the taxpayer knows, or has reason to know, is unlikely to be true, such as an inaccurate representation or assumption as to the taxpayer’s purposes for entering into a transaction or for structuring a transaction in a particular manner. Similarly, the advice must not be based on an assumption that the transaction has a business purpose other than tax avoidance.

  3. "Advice" is defined as any communication, including the opinion of a professional tax advisor, setting forth an analysis or conclusion by a person other than the taxpayer and on which the taxpayer relied in preparing the return. Advice does not have to be in any particular form.

  4. Whether a taxpayer reasonably relied on an opinion or advice cannot be determined without reviewing the opinion(s). At times, a taxpayer may refuse to turn over an opinion the taxpayer claims to have relied on or the taxpayer may assert a privilege claim. If the taxpayer refuses to provide the opinion, disallow the taxpayer's position as not being verifiable.

  5. Whenever the penalty is not asserted because the taxpayer has met the "advice" standard under the reasonable cause exception, contact with the preparer to confirm that the advice was provided, and that the standard under the reasonable cause exception is available, is mandatory before the case is closed from the group. This contact is authorized by IRC 6103(k)(6). The examiner should be mindful that the preparer of the return may not be the person who prepared or provided the advice. Contact with both may be necessary.

  6. Whenever the return preparer’s conduct becomes an issue, the examiner should consider the applicability of the return preparer penalties under IRC 6694 and IRC 6695, and contact the preparer, if necessary. See IRM 20.1.6, Preparer, Promoter, Material Advisor Penalties.

  7. Examiner should be mindful of the third party contact requirements discussed in IRM 4.11.57, Third Party Contacts.

20.1.5.6.5  (07-01-2008)
Reportable Transactions

  1. The failure of a taxpayer to disclose a reportable transaction is a strong indication that the taxpayer did not act in good faith with respect to the portion of an underpayment attributable to a reportable transaction, as defined under IRC 6011. A taxpayer may argue that the failure to disclose was based on the advice of a tax advisor concluding that the transaction was not reportable.

  2. A taxpayer’s reliance on an opinion that a transaction is not reportable must be reasonable and made in good faith. An opinion providing that a transaction is not reportable, and, therefore, need not be disclosed is subject to the same scrutiny as the underlying tax opinion or advice. The taxpayer must demonstrate reasonable cause and good faith as described above. See IRM 20.1.5.15 for additional information on reportable transactions.

20.1.5.6.6  (07-01-2008)
Non-tax Matters

  1. Where a tax benefit depends on non-tax factors, the taxpayer has a duty to investigate the underlying factors rather than simply relying on statements of another person, such as a promoter. Further, if the tax advisor is not versed in these non-tax matters, mere reliance on the tax advisor does not suffice.

20.1.5.6.7  (01-24-2012)
Special Rules for Corporate Tax Shelter Items

  1. If a corporate taxpayer has a substantial understatement that is attributable to a tax shelter item, the accuracy-related penalty applies to that portion of the understatement unless the reasonable cause and good faith exception applies. See Treas. Reg. 1.6664-4(f).

  2. A corporation's legal justification may be taken into account in establishing that the corporation acted with reasonable cause and in good faith in its treatment of a tax shelter item, but only if there is substantial authority within the meaning of Treas. Reg. 1.6662-4(d) for the treatment of the item and the corporation reasonably believed, when the return was filed, that the treatment was more likely than not the proper treatment. See Treas. Reg. 1.6664-4(f)(2)(i)(B).

  3. The reasonable belief standard is generally met if:

    • The corporation analyzed pertinent facts and relevant authorities to conclude in good faith that there would be a greater than 50 percent likelihood ("more likely than not" ) that the tax treatment of the item would be upheld if challenged by the IRS; or

    • The corporation reasonably relied in good faith on the opinion of a professional tax advisor who analyzed all the pertinent facts and authorities, and who unambiguously states that there is a greater than 50 percent likelihood that the tax treatment of the item will be upheld if challenged by IRS. See Treas. Reg. 1.6664-4(c) for requirements with respect to the opinion of a professional tax advisor.

20.1.5.7  (01-24-2012)
IRC 6662(c), Negligence or Disregard of Rules or Regulations

  1. The negligence or disregard of rules or regulations under IRC 6662(c) is not limited to underpayments of income tax, but also applies to other underpayments, such as with respect to excise taxes.

  2. The penalties attributable to negligence and disregard of rules or regulations often overlap, seem to apply equally to any given case, and are often difficult to distinguish. See Treas. Reg. 1.6662-3(b)(1) and (2) for the definitions of negligence and disregard.

  3. The amount of the penalty is 20 percent of the underpayment attributable to negligence or disregard of rules or regulations.

20.1.5.7.1  (01-24-2012)
Negligence

  1. Negligence includes any failure to make a reasonable attempt to comply with the provisions of the tax law, exercise ordinary and reasonable care in tax return preparation, or fails to keep adequate books and records.

  2. Negligence is strongly suggested if a taxpayer fails to make a reasonable attempt to ascertain the correctness of a reported item "which would seem to a reasonable and prudent person to be 'too good to be true,' under the circumstances."

    Example:

    The facts may establish that a taxpayer reported losses from a transaction that lacked economic substance or reported losses or deductions from assets with basis traceable to lease stripping transactions that would have seemed, to a reasonable and prudent person, to be "too good to be true." The accuracy-related penalty attributable to negligence may be applicable if the taxpayer failed to make a reasonable attempt to ascertain the correctness of the claimed losses or deductions by thoroughly investigating the bona fide economic or other relevant actual aspects of the transaction. Consultation with a tax advisor, regardless of the advisor’s independence, is not, standing alone, conclusive evidence of a thorough investigation by the taxpayer. All relevant facts, including the nature of the tax investment, the independence of the tax advisor, the competence of the tax advisor, the quality of the opinion, and the sophistication of the taxpayer must be considered.

  3. The penalty for negligence does not apply if the taxpayer’s position has a reasonable basis. If a return position is reasonably based on one or more of the authorities in Treas. Reg. 1.6662-4(d)(3)(iii), the position will generally satisfy the reasonable basis standard even though it does not rise to the level of substantial authority. The penalty for negligence may, however, apply if the taxpayer fails to keep adequate books and records to substantiate the items.

  4. The negligence penalty does not apply to a return position that has a reasonable basis and will not be asserted solely for filing a return late.

  5. The negligence penalty will not be asserted solely due to the taxpayer’s failure to appear for an audit or respond to an inquiry or notice. However, the facts and circumstances from the return and the case file may warrant assertion of the accuracy-related penalty attributable to negligence.
    Examples:

    1. An Information Return Processing (IRP) document shows the taxpayer received $5,000 of interest income. The tax return reflects AGI of $40,000 but no interest income. The taxpayer does not appear for the examination. The accuracy-related penalty attributable to negligence should be asserted based on the IRP document, information in the return and in the case file.

    2. The Tax Year (TY) 2008 and TY 2009 examinations disallowed the auto expense deduction because the costs were commuting expenses. The TY 2010 return was filed and secured after these examinations and the taxpayer claimed the same deduction for commuting expenses. The taxpayer did not appear for the office appointment. Based on the prior year’s disallowed deduction and the taxpayer’s knowledge of the nondeductible expense, the penalty for negligence should be asserted on the TY 2010 return.

20.1.5.7.2  (01-24-2012)
Disregard of Rules or Regulations

  1. Disregard of rules or regulations relates to the taxpayer’s failure to follow the appropriate law in completing the return, and reflects a disregard of the IRC, temporary or final regulations, revenue rulings, or IRS notices (other than notices of proposed rule making). The term "disregard" includes careless, reckless, or intentional disregard.

  2. Except for a reportable transaction, as defined in the regulations under IRC 6011, entered into on or after January 1, 2003, and reported on a return filed after December 31, 2003, there is no penalty for a position contrary to a revenue ruling or IRS notice published in the Internal Revenue Bulletin (IRB) if the position has a realistic possibility of being sustained on its merits. Otherwise, a taxpayer may not avoid a penalty for disregard of a rule or regulation on the basis that the position had a realistic possibility of being sustained on its merits.

  3. Disregard of rules or regulations are:

    • "Careless" if the taxpayer does not exercise reasonable care to determine the correctness of a tax return.

    • "Reckless" if the taxpayer makes little or no effort to determine if a rule or regulation exists, under circumstances demonstrating a substantial deviation from a reasonable standard of conduct.

    • "Intentional" if the taxpayer knows of a rule or regulation and ignores that rule or regulation.

20.1.5.7.2.1  (01-24-2012)
Adequate Disclosure

  1. The penalty for disregard of rules or regulations does not apply if the taxpayer adequately discloses the position on Form 8275, Disclosure Statement, or Form 8275-R, Regulation Disclosure Statement, (as appropriate).

  2. In the case of a transaction entered into on or after January 1, 2003, and reported on a return filed after December 31, 2003, taxpayers also must disclose reportable transactions on Form 8886, as required under the IRC 6011.

  3. The penalty does not apply to a position that is contrary to a regulation if the taxpayer discloses the position and the position represents a good faith challenge to the regulation. A good faith challenge to the validity of a regulation generally requires a showing that the taxpayer conducted a careful analysis of reasonably available authorities

    1. Relating to the issue, including statutory language,

    2. Legislative history,

    3. The underlying treasury decision,

    4. Relevant case law (including case law pertaining to the presumption of validity to which regulations are entitled), and

    5. The persuasiveness of the rationale supporting the contrary position.

  4. The adequate disclosure exception does not apply if the position with respect to a rule or regulation does not have a reasonable basis or if the taxpayer fails to keep adequate books and records or fails to substantiate records properly.

  5. Courts have also held that a disclosure statement is adequate if it reasonably apprises the IRS of the nature and amount of the potential controversy. This statement should include the following:

    1. A caption identifying the statement as a disclosure under IRC 6662,

    2. An identification of the item with respect to which the disclosure is made,

    3. The amount of the item, and

    4. The facts affecting the tax treatment of the item sufficient to apprise the IRS of the nature of the potential controversy.

      Note:

      If the disclosure statement fails to include all of the above, misrepresents the facts, or is too general to reasonably apprise the IRS of the potential controversy, the disclosure exception does not apply.

  6. Adequate disclosure is an exception to the penalty attributable to disregard of rules or regulations. Since the penalty attributable to negligence is not subject to a disclosure exception, the distinction between negligence and disregard of rules and regulations will sometimes have to be made.

  7. The applicability of the disclosure exception is determined for each item or group of similar items separately.

  8. When the adequate disclosure exception is met, the tax attributable to the disclosed item is not included in the calculation of the underpayment for penalty purposes.

  9. See Treas. Reg. 1.6662-3(c), Treas. Reg. 1.6662-4(f),(1), (3), (4), and (5) on methods of adequate disclosure.

20.1.5.7.2.1.1  (01-24-2012)
Special Rules for Disclosure

  1. Coordinated Industry Case (CIC) Program:Rev. Proc. 94-69, 1994-2 C.B. 804, provides special rules for CIC taxpayers to meet the adequate disclosure exception by providing a written statement after receiving written notice from the IRS requesting such statement.

  2. Pass-through entities: Generally, disclosure for items attributable to a pass-through entity should be made on Form 8275 or Form 8275-R, and attached to the return (or qualified amended return) of the entity. Also, a taxpayer (e.g., partner, shareholder, beneficiary, or holder of a residual interest in a REMIC) may make adequate disclosure by filing Form 8275 or Form 8275-R. See applicable form instructions for additional information on filing requirements for Form 8275 or Form 8275-R.

  3. Recurring items: Disclosure with respect to a recurring item, such as the basis of recovery property, must be made with each return on which the item is taken into account.

  4. Significant book-tax difference: In certain circumstances, a taxpayer is deemed to satisfy the disclosure requirements by disclosing on a Schedule M-3 each item of income, gain, loss, deduction, or credit for which the difference between the amount included in the taxpayer’s financial statement net income (loss) for the taxable year and the amount included in taxable income for the taxable year is greater than $10 million. See Rev. Proc. 2004-45, 2004-31 IRB 140 (August 2, 2004).

20.1.5.8  (01-24-2012)
IRC 6662(d), Substantial Understatement

  1. The substantial understatement penalty apply, if the correct income tax liability for a taxable year exceeds the amount reported by the taxpayer by the greater of 10 percent of the correct tax or $5,000 ($10,000 in the case of a corporation other than an S-Corporation or a personal holding companies, for taxable years beginning on or before October 22, 2004), then a substantial understatement exists and a penalty may be imposed equal to 20 percent of the underpayment of tax attributable to the understatement.

  2. The substantial understatement penalty is limited to understatement of income tax.

  3. An understatement is the excess of the amount of:

    1. The tax required to be shown on the return, over

    2. The amount of tax imposed, which is shown on the return, reduced by any rebate. See Treas. Reg. 1.6662-4(b)(2).

  4. An understatement is substantial when it exceeds the greater of:

    1. 10 percent of the tax required to be shown on the return for a taxable year; or

    2. $5,000 ($10,000 for corporations, other than an S-Corporation or a personal holding companies, for taxable years beginning on or before October 22, 2004).

  5. For taxable years beginning after October 22, 2004, a corporation (other than an S-Ccorporation or a personal holding company) has a substantial understatement of income tax if the amount of the understatement exceeds the lesser of:

    1. 10 percent of the tax required to be shown on the return for a taxable year (or, if greater, $10,000), or

    2. $10,000,000.

  6. For purposes of determining whether an understatement is substantial, the amount of the understatement is increased by the aggregate amount of reportable transaction understatements. See IRM 20.1.5.15 for further information relating to reportable transaction understatements.

  7. The substantial understatement penalty applies only to the excess of the amount of the substantial understatement (after determining that a substantial understatement exists) over the aggregate amount of the reportable transaction understatements. Thus, the substantial understatement penalty does not apply to any amount attributable to a reportable transaction understatement and subject to IRC 6662A.

  8. The substantial understatement penalty will be considered for assertion on all discretionary and EITC cases not worked solely through automation.

  9. When the substantial understatement penalty is applicable, it should be included on the audit report to the taxpayer.

20.1.5.8.1  (01-24-2012)
Exceptions to the Substantial Understatement Penalty

  1. Before asserting the substantial understatement penalty, exceptions to the penalty must be considered.

  2. The amount of an understatement is reduced by that portion of the understatement attributable to:

    1. An item for which there is or was substantial authority, or

    2. An item the relevant facts of which were adequately disclosed and for which there is a reasonable basis.

  3. Special rules apply in the case of a tax shelter item. See IRM 20.1.5.8.1.3.

20.1.5.8.1.1  (01-24-2012)
Substantial Authority Exception

  1. Substantial authority is an objective standard involving an analysis and application of the law to the relevant facts. It is not determined with reference to what the taxpayer actually believed to be the correct treatment of the item. Every item must be separately evaluated to determine whether there is substantial authority for the tax treatment of an item.

  2. There is an exception to the penalty attributable to a substantial understatement when the substantial understatement relates to a tax shelter item of a taxpayer other than a corporation. Specifically, the examiner should not assert the penalty if there is substantial authority for the tax treatment of an item or return position and the taxpayer reasonably believed that the tax treatment was more likely than not the proper tax treatment. See Treas. Reg. 1.6662-4(g) for taxable years beginning after October 22, 2004.

  3. Substantial authority for the tax treatment of an item will exist, if there is substantial authority at the time the return containing the item is filed or there was substantial authority on the last day of the taxable year to which the return relates.

  4. There is substantial authority if the weight of the authorities supporting the treatment of the item is substantial in relation to the weight of the authorities supporting the contrary treatment. See Exhibit 20.1.5-8.

  5. For taxable years beginning on or before October 22, 2004, a taxpayer is considered to reasonably believe that the tax treatment of an item is more likely than not the proper treatment if --

    • The taxpayer analyzes the pertinent facts and authorities and, in reliance on that analysis, reasonably concludes in good faith that there is a greater than 50 percent likelihood that the tax treatment of the item will be upheld, if challenged by the IRS; or

    • The taxpayer reasonably relies in good faith on the opinion of a professional tax advisor, if the opinion is based on the tax advisor’s analysis of the pertinent facts and authorities and unambiguously states that the tax advisor concludes that there is a better than 50 percent likelihood that the tax treatment of the item will be upheld, if challenged by the IRS.

20.1.5.8.1.2  (01-24-2012)
Adequate Disclosure for Purposes of Reducing an Understatement of Tax

  1. When the adequate disclosure exception is met, the tax attributable to the disclosed item or return position is not included in the calculation of the understatement for penalty purposes.

  2. The following revenue procedures provide annual guidance concerning when information shown on a return in accordance with the applicable forms and instructions will be adequate disclosure for purposes of reducing an understatement of income tax under IRC 6662(d) and IRC 6694(a) only.

    1. For 2010 returns, see Rev. Proc. 2011-13.

    2. For 2009 returns, see Rev. Proc. 2010-15.

    3. For 2008 returns, see Rev. Proc. 2008-14.

    4. For 2007 returns, see Rev. Proc. 2008-7.

    5. For prior years review the annual revenue procedures published by the IRS in the Internal Revenue Bulletins for the applicable tax year.

20.1.5.8.1.3  (01-24-2012)
Exceptions for Tax Shelter Items

  1. For purposes of the accuracy-related penalties, tax shelter includes, among other things, any plan or arrangement with a significant purpose of avoidance or evasion of federal income tax. The relevant standard is whether tax avoidance or evasion was the principal purpose.

  2. In general, no taxpayer may reduce an understatement on account of substantial authority or adequate disclosure for an item attributable to a tax shelter for taxable years beginning after October 22, 2004.

  3. The term "tax shelter item" is defined as an item of income, gain, loss, deduction, or credit that is directly or indirectly attributable to the principal purpose of a tax shelter to avoid or evade federal income tax.

20.1.5.8.1.3.1  (07-01-2008)
Non-Corporate Tax Shelter Items

  1. For taxable years beginning on or before October 22, 2004, a non-corporate taxpayer may reduce the amount of the understatement attributable to tax shelter items when:

    1. There is substantial authority for the treatment of the item, and

    2. The taxpayer reasonably believed that the tax treatment of the item was more likely than not the proper treatment. See Treas. Reg. 1.6662-4(g)(4).

20.1.5.8.2  (01-24-2012)
Penalty Assertion

  1. The substantial understatement penalty can be asserted only when the understatement is determined to be substantial.

  2. When the understatement is substantial, but the penalty is not asserted, the examiner should explain the applicable exceptions in the case file.

  3. Managerial involvement is required when the understatement is substantial.

  4. Examiner will identify the penalty attributable to each adjustment in the report and explain each penalty by name, IRC section, and calculated penalty amount.

  5. The penalty can be asserted on "no show" cases when:

    1. The understatement is substantial.

    2. The taxpayer does not appear to meet any exceptions.

  6. When the accuracy-related penalty attributable to a substantial understatement of income tax is not asserted due to the assertion of negligence or disregard of rules or regulations, any unagreed report will include the substantial understatement penalty as an alternative penalty position.

  7. The preparer penalties under IRC 6694 must be considered and documented for all substantial understatement penalty cases with taxpayer contact. Preparer penalties are discussed in IRM 20.1.6.

    Note:

    IRC 6694 is not limited to preparer information in the "Paid Preparer Use Only" section of a return.

20.1.5.8.3  (01-24-2012)
Penalty Calculation

  1. The examiner will determine the substantial understatement penalty amount by:

    1. Calculating the understatement.

    2. Establishing that the understatement is substantial.

    3. Considering whether to reduce the amount of the understatement. If there should be a reduction, recalculating the understatement without including the tax on the adjustments not subject to the penalty.

    4. Determining whether the understatement is substantial after applying the reduction.

    5. Considering adjustments for prepayment and refundable credits.

    6. Applying the penalty rate to the underpayment to arrive at the penalty amount.

  2. For calculation examples see Exhibit 20.1.5-2 and Exhibit 20.1.5-3.

20.1.5.9  (01-24-2012)
IRC 6662(e), Substantial Valuation Misstatement

  1. For the accuracy-related penalty to apply in the case of a substantial valuation misstatement, the portion of the underpayment attributable to a substantial valuation misstatement must exceed $5,000 ($10,000 in the case of a corporation other than a S-Corporation or a personal holding company).

  2. The amount of the penalty is 20 percent of the underpayment attributable to a substantial valuation misstatement and 40 percent in the case of a gross valuation misstatement.

20.1.5.9.1  (01-24-2012)
Penalty Assertion

  1. The examiner is responsible for the assertion of the accuracy-related penalty attributable to a valuation misstatement.

  2. See IRC 6662(e)(1)(B) relating to substantial valuation misstatements under IRC 482 transactions.

  3. If the value or adjusted basis of any property claimed on a return is 200 percent or more of the amount determined to be the correct amount of such value or adjusted basis, the valuation misstatement constitutes a "gross valuation misstatement." See IRC 6662(h)(2)(A). If there is a gross valuation misstatement, then the 20 percent penalty under IRC 6662(a) is increased to 40 percent. See IRC 6662(h)(1).

  4. There is no disclosure exception to this penalty.

  5. The substantial valuation misstatement penalty does not apply to any understatement upon which a penalty under IRC 6662A is imposed. IRC 6662A does not apply to any understatement upon which the gross valuation misstatement penalty is imposed.

20.1.5.9.2  (01-24-2012)
IRC 6662(e)(1)(A), Substantial Valuation Misstatement

  1. A substantial valuation misstatement exists if the value or adjusted basis of any property claimed on a return is 150 percent or more of the amount determined to be the correct amount of such value or adjusted basis. See IRC 6662(e)(1)(A).


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