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Part 20. Penalty and Interest

Chapter 1. Penalty Handbook

Section 5. Return Related Penalties

20.1.5  Return Related Penalties

20.1.5.1  (07-01-2008)
Penalty Policy

  1. The office of Servicewide Penalties, part of Examination Policy, oversees the implementation of Service-wide policies and strategies for all penalties. This office also provides policy guidance in IRM 20.1 across all operating divisions to ensure consistent and accurate treatment of all taxpayers.

  2. Consideration of penalties must be documented in all taxpayer examinations, including those involving tax shelters. A penalty must be developed as the audit progresses. Only after all facts and circumstances surrounding a penalty have been developed can a determination be made as to the application of appropriate penalties.

  3. The consideration and assertion of penalties in audits involving tax shelters is vital to the Service’s 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. Penalties should be considered and developed simultaneously with the examination of the tax shelter transaction, 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 in appropriate circumstances.

  4. All penalties including the accuracy-related and fraud penalties are important deterrents to non-compliance. Examiners and managers should not use penalties as a bargaining point in the development or processing of cases. The penalty Policy Statement 20-1, should be reviewed prior to the assertion of penalties, see IRM 20.1.1, Exhibit 20.1.1-1. See IRM 8.6.4.1.2(6), Office of Appeals guidance on trading penalties. See http://www.irs.gov/pub/irs-ccdm/cc-2004-036.pdf , Office of Chief Counsel, Penalty Administration.

20.1.5.1.1  (07-01-2008)
Background

  1. The return-related penalties covered in this IRM include, IRC section 6662, Imposition of Accuracy-Related Penalty on Underpayments, IRC section 6663, Imposition of Fraud Penalty, IRC section 6662A, Imposition of Accuracy-Related Penalty on Understatements with Respect to Reportable Transactions, IRC section 6707A, Penalty for Failure to include Reportable Transaction Information with Return and IRC section 6676, Erroneous Claim for Refund or Credit penalty.

  2. IRC section 6662 imposes an accuracy-related penalty on any portion of an underpayment attributable to any action or failure to act that results in one or more of the following:

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

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

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

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

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

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

  3. IRC section 6663 imposes a penalty on any portion of an underpayment attributable to fraud. See IRM 20.1.5.12.

  4. IRC section 6662A imposes an accuracy-related penalty on a reportable transaction understatement. See IRM 20.1.5.13.

  5. IRC section 6707A imposes a penalty for failure to include reportable transaction information with return. Information for this penalty is included in IRM 20.1.5.13 of this manual as it relates to the IRC section 6662A penalty. Functional procedures for IRC section 6707A will be forthcoming in IRM 4.32.4.

  6. IRC section 6676, imposes a penalty for erroneous claim for refund or credit with respect to income tax. See IRM 20.1.5.14.

  7. See IRC section 6664, Definitions and special rules for the accuracy-related penalties and See IRM 20.1.5.6, of this manual on penalty relief.

20.1.5.1.2  (07-01-2008)
Large and Mid-Sized Business

  1. LMSB Commissioner issued a memorandum providing guidelines for the consideration of the accuracy-related penalty in LMSB examinations. This memorandum requires agents 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. 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).

  2. On July 10, 2003, the LMSB Commissioner issued a memorandum providing that examiners should not develop the accuracy-related penalty in cases where the taxpayer filed and was considered qualified under the terms of Announcement 2002-2. This determination should be confirmed by the team manager, with no other approval required. The memorandum also provides that, for cases not qualifying for treatment under the Disclosure Initiative outlined in Announcement 2002-2, consideration of penalties remains mandatory.For additional information see http://www.irs.gov/pub/irs-utl/penalty_policy_reiteration_7-10-03_debbie_nolan.pdf .

  3. For discussion of Announcement 2002-2 as it relates to penalties, See IRM 20.1.5.5 of this manual. 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. When an LMSB examiner identifies a new potentially abusive tax shelter transaction or promoter information, the examiner must contact LMSB field counsel as well as the Office of Tax Shelter Analysis (OTSA).

20.1.5.1.3  (07-01-2008)
Small Business/Self Employed Examination

  1. SB/SE examiners should follow existing penalty provisions regarding managerial approval for imposing penalties in a tax shelter case involving a listed transaction. See IRM 20.1.5.1.6 of this manual for existing penalty provisions on managerial approval of penalties.

  2. Examiners should send promoter information to the Lead Development Center (LDC), and contact the appropriate Technical Advisor, responsible for coordinating and assisting in the identification of abusive tax shelters.

20.1.5.1.4  (07-01-2008)
Statutory Changes

  1. This section reflects the current law unless otherwise stated. Below is a list of the relevant statutory changes since the accuracy-related penalty was created. Also listed are other penalty statutory changes that may have an effect on the accuracy-related penalty. If the examiner has questions relating to previous years or relating to the effect of these statutory changes, the examiner should consult with the IRM applicable to that year or contact Area Counsel.

  2. The Omnibus Budget Reconciliation Act of 1989 (OBRA 89) consolidated and renumbered the accuracy-related penalties and the civil fraud penalty and added definitions and special rules under IRC section 6664.

  3. The Omnibus Budget Reconciliation Act of 1990 (OBRA 90) provides that a "substantial valuation misstatement" under IRC section 6662(e) may exist under certain circumstances if IRC section 482 applies to a transaction.

  4. The Omnibus Budget Reconciliation Act of 1993 (OBRA 93) amended the definition of substantial valuation misstatement as it relates to a transaction if IRC section 482 applies.

  5. The Uruguay Round Agreements Act of 1994 eliminated the exception to the accuracy-related penalty attributable to a substantial understatement for which the taxpayer had substantial authority and a reasonable belief that it was more likely than not the proper treatment as it applied to tax shelter items of corporations (other than S corporations and personal holding companies).

  6. The American Jobs Creation Act of 2004 (AJCA) added IRC section 6662A, Imposition of Accuracy-Related Penalty on Understatements with Respect to Reportable Transactions and Reasonable Cause Exception for Reportable Transaction Understatements.

  7. AJCA amended IRC section 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.

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

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

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

20.1.5.1.5  (07-01-2008)
IRS Settlement Initiatives

  1. Described below are two IRS Initiatives which provided an excellent opportunity to quickly bring more taxpayers into compliance in a cost effective manner. It also strengthens the public’s view that the Internal Revenue Service is applying the tax laws in a fair and equitable manner to all taxpayers. The information below discuss the initiatives as they relate to the accuracy-related penalty.

    1. On December 21, 2001, the Service announced a Disclosure Initiative under which the IRS would waive accuracy-related penalties for transactions that produce an underpayment of tax and that the taxpayer discloses to the IRS during the period within which the initiative was in effect. For a limited period, Announcement 2002-2 provided an administrative basis under which a taxpayer could avoid the accuracy-related penalty for an underpayment of tax. The IRS waived the accuracy-related penalty if the taxpayer disclosed an item before the earlier of April 23, 2002, or the date the item was an issue raised during an examination. If a taxpayer was not eligible under Announcement 2002-2 but disclosed regardless, there was no formal or informal administrative policy of waiving the accuracy-related penalty in the case of a taxpayer solely because the taxpayer disclosed to the examination team the existence of the item. Accordingly, if there was an underpayment of tax attributable to a listed transaction and the taxpayer did not (including because he/she was unable to) disclose the transaction under Announcement 2002-2, then the penalty issue should have been developed. The fact that the taxpayer did disclose may, however, be a mitigating factor in some circumstances. This position was consistent with the penalty consideration memorandum from the Commissioner of LMSB. See Announcement 2002-2, for additional information.

    2. On October 27, 2005, the Service issued Announcement 2005-80 (commonly referred to as 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 section 6662 ranging from 5 percent to 20 percent would be 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 Announcement 2005-80, the taxpayer may have qualified for penalty relief. If the taxpayer asserted reliance upon an independent written tax opinion, special service-wide 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. See Announcement 2005-80, for additional information.

20.1.5.1.6  (07-01-2008)
Managerial Approval of Penalties

  1. The Internal Revenue Service Restructuring and Reform Act of 1998 (RRA 98) added IRC section 6751(b), which requires managerial approval of all penalties assessed after June 30, 2001, that are not automatically calculated through electronic means. For additional information. Under IRC 6751(b) written supervisory approval of the initial determination of the penalty is required by the immediate manager or higher level official of the employee initially proposing the penalty. Managerial approval is mandatory.

  2. The employee initially proposing the penalty should indicate the name of the penalty, the Code section and the amount of the penalty on Form 4700, Examination Workpapers, Form 4318, Examination Workpapers Index or Form 5772, EP/EO Workpaper Summary for TE/GE cases. The penalty computation should also be documented in the casefile.

  3. The Service is now requiring a managerial review on the non-assertion of penalties when there is a substantial understatement of tax under IRS section 6662(d).

  4. For SB/SE exam cases, written managerial approval should be documented on the Penalty Approval Form, workpaper 300.

  5. For LMSB cases, managerial approval can be documented on the penalty leadsheets. The LMSB Information Management System provides leadsheets based on the Standard Audit Index Number (SAIN) entry for the penalty issue.

  6. For W&I and SB/SE campus cases, written managerial approval should be documented on Form 4700.

  7. TE/GE and miscellaneous functions that assert penalties should also obtain managerial approval as required by IRC section 6751(b).

  8. Any penalties automatically calculated through electronic means are excluded from this requirement.

    1. When IRC section 6662 accuracy-related penalties for negligence and substantial understatement are assessed under the Automated Underreporter program (AUR) 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 section 6751(b)(1) requires managerial written approval of an employee’s determination to assert the penalty.

20.1.5.1.7  (07-01-2008)
IRS Commissioner

  1. On December 29, 2003, the Commissioner issued a memorandum outlining the Service’s penalty policy concerning reliance on certain tax shelter opinions. The memorandum provides that the Service will question the reasonableness and good faith of taxpayers who know or have reason to know that the tax advisor has a financial arrangement or a referral agreement with a tax shelter promoter.

20.1.5.2  (07-01-2008)
Common Features: Accuracy-Related and Civil Fraud Penalties

  1. The accuracy-related and fraud penalties apply only if a return is filed, except that the penalties do not apply in the case of a return prepared by the Secretary under IRC section 6020(b). See Treas. Reg. 1.6662–2(a). Penalty review, abatement and reconsideration follow guidelines established for the examination of the return. Penalty issues are developed separately from the tax law issues that gave rise to the tax understatement. Penalty issues are subject to higher level review prior to being asserted.

  2. Special abatement procedures for TE/GE apply for those accuracy-related penalties assessed on NMF. These penalties relate to:

    1. Form 4720, Return of Certain Excise Taxes on Charities and Other Persons, Under Chapters 41 and 42 of the Code and

    2. Form 5330, Return of Excise Taxes Related to Employee Benefit Plans assessments prior to January 1, 2001, are posted to NMF, and all assessments after January 2, 2001 are posted to BMF.

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

  4. Return Filing Requirement: The accuracy-related penalties and the civil fraud penalty apply when a return is filed, either timely or late. These penalties cannot be asserted on a substitute-for-return (SFR) filed under IRC section 6020(b). See IRC section 6664(b). The accuracy-related and fraud penalties can be asserted on a secured delinquent return, i.e., 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.

  5. Uniform Definition of Underpayment: IRC section 6664(a) provides a common definition of underpayment. 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, as applicable. See IRC sections 6662(a) and 6663(a).

  6. 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; 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. See IRC section 6662(b).

  7. 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 section 6662A(e).

  8. Interest: Under IRC section 6601(e)(2)(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 section 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 made equals or exceeds $100,000), interest on the amount paid is not imposed for the period after the date of the notice and demand.

  9. 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 30-day letters and statutory notices of deficiency.

20.1.5.2.1  (07-01-2008)
Two and Ten Year Bans on Claiming the Earned Income Tax Credit (EITC)

  1. This section covers the two-year and ten-year bans placed on taxpayers whose EITC disallowance was due to reckless or intentional disregard of the EITC rules (two-year) or fraud (ten-year) for tax years beginning after December 31,1996.

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

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

  4. The two and ten-year sanctions are in addition to any other penalty imposed under present law. The law does not require that an accuracy-related penalty under IRC section 6662(c) for negligence or disregard be asserted in order to impose the EITC two-year ban. The two-year ban is asserted under IRC section 32(k)(1)(B)(ii) for "reckless or intentional disregard of the EITC rules and regulations," while the accuracy-related penalty under IRC section 6662(c) is asserted for either negligence or disregard; "disregard" in this context is "any careless, reckless, or intentional disregard." As a result of these very fine distinctions, the two-year ban may sometimes (though seldom) apply when the accuracy-related penalty does not.

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

  6. The ten-year ban for fraudulently claiming the EITC essentially follows criteria for assertion of civil fraud under IRC section 6663. See IRM 20.1.5.12.2. However, the ten-year ban can be asserted even if the fraud penalty is not (or cannot be) applied.

20.1.5.2.2  (07-01-2008)
Allocation

  1. An allocation is necessary only when both the accuracy-related and the civil fraud penalties apply. When there are three return adjustments, for example, 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 sections 6662 and 6663, adjustments to a return are considered made in the following order. See Treas. Reg. 1.6664–3:

    1. Those for which no penalties are imposed.

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

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

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

  3. See Exhibit 20.1.5-1 for an example calculation of the underpayment on a return with three adjustments—the first with no penalty, the second with the accuracy-related penalty attributable to a substantial understatement, and the third with the civil fraud penalty.

  4. See See IRM 20.1.5.13.3 of this manual for an example of a calculation involving IRC sections 6662, 6663 and 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 and, in unagreed cases, include the other penalty in the report as an alternative 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 examining agent should assert the penalty that is most strongly supported by the facts and circumstances and write up the other as an alternative 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.

    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.

  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. See Treas. Reg. 1.6664–3(c)(1).

    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(b). See Treas. Reg. 1.6664–3(c)(2).

    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  (07-01-2008)
Carrybacks and Carryovers

  1. The amount of an underpayment subject to IRC sections 6662 or 6663 will not be reduced by any carryback of a net operating loss (NOL), deduction, or credit to that year. See Treas. Reg. 1.6664–2(f)

  2. Example:

    1. A Tax Year (TY) 2000 examination adjustment results in an underpayment of $3,000, which is subject to the accuracy-related penalty attributable to negligence.

    2. A $12,000 NOL carryback from TY 2001 to TY 2000 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 2000. The amount of the penalty imposed for TY 2000 is $600 (20% x $3,000).

  3. If an underpayment in a loss year is subject to IRC section 6662 or 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 be subject to IRC section 6662 or 6663. See Treas. Reg. 1.6662-3(d) and 1.6662-4(c).

  4. Example:

    1. The taxpayer filed a TY 2002 return with an NOL of $45,000. The taxpayer carried forward $20,000 of the NOL to TY 2003.

    2. An examination of the TY 2002 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 2002.

    3. The $20,000 amount carried over from TY 2002 to TY 2003 is disallowed. This produces a TY 2003 underpayment of $2,000. Because this is the result of an adjustment for which negligence applied in TY 2002, the penalty also applies to the TY 2003 underpayment.

      Note:

      If the NOL disallowance for TY 2002 did not result in an underpayment, but did create an underpayment for TY 2003 (due to the disallowed carryover from TY 2002), then the penalty would still apply to the underpayment in TY 2003.

  5. 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).

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

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

20.1.5.2.4  (07-01-2008)
Definitions

  1. Amount of tax imposed: The term "amount of tax imposed" is the corrected tax imposed by Internal Revenue Service Title 26, 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: Means a reportable transaction, which is the same as, or substantially similar to, a transaction specifically identified by the Secretary as a tax avoidance transaction for purposes of IRC section 6011. See IRC section 6707A(c)(2) and Treas. Reg. 1.6011-4(b)(2).

  3. Qualified amended return: Treas. Reg. 1.6664-2(c)(3). A qualified amended return is an amended return or a timely request for administrative adjustment under IRC section 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 section 6700,

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

    4. The date the Service 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 Commissioner 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 section 6707(a) or contact concerning a list described in IRC section 6112.

  4. Rebate: A rebate is the amount of an abatement, credit, refund, or other repayment, as was 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 section 6011, such transaction is of a type which the Secretary determines as having a potential for tax avoidance or evasion. See IRC section 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 section 1 for individuals or IRC section 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 20.1.5.13.2 of this manual for a calculation example.

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

    • IRS campus 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: See Treas. Reg. 1.6664–2. 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 or prepayment credits for withholding or estimated tax are included.

    4. See Exhibit 20.1.5-1 for an example calculation of an underpayment.

20.1.5.2.5  (07-01-2008)
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 Service of any inconsistency between the tax treatment of an item by a person listed above and the way the pass-through entity treated and reported such item.

  3. Form 8082 is also used to notify the Service if a person listed above 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 section 6662 or the fraud penalty under IRC section 6663.

  5. See IRC section 6227 and IRM 4.31.4 IRM for additional information on AARs.

20.1.5.3  (07-01-2008)
Examination Penalty Assertion

  1. The examiner is responsible for the assertion of the accuracy-related penalties and the fraud penalty. The term "examiner" includes revenue agents, tax compliance officers, examiners and other officers who are auditing income tax returns, excise tax returns, employment tax returns, estate and gift tax returns or tax exempt and government entities related tax returns.

  2. The accuracy-related penalties 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. Examiners are required to document the procedures used, information obtained, and conclusions reached in deciding to recommend or not recommend applicable penalties during examinations. Penalties should not be asserted without an explanation. Standard statements such as "negligence penalty deemed not to be applicable" are not sufficient. Alternative penalty positions should be documented in the workpapers when applicable (e.g., fraud versus negligence penalties, and various components of the accuracy-related penalty). Documentation for TE/GE cases should be made on appropriate Forms 5772.

    3. The Service is now requiring a 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.

    4. 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 section 6662(d).

    5. SB/SE exam should document managerial involvement on workpaper 300-1.1. The substantial understatement penalty leadsheet may also be used for the development of the 6662(d) Penalty.

    6. LMSB team members should use the leadsheets available in the Information Management System 3.0. Managerial approval can be documented on the penalty leadsheet.

    7. For W&I and SB/SE campus cases, written managerial approval should be documented on Form 4700.

    8. TE/GE and miscellaneous functions that assert penalties should also obtain managerial approval as required by IRC section 6751(b).

    9. When adjustments would appear to warrant the penalty, but it is not asserted, the applicable exceptions to the penalty will be documented in the workpapers.

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

    11. Area Counsel should be utilized to assist in penalty development and evaluating a taxpayer's reasonable cause and substantial authority defenses. See http://www.irs.gov/pub/irs-ccdm/cc-2004-036.pdf.

  3. The Form 3198, Special Handling Notice for Examination Case Processing or Form 3198-A for TE/GE Special Handling Notice, should be attached to all penalty cases. The examiner will identify the applicable IRC section on the special handling notice for the Centralized Case Processing (CCP) function.

  4. Examiners will identify the adjustments related to each penalty in the report, and identify each one 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 all the reasons why the penalty assertion is appropriate, and

    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. 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: the Service will assert the penalty with the strongest position.

    2. On unagreed cases: the Service will assert the penalty with the strongest position, but the examiner also will calculate and explain any alternative position(s) on Form 886–A, Explanation of Items, attached to the report. Alternative positions will also be included in the 30-day letter and statutory notice of deficiency.

20.1.5.3.1  (07-01-2008)
Underreporter Penalty Assertion

  1. The Automated Underreported Program/Project (AUR) is for computer-generated notices. If the accuracy-related penalty is applicable, the AUR system generates the appropriate paragraph for CP-2501, Initial Inquiry Letter, or the CP-2000, Notice of Proposed Adjustment. In the absence of a response, the determination will be made on the basis of return information and the significance of the amounts omitted.

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

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

  4. 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 casefile.

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

  6. See IRM 4.19.3.16.5 for additional information on AUR.

20.1.5.3.2  (07-01-2008)
Penalty Assessment

  1. The examiner will compute the penalty for Centralized Case Processing (CCP). The examiner will complete and attach the appropriate special handling notice: Form 3198, Special Handling Notice for Examination Case Processing, or Form 3198-A for TE/GE Special Handling Notice to identify the penalty IRC section and to provide any additional closing instructions.

  2. The amount of the 6662 penalty is 20 percent of the portion of the underpayment resulting from the misconduct. The penalty rate is increased to 40 percent in certain circumstances involving gross valuation misstatements.

  3. The amount of the 6663 penalty is 75 percent of the underpayment due to fraud. See IRM 20.1.5.12 of this manual.

  4. The amount of the 6662A penalty is 20 percent of the reportable transaction understatement, and 30 percent of the reportable transaction understatement where the transaction wasnot properly disclosed. See IRM 20.1.5.13.4 of this manual.

  5. The amount of the 6676 penalty is 20 percent of the " excessive amount" See IRM 20.1.5.14 of this manual.

  6. Stacking of the 6662, 6663, 6662A, and 6676 penalties are not permitted. The maximum amount of the 6662 penalty imposed on a portion of an underpayment of tax is 20 percent (or 40 percent in the case of a gross valuation misstatement) of that portion of the underpayment, even if that portion of the underpayment is attributable to more than one type of misconduct proscribed under IRC section 6662. See IRM 20.1.5.13.3 of this manual.

  7. The computed penalty amount and Penalty Reference Number (PRN) should be entered on Form 5344, Examination Closing Record, Form 5403, Appeals Closing Record or Form 5599, TE/GE Examined Closing Record.

  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:

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

    • 6662(d), substantial understatement

    • 6662(e), substantial valuation misstatement

    • 6662(f), substantial overstatement of pension liabilities

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

    • 6662(h), gross valuation misstatement

  9. Enter PRN 681 to assess a reportable transaction understatement penalty under IRC section 6662A. See IRM 20.1.5.13.4 of this manual.

  10. A Transaction Code (TC) 240 will post to the Master File (MF) account that relates to the assessment of a penalty.

  11. Master File will systemically compute interest on the 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.

  12. When abating an assessed 6662 penalty, enter PRN 680 with a negative dollar amount. Enter PRN 681 with a negative dollar amount to abate the 6662A penalty. A TC 241 will post to the MF account that relates to the abatement of the penalty. A penalty abatement amount can be in part or in full.

  13. See additional penalty assessment procedures for the 6662 penalty, 6663 penalty, 6662A penalty and the 6676 penalty in their respective sections of this IRM.

20.1.5.4  (07-01-2008)
Post-Assessment Abatement Consideration of the Accuracy-Related Penalties

  1. Whenever a taxpayer has the benefit of Service contact with respect to an examination and is afforded the opportunity to provide documentation to explain unreported income, but does not contact the Service, we issue the statutory notice showing additional tax and applicable penalties.

  2. When the notice defaults and no taxpayer contact was made, the tax, penalties and interest are assessed.

  3. If a taxpayer receives notice and demand for payment and then makes his/her first response to the Service requesting abatement of the accuracy-related penalties (while not disputing the tax liability and not requesting or not being eligible for audit reconsideration procedures), abatement should 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 section 6662 and 6662A accuracy related penalty abatement requests are not forwarded to Appeals.

20.1.5.5  (07-01-2008)
Statute of Limitations

  1. Examiners are responsible for protecting the statute of limitations on assessment. Consent forms to extend the statute of limitations are available for this purpose, along with Cover Letter 907. See IRM 25.6, Statute of Limitations.

    Note:

    LMSB team members must follow the steps detailed in PQA Director Kelly L. Cables’ July 13, 2007 memorandum, Statute Control Responsibilities.

  2. IRC section 6501(c)(1) extends the statute of limitations for assessment on false or fraudulent returns indefinitely.

  3. Under IRC section 6501(c)(10), the period of limitations for assessment of tax related to an undisclosed listed transaction will not expire before one year after the earlier of:

    1. The date the taxpayer satisfies the requirements of section 4 of Rev. Proc. 2005-26, 2005-17 I.R.B. 965 (April 25, 2005) or

    2. The date a material advisor makes available for inspection by the IRS a list under IRC section 6112 relating to the transaction with respect to the taxpayer.

      Note:

      See Rev. Proc. 2005-26 for further guidance on the statute of limitations on assessment of tax related to an undisclosed listed transaction.

  4. A six-year statute of limitations applies when the taxpayer omits more than 25 percent of the:

    1. Gross income reported on the return (IRC section 6501(e)(1)),

    2. Gross estate or total amount of gifts stated on the return (IRC section 6501(e)(2)), or

    3. Excise tax reported on the return (IRC section 6501(e)(3)).

  5. When the three-year period of limitations under section 6501(a) is about to expire, the examiner should try to secure an extension whenever possible, even if the examiner believes an exception may apply. See IRM 25.6, Form 895 and 180 day time-line. In litigation, a court may disagree with the Service as to whether an exception applies and determine that the three year statue has expired. Securing an extension, whenever possible, is therefore recommended.

  6. Criminal Investigation (CI) must give approval to solicit a consent to extend the statute of limitations for assessment where the return is being investigated jointly by Examination and CI.

20.1.5.6  (07-01-2008)
Penalty Relief

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

  2. Exceptions specific to each of the components of the accuracy-related penalty and the civil fraud penalty are also discussed in their respective sections of this IRM, for example See IRM 20.1.5.13.5 for reasonable cause for IRC section 6662A.

20.1.5.6.1  (07-01-2008)
Reasonable Cause

  1. No accuracy-related penalty under IRC section 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 section 6662A does not apply with respect to any portion of a reportable transaction understatement if, pursuant to IRC section 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.

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

  3. Section 6664(c) provides an exception, applicable to all types of taxpayers, 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. See Treas. Reg. 1.6664-4(b)(1).

  5. Special rules apply to items of a corporation attributable to a tax shelter resulting in a substantial understatement. See Treas. Reg. 1.6664-4(f). See IRM 20.1.5.6.8 of this manual.

  6. Generally, the most important factor is the taxpayer’s effort to report the proper tax liability. Other factors to consider are the taxpayer’s experience, knowledge, sophistication and education and the taxpayer’s reliance on the advice of a tax advisor. The credibility of the taxpayer’s reasons for not determining the proper tax liability should be evaluated.

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

  8. After the AJCA of 2004, IRC section 6664 regulations were updated to provide that the failure to disclose a reportable transaction on Form 8886, Reportable Transaction Disclosure Statement, 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 section 6011. See Treas. Reg. 1.6664-4(c)(1)(iii). See below for a discussion of reliance on advice, in general, and reportable transactions, in particular. In addition, Treas. Reg. 1.6664-4(c)(iii) provides that a taxpayer may not rely on an opinion or advice that a regulation is invalid to establish that the taxpayer acted with reasonable cause and good faith unless the taxpayer adequately disclosed, in accordance with Treas. Reg. 1.6662-3(c)(2), the position that the regulation in question is invalid. If any portion of an underpayment is attributable to a reportable transaction, then failure by the taxpayer to disclose the transaction in accordance with IRC section 6011 is a strong indication that the taxpayer did not act in good faith with respect to the portion of the underpayment attributable to the reportable transaction.

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

  10. Treas. Reg. 1.6664-4(f) provides guidelines for applying the reasonable cause and good faith exception to IRC section 6662(e) penalties for transactions between persons described in IRC section 482 and net IRC section 482 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. See Treas. Reg. 1.6664-4(b)(1); see also Larson v. Commissioner, T.C. Memo 2002-295. 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. See, e.g., Vandeyacht v. Commissioner, T.C. Memo. 1994-148 (taxpayers not required to duplicate work done by bookkeepers and accountants; ordinary business care and prudence require taxpayers to take precautions to prevent inaccuracies in income tax returns and books and records used to prepare them).

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. See Kees v. Commissioner, T.C. Memo. 1999-41.

  2. If the taxpayer is misguided and unsophisticated in tax law, but acts in good faith, a penalty is not warranted. See Collins v. Commissioner, 857 F.2d 1383 (9th Cir. 1988).

20.1.5.6.4  (07-01-2008)
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. See Treas. Reg. 1.6664-4(c); Neonatology Associates, P.A. v. Commissioner, 299 F.3d 221 (3rd Cir. 2002). The advice also must be based on all pertinent facts and 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. See Treas. Reg. 1.6662-4(c)(1)(ii). 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 does so, seek the assistance of subject matter technical advisors or local area Counsel.

  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 section 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 sections 6694 and 6695, and contact the preparer, if necessary. See IRM 20.1.6.

  7. Examiner should be mindful of the third party contact requirements discussed in IRM 4.10.4.5.2 and IRC section 7602(c).

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 section 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 20.1.5.13 of this manual 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. See Novinger v. Commissioner, T.C. Memo. 1991-289. Further, if the tax advisor is not versed in these non-tax matters, mere reliance on the tax advisor does not suffice. See Addington v. United States, 205 F.3d 54 (2d Cir. 2000); Collins v. Commissioner, 857 F.2d 1383 (9th Cir. 1988).

20.1.5.6.7  (07-01-2008)
Advisor Independence

  1. Although a tax advisor’s lack of independence is not alone a basis for rejecting a taxpayer's claim of reasonable cause and good faith, the fact that a taxpayer knew or should have known of the advisor's lack of independence is strong evidence that the taxpayer may not have relied in good faith upon the advisor's opinion. Goldman v. Commissioner, 39 F.3d 402 (2nd Cir. 1994); Pasternak v. Commissioner, 990 F.2d 893, 903 (6th Cir. 1993) (finding reliance on promoters or their agents unreasonable, as "advice of such persons can hardly be described as that of ‘independent professionals’ " ); Roberson v. Commissioner, 98-1 U.S.T.C. 50,269 (6th Cir. 1998) (the Court dismissed the taxpayer’s purported reliance on advice of a tax professional because of all professional’s status as " promoter with a financial interest" in the investment); Rybak v. Commissioner, 91 T.C. 524, 565 (1988) (negligence penalty sustained where taxpayers relied only upon advice of persons who were not independent of promoters); Illes v. Commissioner, 982 F.2d 163 (6th Cir. 1992) (taxpayer found negligent for reliance upon a professional with a personal stake in the venture not reasonable); Gilmore & Wilson Construction Co. v. Commissioner, 99-1 U.S.T.C. 50,186 (10th Cir. 1999) (taxpayer liable for negligence since reliance on representations of the promoters and offering materials unreasonable); Neonatology Associates, P.A. v. Commissioner, 299 F.3d 221 (3rd Cir. 2002) (reliance may be unreasonable when placed upon insiders, promoters, or their offering materials, or when the person relied upon has an inherent conflict of interest that the taxpayer knew or should have known about).

  2. Similarly, the fact that a taxpayer consulted an independent tax advisor is not, if standing alone, conclusive evidence of reasonable cause and good faith if additional facts suggest that the advice is not dependable. Edwards v. Commissioner, T.C. Memo. 2002-169. For example, a taxpayer may not rely on an independent tax advisor if the taxpayer knew or should have known that the tax advisor lacked sufficient expertise, the taxpayer did not provide the advisor with all necessary information, the information the advisor was provided was not accurate, or the taxpayer knew or had reason to know that the transaction was "too good to be true." Baldwin v. Commissioner, T.C. Memo. 2002-162.

20.1.5.6.8  (07-01-2008)
Special Rules for Tax Shelter Items of a Corporation

  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. Treas. Reg. 1.6664-4(f)(2)(i)(B).

  3. The reasonable belief standard is 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.

  4. Satisfaction of the minimum requirements for legal justification is an important factor in determining whether a corporation acted with reasonable cause and in good faith, but not necessarily dispositive. See Treas. Reg. 1.6664-4(f)(3). For example, the taxpayer’s participation in a tax shelter lacking a significant business purpose or the taxpayer is claiming benefits that are unreasonable in comparison to the taxpayer’s investment should be considered. Failure to satisfy the minimum standards will, however, preclude a finding of reasonable cause and good faith based (in whole or in part) on a corporation’s legal justification. See Treas. Reg. 1.6664-4(f)(2)(i). See Treas. Reg. 1.6664-4(f)(4).

20.1.5.7  (07-01-2008)
IRC Section 6662(c): Negligence or Disregard of Rules or Regulations

  1. The negligence or disregard of rules or regulations under IRC section 6662(c) is not limited to underpayments of income tax imposed under subtitle A of the Code, but also applies to other underpayments, such as with respect to excise taxes, notwithstanding the restriction in Treas. Reg. 1.6662-3(a).

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

  3. 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.

20.1.5.7.1  (07-01-2008)
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 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." Treas. Reg. 1.6662–3(b)(1)(ii).

    For 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 bases 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.

  6. 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 information on the return and in the casefile.

    2. The Tax Year (TY) 2001 and TY 2002 examinations disallowed the auto expense deduction because the costs were commuting expenses. The TY 2003 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 2003 return.

     

20.1.5.7.2  (07-01-2008)
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 Code, temporary or final regulations, revenue rulings or notices (other than notices of proposed rule making). The term "disregard" includes careless, reckless, or intentional disregard. See Treas. Reg. 1.6662–3(b)(2).

  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 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  (07-01-2008)
Adequate Disclosure

  1. The penalty for negligence or 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 regulations.

  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 relating to the issue, including statutory language, legislative history, the underlying Treasury decision, relevant case law (including case law pertaining to the presumption of validity to which regulations are entitled), and 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 Service 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 section 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 Service 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 Service of the potential controversy, the disclosure exception does not apply.

    5. See Schirmer v. Commissioner, 89 T.C. 277, 285-86 (1987); Dibsy v. Commissioner, T.C. Memo. 1995-477.

  6. Treas. Reg. 1.6662-3(c), 1.6662-4(e) and (f) define methods of adequate disclosure.

  7. 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.

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

  9. 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.

20.1.5.7.2.1.1  (10-01-2005)
Special Rules for Disclosure

  1. Coordinated Industry Case (CIC) Program (formerly Coordinated Examination Program (CEP)): 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, as appropriate, and attached to the return (or qualified amended return) of the entity. A taxpayer (i.e., partner, shareholder, beneficiary or holder of a residual interest in a REMIC) also may make adequate disclosure by filing Form 8275 or Form 8275-R, in duplicate, one copy attached to the taxpayer’s copy of the return and another filed with the IRS Campus with which the return of the entity is required to be filed.

  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 I.R.B. 140 (August 2, 2004).

20.1.5.7.3  (07-01-2008)
Penalty Assessment

  1. See IRM 20.1.5.3.2 of this manual.

20.1.5.7.4  (07-01-2008)
Penalty Relief

  1. See IRM 20.1.5.6 of this manual.

20.1.5.7.5  (07-01-2008)
Penalty Assertion

  1. See IRM 20.1.5.3 of this manual.

20.1.5.8  (07-01-2008)
IRC Section 6662(d): Substantial Understatement

  1. 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 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 underpayments 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 S corporations and 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 corporation 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 IRC section 6662A(e)(1)(A). See IRM 20.1.5.13 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. See IRC section 6662A(e)(1)(B). Thus, the substantial understatement penalty does not apply to any amount attributable to a reportable transaction understatement and is subject to IRC section 6662A.

  8. The substantial understatement penalty will be automatically asserted on Wage & Investment (W&I) and SB/SE campus cases when mathematically applicable under the correspondence examination batch program. For consistency, the substantial understatement penalty should be asserted on all discretionary program cases.

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

20.1.5.8.1  (07-01-2008)
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 of this manual.

20.1.5.8.1.1  (07-01-2008)
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(d) 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 Service; 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 Service. See IRM 20.1.5.6.4 of this manual.

20.1.5.8.1.2  (07-01-2008)
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 section 6662(d) and 6694(a) only.

    1. For 2007 returns, see Rev. Proc. 2008-14,2008-7 I.R.B. 435.

    2. For 2006 returns, see Rev. Proc. 2006-48, 2006-47 I.R.B. 4.

    3. For 2005 returns, see Rev. Proc. 2005-75, 2005-50 I.R.B. 113.

    4. For 2004 returns, see Rev. Proc. 2004-73, 2004-51 I.R.B. 999.

    5. For 2003 returns, see Rev. Proc. 2003-77, 2003-2 C.B. 964.

    6. For 2002 returns, see Rev. Proc. 2002-66, 2002-2 C.B. 724.

    7. For 2001 returns, see Rev. Proc. 2001-52, 2001-2 C.B. 491.

    8. For 2000 returns, see Rev. Proc. 2001-11, 2001-1 C.B. 275.

    9. Prior to 1999, it is necessary to review the annual revenue procedures published by the Service in the Internal Revenue Bulletins for the applicable tax year.

20.1.5.8.1.3  (07-01-2008)
Exceptions for Tax Shelter Items

  1. For purposes of the accuracy-related penalties, tax shelter includes, among other things, any plan or arrangement a significant purpose of which is the avoidance or evasion of Federal income tax.

  2. In general, no taxpayer may reduce an understatement for an item attributable to a tax shelter for taxable years beginning after October 22, 2004.

  3. For transactions entered into on or after August 6, 1997, the definition of tax shelter includes, among other things, any plan or arrangement or other entity a significant purpose of which is the avoidance or evasion of Federal income tax. The term "tax shelter" is defined in IRC section 6662(d)(2)(C)(ii).

  4. For transactions entered into before August 6, 1997, the relevant standard is whether tax avoidance or evasion was the principal purpose of the entity, plan, or arrangement. See Treas. Reg. 1.6662-4(g)(2).

  5. The term "tax shelter item" is defined in Treas. Reg. 1.6662-4(g)(3) 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 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 IRC section 6662(d)(2)(C)(i)(II) (before amendment by the AJCA) and Treas. Reg. 1.6662-4(g)(4).

20.1.5.8.1.3.2  (07-01-2008)
Corporate Tax Shelter Items

  1. A corporation may avoid the substantial understatement penalty for a tax shelter item only if the corporation has reasonable cause and acted in good faith. See IRM 20.1.5.6.8 of this manual.

20.1.5.8.2  (07-01-2008)
Penalty Assertion

  1. The penalty can be asserted only when the understatement is substantial. See IRM 20.1.5.8 of this manual.

  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, but the penalty is not asserted.

  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 return on its face is patently suspect, and

    3. 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 position.

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

20.1.5.8.3  (07-01-2008)
Penalty Calculation

  1. The examiner will determine the correct penalty amount by:

    1. Calculating the understatement.

    2. Establishing that the understatement is substantial.

    3. Considering whether to reduce the amount of the understatement.

    4. If there should be a reduction, recalculating the understatement without including the tax on the adjustments not subject to the penalty.

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

    6. Considering adjustments for prepayment and refundable credits.

    7. 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.

20.1.5.8.4  (07-01-2008)
Penalty Assessment

  1. See IRM 20.1.5.3.2 of this manual.


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