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§ 6060, 6107, 6109, 6111, 6662, 6662A, 6694, 6695, 6696, 6701, 6707A, 6713, 7206, 7213, 7216, 7407, 7421, 7427, 7701(a)(36),

Part 20. Penalty and Interest
Chapter 1. Penalty Handbook
Section 5. Return Related Penalties

20.1.5  Return Related Penalties 20.1.5.1  (10-01-2005)
Background
  1. This section covers return-related penalties, including IRC section 6707A, Penalty for Failure to Include Reportable Transaction Information with Return, IRC section 6662, Imposition of Accuracy-Related Penalty on Underpayments, and IRC section 6663, Imposition of Fraud Penalty. This section also covers IRC section 6662A, Imposition of Accuracy-Related Penalty on Understatements with Respect to Reportable Transactions.
  2. IRC section 6707A imposes a penalty on taxpayers who fail to disclose information relating to reportable transactions. See IRM 20.1.5.2.
  3. IRC section 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;
    2. Substantial understatement of income tax See IRM 20.1.5.8;
    3. Substantial valuation misstatement See IRM 20.1.5.9;
    4. Substantial overstatement of pension liability See IRM 20.1.5.10;
    5. Substantial estate or gift tax valuation understatement See IRM 20.1.5.11;
  4. IRC section 6662A imposes an accuracy-related penalty on a reportable transaction understatement. See IRM 20.1.5.13.
  5. IRC section 6663 imposes a penalty on any portion of an underpayment attributable to fraud. See IRM 20.1.5.12.
  6. IRC section 6664 provides definitions and special rules that apply to the accuracy-related penalties and the civil fraud penalty.

20.1.5.1.1  (10-01-2005)
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. 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) redesignated IRC section 6662(e) as a "substantial valuation misstatement " under chapter 1 and added a penalty for valuation misstatements under IRC section 482.
  4. The Omnibus Budget Reconciliation Act of 1993 (OBRA 93) amended the definition of substantial valuation misstatement as it relates to IRC section 482.
  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 6707A, Penalty for Failure to Include Reportable Transaction Information with Return, IRC section 6662A, Imposition of Accuracy-Related Penalty on Understatements with Respect to Reportable Transactions, and IRC section 6664(d), Reasonable Cause Exception for Reportable Transaction Understatements. The AJCA also 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.

20.1.5.1.2  (10-01-2005)
Penalty Policy
  1. The accuracy-related and fraud penalties are important deterrents to non-compliance and should not be used as "bargaining chips" during the development or processing of cases. The Service re-issued Penalty Policy Statement P-1-18 as Penalty Policy Statement P-20-1, effective June 29, 2004. All examining officers should review P-20-1 prior to assertion of penalties.
  2. The Audit Technique Guide (ATG), Accuracy-Related Penalties For Taxpayers Involved in Tax Shelter Transactions, was developed to support the field in the consistent development and application of penalties when a taxpayer is involved in an abusive tax shelter, including "technical" tax shelters.
  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.
  4. The Office of Penalties and Interest (OPI), part of Examination Policy, oversees the implementation of Service-wide policies and strategies for penalties and interest. This office also provides policy guidance on penalty and interest processes across all operating divisions to ensure consistent and accurate treatment of all taxpayers.
  5. The ATG and P-20-1 can be downloaded from the OPI website http://sbse.web.irs.gov/opi.
20.1.5.1.3  (10-01-2005)
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, see IRM 20.1.1.
  2. Under IRC section 6751(b), written supervisory approval of the initial determination of the penalty assessment is required by the immediate manager or higher level official of the employee initially proposing the penalty.
  3. The employee initially proposing the penalty should indicate the name of the penalty, the Code section and a computation of the penalty on Form 4700, Examination Workpapers, Form 4318, Examination Workpapers Index or Form 5772, EP/EO Workpaper Summary for TE/GE cases. Written managerial approval may be indicated on the Forms under the proposed penalty sections.
    4. Note:

    Use of the Forms are intended to ensure that the approval is obtained before the initial determination.

  4. 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, without an employee independently determining the appropriateness of the penalty, 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, a Service 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.
20.1.5.2  (10-01-2005)
IRC Section 6707A - Penalty for Failure to Include Reportable Transaction Information with Return
  1. Under IRC section 6011, a taxpayer must file a disclosure statement on Form 8886, Reportable Transaction Disclosure Statement, for each reportable transaction in which the taxpayer participated.
  2. IRC section 6707A penalizes any person who fails to include with any return or statement any required information with respect to a reportable transaction, including:

    1. The failure to attach Form 8886 to an original or amended return (for each year in which the taxpayer participated in a reportable transaction) and
    2. The failure to send a copy of a disclosure statement to the Office of Tax Shelter Analysis (OTSA).
  3. IRC section 6707A applies without regard to whether the transaction ultimately results in an understatement of tax, and applies in addition to any accuracy-related penalty that may be imposed.
  4. The provision is effective for returns and statements with due dates after October 22, 2004.
20.1.5.2.1  (10-01-2005)
Penalty Computation
  1. The penalty for failing to disclose a reportable transaction is $10,000 for an individual taxpayer and $50,000 for a business taxpayer.
  2. The penalty for failing to disclose a listed transaction is $100,000 for an individual taxpayer and $200,000 for a business taxpayer.
20.1.5.2.2  (10-01-2005)
Rescission
  1. The Commissioner may rescind all or a portion of the penalty if:

    1. The violation is with respect to a reportable transaction other than a listed transaction and
    2. Doing so would promote compliance.

  2. The Commissioner will make this determination on a case-by-case basis, considering whether the taxpayer has a history of complying with the tax laws, whether the violation results from an unintentional mistake of fact, and whether imposing the penalty would be against equity and good conscience. See Notice 2005-11, 2005-7 I.R.B. 493 (February 14, 2005). The Commissioner may delegate this authority in the future.
  3. The Commissioner’s determination whether to rescind the penalty in whole or in part is not reviewable by the IRS Appeals Division or any court.
20.1.5.3  (10-01-2005)
Common Features: Accuracy-Related and Civil Fraud Penalties
  1. All accuracy-related and civil fraud penalties are associated with the examination of a tax return. 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.
  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 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. Examiners, however, cannot apply the accuracy-related penalties to a delinquent return after an assessment (TC 290/300) is made under substitute-for-return procedures. Examiners should review available IRS CFOL information when making penalty determinations to establish payment patterns and 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.

20.1.5.3.1  (10-01-2005)
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. However, the ten-year ban can be asserted even if the fraud penalty is not (or cannot be) applied.

20.1.5.3.2  (10-01-2005)
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, the underpayment is derived as follows:

    1. Calculate the underpayment for all adjustments.
    2. Calculate the underpayment using only the two adjustments for which there is no penalty.
    3. Subtract "b" from "a" .
    4. Apply the penalty rate times the amount derived in "c" above. This is the amount of the penalty.

  2. In allocating the portions of an underpayment for penalty assertion under IRC sections 6662 and 6663, follow the ordering rules of Treas. Reg. 1.6664–3:

    1. Those for which no penalties are asserted.
    2. Those for which a penalty is asserted at a 20 percent rate under IRC section 6662(b).
    3. Those for which a penalty is asserted at a 40 percent rate under IRC section 6662(h) for penalties defined in IRC section 6662(b)(3), (4), and (5).
    4. Those for which a penalty is asserted at a 75 percent rate under IRC 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. RESERVED - Example calculation on allocation of IRC sections 6662, 6662A and 6663.
  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. 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.

  6. 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 credits 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.

20.1.5.3.3  (10-01-2005)
Carrybacks and Carryovers
  1. The amount of an underpayment subject to IRC sections 6662 or 6663 will not be reduced by any carryback or carryover of a net operating loss (NOL), deduction, or credit to that year. See Treas. Reg. 1.6662–3(d), 1.6662–4(c) and 1.6664–2(f).
  2. Example:

    1. A 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 2001 to 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 2000: 20% x $3,000 = $600.

  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), 1.6662-4(c).
  4. Example:

    1. The taxpayer filed a 2002 return with an NOL of $45,000. The taxpayer carried forward $20,000 of the NOL to 2003.
    2. An examination of the 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 2002.
    3. The $20,000 amount carried over from 2002 to 2003 is disallowed. This produces a 2003 underpayment of $2,000. Because this is the result of an adjustment for which negligence applied in 2002, the penalty also applies to the 2003 underpayment.
    4. Note: If the NOL disallowance for 2002 did not result in an underpayment, but did create an underpayment for 2003 (due to the disallowed carryover from 2002), then the penalty would still apply to the underpayment in 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 for more information relating to adequate disclosure

20.1.5.3.4  (10-01-2005)
Definitions
  1. Amount of tax imposed: The term "amount of tax imposed" is the corrected tax imposed by 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).
  3. Qualified amended return: Treas. Reg. 1.6664-2T(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 so 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).
  6. 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).

  7. 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 so shown that were previously assessed (or collected without assessment), over
    3. The amount of rebates made.
    4. Note: In calculating the amount of the underpayment, adjustments to refundable credits or prepayment credits for withholding or estimated tax are included.
    5. See Exhibit 20.1.5-1 for an example calculation of an underpayment.

20.1.5.3.5  (10-01-2005)
Administrative Adjustment Request (AAR)
  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 for additional information on administrative adjustment requests.

20.1.5.4  (10-01-2005)
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, employment tax returns, or tax exempt and government entities related tax returns.
  2. Penalty considerations are to be addressed in all examinations and 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. 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.
    3. On agreed examinations, the assertion of the penalty is documented in the workpapers and fully explained in the report.
    4. When the penalty is asserted on unagreed cases, the Service position must be fully developed and documented, including the applicability of any exceptions. As with any other issue, the examiner must develop the facts in order to evaluate whether a penalty should be asserted. The facts should be evaluated and the law applied appropriately to reach a sustainable position. The facts, law and argument, taxpayer’s position and conclusion must clearly demonstrate that the penalty applies. 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. If the taxpayer provides a legal opinion to support the claim, examiners should seek advice from their assigned Area Counsel in evaluating the legal opinion.
    5. Note: The above guidelines do not apply to returns examined under the Coordinated Industry Case (CIC) Program (formerly Coordinated Examination Program (CEP)).
  3. Form 3198, Special Handling Notice for Examination Case Processing or Form 3198-A, TE/GE Special Handling Notice, should be attached to all cases when the accuracy-related penalties and the fraud penalty are asserted.
  4. Examiners will identify the adjustments related to each penalty in the report, and identify each one separately by name, Code section and penalty computation.
  5. In proposing the penalty to the taxpayer or taxpayer’s representative, the examiner will:

    1. Document all the reasons why the penalty assertion is appropriate, and
    2. 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 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 statutory notice of deficiency.
20.1.5.4.1  (10-01-2005)
Underreporter Penalty Assertion
  1. 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. Notices and reports will fully identify the names, Code sections and the computation of the penalty amounts being asserted.
  3. All penalty determinations involving a reasonable cause exception will be documented in the workpapers. This will be done by identification on the Underreporter case analysis screen and will remain with the case file.
  4. In unagreed cases, the Service will provide the taxpayer or representative with a complete explanation of the penalty.

20.1.5.4.2  (10-01-2005)
Penalty Assessment
  1. The examiner will compute the penalty for the Case Processing Areas. Form 3198, Special Handling Notice for Examination Case Processing or Form 3198-A, TE/GE Special Handling Notice, will be completed by the examiner indicating penalty assertion.
  2. Enter the accuracy-related penalty amount using Reference Number 680 for the following:

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

  3. Enter Reference Number 681 for reportable transaction understatement assessments under IRC section 6662A.
  4. Enter the accuracy-related penalty amount with Reference Number 680 on the Form 5403, Appeals Closing Record, Form 5344, Examination Closing Record, or Form 5599, TE/GE Examined Closing Record. Master File will compute interest on this 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.

  5. See discussion of individual penalty provisions for specific assessment procedures that differ from the general rules here.

20.1.5.4.2.1  (10-01-2005)
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 fails to 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  (10-01-2005)
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.
  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. If, in litigation, a court determines that none of the exceptions under IRC section 6501 is applicable, then the statute of limitations for the assessment of the underlying tax and penalties will have expired if the examiner does not secure an extension.
  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  (10-01-2005)
Penalty Relief
  1. General penalty relief is discussed in IRM 20.1.1, Penalty Relief. Exceptions specific to each of the accuracy-related penalties and the civil fraud penalty are discussed in their respective sections.

20.1.5.6.1  (10-01-2005)
Reasonable Cause
  1. No accuracy-related penalty is imposed if it is shown that the taxpayer had reasonable cause for the position taken and that the taxpayer acted in good faith.

    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 .

  2. The reasonable cause exception will be determined on a case-by-case basis taking into account all the pertinent facts and circumstances. Generally, the most important factor is the taxpayer’s effort to assess the proper tax liability. The credibility of the taxpayer’s reasons for not determining the proper tax liability should be evaluated.
  3. 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.
  4. Treas. Reg. 1.6664-4T(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.
  5. IRM 20.1.1 and Treas. Reg. 1.6664-4 contain additional information and examples.

20.1.5.6.2  (10-01-2005)
Reliance on Advice
  1. Reliance on advice as defined by Treas. Reg. 1.6664-4(c) may satisfy the reasonable cause exception of IRC section 6664(c).
  2. "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.
  3. Under Treas. Reg. 1.6664-4(c)(1), taxpayers may meet the reasonable cause exception if they reasonably relied on advice that was based upon:

    1. Reasonable factual or legal assumptions,
    2. All pertinent facts and circumstances, and
    3. The law as it relates to the facts and circumstances.

  4. Having met the above requirements, the exception will not apply unless, with respect to all the pertinent facts and circumstances, there was reasonable reliance on the advice in good faith.

    1. The fact that a taxpayer knew or should have known of an advisor’s lack of independence is strong evidence that the taxpayer may not have relied in good faith upon the advisor’s opinion.
    2. The fact that a taxpayer consulted an independent tax advisor is not, standing alone, conclusive evidence of reasonable cause and good faith if additional facts suggest that the advice is not dependable.

  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 for 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.

20.1.5.7  (10-01-2005)
IRC Section 6662(c): Negligence or Disregard of Rules or Regulations
  1. The amount of the penalty is 20 percent of the underpayment attributable to negligence or disregard of rules or regulations.
  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. 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).

20.1.5.7.1  (10-01-2005)
Negligence Penalty Assertion
  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. See Treas. Reg. 1.6662-3(b).
  2. Negligence is strongly indicated when a taxpayer fails to report income shown on an information return, fails to make a reasonable inquiry into the correctness of a deduction, credit, or exclusion on a tax return that seems "too good to be true," or when the returns of partners or S corporation shareholders are clearly inconsistent with the tax returns of their respective entities.
  3. Some indications of negligence follow:

    • Unreported or understated income,
    • Deductions or credits significantly overstated,
    • Careless, improper, or exaggerated deductions,
    • Misrepresenting or miscategorizing deductions in such a manner as to conceal the true nature of the deduction,
    • Unexplainable items,
    • Inadequate books and records,
    • Cooperative state programs and state reports showing a negligence penalty (taking into account other factors and not relying entirely on the findings of taxing agency),
    • Substantial errors on an issue (e.g., Earned Income Credit) that had been adjusted in a prior year, and
    • Giving the preparer incorrect or incomplete information to prepare the returns.

  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. Example:
    a) An 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 case file.
    b) The 2001 and 2002 examinations disallowed the auto expense deduction because the costs were commuting expenses. The 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 accuracy-related penalty attributable to negligence should be asserted on the 2003 return.
20.1.5.7.2  (10-01-2005)
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, notices (other than notices of proposed rulemaking), or revenue rulings. The term "disregard " includes careless, reckless, or intentional disregard.

    1. Disregard is "careless" if the taxpayer does not exercise reasonable care to determine the correctness of a tax return.
    2. Disregard is "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.
    3. Disregard is "intentional" if the taxpayer knows of a rule or regulation and ignores that rule or regulation.

  2. The penalty for disregard usually applies if an item on the return is contrary to the Internal Revenue Code, temporary or final regulations issued under the Internal Revenue Code, or a revenue ruling or notice (other than notices of proposed rulemaking) published in the Internal Revenue Bulletin.
  3. A taxpayer who takes a position contrary to a revenue ruling or notice (other than with respect to a reportable transaction) has not disregarded the ruling or notice if the position has a realistic possibility of being sustained on its merits.

20.1.5.7.2.1  (10-01-2005)
Adequate Disclosure
  1. The penalty for disregard of rules or regulations does not apply if the taxpayer adequately disclosed a position contrary to a rule or regulation. See IRM 20.1.5.7.2.1.1 for special rules relating to adequate disclosure.
  2. Disclosure is adequate if:

    1. It is made with the return, or on a qualified amended return, and
    2. Unless otherwise prescribed by the Commissioner, a completed Form 8275, Disclosure Statement, is filed with the original return or qualified amended return. Form 8275-R, Regulations Disclosure Statement, is necessary for disclosing a position contrary to a regulation.

  3. The exception for adequate disclosure will not apply if:

    1. The taxpayer has not kept adequate books and records, or fails to substantiate items on the return,
    2. The item or position on the return does not have a reasonable basis, or
    3. In the case of a reportable transaction, the taxpayer failed to disclose the transaction in accordance with IRC section 6011.

  4. 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.
  5. The applicability of the disclosure exception is determined for each item or group of similar items separately. 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, 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  (10-01-2005)
Penalty Assessment
  1. The examiner will compute the accuracy-related penalty attributable to negligence for the Case Processing Areas. Form 3198, Special Handling Notice for Examination Case Processing or Form 3198-A, TE/GE Special Handling Notice, will be completed by the examiner to indicate the penalty assertion.
  2. Enter the accuracy-related penalty amount using Reference Number 680 on Form 5403, Appeals Closing Record, Form 5344, Examination Closing Record or Form 5599, TE/GE Examined Closing Record.

20.1.5.7.4  (10-01-2005)
Penalty Relief
  1. The penalty does not apply if the taxpayer has reasonable cause and acted in good faith, i.e., if an error was due to an honest misunderstanding of the facts or the law and the taxpayer took reasonable steps to comply with the law. See IRM 20.1.1.

20.1.5.8  (10-01-2005)
IRC Section 6662(d): Substantial Understatement
  1. The amount of the penalty is 20 percent of the underpayment attributable to the substantial understatement of income tax.
  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 subject to IRC section 6662A.

20.1.5.8.1  (10-01-2005)
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.

20.1.5.8.1.1  (10-01-2005)
Substantial Authority Exception
  1. The penalty under IRC section 6662(d) will not be asserted if there is substantial authority for the tax treatment of an item or return position. Authorities relevant to both sides of the tax treatment of an item are taken into account.
  2. 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.

    1. The substantial authority standard is less rigid than the " more likely than not" standard. The "more likely than not" standard is met when there is more than a 50 percent likelihood that the position would be sustained.
    2. The substantial authority standard is more rigid than the reasonable basis standard. The reasonable basis standard is defined by Treas. Reg. 1.6662-3(b)(3) as a relatively high standard of tax reporting, that is, significantly higher than not frivolous or not patently improper.
    3. The reasonable basis standard is not satisfied by a return position that is merely arguable or merely a colorable claim. A return position will satisfy this standard if it is reasonably based on one or more authorities.

  3. "Authority" under Treas. Reg. 1.6662-4(d)(3)(iii) is established by reference to:

    1. The Internal Revenue Code and other statutory provisions;
    2. Proposed, temporary and final regulations;
    3. Revenue rulings and revenue procedures;
    4. Tax treaties, the regulations thereunder, and Treasury Department and other official explanations of such treaties;
    5. Court cases;
    6. Congressional intent as reflected in committee reports, joint explanatory statements of managers included in conference committee reports, and floor statement made prior to enactment by one of a bill’s managers;
    7. General Explanations of tax legislation by the Joint Committee on Taxation (the "Blue Book" );
    8. Private letter rulings and technical advice memoranda issued after October 31, 1976;
    9. Actions on decisions and general counsel memoranda issued after March 12, 1981 (as well as general counsel memoranda published in pre-1955 volumes of the Cumulative Bulletin);
    10. IRS information releases and press releases;
    11. Notices announcements and other administrative pronouncements published by the Service in the Internal Revenue Bulletin.

  4. Taxpayers automatically meet the substantial authority standard if the tax treatment is supported by the conclusion of:

    1. A technical advice memorandum in which the taxpayer is named,
    2. An area director’s determination letter issued to the taxpayer,
    3. A private letter ruling issued to the taxpayer, or
    4. A revenue agent’s report for a prior taxable year with an affirmative statement on the same item.

  5. Taxpayers do not automatically meet the substantial authority standard if there was a material misstatement of the facts upon which the written determination was based or the written determination is revoked or is inconsistent with:

    1. Subsequent temporary or final regulations,
    2. Subsequent revenue rulings, revenue procedures or other administrative pronouncements published in the Internal Revenue Bulletin,
    3. Subsequent legislation, or
    4. Subsequent decisions of the United States Supreme Court.
    5. See Treas. Reg. 1.6662-4(d)(3)(iv).

  6. The term "authority" does not include treatises, legal periodicals, legal opinions or opinions rendered by other tax professionals.
  7. An authority does not continue to be an authority if it is overruled or modified, implicitly or explicitly, by a body having the power to overrule or modify the earlier authority, such as a U.S. Court of Appeals overruling a district court which originally issued the authority used by the taxpayer.
  8. A Tax Court opinion is not considered overruled or modified by a court of appeals to which a taxpayer does not have a right of appeal, unless the Tax Court adopts the holding of the court of appeals.
  9. Subsequent authority is determined as of the date of filing or the last day of the taxable year. See Treas. Reg. 1.6662-4(d)(3)(iv)(C).
  10. For determining the weight of various "authorities" see Treas. Reg. 1.6662-4(d)(3)(ii).
  11. Additional information on the substantial authority exception can be found in the ATG, Accuracy-Related Penalties for Taxpayers Involved in Tax Shelter Transactions.

20.1.5.8.1.2  (10-01-2005)
Adequate disclosure Exception
  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. Generally, the accuracy-related penalty attributable to a substantial understatement will not be asserted on the underpayment attributable to an item that is adequately disclosed and for which there is a reasonable basis for the tax treatment of the item.
  3. However, even when the item is adequately disclosed the penalty will be asserted if:

    1. The taxpayer failed to keep adequate books and records or failed to substantiate the disclosed item, or
    2. The item is attributable to a tax shelter as defined in IRC section 6662(d)(2)(C)(ii).

  4. Disclosure is adequate if it is made in a statement attached to a return, i.e., Form 8275, Disclosure Statement, or Form 8275-R, Regulation Disclosure Statement.

    1. Disclosure is considered adequate for tax return line item entries identified in and disclosed according to the annual revenue procedure that applies for the year of the return.
    2. If the revenue procedure does not expressly provide that disclosure of an item on the return is sufficient, disclosure should be made on Form 8275 or Form 8275-R, as appropriate.

  5. 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 2004 returns, see Rev. Proc. 2004-73, 2004-51 I.R.B. 999.
    2. For 2003 returns, see Rev. Proc. 2003-77, 2003-2 C.B. 964.
    3. For 2002 returns, see Rev. Proc. 2002-66, 2002-2 C.B. 724.
    4. For 2001 returns, see Rev. Proc. 2001-52, 2001-2 C.B. 491.
    5. For 2000 returns, see Rev. Proc. 2001-11, 2001-1 C.B. 275.
    6. For 1999 returns, see Rev. Proc. 99-41, 1999-2 C.B. 566.
    7. For 1998 returns, see Rev. Proc. 98-62, 1998-2 C.B. 816.
    8. For 1997 returns, see Rev. Proc. 97-56, 1997-2 C.B. 582.
    9. Prior to 1997, it is necessary to review the annual revenue procedures published by the Service in the Internal Revenue Bulletins for the applicable tax year.

  6. 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.

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

20.1.5.8.1.3  (10-01-2005)
Exceptions for Tax Shelter Items
  1. In general, no taxpayer may reduce an understatement for an item attributable to a tax shelter for taxable years beginning after October 22, 2004.
  2. 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).
  3. 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).
  4. 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  (10-01-2005)
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).

  2. The reasonable belief standard is met if:

    1. The taxpayer analyzed the pertinent facts and relevant authorities to reasonably conclude in good faith that there would be a greater than 50 percent likelihood that the tax treatment of the item would be upheld if challenged by the IRS; or
    2. The taxpayer reasonably relied in good faith on the opinion of a professional tax advisor who analyzed all the pertinent facts and authorities, and who unambiguously concludes that there is a greater than 50 percent likelihood that the tax treatment of the item will be upheld if challenged by the IRS.

  3. Non-Corporate pass-through entities: In the case of tax shelter items attributable to a pass-through entity, if the entity satisfies the reasonable belief requirement, the taxpayer is deemed to have also met the requirement.
20.1.5.8.1.3.2  (10-01-2005)
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.
  2. All relevant facts and circumstances are taken into account in determining whether the corporation acted with reasonable cause and in good faith.
  3. The taxpayer may meet the reasonable cause exception in IRC section 6664(c) by establishing legal justification. Legal justification, as defined in Treas. Reg. 1.6664-4(f)(2), includes any justification under the federal tax law for the treatment or characterization of the tax shelter item or of the entity, plan, or arrangement that gave rise to the item. A corporation establishes legal justification with respect to a tax shelter item by first meeting these minimum requirements:

    1. substantial authority and
    2. reasonable belief. See IRM 20.1.5.8.1.3.1.

  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 may not be dispositive. Failure to satisfy the minimum requirements will, however, preclude a finding of reasonable cause and good faith based (in whole or in part) on a corporation’s legal justification.
  5. The reasonable cause exception for corporate tax shelter items may also be met under general guidelines in IRM 20.1.5.6 and IRM 20.1.1.
20.1.5.8.2  (10-01-2005)
Penalty Assertion
  1. The penalty can be asserted only when the understatement is 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. 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. and IRM 4.32.
  4. Examiner will identify the penalty attributable to each adjustment in the report, and explain each penalty by name, Code section and calculated penalty amount.
  5. 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.
  6. 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 would not appear to meet any exceptions.

20.1.5.8.3  (10-01-2005)
Penalty Calculation of Substantial Understatement
  1. To determine the correct penalty:

    1. Calculate the understatement.
    2. Establish the understatement is substantial..
    3. Consider whether to reduce the amount of the understatement.
    4. If there should be a reduction, recalculate the understatement without including the tax on the adjustments not subject to the penalty.
    5. Determine whether the understatement is substantial after applying the reductions.
    6. Consider adjustments to prepayment and refundable credits and establish the underpayment.
    7. Apply the penalty rate to the underpayment.

  2. For example calculations See Exhibit 20.1.5-2. and See Exhibit 20.1.5-3.

20.1.5.8.4  (10-01-2005)
Penalty Assessment
  1. To assess or abate penalties imposed under this code section, complete code and edit Forms 5344, 5403 or 5599 in the normal manner with the following exceptions:

    1. Do not enter either Transaction Codes (TC) 240/241 or the penalty amount;
    2. Enter Reference Number 680 (negative/positive) and the penalty amount (TC 240/241) will automatically be generated to the Master File.

  2. When a manual computation of interest on the penalty is required, see established procedures. See Interest IRM 20.2.

20.1.5.8.5  (10-01-2005)
Penalty Relief
  1. The accuracy-related penalty attributable to a substantial understatement will not be applied if the taxpayer shows reasonable cause for the understatement and acted in a good faith effort to derive the correct tax liability. (See IRM 20.1.1 and IRM 20.1.5.6 for a more detailed discussion of the reasonable cause exception and Treas. Reg. 1.6664-4 for examples.)

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