Accuracy - Substantial Understatement - Audit Techniques Guide | irstaxattorney.com



Accuracy-Related Penalties: Up Introduction Accuracy Related Penalty Negligence of Rules Substantial Understatement Valuation Misstatement Fraud Penalty Reasonnable Cause Annoucement 2002-2 Policy Statements Audit Techniques	Audit Techniques Guide Chapter 4: Substantial Understatement In General 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 company), then a substantial understatement exists and a penalty may be imposed equal to 20 percent of the underpayment of tax attributable to the understatement. Definition of Tax Shelter for Purposes of IRC § 6662(d) For transactions entered into on or after August 6, 1997, the definition of tax shelter includes, among other things, any plan or arrangement a significant purpose of which is the avoidance or evasion of Federal income tax. IRC § 6662(d)(2)(C)(iii). 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. Treas. Reg. § 1.6662-4(g)(2)(i). The former principal purpose standard is more difficult for the government to meet than the current significant purpose standard. Typical of tax shelters are transactions structured with little or no motive for the realization of economic gain, and transactions that utilize mismatching of income and deductions, overvalued assets or assets with values subject to substantial uncertainty, certain nonrecourse financing, financial techniques that do not conform to standard commercial business practices, or the characterization of the substance of the transaction. See generally Treas. Reg. § 1.6662-4(g)(2)(i)(c). Substantial Authority Exception 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. 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. 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 6 for a list of those authorities. 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 discussion of IRC § 6664 below for additional information relating to what constitutes reasonable reliance.) In the case of tax shelter items attributable to a pass-through entity, the actions taken by the entity (e.g., the general partners of a partnership) to establish reasonable belief are deemed taken by the taxpayer. No exception under IRC § 6662 applies to any item of a corporation which is attributable to a tax shelter. Therefore, if a corporate taxpayer has a substantial understatement that is attributable to a tax shelter item, the accuracy-related penalty applies to the understatement unless the reasonable cause and good faith exception under IRC § 6664 applies. (See Treas. Reg. § 1.6662-4(g)(1)(ii)(B) for special rules relating to transactions entered into by a corporation prior to December 9, 1994.) See IRM 20.1.5.8.4.1 (at page 18) for additional information relating to the substantial authority exception to the IRC § 6662(d) penalty.

Audit Techniques Guide

Chapter 4: Substantial Understatement