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:: Accuracy - Substantial Understatement
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
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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
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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.
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