Tax I APRIL 16, 2014

Defenses to Accuracy-Related Penalties for Filing Inaccurate Tax Returns

It is often said that two things in life are certain (1) death; and (2) taxes.  In light of this certainty, taxes must be accurate as they are signed, sworn statements of the taxpayer.  Sometimes, a taxpayer may substantially understate income, provide certain over-and-underevaluations, or disregard Internal Revenue Service rules and/or regulations.  If this happens, Section 6662 of the Internal Revenue Code ('I.R.C.') provides for the imposition of an accuracy-related penalty for filing an inaccurate tax return.  However, there are some defenses available to a taxpayer that may rebut the accuracy-related penalty.

The accuracy-related penalty under I.R.C. § 6662 does not apply with respect to any portion of an underpayment if it is shown that: (1) there was reasonable cause for such portion; and (2) the taxpayer acted in good faith with respect to such portion. Whether a taxpayer acted with reasonable cause and in good faith is determined on a case-by-case basis taking into account all pertinent facts and circumstances, including the taxpayer’s education, sophistication and business experience. Reasonable cause “requires that the taxpayer have exercised ordinary business care and prudence as to the disputed item.” Thus, the “good faith reliance on the advice of an independent, competent professional as to the tax treatment of an item may meet this requirement.”
For a taxpayer to reasonably rely in good faith upon the advice of an independent, competent professional, the “taxpayer must prove by a preponderance of the evidence that the taxpayer meets each requirement of the following three-prong test: (1) [t]he adviser was a competent professional who had sufficient expertise to justify reliance, (2) the taxpayer provided necessary and accurate information to the adviser, and (3) the taxpayer actually relied in good faith on the adviser’s judgment.”

Similarly, a position giving rise to an accuracy-related penalty under I.R.C. § 6662 is not imposed if there is substantial authority for the position. For an understatement to be reduced by the portion attributable to an item for which there is or was substantial authority, the substantial authority must have existed either at the time the return containing the item was filed or on the last day of the taxable year to which the return relates.

The substantial authority standard “is an objective standard involving an analysis of the law and application of the law to relevant facts.”  Due to the fact that the substantial authority standard is objective, “the taxpayer’s belief that there is substantial authority for the tax treatment of an item is not relevant in determining whether there is substantial authority for that treatment.” The substantial authority standard “is less stringent than the more likely than not standard (the standard that is met when there is a greater than 50-percent likelihood of the position being upheld), but more stringent than the reasonable basis standard [(i.e., the position claimed is arguable but fairly unlikely to prevail in court)].”
Simply stated, “[t]here is substantial authority for the tax treatment of an item only if the weight of the authorities supporting the treatment is substantial in relation to the weight of authorities supporting contrary treatment.” The weight prescribed to the authorities is determined in light of the pertinent facts and circumstances, including the relevance, persuasiveness, and the type of document providing the authority.  Thus, for example, a revenue ruling addressing a question generally has greater weight than a private letter ruling addressing the same question.

The following are considered authority for purposes of determining whether there is substantial authority for the tax treatment of an item: [a]pplicable provisions of the Internal Revenue Code and other statutory provisions; proposed, temporary and final regulations construing such statutes; revenue rulings and revenue procedures; tax treaties and regulations thereunder, and Treasury Department and other official explanations of such treaties; court cases; congressional intent as reflected in committee reports . . .” However, conclusions reached in treatises, legal periodicals, legal opinions or opinions rendered by tax professionals are not authority.
It is important for taxpayers to ensure they are providing the IRS with accurate information.  For most taxpayers who rely on the advice of an independent accountant or other advisor, the taxpayer must remember to provide such third party advisor with all pertinent information necessary for filing the taxpayer’s return.  Otherwise, the taxpayer may be assessed an accuracy-related penalty for any understatement of income.  
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