The substantial underpayment penalty applies to underpayment
of individual and corporate income taxes (as well as certain
other taxes). This penalty equals the portion of an underpayment
of tax that is attributable to a substantial understatement
of income tax, multiplied by 20% (the regular accuracy-related
penalty rate).
An understatement is computed by reducing
the amount of tax required to be shown on the return by
(a) the excess of the tax which is shown on the return
over any “rebate ”(i.e.,
refund, credit, etc.) and (b) the portion of the understatement
that is attributable to either:
 (1)
the treatment of an item for which there is or was substantial
authority, or
(2) an item if the relevant facts affecting its tax treatment
are adequately disclosed and there is a reasonable basis
for the taxpayer's treatment.
Reductions (1) and (2) do not apply to
items attributable to tax shelters. For this purpose, a “tax shelter” is
a partnership or other entity, any investment plan or arrangement,
or any other plan or arrangement which has as a significant
purpose the avoidance or evasion of federal income tax. An
item of income, gain, loss, deduction or credit is a tax
shelter item if it is directly or indirectly attributable
to the principal purpose of a tax shelter to avoid or evade
federal income tax.
Except in the case of certain corporate taxpayers,
an understatement of income tax for a tax year is substantial
for purposes of the accuracy-related penalty for substantial
understatement of income tax if the understatement exceeds
the greater of 10% of the tax required to be shown on the
return for that year, or $5,000. For corporate taxpayers
(other than S corporations and personal holding companies),
an understatement is substantial if the amount of the understatement
exceeds the lesser of:
(a) 10% of the tax required to be
shown on the return for that tax year (or $10,000 if that
is greater), or
(b) $10 million. Thus, in the case of corporate
taxpayers an understatement of more than $10 million
is substantial regardless of the proportion it represents
of the total tax liability.
What is substantial
authority? The substantial authority standard is
an objective standard involving an analysis of the law
and application of the law to relevant facts. The substantial
authority standard is less stringent than a “more
likely than not” standard (generally, a good faith
opinion that there is a more than 50% chance that a position
will be upheld if challenged), but more stringent than
a “reasonable basis” standard.
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The “substantial
authority” definition puts a premium on professional
analysis and research and makes it advisable to retain
contemporaneous written documentation of conclusions reached
and authorities relied on. It is in your interest to have
an adviser who will fully analyze and report in writing
on important tax moves.
Avoiding the penalty by disclosure. Disclosure
is adequate with respect to the tax treatment of an item
(or group of similar items) or a position on a return if
the disclosure is made on a properly completed Form 8275
(or Form 8275-R, if the position is contrary to a regulation)
attached to the return or to a qualified amended return for
the tax year. But IRS can prescribe circumstances in annual
revenue procedures under which disclosure on a return is
adequate, as discussed below. There is no adequate disclosure
of required information if there's no reasonable basis for
the tax treatment of the item, the item or position on the
return isn't properly substantiated, or you failed to keep
proper books and records with respect to the item or position.
Disclosure on the return under annual revenue
procedures. IRS issues annual revenue procedures that describe
when disclosure of information on a return is adequate for
purposes of reducing the substantial understatement penalty
discussed above. Under the revenue procedure, it is generally
unnecessary for taxpayers to make any additional disclosure
of facts relevant to, or positions taken with respect to,
issues involving any of the items listed in the procedure
if the relevant forms and attachments are completed in a
clear manner and in accordance with their instructions.
The most recent revenue procedure states that
money amounts entered on the forms must be verifiable and
the information on the return must be disclosed in the manner
described in the procedure. Numbers are verifiable if on
audit, the taxpayer can show the origin of the number (even
if that number is not ultimately accepted by IRS), and can
show good faith in entering that number on the applicable
form. The disclosure of an amount is not adequate when the
understatement arises from a transaction between related
parties. If an entry may present a legal issue or controversy
because of a related party transaction, then that transaction
and the relationship must be disclosed on a Form 8275, or
Form 8275-R.
Where the amount of an item is shown on a line
that does not have a preprinted description identifying that
item (such as on an unnamed line under an “Other Expense” category)
the taxpayer must clearly identify the item by including
the description on that line. If space limitations on a form
do not allow for an adequate description, the description
must be continued on an attachment.
If the revenue procedure does not include an
item, disclosure is adequate with respect to that item only
if made on a properly completed Form 8275 or Form 8275-R
attached to the return or to a qualified amended return. |
