Notice 90-20, 1990-1 CB 328, (Mar. 05, 1990); Cumulative Bulletin
[Code Sec. 6662 ]


Penalties: Substantial understatement: Adequate disclosure.--Guidance is provided with respect to the portions of the accuracy-related penalty imposed under Code Sec. 6662(b)(1) and (2) on underpayments of tax attributable to negligence or disregard of rules or regulations and to substantial understatements of income tax. BACK REFERENCE: 90FED ¶40,554.01.

I. PURPOSE


This notice provides guidance with respect to the portions of the accuracy-related penalty imposed under sections 6662(b)(1) and (2) of the Internal Revenue Code on underpayments of tax attributable to negligence or disregard of rules or regulations and to substantial understatements of income tax. To the limited extent indicated in section V(A) of this notice (which deals with the "substantial authority" test under the penalty for substantial understatements of income tax), the notice also provides rules which are effective under section 6661 of prior law. In addition, this notice provides guidance with respect to the penalties imposed under section 6694 of the Code for any understatement of a taxpayer's tax liability caused by an income tax return preparer on any return or claim for refund.


II. BACKGROUND


Subtitle G (sections 7701-7743) of the Revenue Reconciliation Act of 1989 (the "Act"), Pub. L. No. 101-239, 103 Stat. 2106, has substantially revised the civil tax penalty provisions of the Internal Revenue Code. In particular, section 7721 of the Act, among other things, has modified the rules that formerly were contained in section 6653 of the Code (which included the negligence and fraud penalties), section 6659 (the valuation overstatement penalty), section 6659A (the penalty for overstatement of pension liabilities), section 6660 (the estate and gift tax valuation understatement penalty), and section 6661 (the substantial understatement penalty). Penalties similar to those formerly imposed under sections 6653(a) and (b), 6659, 6659A, 6660, and 6661 are contained in new sections 6662 and 6663. New sections 6664 and 6665 contain definitions and other rules applicable with respect to these penalties.


New section 6662 of the Code imposes a penalty (the "accuracy-related penalty") equal to 20 percent (40 percent, in the case of a gross valuation misstatement) of the portion of an underpayment of tax that is attributable to one or more of the following: (1) negligence or disregard of rules or regulations; (2) any substantial understatement of income tax; (3) any substantial valuation overstatement under chapter 1 of the Code; (4) any substantial overstatement of pension liabilities; and (5) any substantial estate or gift tax valuation understatement. New section 6664(c) provides that, subject to special rules for certain valuation overstatements, the penalty provided in section 6662 is not imposed with respect to any portion of an underpayment if it is shown that there was a reasonable cause for such portion and that the taxpayer acted in good faith with respect to such portion.


Section 7732 of the Act has substantially amended paragraphs (a) and (b) of section 6694 of the Code (the "preparer penalties"). In addition, section 7733 of the Act has modified the amounts of the penalties under section 6695 concerning failures by income tax return preparers to take certain required administrative actions.


III. EFFECTIVE DATES


New sections 6662, 6663, 6664, and 6665 of the Code apply to returns the due date for which (determined without regard to extensions) is after December 31, 1989. The amendments to sections 6694 and 6695 apply to documents prepared after December 31, 1989.


The Internal Revenue Service will be issuing regulations and other guidance concerning the changes made by the Act with respect to the accuracy-related penalty and preparer penalties. Until further guidance is issued by the Service, this notice sets forth rules on which taxpayers and preparers may rely with respect to the negligence (sections 6662(b)(1) and (c)) and substantial understatement (sections 6662(b)(2) and (d)) portions of the accuracy-related penalty, and with respect to the preparer penalties. To the extent inconsistent with this notice, any future guidance will have only prospective application.


IV. PENALTY FOR NEGLIGENCE OR DISREGARD OF RULES OR REGULATIONS


The penalty provided in sections 6662(b)(1) and (c) of the Code for underpayments attributable to negligence or disregard of rules or regulations is substantially the same as the penalty provided under former section 6653(a) with two principal modifications. First, the rate of the penalty has been increased from 5 percent to 20 percent. Second, the penalty is only imposed on the portion of the underpayment attributable to negligence or disregard of rules or regulations rather than on the entire underpayment (as was the case under former section 6653(a)). Under section 6664(c), the penalty provided in sections 6662(b)(1) and (c) will not be imposed with respect to a portion of an underpayment if it is shown that there was reasonable cause for such portion and that the taxpayer acted in good faith with respect to such portion.


Pursuant to the reasonable cause and good faith exception in section 6664(c) of the Code, the Service will not impose the penalty under sections 6662(b)(1) and (c), relating to negligence or disregard of rules or regulations, with respect to a nonfrivolous position if the taxpayer has made a complete, item-specific disclosure of such nonfrivolous position. Such disclosure must be full and substantive and be clearly identified as being made to avoid imposition of the accuracy-related penalty.


Until further guidance is issued by the Service, the Service will consider disclosure to have been made in accordance with the preceding paragraph if it is made according to the rules set forth in this paragraph. The disclosure must be made on the return or on a properly completed Form 8275, Disclosure Statement Under Section 6661, attached to the return. (Taxpayers may use Form 8275 even though the form was designed for disclosure under former section 6661 and refers to that section.) If the disclosure is made on the return (rather than on Form 8275) the disclosure must contain the caption, "DISCLOSURE MADE UNDER SECTION 6662". The caption must appear at the top left-hand corner of the return (for example, above the title "1040 U.S. Individual Income Tax Return 1989" in the case of Form 1040) and clearly refer to the page or line number containing the disclosure. For example, a taxpayer wishing to avoid the imposition of the penalty under sections 6662(b)(1) and (c) with respect to the deduction of certain medical expenses would write in the top left-hand corner of the first page of Form 1040, "DISCLOSURE MADE UNDER SECTION 6662. SEE LINES 1-4 OF SCHEDULE A" and then describe on Schedule A the additional information necessary to make full disclosure. (Taxpayers should not write in the upper right-hand corner of the return--on Form 1040, this is the area to the right of the numerals "1989"--because this area is used in IRS processing.)


In no event will completing and filling in a tax form or line item in accordance with applicable forms and instructions be considered sufficient disclosure, in itself, for purposes of avoiding the penalty under sections 6662(b)(1) and (c) for negligence or disregard of rules or regulations. Thus, disclosure for purposes of sections 6662(b)(2) and (d), relating to the penalty for substantial understatement of income tax, that is made in accordance with Rev. Proc. 90-16, published concurrently with this notice, will not be sufficient to avoid the imposition of the penalty provided in sections 6662(b)(1) and (c). In addition, disclosure is not effective to avoid the imposition of the penalty under sections 6662(b)(1) and (c) for negligence or disregard of rules or regulations where the penalty is imposed because the taxpayer failed to keep proper books and records or to substantiate items properly. In no event will disclosure avoid the imposition of this penalty with respect to a position that is frivolous.


V. PENALTY FOR SUBSTANTIAL UNDERSTATEMENT OF INCOME TAX


The penalty provided in sections 6662(b)(2) and (d) of the Code for a substantial understatement of income tax is substantially the same as the penalty provided under former section 6661 with three principal modifications. First, the rate of the penalty has been decreased from 25 percent to 20 percent. Second, as explained in more detail below, the definition of the term "authority" has been expanded to include additional items. Third, under section 6662(d)(2)(D), the Service is required to publish (solely as an informational aid to taxpayers) an annual list of positions for which it believes there is not "substantial authority" and which affect a significant number of taxpayers.


Sections 6662(b)(2) and (d) of the Code provide that a penalty is imposed on the portion of an underpayment on a return that is attributable to a "substantial understatement of income tax." Section 6662(d)(1) provides that an understatement is substantial if it exceeds the greater of 10 percent of the amount of tax required to be shown on the return or $5,000 ($10,000 in the case of a corporation other than an S corporation or a personal holding company). Section 6662(d)(2) provides that for purposes of applying this penalty, the amount of any understatement is reduced by that portion of the understatement which is attributable to (1) the tax treatment of any item by the taxpayer if there is or was substantial authority for such treatment, or (2) any item with respect to which the relevant facts affecting the item's tax treatment are adequately disclosed in the return or in a statement attached to the return. Special rules apply in the case of a tax shelter (as defined in section 6662(d)(2)(C)).


(A). Substantial Authority


For purposes of the "substantial authority" test under section 6662(d)(2)(B)(i), as under former section 6661, authority includes the following: applicable provisions of the Internal Revenue Code and other statutory provisions; temporary and final regulations construing such statutes; court cases; administrative pronouncements (including revenue rulings and revenue procedures); tax treaties and regulations thereunder, and Treasury Department and other official explanations of such treaties; and congressional intent as reflected in committee reports, joint explanatory statements of managers included in conference committee reports, and floor statements made prior to enactment by one of the bill's managers.


For purposes of section 6662(d)(2)(B)(i) of the Code, the Service also will treat as authority General Explanations of tax legislation prepared by the Joint Committee on Taxation (the "Blue Book"), proposed regulations, information or press releases, notices, announcements, and any other similar documents published by the Service in the Internal Revenue Bulletin. In addition, for purposes of section 6662(d)(2)(B)(i), the Service will treat as authority private letter rulings, technical advice memoranda, actions on decisions, and general counsel memoranda after they have been released to the public and provided they are dated after December 31, 1984 (the date that is five years prior to the general effective date of the penalty provisions of the Act). The Service is considering whether regulations should provide rules under which, on a continuing basis, private letter rulings, technical advice memoranda, actions on decisions, and general counsel memoranda issued prior to a specified date (for example, more than a specified number of years before the date on which a tax return is due) would be considered outdated and would no longer constitute authority with respect to items on a return. The Service requests comments with respect to this question.


As under former section 6661, "authority" does not include conclusions reached in treatises, legal periodicals, and opinions rendered by tax professionals.


With respect to returns that were due (without regard to extensions) on or before December 31, 1989, the Service will apply section 6661(b)(2)(B)(i) of prior law using the definition of authority provided, for purposes of section 6662(d)(2)(B)(i), in this notice.


In determining whether the authority supporting treatment of an item is substantial under section 6662(d)(2)(B)(i) of the Code, the Service will continue to apply the principles of section 1.6661-3 of the Income Tax Regulations, except to the extent that section 1.6661-3 is inconsistent with the listing of authorities set forth in this notice. Thus, there is substantial authority for the tax treatment of an item only if the weight of authorities supporting such tax treatment is substantial in relation to the weight of authorities supporting contrary tax treatments. The weight to be accorded an authority is affected by the type of document providing the authority. For example, a revenue ruling addressing a question generally will have greater weight than a private letter ruling addressing the same question. Also, the weight of an authority from which information has been deleted, such as a private letter ruling, is further diminished to the extent that such deleted information may have affected the conclusions reached therein. For example, a private letter ruling holding that a particular amount is de minimis for purposes of section 368 of the Code will be given little or no weight with respect to the question of what is a de minimis amount if the amount on which the holding relies has been deleted from the private letter ruling as released to the public.


(B). Adequate Disclosure


Under section 6662(d)(2)(B)(ii) of the Code, except in the case of a tax shelter, the amount of an understatement is reduced by that portion of the understatement that is adequately disclosed in the return or in a statement attached to the return.


Until further guidance is issued by the Service, for purposes of determining what constitutes adequate disclosure under section 6662(d)(2)(B)(ii) of the Code, the rules that have been applicable under former section 6661 shall apply. Thus, for example, if the taxpayer's disclosure of an item would be considered adequate under either section 1.6661-4 of the regulations or Rev. Proc. 85-26, 1985-1 C.B. 580 (concerning taxpayers subject to the Service's Coordinated Examination Program), such disclosure will be considered adequate for purposes of section 6662(d). Until the issuance of further guidance by the Service, a properly completed Form 8275 as currently available will also constitute adequate disclosure with respect to an item for purposes of section 6662(d)(2)(B)(ii), notwithstanding that the form refers to former section 6661 of the Code.


Rev. Proc. 90-16, published concurrently with this notice and updating Rev. Proc. 89-11, 1989-1 C.B. 797, identifies circumstances under which the completion of certain forms and schedules in an income tax return can constitute adequate disclosure for purposes of reducing the understatement of income tax under section 6662(d) of the Code.


Taxpayers should note that, in some circumstances, disclosure adequate to avoid the penalty under sections 6662(b)(2) and (d) of the Code for substantial understatement of income tax (such as disclosures made pursuant to Rev. Proc. 90-16) will not suffice to avoid imposition of the penalty under sections 6662(b)(1) and (c) for negligence or disregard of rules or regulations. However, a disclosure sufficient to avoid the penalty under sections 6662(b)(1) and (c) for negligence or disregard of rules or regulations, as described in Section IV of this notice, will also constitute adequate disclosure for purposes of the penalty under sections 6662(b)(2) and (d) for substantial understatement of income tax. Therefore, taxpayers wishing to make a single disclosure that is effective for both of these portions of the accuracy-related penalty (subject to the limitations described in Section IV) should follow the procedures for making sufficient disclosure set forth in Section IV.


VI. PENALTY FOR UNDERSTATEMENT OF A TAXPAYER'S TAX LIABILITY ON A RETURN OR CLAIM FOR REFUND CAUSED BY AN INCOME TAX RETURN PREPARER


Section 7732 of the Act has substantially amended the preparer penalties contained in sections 6694(a) and (b) of the Code.


Under section 6694(a) of the Code, as amended by the Act, if (1) any part of any understatement of liability with respect to any income tax return or claim for refund is due to a position for which there was not a realistic possibility of being sustained on its merits, (2) any person who is an income tax return preparer with respect to such return or claim knew (or reasonably should have known) of such position, and (3) such position was not disclosed (as provided in section 6662(d)(2)(B)(ii)) or was frivolous, such person shall pay a penalty of $250 with respect to such return or claim unless it is shown that there is reasonable cause for the understatement and such person acted in good faith.


The new "realistic possibility of being sustained on its merits" standard under section 6694(a) of the Code is a stricter standard than that of section 6694(a) prior to revision by the Act. The new standard does not, however, require certainty, nor does it require a preparer to conclude that the position is more likely than not to succeed. For example, the Service will treat a position as having a realistic possibility of being sustained on its merits if a reasonable and well-informed analysis by a person knowledgeable in the tax law would lead such a person to conclude that the position has approximately a one in three, or greater, likelihood of being sustained on its merits.


Negligent behavior that would have been subject to the penalty under former section 6694 of the Code will continue to be subject to the penalty as amended by the Act. Until the release of further guidance by the Service, the preparer's duty of inquiry into factual matters will remain the same as under prior law. For example, a failure by a preparer to make reasonable inquiries if the information furnished to the preparer appears to be incorrect or incomplete can support imposition of the amended penalty, just as it could have supported imposition of the penalty under prior law. See Rev. Proc. 80-40, 1980-2 C.B. 774.


Under section 6694(b) of the Code, as amended by the Act, if any part of any understatement of liability with respect to any return or claim for refund is due (1) to a willful attempt in any manner to understate the liability for tax by a person who is an income tax return preparer with respect to such return or claim, or (2) to any reckless or intentional disregard of rules or regulations by any such person, the return preparer shall pay a penalty of $1,000 with respect to such return or claim. As under prior law, with respect to any return or claim for refund, the amount of any penalty payable by a person under section 6694(b) is reduced by the amount of any penalty paid by such person under section 6694(a).


With respect to nonfrivolous positions, the penalties provided in sections 6694(a) and (b) of the Code will not be imposed if such position is sufficiently disclosed on the return or claim for refund. For purposes of section 6694(a), disclosure is sufficient if it constitutes adequate disclosure for purposes of section 6662(d), as described in Section V(B) of this notice. Thus, if an item is disclosed as provided in Rev. Proc. 90-16, or otherwise meets the requirements of Section V(B) of this notice, no penalty will be imposed under section 6694(a) unless such position is frivolous. However, for purposes of section 6694(b), disclosure is sufficient only if it meets the requirements for waiver, on the basis of sufficient disclosure, of the penalty under sections 6662(b)(1) and (c) for negligence or disregard of rules or regulations. These requirements are described in Section IV of this notice.


Because the penalties under both sections 6694(a) and (b) of the Code may be imposed with respect to a single position on the return, income tax return preparers may wish to make a single disclosure statement to avoid the imposition of both penalties. In order to afford protection against the penalties under both sections 6694(a) and (b), a preparer must make disclosure of the kind required for waiver, on the basis of sufficient disclosure, of the penalty under sections 6662(b)(1) and (c) for negligence or disregard of rules or regulations, as described in Section IV of this notice.


If there is more than one income tax return preparer with respect to a return or claim for refund, the preparer who, under section 1.6695-1(b) of the regulations, is required to sign such return or claim is the preparer who is responsible for making the disclosure statement to avoid imposition of the penalties under sections 6694(a) and (b) of the Code. A person may be an income tax return preparer by reason of having furnished information or advice with respect to a substantial portion of a return or claim for refund, but may nevertheless not be the person required to sign the return or claim. See sections 6695 and 7701(a)(36) of the Code and the regulations thereunder. The Service is considering the degree to which such a person has an obligation to advise either the taxpayer filing the return or claim, or the preparer who is required to sign the return or claim, of disclosures that might be necessary in order to avoid the imposition of penalties. The Service invites comments on rules that may be appropriate with respect to the application of the preparer penalties to an income tax return preparer who was not required to sign a return or claim for refund, including ways by which such a person may avoid imposition of the penalties.


Until the release of further guidance, the Service will not assert the preparer penalties, with respect to a return or claim for refund, prepared after December 31, 1989, against a preparer who is not required to sign the return. Nonsigning preparers are reminded, however, that as was true under prior law, they may be subject to other penalties (such as the penalty for aiding and abetting understatements of tax liability under section 6701 of the Code) for knowingly or recklessly assisting others to understate their tax liabilities.


VII. PROCEDURAL INFORMATION


In the past, notices and announcements issued by the Service, which did not, by reason of the regulations under former section 6661, necessarily constitute authority for purposes of the substantial understatement penalty, contained a special statement if the Service intended for taxpayers to rely on them as authority. See Rev. Rul. 87-138, 1987-2 C.B. 287. The Service hereby announces that, in keeping with section V(A) of this notice, all notices and announcements issued by the Service and published in the Internal Revenue Bulletin will constitute authority for purposes of the substantial understatement portion of the accuracy-related penalty, and may be relied upon to the same extent as revenue rulings or revenue procedures. Accordingly, such documents issued after March 5, 1990, the date of publication of this notice, generally will not contain a statement indicating the extent to which they can be relied upon.


IX. REQUEST FOR COMMENTS


The Service requests comments on the matters addressed in this notice. In particular, the Service requests comments on (i) items to be included in the annual list of taxpayer positions for which the Service believes there is not "substantial authority," which list is required to be published under section 6662(d)(2)(D) of the Code; (ii) whether regulations should specify that, on a continuing basis, private letter rulings, technical advice memoranda, actions on decisions, and general counsel memoranda issued more than a specified number of years in the past should be considered outdated and not useful as authority for purposes of section 6662(d)(2)(B)(i); and (iii) the preparer penalties, particularly with respect to the waiver for adequate disclosure as it may apply to an income tax return preparer who is not required to sign a return or claim for refund. Comments may be addressed to the Associate Chief Counsel (Technical), Internal Revenue Service, 1111 Constitution Ave. N. W., Room 3527, Washington, D. C. 20224. Comments should be received by April 10, 1990, in order to ensure that they will receive full consideration.


X. DRAFTING INFORMATION


The principal authors of this notice are Gail M. Winkler and Vincent G. Surabian of the Office of the Assistant Chief Counsel (Income Tax and Accounting). For further information regarding this notice, call (202) 566-5985 (not a toll-free number).