Section 1.6694-2(a)(2)(ii) reasonable basis

Section 1.6694-2(a)(2)(ii) of the Temporary Regulations provides that the “reasonable basis” standard applies for disclosed positions.

The explanation for the meaning of “reasonable basis” is found in § 1.6694-2(c)(2). “Reasonable basis” has the same meaning as in § 16662-3(b)(3), as follows:

(3) Reasonable basis. --Reasonable basis is a relatively high standard of tax reporting, that is, significantly higher than not frivolous or not patently improper. The reasonable basis standard is not satisfied by a return position that is merely arguable or that is merely a colorable claim. If a return position is reasonably based on one or more of the authorities set forth in §1.6662-4(d)(3)(iii) (taking into account the relevance and persuasiveness of the authorities, and subsequent developments), the return position will generally satisfy the reasonable basis standard even though it may not satisfy the substantial authority standard as defined in §1.6662-4(d)(2). (See §1.6662-4(d)(3)(ii) for rules with respect to relevance, persuasiveness, subsequent developments, and use of a well-reasoned construction of an applicable statutory provision for purposes of the substantial understatement penalty.) In addition, the reasonable cause and good faith exception in §1.6664-4 may provide relief from the penalty for negligence or disregard of rules or regulations, even if a return position does not satisfy the reasonable basis standard.
The language of § 1.6662-4(d)(3)(ii) follows:
(ii) Nature of analysis. --The weight accorded an authority depends on its relevance and persuasiveness, and the type of document providing the authority. For example, a case or revenue ruling having some facts in common with the tax treatment at issue is not particularly relevant if the authority is materially distinguishable on its facts, or is otherwise inapplicable to the tax treatment at issue. An authority that merely states a conclusion ordinarily is less persuasive than one that reaches its conclusion by cogently relating the applicable law to pertinent facts. The weight of an authority from which information has been deleted, such as a private letter ruling, is diminished to the extent that the deleted information may have affected the authority's conclusions. The types of document also must be considered. For example, a revenue ruling is accorded greater weight than a private letter ruling addressing the same issue. An older private letter ruling, technical advice memorandum, general counsel memorandum or action on decision generally must be accorded less weight than a more recent one. Any document described in the preceding sentence that is more than 10 years old generally is accorded very little weight. However, the persuasiveness and relevance of a document, viewed in light of subsequent developments, should be taken into account along with the age of the document. There may be substantial authority for the tax treatment of an item despite the absence of certain types of authority. Thus, a taxpayer may have substantial authority for a position that is supported only by a well-reasoned construction of the applicable statutory provision.
The language of § 1.6662-4(d)(3)(iii) follows:
(iii) Types of authority. --Except in cases described in paragraph (d)(3)(iv) of this section concerning written determinations, only the following are authority for purposes of determining whether there is substantial authority for the tax treatment of an item: applicable 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, joint explanatory statements of managers included in conference committee reports, and floor statements made prior to enactment by one of a bill's managers; General Explanations of tax legislation prepared by the Joint Committee on Taxation (the Blue Book); private letter rulings and technical advice memoranda issued after October 31, 1976; actions on decisions and general counsel memoranda issued after March 12, 1981 (as well as general counsel memoranda published in pre-1955 volumes of the Cumulative Bulletin); Internal Revenue Service information or press releases; and notices, announcements and other administrative pronouncements published by the Service in the Internal Revenue Bulletin. Conclusions reached in treatises, legal periodicals, legal opinions or opinions rendered by tax professionals are not authority. The authorities underlying such expressions of opinion where applicable to the facts of a particular case, however, may give rise to substantial authority for the tax treatment of an item. Notwithstanding the preceding list of authorities, an authority does not continue to be an authority to the extent it is overruled or modified, implicitly or explicitly, by a body with the power to overrule or modify the earlier authority. In the case of court decisions, for example, a district court opinion on an issue is not an authority if overruled or reversed by the United States Court of Appeals for such district. However, a Tax Court opinion is not considered to be overruled or modified by a court of appeals to which a taxpayer does not have a right of appeal, unless the Tax Court adopts the holding of the court of appeals. Similarly, a private letter ruling is not authority if revoked or if inconsistent with a subsequent proposed regulation, revenue ruling or other administrative pronouncement published in the Internal Revenue Bulletin.
The “reasonable basis” standard for disclosed positions is obviously defined by complex relevancy and legal authority standards. If a reference is made by a return preparer to a section of the Internal Revenue Code, the more relevant authority might be found in a tax treaty. The point is that the “reasonable basis” standard for disclosed positions cannot be assumed to be a walk in the park. If you fail the “reasonable basis” standard, the section 6694 penalties kick in.

Suppose you are dealing with a business that could be viewed as a hobby. Is the relevant authority the Code, the regulations, the case law, the Internal Revenue Manual, etc? One would have to be a fool to just rely on the Code or the regulations because the IRS examiner may surface and determine that there is judicial precedent for the position and that case is precedent. Even if you are correct on that position, the IRS Examiner can still argue that the most relevant authority is the case with similar facts. It would not be wise to use just one authority, as authorized by § 1.6694-2(c)(2). To play it safe, the disclosed position should address all of the relevant authority.

It is obvious that when the position is disclosed the IRS is in a position to second guess the authority selected by the return preparer because the ultimate decision of what is the most relevant authority and what is the best authority is a subjective decision subject to the discretion of the IRS Examiner. It is my personal option that the IRS Examiners have become increasingly aggressive because there is very little oversight over IRS determinations and the courts have created a very high threshold to overrule the discretion of the IRS.

Keep in mind that disclosed factually complex or legally complex issues are likely to be selected for audit examination. If the position disclosed is not supported by the appropriate “analysis” of the more relevant “authority,” you are an easy target for the 6694 penalty.

Here are some questions to consider:

1. Do you have the skill to do the research?
2. If you have that skill, will your client compensate you for the time you spend to provide comprehensive support for the disclosed position?
3. When would you do the research: in 2008, when the returns are filed in 2009, or when or if you are audited? Will you remember the facts and the law if the audit of the return filed in 2009 is audited in 2011?
4. Is it worth the risk for tax returns with fees in excess of $2,000 (50% of $2,000 is the minimum $1,000 penalty)?

I do not think the return preparation industry has had its wake-up call that the paradigm for tax return preparation has been seriously changed, requiring a high degree of technical skills: research, analysis and drafting Clients are not currently educated that they will have to pay for that effort. And how will you find the time to get it all done?

If you think the best action is to not disclose the position, but that means that the level of technical research, analysis and drafting is set at the far higher “more likely than not” standard.

You also have to assume that the IRS Examiners will be aggressive on these issues.

This is a very interesting topic. Please make your comment to any of the above points. Send any questions you may have to ab@irstaxattorney.com.