Do not rely on the "reasonable basis" standard

6694(a)(2)(B), as recently amended, provides that the penalty under 6694(a)(1)(B), as amended, ($1,000 or 50% of the income derived) will not apply to positions properly disclosed to the IRS.

Section 1.6694-2(c)(2) of the regulations defines “reasonable basis” as the standard for disclosed positions and provides: “For purposes of this section, “reasonable basis” has the same meaning as in §1.6662-3(b)(3) or any successor provision of the accuracy-related penalty regulations. For purposes of determining whether the tax return preparer has a reasonable basis for a position, a tax return preparer may rely in good faith without verification upon information furnished by the taxpayer, advisor, other tax return preparer, or other party (including another advisor or tax return preparer at the tax return preparer’s firm), as provided in §1.6694-1(e).

§1.6662-3(b)(3) of the regulations defines 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 6694 regulations are based on 6662(d)(2)(B) law that the negligence penalty will be reduced when the relevant facts affecting the item's tax treatment are adequately disclosed in the return or in a statement attached to the return, and there is a reasonable basis for the tax treatment of the item by the taxpayer. Note also:

Section 301.7430-5(c) (1) providing the general rule that the position of the Internal Revenue Service is substantially justified if it has a reasonable basis in both fact and law. A significant factor in determining whether the position of the Internal Revenue Service is substantially justified as of a given date is whether, on or before that date, the taxpayer has presented all relevant information under the taxpayer's control and relevant legal arguments supporting the taxpayer's position to the appropriate Internal Revenue Service personnel.

Under the authority of §301.7430-5(c) (1), “reasonable basis” is a position that is substantially justified in both fact and law. Curiously, this regulation places “reasonable basis” relatively close to “substantial authority.” I find it impossible to find a difference between “substantial justification” for a position and “substantial authority” for a position. In addition "reasonable basis" is a subjective term and can mean anything to any IRS examiner. The fact is that the return prepares have as much risk with a disclosed position as an undisclosed position because the term "reasonable basis" is entirely subjective, and if the IRS references "substantial justification" then I see no difference with that term and the "substantial authority" standard for undisclosed positions.

You also have to take into account the incompetence and aggressiveness of IRS examiners. I had an office conference yesterday representing a client who got caught up in a tax shelter promoted by a CPA who has been indicted for tax fraud by the DOJ. My client was a compliant taxpayer who, with others, got sucked into a bad tax shelter. Her underpayment of tax triggered the 6662 20% statutory penalty. The examiner never heard of "reasonable cause" and would not allow it because her reviewer will never accept it. She only had two years of experience and she brought in a new IRS examiner to observe her. He has been with the IRS for only 29 days. He is around 40 years old and has had a career in sales. Understand that you have to take into account the low level of knowledge of the IRS examiners and their lack of training and tendancy to be aggressive.

Notwithstanding the difficulties with the ambiguity in the "reasonable basis" standard for disclosed position, it would be foolish to not take advantage of the stipulation in the regulations that it is lower than the substantial authority standard. If you need to deal with the IRS, go for the disclosed "reasonable basis" standard.

All disclosed postions should be accompanied by a legal memorandum to discuss the facts and the law and even argue the benefits of the lower threshold for the reasonable basis standard.

The calls to my office and e-mails to me indicate that there is still a great deal of confusion on how to deal with the complex factual and legal issues and how to support a disclosure that meets the "reasonable basis" standard." My advice is that "more authority" and analysis is better than less authority and analysis. My solution to the subjective nature of the reasonable basis standard is to assume that I need to meet the highest level of analysis and authority in order to reduce the possibility of an examination and the penalty.

Let me know if you have any questions on any of the above. ab@irstaxattorney.com or 703 425-1400.