IRS position on "substantial authority" 6694

The IRS position paper is an interesting exposition of "substantial authority" under the prececessor statute to section 6662. It explains to me why the current 6662 regulations calls the "substantial authority" an objective standard. That languages was meant to exclude the intent of the taxpayer, or in our case, the intent of the tax return preparer as applied to section section 6694. Instead, it pertains to the weight of the data. There is something amusing about that distinction because reasonable people can disagree about the weight of the evidence, and that makes the standard subjective. Notwithstanding, this IRS exposition of the term "substantial authority" is interesting and is important as background information to interpret that term in section 6694(a)(2)(A) under the Emergency Stabilization Act.


LGM-RUL, I.R.C. §6661 SUBSTANTIAL UNDERSTATEMENT OF LIABILITY PENALTY, TL-24

(January 22, 1988)

I.R.C. §6661 SUBSTANTIAL UNDERSTATEMENT OF LIABILITY PENALTY, TL-24

January 22, 1988

CC:TL:TS/JLRICKS



I. BACKGROUND


I.R.C. §6661, added by the Tax Equity and Fiscal Responsibility Act of 1982, imposes a no-fault penalty on taxpayers who substantially underreport their tax liabilities. This provision was enacted as a deterrence to taxpayers attempting to play the "audit lottery", that is, the taking of a questionable position not amounting to fraud or negligence on a return in the hope that it would not be audited. Under prior law, if the return was audited and the questionable position challenged, the taxpayer usually paid only the additional tax owing plus interest. The section 6661 penalty was designed to deter the use of such undisclosed questionable reporting positions. This Guideline provides instruction on the key operative phrases of section 6661, some of which are new terms with no prior judicial or administrative interpretations, and sets forth criteria for waiving the section 6661 penalty.




II. Overview


In general, effective for tax returns due (determined without regard to extensions) for filing after December 31, 1982, the penalty applies to a "substantial understatement" of income tax. An understatement of tax liability is a "substantial understatement" if it exceeds the greater of (1) 10% of the tax required to be shown on the tax return, or (2) $5,000 ($10,000 in the case of a corporation other than an S corporation or a personal holding company). Under TEFRA, section 6661(a) imposed a penalty equal to 10% of the amount of any underpayment attributable to such understatement with respect to returns due after December 31, 1982.



Section 1504 of the Tax Reform Act of 1986 ("Tax Reform Act"), which became effective on October 22, 1986, increased the penalty for the substantial understatement of tax liability from 10% to 20% for returns due after December 31, 1986. Section 8002 of the Omnibus Budget Reconciliation Act of 1986 ("Budget Act"), which became effective on October 21, 1986, provided for a further increase in the penalty to 25%, effective for penalties assessed after October 21, 1986. These amendments were brought into apparent conflict when the President inadvertently signed the Budget Act (on October 21, 1986) before the Tax Reform Act (on October 22, 1986) even though Congress clearly intended that the Budget Act would repeal the Tax Reform Act's provisions.



On November 6, 1986, the Service issued a press release (IR-86-149) stating that the 25% Budget Act rate applied to penalties assessed after October 21, 1986, with respect to returns due on or after January 1, 1983 (post-TEFRA returns).1 The Service reaffirmed this position in Notice 87-78, 1987-49 I.R.B. 36. Notice 87-78 also states that the 25 percent penalty rate will apply to substantial understatements of income tax on returns due on or after January 1, 1987 (regardless of extensions).



Various safe havens are provided in section 6661. First, with respect to understatements involving nontax shelter items, the penalty will not apply to that portion of an understatement for which (1) there is or was "substantial authority" for the taxpayer's treatment, or (2) the taxpayer "adequately disclosed" the relevant facts with respect to the item's tax treatment in the return or in a statement attached to the return. I.R.C. §6661(b)(2)(B)(i) and (ii). As to items attributable to a "tax shelter", the penalty is inapplicable only if the taxpayer had "substantial authority" for his position and "reasonably believed" that the tax treatment of an item was "more likely than not" the proper treatment. I.R.C. §6661(b)(2)(C). In addition, section 6661(c) provides that the Service may waive all or any part of the penalty upon a showing by the taxpayer that there was "reasonable cause" for the understatement and that the taxpayer acted in good faith.



An analysis of the key phrases listed below is set forth in this Guideline:



III. Substantial Authority



IV. Adequate Disclosure



V. More Likely Than Not



VI. Waiver



VII. Hazards of Litigation



Section 6661 is also applicable to deficiencies determined against nonfilers. The penalty isapplicable to nonfiled returns with a due date (without regard to extensions) after December 31, 1982. The understatement will be calculated as provided in the regulations, with the amount of the tax shown on the return considered to be zero. *****



*****




III. "Substantial Authority"


The substantial authority test, as finally adopted2 calls for an objective after-the-fact analysis of whether the weight of the authorities, if any, supporting the taxpayer's position is substantial when compared to the weight of contrary authorities. See Treas. Reg. §1.6661-3(b)(1).3



*****




IV. Adequate Disclosure


The substantial understatement penalty in nontax shelter cases may be avoided with respect to any item if the relevant facts affecting the item's tax treatment are "adequately disclosed" in the return or in a statement attached to the return. I.R.C. §6661(b)(2)(B)(ii). Under the final regulations, a statement is deemed adequate if it includes: (1) a caption identifying it as a section 6661 disclosure; (2) an identification of the item (or group of similar items) with respect to which disclosure is made; (3) the amount of the item (or group of similar items); and (4) the facts affecting the tax treatment of the item (or group of similar items) which reasonably may be expected to apprise the Service of the nature of the potential issue involving the tax treatment of the item(s). Treas. Reg. §1.6661-4(b)(1). In lieu of explaining the facts affecting the tax treatment of an item in his disclosure statement, Treas. Reg. §1.6661-4(b)(2) allows the taxpayer to set forth a concise description of the legal issue presented by such facts.



In the case of a recurring item, such as the basis of recovery property, an adequate disclosure in one taxable year does not constitute adequate disclosure for a subsequent year. Treas. Reg. §1.6661-4(a). Disclosure, in the case of a pass-through entity, is to be made in the return filed by the entity. However, the final regulations also allow the taxpayer on whose return the pass-through items are reported to make adequate disclosure by filing a separate statement in duplicate, one copy attached to his return and the other copy filed with the Service Center where the entity is required to file, which identifies the pass-through items. Treas. Reg. §1.6661-4(e).



Rev. Proc. 83-21, 1983-1 C.B. 680, Rev. Proc. 84-19, 1984-1 C.B. 433, Rev. Proc. 85-19, 1985-1 C.B. 520, Rev. Proc. 86-22, 1986-1 C.B. 562, and Rev. Proc. 87-48, 1987-38 I.R.B. 45, identify several categories of items of a more routine type which, if properly reported on the taxpayer's return in accordance with the applicable forms and instructions thereto, will be considered adequately disclosed for purposes of section 6661, with no further statement required. For returns due (regardless of extensions) after December 31, 1985, the taxpayer must also be able to verify the money amounts entered on the form in order for the items to be considered adequately disclosed. Rev. Proc. 86-22; Rev. Proc. 87-48. These items include: taxes, interest expense, medical expenses and contributions reported on Schedule A; casualty losses reported on Form 4684; sale or exchange of a principal residence reported on Form 2119; employee business expenses reported on Form 2106; moving expenses reported on Form 3903; and several trade or business expense items. Submission of a form not completed in strict accordance with the form's general instructions and the revenue procedure's specific instructions may prevent the application of the revenue procedure's safe harbor and the taxpayer may be subject to the section 6661 penalty if the disclosure is inadequate.



*****



As to the requisite degree of particularity for an "adequate disclosure," Treas. Reg. §1.6661-4(b)(4) cautions that disclosure is not adequate with respect to an item if it consists of only undifferentiated information that is not arranged so as to apprise the Service of the identity of the item, its amount and the potential controversy concerning the item. The legislative history indicates that the adequate disclosure standard was intended to require the taxpayer to furnish facts "sufficient to enable the Internal Revenue Service to identify the potential controversy", General Explanation, supra, at 218, and was "intended to require greater disclosure than is necessary to avoid the six-year statue [sic] of limitation provided for in section 6501(e)(1)(A)." Id. Thus, mere satisfaction of the standards developed under section 6501(e)(1)(A), such as whether there is sufficient information to provide a "clue" to the existence of the disputed item, Colony, Inc. v. Commissioner, 357 U.S. 28 (1958) [58-2 USTC ¶9593], or whether an adjustment is "apparent from the face of the return to the ... 'reasonable man' ", University Country Club, Inc. v.Commissioner, 64 T.C. 460, 471 (1975) [CCH Dec. 33,277], is not sufficient under section 6661(b)(2)(B)(ii).




V. More Likely Than Not


Section 6661 imposes a much stricter standard for support for tax shelter items. Under section 6661(b)(2)(C), in order to avoid the penalty if a tax shelter item is involved, not only must the objective substantial authority test be met, but the taxpayer must also prove that he "reasonably believed that the tax treatment ... was more likely than not the proper treatment." Furthermore, the "adequate disclosure" safe harbor is unavailable with respect to tax shelter items.



A "tax shelter" is any arrangement the principal purpose of which, based on objective evidence, is the avoidance or evasion of federal income tax. S. Conf. Rep. No. 530, 97th Cong., 2d Sess. 576 (1982) [hereinafter referred to as Conf. Rep.]. The regulations further define "principal purpose" (consistent with the principal purpose test of Treas. Reg. §1.269-3(9)) as whether the tax avoidance or evasion purpose "exceeds any other purpose." Treas. Reg. §1.6661-5(b)(1).



The "more likely than not" standard is simply the "preponderance of the evidence" test for the burden of proof applicable in civil actions.7 For a statement of this test, see Rogers v. Hyatt, 81-1 U.S.T.C. par. 9218 (D. Colo. 1981); Jacobson v. United States, 78-1 U.S.T.C. par. 13,231 (D.N.D. 1977). See also Gower v. Commissioner, T.C. Memo. 1982-72 [CCH Dec. 38,787(M)]; Miller v. Commissioner, T.C. Memo. 1980-445 [CCH Dec. 37,321(M)]; Popa v. Commissioner, 73 T.C. 130, 135 (1979) [CCH Dec. 36,398] (concurring opinion).



***** For "pass-through entities (partnerships, S corporations, trusts, estates, regulated investment companies and real estate investment trusts) the proposed regulations applied this test at the entity level; that is, the taxpayer was required to prove that the entity reasonably believed that the treatment claimed was more likely than not the proper tax treatment. Prop. Reg. §1.6661-5(e).



Under the final regulations, however, the test of reasonable belief is applied at the taxpayer level, rather than at the entity level. Treas. Reg. §1.6661-5(e). That is, in the case of pass-through items, the final regulations require that the taxpayer have the reasonable belief that the claimed tax treatment was more likely than not the proper treatment, and the activities of the entity (such as relying on a legal opinion) will generally be imputed to the taxpayer.



*****




VI. Waiver


Section 6661(c) allows the Service to waive all or any part of the understatement penalty "on a showing by the taxpayer" that (1) there was reasonable cause for the understatement, and (2) he acted in good faith. *****



*****




VII. Hazards of Litigation


*****



MARLENE GROSS



Director



Tax Litigation Division





APPENDIX A





Congressional History Of I.R.C. §6661



The evolution of present section 6661 proceeded essentially in six stages:



A)

First Version. As originally proposed, the substantial understatement of liability penalty was part of the Taxpayer Compliance Improvement Act of 1982, introduced in the Senate as S. 2198 by Senator Dole on March 11, 1982; on March 15, 1982, an identical Bill (H.R. 5829) was introduced by Congressman Conable in the House. Section 125 of that Act provided for a simple outright penalty, in the case of an understatement of tax liability, amounting to 10% of any "substantial" understatement of tax, which was defined as any amount exceeding the greater of $5,000 or 10% of the amount of tax required to be shown on the return. The only saving provision allowed was if the taxpayer made a disclosure of the item producing the underpayment "in a manner adequate to apprise the Secretary of the nature and amount of such item." There was no exception for aposition taken on a tax item based either on a "substantial authority" or "more likely than not" standard.

In hearings in the Senate on S. 2198, Hearings on S. 2198 Before the Subcommittee on Oversight of the Internal Revenue Service of the Senate Committee on Finance, 97th Cong., 2d Sess. (March 22, 1982), and in the House on H.R. 5829, Hearing on H.R. 6300 and related legislative proposals Before the House Committee on Ways and Means, 97th Cong., 2d Sess. (May 18, 1982) hereinafter referred to as House Hearings]; the proposed penalty was criticized as being too broad. It was recommended that provisions be made for waiver of the penalty if "clear judicial authority" existed for the taxpayer's position. House Hearings, supra, at 176.




B)

Second Version. In response to the above criticisms, the Senate Finance Committee rewrote the original proposal, incorporating it as section 341 of the Tax Equity and Fiscal Responsibility Act of 1982. H.R. 4961, 97th Cong., 2d Sess. 558 (1982). This second version was substantially the same as present section 6661, except for subsections (B) and (C), which provided as follows:



(2)

Reduction For Understatement Due to Position of Taxpayer or Disclosed Item.--The amount of the understatement under subparagraph (A) shall be reduced by that portion of the understatement which is attributable to--



(1)

the treatment of any item by the taxpayer on the return if the taxpayer establishes that such treatment was more likely than not to be the proper 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.






(3)

Disclosure Not Sufficient In Cases Involving Abusive Tax Shelters.--Subparagraph (B)(ii) shall not apply to any item with respect to--



(1)

a partnership or other entity,




(2)

any investment plan or arrangement, or




(3)

any other plan or arrangement, if the principal purpose of such partnership, entity, plan or arrangement is the avoidance or evasion of Federal income tax.






Thus, the second version allowed for the reduction of an understatement (absent disclosure) only where "the taxpayer had a subjective belief that such treatment was more likely than not to be sustained if the issue were challenged and litigated" as opposed to a mere "reasonable basis" for the treatment. S. Rep. No. 494, 97th Cong., 2d Sess. 273-74 (1982).




C)

Third Version. After the Bill was reported to the Senate, Colorado Senator Armstrong criticized the "more likely than not" standard, claiming that it would impose an "impossible" burden to satisfy for taxpayers in view of the complexity of the tax laws. See 128 Cong. Rec. S8791 (daily ed. July 21, 1982). He also claimed that the stringent more-likely-than-not test would have a "chilling effect on the relationship between the taxpayers and those to whom they go for guidance and counsel in the preparation of their tax return." Id. at S8790. He proposed to amend the Committee's version by eliminating altogether the "more likely than not" language, and substituting instead a test which would reduce the amount of an understatement "if the taxpayer believed that there was substantial authority for such treatment." Id. at S8789.

After further discussions in the Senate, a compromise was reached adopting a third version of the penalty whereby the stricter more-likely-than-not test was not entirely eliminated, but was relegated to only tax shelter items, and the less stringent substantial authority standard was implemented for nontax shelter items. This version reads as follows:



(1)

the treatment of any item by the taxpayer on the return if the taxpayer believed that there 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.





(3)

Special Rules In Cases Involving Abusive Tax Shelters.--Subparagraph (B)(ii) shall not apply to any item with respect to--



(1)

a partnership or other entity,




(2)

any investment plan or arrangement, or




(3)

any other plan or arrangement, if the principal purpose of such partnership, entity, plan or arrangement is the avoidance or evasion of Federal income tax, and subparagraph (B)(i) shall not apply to such an item unless the taxpayer believed that the treatment of such item on the return of the taxpayer was more likely than not the proper treatment.








D)

Fourth Version. The above revised version of the penalty was passed by the Senate as H.R. 4961 on July 12, 1982. On August 3, 1982, the House--Senate Conference Committee began considering the Bill and it, in turn, made several changes resulting in the fourth version. Specifically, the test for "substantial authority. under subsection (b)(2)(B)(i) was changed from a subjective test of "if the taxpayer believed" that there was substantial authority, asprovided in the Senate version, to an objective test of whether "there is or was" substantial authority for the treatment. Secondly, the "more likely than not" test of subsection (B)(2)(c) was modified from whether "the taxpayer believed" to whether "the taxpayer reasonably believed" that the treatment was more likely than not the proper treatment.




E)

1984 Amendment. The Deficit Reduction Act of 1984 amended section 6661(b)(2)(A) by providing that in determining the amount of the "understatement" of income tax for the taxable year, the excess of the amount of the tax required to be shown on the return for the taxable year, over the amount of the tax imposed which is shown on the return, is to be reduced by any rebate received (within the meaning of section 6211(b)(2)).




F)

1986 Amendments. Section 1504 of the Tax Reform Act of 1986 ("Tax Reform Act"), which became effective on October 22, 1986, increased the penalty for the substantial understatement of tax liability from 10 percent to 20 percent for returns due after December 31, 1986.

Section 8002 of the Omnibus Budget Reconciliation Act of 1986 ("Budget Act"), which became effective on October 21, 1986, provided for a further increase in the penalty to 25 percent, effective for penalties assessed after October 21, 1986.

These amendments were brought into apparent conflict when the President inadvertently signed the Budget Act (on October 21, 1986) before the Tax Reform Act (on October 22, 1986), even though Congress clearly intended that the Budget Act would repeal the Tax Reform Act's provisions. On November 6, 1986, the Service issued a press release (IR-86-149) stating that the 25 percent Budget Act rate applied to penalties assessed after October 21, 1986, with respect to returns due on or after January 1, 1983 (post-TEFRA returns).

In Notice 87-78, 1987-49 I.R.B. 36, the Service reaffirmed this rule and also provided that the 25 percent penalty rate will apply to substantial understatements of income tax on returns due on or after January 1, 1987 (regardless of extensions). Although section 115(c) of the Technical Corrections Bill of 1987 provides that the Budget Act rate of 25 percent takes effect as if the Tax Reform Act had been enacted on the day before enactment of the Budget Act, this Bill has yet to be passed by Congress.






APPENDIX B



Congressional History of "Substantial Authority" Under I.R.C. §6661



The section 6661 legislative history is contradictory as to Congress' understanding of the phrase "substantial authority." In the Senate debate of July 21, 1982, Senator Armstrong explained that "the term 'substantial authority' was selected because, I am advised, those words have in fact been litigated and have been the subject of judicial determination." 128 Cong. Rec., supra, at S8795. However, the subsequent statement of the Conference Committee is contrary:



The standard of substantial authority was adopted, in part, because it is a new standard. The conferees are unaware of any judicial or administrative decision interpreting the phrase "substantial authority." Thus, the courts will be free to look at the purpose of this new provision in determining whether substantial authority existed for a position taken in any particular case.

S. Conf. Rep. No. 530, 97th Cong., 2d Sess. 575 (1982).



In order to understand the meaning of this phrase, it is necessary to begin with the remarks of Senator Armstrong, who introduced the language. At the time he introduced the phrase, Senator Armstrong noted that, under the then current law, if a taxpayer hired a tax attorney or CPA to prepare his return, that alone was evidence of good faith and, ordinarily penalties for negligence or fraud were not asserted for under reporting of tax because the taxpayer had "relied on" his representative's advice. Under H.R. 4961 (second version), however, the standard was to be changed to impose a penalty for understatements unless the taxpayer believed that the treatment was "more likely than not" the correct one. Senator Armstrong's amendment, in his words, "splits the difference", Cong. Rec., supra, at S8792, between the then current law and the strict "more likely than not" standard, which he felt was too onerous. Senator Armstrong further elaborated on the meaning of the phrase "substantial authority" as follows:



[I]t should connote the factors which are taken into account in order to reach a decision. Those factors should include more than the unsupported opinion of a tax advisor, but less than the certainty implied by a test of "more likely than not" to ultimately prevail in litigation. As applied to the taxpayer penalty, if the taxpayer position is taken upon the advice of a tax advisor, a "substantial authority" waiver would require the further examination of the rationale on which the tax advisor based his advice...."

Id. at S8810. Thus, "it cannot just look right, sound right, or seem reasonable, but you have to be able to show that there is actually substantial authority for the tax treatment you are claiming." Id. at S8792 (emphasis added).



It is important to recognize, however, that the Conference Committee later changed the orientation of Senator Armstrong's "substantial authority" test from a subjective inquiry of whether the taxpayer "believed" that there was substantial authority, to an objective question of whether there "is or was" (fourth version) substantial authority. This change makes an important difference in application, since the test, as finally adopted, is not concerned with the bona fides of the taxpayer's position, or whether he actually "weighed" the authorities prior to taking his position; rather, it concerns only whether the requisite authority "existed for a position taken." Conf. Rep., supra, at 575. As finally adopted, the General Explanation of TEFRA explained "substantial authority" as follows:



Congress believed such a standard should be less stringent than a "more likely than not" (i.e., more than 50 percent) standard and more stringent than a "reasonable basis" (i.e., non-negligent) standard. This new standard will require that a taxpayer have stronger support for a position than a mere "reasonable basis." Thus, a taxpayer is required to have more support for his position than that it is arguable, but fairly unlikely to prevail in court upon a complete review of the relevant facts and authorities. Rather, when the relevant facts and authorities are analyzed with respect to the taxpayer's case, the weight of authorities that support the taxpayer's position should be substantial when compared with those supporting other positions.

General Explanation, supra, at 218.


1 See L.G.M., "Assertion of the I.R.C. §6661 Penalty in Increased Amounts in Accordance with 1986 Legislation" Jan. 22, 1988), for a discussion of the constitutionality of the retroactive application of the increased penalty rate.

2 For a summary of the Congressional history of the "substantial authority" standard, see Appendix B.

3 Final regulations under section 6661 (T.D. 8017, 1985-1 C.B. 376) were published in the Federal Register on March 27, 1985 (50 Fed. Reg. 12,012).



7 Its immediate derivation in section 6661 was from Treasury Circular 230. See 128 Cong. Rec. S8794-95 (daily ed. July 21, 1982) [hereinafter referred to as Cong. Rec.] for the comments of Senator Armstrong regarding the derivation of "more likely than not." Circular 230 first adopted the phrase in 1980 in a proposed amendment providing rules for the furnishing of opinions used in the promotion of tax shelters. 44 Fed. Reg. 58,594 (Sept. 4, 1980). The proposed rule would allow a practitioner to provide an opinion for a tax shelter only if the opinion concluded that it was "more likely than not" that the bulk of the tax benefits on the basis of which the tax shelter had been promoted were allowable under the tax law. Since then, the proposed rule has undergone two revisions (see 47 Fed. Reg. 56,144 (Dec. 15, 1982) and 49 Fed. Reg. 6,719 (Feb. 23, 1984)) and is currently codified at 31 C.F.R. §10.33. For a historical analysis of the Circular 230 amendments and the A.B.A.'s response in its Formal Opinion 346, see Schlenger & Watkins, Exploring the Myths of Circular 230, 62 TAXES 283 (1984).