Substantial authority under TEFRA

The Joint Tax Committee explained the term "substantial authority" when it was added as a standard for the section 6662 negligence penalty (previously, section 6661). It is instructive for the used of that term under section 6694(a)(2)(A), recently enacted under the Emergency Economic Stabilization Act of 2008 on October 3, 2008. Most of this legislative explanation is found in the current section 6662 regulations. The "substantial authority" standard is not an easy standard to meet because it has to be supportd by a credible analysis of the relevant authorities. I am struck with the statement that the "substantial authority" standard will not be met when the position taken is "fairly unlikely to prevail in court upon a complete review of the relevant facts and authorities." For this reason, the "substantial authority" is arguably met if it is "fairly likely" that the position would prevail and if one cannot determine if one is fairly likely to either prevail or not prevail.

The proposed regulations on 6694 refer to the section 6662 definitions. For this reason, this legislative report will likely be used in 6694 cases in the forward years. Although we are working with a legislative nuance, in the real world, you can expect the IRS examiners to be very aggressive on this discretionary issue. Further, most mistakes made by return preparers are "negligence" mistakes or careless mistakes, including inadequate substantiation of expenses and deductions or missing items of income that should have been reported. These mistakes will always justify the 6694 penalty, including the $5,000 6694(b) penalty. These mistakes will likely incur the 6694(a) penalty even for disclosed positions.

JCT-DOC, JCS- 38-82, General Explanation of the Revenue Provisions of the Tax Equity and Fiscal Responsibility Act of 1982, JCS-38-82, (December 31, 1982)



d. Penalty for substantial understatement (sec. 323 of the Act and new sec. 6661 of the Code) *



Prior Law


Under both prior and present law, a penalty is imposed on the failure to pay certain taxes shown on a return (or if not paid within 10 days of notice and demand, an amount of tax required to be shown on a return) unless it is shown that such a failure to pay is due to reasonable cause and not willful neglect. If any portion of an underpayment of tax is due to negligence or intentional disregard of rules and regulations (negligence) but without intent to defraud, the addition to tax is equal to 5 percent of the entire underpayment. In addition, if the negligence penalty applies, an additional amount equal to 50 percent of the interest payable on that portion of the underpayment due to negligence, for the period running from the last date prescribed for payment of the tax (determined without regard to extensions) to the date the tax is paid, is imposed.

If any portion of an underpayment is due to fraud, then an addition to tax equal to 50 percent of the underpayment is imposed and (in the case of the income and gift taxes) the negligence penalty cannot be imposed. Further, if the fraud penalty is imposed, no penalty for failure to timely file a return or pay the tax may be imposed. Reasonable reliance on the advice of a tax advisor generally will prevent application of the fraud and negligence penalties.

In 1981, Congress enacted a "no-fault" penalty on valuation overstatements. Generally, under that provision, if a taxpayer makes a large error in placing too high a value on property which results in an understatement of tax, then a penalty measured as a percentage of the underpayment resulting from the valuation overstatement is imposed. Although the penalty is imposed without regard to fault, the Secretary may waive all or part of the penalty if there was a reasonable basis for the valuation and it was claimed in good faith. This penalty does not apply in the case of an overvaluation of services.


Reasons for Change


Congress believed that an increasing part of the compliance gap is attributable to taxpayers playing the "audit lottery." The audit lottery is played by taxpayers who take questionable positions not amounting to fraud or negligence on their returns in the hope that they will not be audited. If the taxpayer is audited and the questionable position challenged, then the taxpayer pays the additional tax owing plus interest. Under prior law, taxpayers were, generally, not exposed to any downside risk in taking questionable positions on their tax returns since resolution of the issue against the taxpayer required only payment of the tax that should have been paid in the first instance with interest to reflect the cost of the "borrowing." Taxpayers relied on opinions of tax advisors to avoid the possibility of fraud or negligence penalties in taking such questionable positions, even though the advisor's opinion may have clearly indicate that if the issue were challenged by the Internal Revenue Service, the taxpayer would probably lose the contest. Thus, in the event that the questionable position was not detected, the taxpayer achieved an absolute reduction in tax without cost or risk.

Congress believed, therefore, that taxpayers should be deterred from playing the audit lottery through the imposition of a penalty designed to deter the use of undisclosed questionable reporting positions. On the other hand, the Congress recognized that taxpayers and the Government may reasonably differ over the sometimes complex Federal tax laws, and that a penalty is not appropriate in many cases in which there is a large underpayment because there was substantial authority for the taxpayer's position. Finally, Congress believed that taxpayers investing in tax shelters should be held to a higher standard of care in determining the tax treatment of items arising from the shelter or risk a significant penalty.


Explanation of Provision


In general, under the Act, when there is a substantial understatement in income tax for any taxable year attributable to a filing position not disclosed by the taxpayer in the return, or for which the taxpayer did not have substantial authority, an addition to tax equal to 10 percent of the underpayment attributable to such understatement is imposed.

For this purpose, an understatement of income tax is the excess of the amount of income tax imposed on the taxpayer for the taxable year, over the amount of tax shown on the return. An understatement of income tax is substantial if the understatement for the taxable year exceeds the greater of 10 percent of the tax required to be shown on the return for the taxable year or $5,000 ($10,000 for corporations other than subchapter S corporations and personal holding companies). Thus, for example, in 1982 a married couple filing jointly would not be subject to the penalty unless they have taxable income in excess of approximately $27,900 and report no tax liability whatever. Similarly, a corporation would need a taxable income of approximately $30,300 (in 1982) before it could be subject to the penalty. Congress believed it was appropriate to exclude low and moderate income taxpayers from the scope of the penalty because of the greater access of higher income taxpayers to professional tax advice.

In determining whether an understatement is substantial, the amount of the understatement is reduced by any portion of the understatement attributable to the treatment of any item if (1) the treatment of the item on the return is or was supported by substantial authority or (2) in non-tax shelter cases, all of the facts relevant to the tax treatment of the item were disclosed on the return or in a statement attached to the return. Whether the taxpayer's filing position is or was supported by substantial authority depends on the circumstances of the particular case. It is necessary to weigh statutory provisions, court opinions, Treasury regulations and official administrative pronouncements (such as published revenue rulings and revenue procedures) that involve the same or similar circumstances and are otherwise pertinent (giving each its proper weight), as well as the Congressional intent reflected in the committee reports, to determine whether a particular position is supported by the law and may be taken with the good faith expectation that it reflects the proper treatment of the item. Congress did not adopt an absolute standard that a taxpayer may take a position on a return only if, in fact, the position reflects the correct treatment of the item because, in some circumstances, tax advisors may be unable to reach so definitive a conclusion. Rather, Congress adopted a more flexible standard under which the courts may assure that taxpayers who take non-disclosed highly aggressive filing positions are subject to the penalty while those who endeavor in good faith to fairly self-assess are not penalized.

The standard of substantial authority was adopted, in part, because it is a new standard. Congress was unaware of any relevant judicial or administrative decision interpreting the phrase "substantial authority." It was intended that the courts 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. 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 the authorities that support the taxpayer's position should be substantial when compared with those supporting other positions. In determining whether a position is supported by substantial authority, the courts are not bound by the conclusions reached in law review articles, opinion letters, or private letter rulings or determination letters and technical advice memoranda of the Internal Revenue Service issued to or concerning a third party, but will instead examine the authorities that underlie such expressions of opinion. Similarly, when a partner in a partnership or a shareholder of an S corporation treats an item on his or her return in a manner consistent with the treatment of the item on the return of the partnership or corporation, it will be necessary to examine the authorities that underlie the position taken on the partnership's or S corporation's return.

The substantial understatement penalty in non-tax 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. This disclosure relief permits taxpayers to avoid the penalty when there is uncertainty as to whether there is substantial authority for the treatment of the item. Under generally applicable regulatory authority, the Commissioner may prescribe the form of such disclosure. In no event, however, may such regulations require disclosure of attorney or accountant's work-papers. Disclosure is adequate if the taxpayer discloses facts sufficient to enable the Internal Revenue Service to identify the potential controversy, if it analyzed that information. This standard was intended to require greater disclosure than is necessary to avoid the six-year statute of limitations provided for in section 6501(e)(1)(A). For example, if a taxpayer has less than substantial authority for the position that an amount received was a business gift and therefore not includable in income, he may avoid a penalty by attaching a readily identifiable statement to his tax return disclosing the amounts received and the name and business relationship of the payor. Also, a taxpayer taking a bad debt deduction in a particular year, when there is a question as to the correct year in which the loss is allowable, could avoid the penalty by disclosing the relevant facts to the Secretary.

With respect to tax shelter items, the penalty may be avoided only if the taxpayer establishes that, in addition to having substantial authority for his position, he reasonably believed that the treatment claimed was more likely than not the proper treatment of the item. For this purpose, a tax shelter is a partnership or other entity, plan or arrangement the principal purpose of which, based on objective evidence, is the avoidance or evasion of Federal income tax. Congress believed that if the principal purpose of a transaction is the reduction of tax, it is not unreasonable to hold participants to a higher standard than ordinary taxpayers. Congress was also aware, however, that no reasonably informed business decision is made without regard to its tax effects.

The Secretary may waive the penalty with respect to any item if the taxpayer establishes reasonable cause for his treatment of the item and that he acted in good faith. A waiver could be appropriate, for example, if the taxpayer made a good faith mistake in deciding the proper timing of a deduction.

The Act establishes no special procedural rules with respect to the application of the substantial underpayment penalty. Thus, the usual deficiency procedures apply with respect to assessment and collection of the penalty. In litigation concerning liability for the penalty (including whether there is or was substantial authority for a position), the burden of proof falls upon the taxpayer.

Finally, this penalty applies only to that portion of the substantial understatement attributable to items on which the overvaluation penalty under section 6659 is not imposed.


Effective Date


This penalty is effective with respect to returns due after December 31, 1982 (without regard to extensions).

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The above legislative history is worth keeping as guidance and review when decisions are being made on positions that will be taken in the 2008 tax year and the tax years beyond 2008.

The main lesson to learn from the above legislative history is to make sure your tax research on a position is complete and comprehensive. If you need technical assistance, get that guidance as soon as a probematical position is identified. One of the goals of all tax return preparers going forward is to make sure you identify problematical factual and legal issues that should be made the subject of a resarch and analysis project.

Send requests for guidance to ab@irstaxattorney.com