Taxpayer Penalties

Tax return preparers are often asked by their clients to view a controversial treatment in a favorable light. Under the law, both taxpayers and their preparers may face penalties if they cannot support a tax treatment used in a return.

Under IRC section 6662, taxpayers who understate their income tax liability by more than 10% or $5,000 (whichever is greater) are subject to a 20% accuracy-related penalty.

Preparers who agree to take a position that does not have a realistic possibility of being sustained on its merits are subject to penalties under IRC section 6694.

In general, penalties to taxpayers and preparers may be avoided if the taxpayer can show good faith for the position taken and can demonstrate that the following are present:

• Substantial authority supporting the position.
• Disclosure of all relevant facts affecting the tax treatment.
• Reasonable basis for such treatment.

The disclosure test is easily met by filling out form 8275 and attaching it to the return. But beware, this form is a red flag that significantly increases the chances a return will be audited. On the other hand, return preparers who fail to use form 8275 must advise clients of any penalties that may result from their taking an aggressive position.

In such cases a taxpayer must be certain that the position taken has “substantial authority”—a term preparers have had difficulty defining. Do you need substantial authority to support your initial interpretation of the facts or the court’s ultimate interpretation of the facts? Now the Sixth Circuit Court of Appeals has answered this question and made it easier for taxpayers to avoid the 20% penalty.

Estate of Robert G. Kluener, et al. v. Commissioner, CA-6 (9-9-98), illustrates how courts interpret substantial authority. In this case the taxpayer was the sole shareholder, CEO and director of a corporation that had significant net operating loss carryovers. He owned thoroughbred horses, worth more than $2 million, which he intended to sell. His tax advisers had cautioned him that a direct sale would be taxable to him personally. So, on their advice, Kluener transferred ownership of the horses to his corporation and had it sell them for $2.2 million, offsetting the gain with its losses and paying no taxes. The corporation then distributed the $2.2 million to him as a tax-free return of capital—enabling him, thus, to use this treatment as a tax shelter.

The Tax Court disagreed with the taxpayer’s interpretation of the facts and found that he, not his corporation, should be taxed on the gain. The Tax Court agreed with the IRS that the 20% accuracy-related penalty should be imposed. The taxpayer’s estate contested the penalty arguing that substantial evidentiary authority supported the initial tax treatment of this transaction.

On appeal, the question before the Sixth Circuit was whether the word “authority” included factual evidence as well as legal sources. The IRS argued factual evidence couldn’t provide substantial authority because regulations section 1.6662-4(d)(3)(iii) is prefaced by the wording, “Only the following are authority.” The section then lists only legal sources of authority. The court interpreted this to mean that certain types of legal sources are excluded but examination of factual evidence is mandated.

The Sixth Circuit concluded that, based on the taxpayer’s reasonable view of the facts, he had substantial authority to structure the transaction as proposed. This new test of “substantial evidentiary authority” (Can you support your initial view of the facts?) not only makes it easier to avoid the substantial underpayment penalty but also makes it easier for tax return preparers to decide not to file a form 8275.

Observation. IRC section 6662(d) (2)(C)(iii) provides stringent rules concerning tax shelters. A tax shelter is defined as an arrangement for avoiding or evading federal income tax. Therefore, to avoid penalties, a taxpayer must reasonably believe that the tax treatment used was more likely than not—meaning with a greater than 50% probability—the proper tax treatment. For their part, tax return preparers should support only treatments by the taxpayer that can be substantiated on their own merits.

—Michael Lynch, CPA, Esq.,
associate professor of tax accounting at
Bryant College, Smithfield, Rhode Island.