For penalty calculation, amount of tax shown on return reduced by credits, Tax Court holds

The Tax Court held that the amount of tax shown on the taxpayers’ return was reduced by refundable credits, but not below zero, for purposes of calculating the Sec. 6662(a) accuracy-related penalty (Rand, 141 T.C. No. 12 (2013)). The court reached that conclusion even though the taxpayers were not entitled to the credits they had claimed.

The taxpayers had filed returns for 2006, 2007, and 2008 for which the IRS sent notices of deficiency.  The issues arising in the 2006 and 2007 tax years were settled by stipulation and only the issues arising in 2008 year were before the Tax Court. The taxpayers had claimed an earned income tax credit (EITC) and an additional child tax credit to which they agreed they were not entitled. The issue before the court was how to determine the “amount of tax required to be shown on [the] return,” for purposes of applying the 20% Sec. 6662(a) penalty. 

The taxpayers reported $18,148 of income on the return, including the wife’s $1,020 of income from self-employment as a tutor. Deducting the $10,900 standard deduction and $14,000 of personal exemptions reduced their taxable income to $0. They showed a tax on their return of $144 for the wife’s self-employment tax.

The taxpayers argued that the 20% penalty should be applied to the $144 of tax, but the IRS claimed that the penalty should apply to the full amount of the taxpayer’s deficiency, including the disallowed refundable credits, so that the base for the penalty was $8,127, resulting in a Sec. 6662(a) penalty of $1,625.

The Tax Court, however, came up with its own interpretation. The tax shown on the return, the Tax Court concluded, should be reduced by the credits at issue in this case, but not below $0. The phrase “tax shown on a return” occurs in the Code three times, the court explained, and it examined Sec. 6211(b), “Definition of a deficiency,” which defines the tax shown on a return as excluding certain credits. Because the specific credits in Sec. 6211(b) that are to be excluded did not include the EITC or the child tax credit, the court, applying the rules of statutory construction, concluded that the EITC and child tax credits were intended to be included. It similarly found that the credits could not create a negative tax for these purposes based on Sec. 6211(b)(4) and the rules of statutory construction.

The majority opinion also invoked the rule of lenity, which requires that statutes that impose a penalty be interpreted in favor of more lenient punishment.

In a dissenting opinion joined by two other judges, Judge David Gustafson objected to the conclusion that the amount shown as the tax by taxpayers on their return should be reduced by credits that the taxpayers admitted they did not qualify for. In his opinion, the tax shown on the return, for purposes of Sec. 6662(a), was the $144 tax actually shown on the return.

The dissenting judges concluded that, because the taxpayers showed a total tax of $144 on their return, there was no underpayment under Sec. 6664(a) and, thus, no penalty could be imposed under Sec. 6662(a).   

—Sally P. Schreiber (sschreiber@aicpa.org) is a JofA senior editor.