Navigating the Shoals of IRS Penalty Abatement - part 2 - types of defense - John R. Dundon II, Enrolled Agent
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Navigating the Shoals of IRS Penalty Abatement – part 2 – types of defense

The Perturbing New Treatment of Patents Under the Tax Cut & Jobs Act (TCJA)

Navigating the Shoals of IRS Penalty Abatement – part 2 – types of defense

Navigating the Shoals of IRS Penalty Abatement – part 2 – types of defense.

Now that you may have missed the income tax filing and payment deadline perhaps it is a good time to understand how to cope with penalization as it can get woefully expensive – not to mention mind numbing – if you go about it have baked.

There are a handful of defenses you can attempt to assert when it comes to navigating the shoals of IRS penalty abatement, chose with care and proper counsel.

The key IMHO is to comport yourself with law abiding dignity whilst deliberately navigating through these general options, including:

Reasonable Basis Defense

  • The negligence penalty does not apply if the position on the return has a reasonable basis.
  • Reasonable basis is a relatively high standard of tax reporting that falls between being not frivolous and the substantial authority standard.
  • As per Reg. §1.6662-3(b)(3) – it is a position based on one or more authorities and is not necessarily satisfied by a return position that is merely arguable.

Adequate Disclosure Defense

  • As per Reg. §1.6662-3(c)(1) – you can indeed take a position that is contrary to a rule or regulation and not be subject to the negligence penalty if you have both a reasonable basis AND adequate disclosure.
  • Adequate disclosure alone is not a sufficient defense.
  • Generally, if you reasonably base a return position on one or more valid authorities, the position generally satisfies the reasonable basis standard.
  • The disclosure exception provided in Reg. §1.6662-3(c)(1) does not apply if you do NOT keep adequate books and records or cannot properly substantiate an item on the return.
  • If you have a reasonable basis, use IRS Form 8275, Disclosure Statement, to adequately disclose a position taken on a return.
  • If the return position is contrary to a regulation, use IRS Form 8275-R, Regulation Disclosure Statement, instead.
  • The IRS issued Rev. Proc. 2014-15, which updated Rev. Proc. 2012-51 and identified the circumstances under which disclosure of information on your income tax return is adequate for purposes of reducing the accuracy-related penalty.
  • Depending on facts and circumstances, you might consider disclosing an item (or group of items) in any of the following circumstances.
    • You are trying to avoid all penalties.
    • You base an item or position on an unresolved area of law and there is little or no authority for the position.
    • The amount of tax due is substantial if the IRS prevails.
    • The item or position is contrary to IRS rules or regulations and reasonable basis exists for the position.

TurboTax Defense

  • My go to source on this is Brenda F. Bartlett vs. Commissioner, TC Memo 2012-254.
  • Here the court noted that TurboTax is only as good as the information entered into its software program.
  • Simply put: garbage in, garbage out.

Good Faith Defense

  • The negligence penalty does not apply if you had reasonable cause and acted in good faith according to Reg. §1.6662-3(b)(3).
  • Interestingly enough – the IRC and IRS do not provide guidance as to what ‘is’ a reasonable cause as it depends on the facts and circumstances of each case.
  • If you do not have substantial authority for a position or failed to adequately disclose the position, the substantial understatement penalty does not apply if you had reasonable cause and acted in good faith §6664(c) and Reg. §1.6664-4(a).
  • The IRC nor IRS provide guidance as to what is reasonable cause and depends on the facts and circumstances of each case.

Substantial Authority Defense

  • As per Reg. §1.6662-4(d)(1) the IRS does not assess the understatement penalty if you can prove there was substantial authority for the tax treatment of the item that caused the understatement
  • The substantial authority standard is an objective standard, which involves an analysis of the law and relevant facts.
  • It is less stringent than the more-likely-than-not standard but is more stringent than the reasonable basis standard.
  • The possibility that the IRS will not audit a return or, if they audit it, they will not raise the item on audit is not relevant in determining whether you satisfy the substantial authority standard.
  • You meet the more-likely-than-not standard when there is a greater than 50% likelihood the position is upheld.
  • Substantial authority is present if the weight of the authorities supporting the treatment is substantial in relation to the weight of the authorities supporting a contrary treatment
    • The weight given to a particular authority depends on its relevance and persuasiveness.
    • You cannot establish substantial authority using treatises, IRS publications, articles, legal opinions, or opinions of tax professionals.
    • However, the actual underlying authorities contained in the guidance can give rise to substantial authority if relevant to the facts of a particular situation.

Once an understatement is calculated, it must be determined whether the understatement is substantial.

As per §6662(d)(1)(A) for an individual, an understatement is substantial if it exceeds the greater of:

  • 10% of the tax required to be shown on the return.
  • $5,000.

As per §6662(d)(1)(B) for corporations (other than an S corporation or personal holding company), an understatement is substantial if it exceeds the lesser of:

  • 10% of the tax required to be shown on the return (or, if greater, $10,000).
  • $10,000,000.

If a partnership or S corporation takes a position on its return, the partner or shareholder determines whether there is a substantial understatement.

Bottom line – chose your defense wisely and deliberately after considering all the facts and circumstances.

For more information on this please feel welcome to contact me at your convenience.