Editor: Jon Almeras, J.D., LL.M.
Procedure & Administration
The Internal Revenue Code imposes an accuracy-related penalty on understatements of tax. In many cases, the basic formula for calculating this penalty is relatively straightforward; however, calculating a penalty can quickly become a complex and sometimes daunting task that requires careful consideration and insight.
When calculating the accuracy-related penalty, one must determine the correct amount of tax and whether any penalty defenses apply. If multiple adjustments are made to a taxpayer’s return, then multiple penalties may need to be coordinated. The penalty calculation can become even more complex when multiple years are involved. Net operating loss (NOL) carrybacks and carryovers further complicate the calculation.
This item offers insight into some of the complexities of calculating the accuracy-related penalty.
Sec. 6662: The Basics
A 20% accuracy-related penalty will be imposed on any portion of an underpayment to which Sec. 6662 applies. There are a number of Sec. 6662 accuracy-related penalties, including:
- Negligence or disregard of rules or regulations (Sec. 6662(b)(1));
- A substantial understatement of income tax (Sec. 6662(b)(2));
- A substantial valuation misstatement under chapter 1 of the Code (normal taxes and surtaxes) (Sec. 6662(b)(3));
- A substantial overstatement of pension liabilities (Sec. 6662(b)(4)); and
- A substantial estate or gift tax valuation understatement (Sec. 6662(b)(5)).
In certain circumstances, the accuracy-related penalty rate is 40%. These circumstances include:
- A gross valuation misstatement (Sec. 6662(h));
- An underpayment attributable to one or more undisclosed transactions lacking economic substance (Sec. 6662(i)); or
- An understatement attributable to a transaction involving an undisclosed foreign financial asset (Sec. 6662(j)).
Each of the above penalties applies only to the portion of an underpayment attributable to the particular type of misconduct. Imposing multiple accuracy-related penalties with respect to the same underpayment—commonly referred to as “stacking”—is not permitted. The maximum accuracy-related penalty imposed on any portion of an underpayment is 20% (40% if one of the circumstances listed above exists) even if more than one penalty applies to that portion. For example, if a portion of an underpayment of tax is attributable to both a substantial understatement and a gross valuation misstatement, the maximum accuracy-related penalty is 40% of the underpayment, rather than a combined 60%.
Although there are a number of separate penalties contained in Sec. 6662, this item focuses primarily on the substantial understatement of income tax in Sec. 6662(d). Essentially, a substantial-understatement penalty is imposed when a taxpayer fails to report the correct amount of tax on its return and the resulting understatement exceeds a threshold amount.
Calculating the Substantial-Understatement Penalty
Sec. 6662(b)(2) imposes a 20% penalty on any portion of an underpayment of income tax required to be shown on a tax return that is attributable to a substantial understatement of income tax. An understatement of tax is defined in Sec. 6662(d) as the difference between the amount of tax the taxpayer was required to report on the tax return for the year and the amount of tax actually reported by the taxpayer on the tax return (minus any rebates). In other words: Understatement = X − (Y − Z), where X is the amount of tax required to be shown on the return, Y is the amount of tax shown on the return, and Z is any rebate. The amount of the understatement can be reduced by the defenses described below.
For corporate taxpayers, other than S corporations or personal holding companies, an understatement of income tax is substantial if its amount for the tax year exceeds the lesser of (1) 10% of the tax required to be shown on the return for the tax year (or, if greater, $10,000) or (2) $10 million. For other taxpayers, an understatement of income tax is substantial if its amount for the tax year exceeds the greater of (1) 10% of the tax required to be shown on the return for the tax year or (2) $5,000.
Sec. 6662(d) Defenses
Under Secs. 6662(d)(2)(B)(i) and (ii), taxpayers can avoid the substantial-understatement penalty for non–tax shelter items by either (1) establishing that substantial authority exists for the treatment of the item or (2) adequately disclosing the relevant facts affecting the item’s tax treatment in the return or in a statement attached to the return (i.e., Form 8275, Disclosure Statement) and establishing that there is a reasonable basis for the tax treatment of the item.
Substantial authority is an objective standard that requires an analysis and application of the law to the relevant facts. The substantial-authority standard is less stringent than the more-likely-than-not standard (a greater than 50% likelihood that the position will be upheld) but more stringent than the reasonable-basis standard (defined in Regs. Sec. 1.6662-3(b)(3)). The tax treatment of an item has substantial authority only if the weight of the authorities supporting the treatment is substantial in relation to the weight of the authorities supporting contrary treatment. To avoid the substantial-understatement penalty, substantial authority must exist either at the time the return containing the applicable item is filed or on the last day of the tax year to which the return relates (Regs. Sec. 1.6662-4(d)).
Disclosure is deemed adequate if it is made on a properly completed form attached to the return or to a qualified amended return for the tax year. In the case of an item or position that is not contrary to a regulation, disclosure must be made on Form 8275; however, a position or item contrary to a regulation must be disclosed on Form 8275-R, Regulation Disclosure Statement (Regs. Sec. 1.6662-4(f)). Note that with the introduction of the uncertain tax position (UTP) disclosure requirement, for affected corporations, a complete and accurate disclosure of a tax position on the appropriate year’s Schedule UTP, Uncertain Tax Position Statement, is treated as if the corporation had filed a Form 8275 or 8275-R regarding the position. A separate Form 8275 or 8275-R does not need to be filed to avoid certain accuracy-related penalties with respect to that tax position (see Announcement 2010-75 and Schedule UTP instructions). As noted above, disclosure of a return position is not sufficient by itself to avoid a substantial-understatement penalty. The taxpayer must establish there is a reasonable basis for the tax treatment of the item. A tax return position will generally satisfy the reasonable-basis standard if the return position is reasonably based on one or more of the authorities set forth in Regs. Sec. 1.6662-4(d)(3)(iii), even though it might not satisfy the substantial-authority standard.
Adequate disclosure can also be made on a qualified amended return. A qualified amended return is an amended return, or a timely request for an administrative adjustment, filed after the due date of the return and before the earliest of certain dates (including the date the taxpayer is first contacted by the IRS about an examination, including a criminal investigation, of the return) (Regs. Sec. 1.6664-2(c)(3)).
As this item discusses later, carrybacks and carryovers can complicate the computation of penalties. Note that the disclosure requirement for an item included in any loss, deduction, or credit that is carried to another year must be met in the year the carryback or carryover arises. Disclosure is not required in the year the carryback or carryover is used (Regs. Sec. 1.6662-4(f)(4)).
Rev. Proc. 94-69 allows Coordinated Industry Case (CIC, formerly Coordinated Examination Program) taxpayers to make a disclosure at the beginning of an audit cycle. Specifically, a written statement provided by a CIC taxpayer to the IRS is treated as a qualified amended return if the statement is provided after the tax return has been filed but no later than 15 days (or any later date agreed to in writing by the appropriate district official upon a showing of reasonable cause) from the date of written notice from the IRS to the taxpayer requesting the statement to be furnished with respect to the tax year(s) involved.
In addition, the reasonable-cause and good-faith exception of Sec. 6664 can provide additional relief from an accuracy-related penalty even if a return position does not satisfy the reasonable-basis standard. Sec. 6664(c) provides that no penalty will be imposed under Sec. 6662 for any portion of an underpayment of tax (other than by a transaction lacking economic substance under Sec. 7701(o) or certain valuation overstatements) for which the taxpayer shows that there was reasonable cause and the taxpayer acted in good faith. That conclusion is made on a case-by-case basis, taking into account all pertinent facts and circumstances. Generally, the most important factor is the taxpayer’s efforts to assess the proper tax liability. Reliance on professional tax advice constitutes reasonable cause and good faith if, under all the circumstances, the reliance was reasonable and made in good faith (Regs. Sec. 1.6664-4(c)).
Calculating the Understatement
The steps for calculating a substantial-understatement penalty are:
Step 1: Compute the tax required to be shown on the return (minus any rebates).
Step 2: Determine the amount of tax actually reported on the return. Include adjustments for which there is substantial authority or adequate disclosure.
Step 3: Calculate the understatement (Step 1 − Step 2).
Step 4: Determine whether the understatement in Step 3 is substantial: for corporations, if it exceeds the lesser of (1) 10% of the tax required to be shown on the return or, if greater, $10,000; or (2) $10 million. For other taxpayers, if it exceeds the greater of (1) 10% of the tax required to be shown on the return, or (2) $5,000.
Step 5: If the understatement is substantial, calculate the penalty. Multiply the tax underpayment caused by the substantial understatement by 20%.
Example 1. Calculating the understatement: In 2012, ABC Corp. files its 2011 federal income tax return showing a taxable income of $20 million and a tax liability of $7 million (reflecting a tax rate of 35%). The IRS examines ABC’s return, resulting in a $40 million increase to taxable income and a $14 million increase to tax liability. Part of the adjustment increases taxable income by $5 million for an item for which there was substantial authority.
Step 1: The amount of tax required to be shown on ABC’s return is $21 million, i.e., the tax on $60 million ($20 million on the original return plus the $40 million increase to taxable income as a result of the IRS examination).
Step 2: The amount of tax shown on ABC’s return is determined as if the item for which there was substantial authority had been given the proper tax treatment. The amount of tax shown on the return is $7 million (the tax on the $20 million taxable income actually shown on ABC’s return), plus $1.75 million (the tax on the $5 million adjustment for which there was substantial authority), for a total of $8.75 million.
Step 3: The amount of understatement is $12.25 million, i.e., $21 million (the amount of tax required to be shown), less $8.75 million (the amount treated as shown on ABC’s return after adjustment for the item for which there was substantial authority).
Step 4: The $12.25 million understatement exceeds the lesser of (1) 10% of the tax required to be shown on the return for the tax year, i.e., $2.1 million ($21 million × 10%) (or, if greater, $10,000) or (2) $10 million. Therefore, ABC Corp. has a substantial understatement of income tax for the year.
Step 5: Because the understatement is deemed substantial, the penalty is computed at 20%. Therefore, the penalty is $2.45 million ($12.25 million × 20%).
Coordinating the Penalties
As noted above, a taxpayer with multiple adjustments to its tax return could be in a situation where each adjustment is subject to a different penalty. For example, a taxpayer could find itself with certain adjustments subject to a 20% negligence penalty and other adjustments subject to a 40% gross valuation misstatement penalty. Regs. Sec. 1.6664-3 provides rules for determining the order in which adjustments to a tax return are taken into account for the purpose of computing the total amount of penalties imposed in the following instances:
- There are at least two adjustments, but only one adjustment is subject to a penalty; or
- There are at least two adjustments subject to penalties, and the penalties are imposed at different rates.
According to Regs. Sec. 1.6664-3(b), adjustments are made in the following order:
- Those with respect to which no penalties have been imposed.
- Those with respect to which a 20% penalty has been imposed.
- Those with respect to which a 40% penalty has been imposed.
- Those with respect to which a 75% penalty has been imposed.
Example 2. Coordination among penalties: ABC Corp. reported $5 million of taxable income on its federal income tax return and is in a 35% tax bracket. After examining ABC Corp.’s tax return, the IRS proposed three adjustments. The first adjustment has no penalty associated with it. The second adjustment is subject to the 20% substantial-understatement penalty. The third adjustment is subject to a 75% fraud penalty. The amount of each adjustment and the computation of the taxpayer’s understatement of its tax liability are shown in Exhibit 1.
The steps to calculate the total amount of penalties according to Regs. Sec. 1.6664-3 are:
Step 1: Adjustments not subject to a penalty: Determine the portion, if any, of the underpayment on which no penalty is imposed (see Exhibit 2).
Step 2: Adjustments subject to 20% penalty: Determine the portion, if any, of the understatement on which the 20% penalty is imposed (see Exhibit 3).
Step 3: Adjustments subject to 75% penalty: Determine the portion, if any, of the understatement on which the 75% penalty is imposed (see Exhibit 4).
Step 4: Determination of whether understatement is substantial: The $1.05 million understatement exceeds the lesser of (1) 10% of the tax required to be shown on the return for the taxable year, i.e., $490,000 ($4.9 million × 10%) (or, if greater, $10,000); or (2) $10 million. Therefore, the taxpayer has a substantial understatement of income tax for the year.
Step 5: Calculation of penalty: Multiply the penalty rate by each portion of the underpayment of tax subject to that penalty (see Exhibit 5).
Impact of NOL Carrybacks or Carryovers
Calculating penalties is more complicated with NOL carrybacks and carry-overs. As stated above, an accuracy-related penalty may apply if a taxpayer underpays its tax liability for the year. Thus, if a taxpayer has a loss in a year and, after the IRS proposes adjustments reducing the amount of the loss, the taxpayer remains in a loss position, an accuracy-related penalty will not be assessed. However, if that loss was carried back or over to another year to reduce the taxable income in that year, then an understatement of tax and accuracy-related penalty may result because the IRS adjustments to the loss year reduced the NOL amount.
The substantial-understatement penalty applies to any portion of an underpayment for a year to which a loss, deduction, or credit is carried that is attributable to a “tainted item” for the year in which the carryback or carryover of the loss, deduction, or credit arises (the “loss or credit year”) (Regs. Sec. 1.6662-4(c)(1)). Thus, whether an understatement is substantial for a carryback or carryover year is determined with respect to the tax return for the carryback or carryover year. Tainted items are taken into account with items arising in a carryback or carryover year to determine whether the understatement is substantial for that year (Regs. Sec. 1.6662-4(c)(1)).
Except in the case of a “tax shelter item” (see Regs. Sec. 1.6662-4(g)) a “tainted item” is any item arising in the loss or credit year for which there is neither substantial authority nor adequate disclosure (Regs. Sec. 1.6662-4(c)(3)(i)). A tax shelter item is “tainted” if, with respect to the loss or credit year, it lacks both substantial authority and a reasonable belief that its tax treatment is more likely than not proper (Regs. Sec. 1.6662-4(c)(3)(ii)).
Although a loss, deduction, or credit that is carried back or carried over to another tax year could result in the imposition of a substantial-understatement penalty in the carryback or carryover year, a taxpayer cannot reduce a substantial understatement for a carryback year by an allowable carryback of a loss, deduction, or credit to that year (Regs. Sec. 1.6662-4(c)(2)). A similar rule applies for the valuation misstatement penalty. The penalty for a substantial or gross valuation misstatement applies to any portion of an underpayment for a year to which a loss, deduction, or credit is carried that is attributable to a substantial or gross valuation misstatement for the year in which the carryback or carryover of the loss, deduction, or credit arises (see Regs. Sec. 1.6662-5(c)(1)).
Example 3. Adjustments do not overcome NOL; no carryback/over: ABC Corp. reported a current-year loss of $4.5 million on its year 1 original income tax return. ABC excluded from its year 1 income a $2.5 million payment it received as a return of capital. An IRS examination determined that the $2.5 million payment was actually a dividend and was includible in ABC’s year 1 taxable income. After adjustment, ABC’s taxable income is shown in Exhibit 6.
It is determined that there was no substantial authority to exclude the $2.5 million payment from ABC’s year 1 income. Moreover, ABC did not attach a Form 8275 to its year 1 tax return to disclose the position, and ABC does not meet the reasonable-cause and good-faith exception of Sec. 6664.
Although the adjustment to ABC’s year 1 taxable income reduces its NOL, the adjustment does not result in ABC’s incurring taxable income for year 1. Because the accuracy-related penalty is based on an understatement of tax and ABC does not owe any tax for year 1, it is not subject to an accuracy-related penalty for the year. However, if this loss is carried over or back to another year, an accuracy-related penalty may apply in the carryback or carryover year.
Example 4. Adjustments do not overcome NOL; loss carried over to another year: In year 2, ABC reported income on its originally filed return but used the NOL from year 1 to offset the income (see Exhibit 7).
ABC’s underpayment of income tax for year 2 attributable to the year 1 NOL adjustment is calculated as shown in Exhibit 8.
As discussed above, the substantial-understatement penalty can apply to a carryover year as a result of “tainted items” from a loss year. The tainted items are taken into account with items arising in the carryback or carryover year to determine whether the understatement is substantial for that year. The adjustment to the year 1 NOL is considered a tainted item because there was neither substantial authority for the position nor adequate disclosure.
ABC’s understatement of its year 2 tax liability is substantial, since it exceeds 10% of the tax required to be shown on the return for the tax year and exceeds $10,000. As a result, ABC is subject to a penalty of $175,000 ($875,000 × 20%).
At first glance, the formula for calculating the substantial-understatement penalty seems straightforward and easy, but numerous factors may cause complications. Because applicable defenses, coordination with other penalties, and carryback and carryover implications may increase the complexity, practitioners must exercise care in computing and verifying penalty amounts.
Jon Almeras is a tax manager with Deloitte Tax LLP in Washington, D.C.
For additional information about these items, contact Mr. Almeras at 202-758-1437 or firstname.lastname@example.org.
Unless otherwise noted, contributors are members of or associated with Deloitte Tax LLP.