Adequate Disclosure Avoids Sec. 6662 Penalty

In Rev. Proc. 2001-5, the IRS recently updated the circumstances under which disclosure of an item on a tax return was adequate for avoiding the Sec. 6662 20% substantial-understatement penalty. Generally, under Sec. 6662, there is a substantial understatement of income tax if the understatement amount for any tax year exceeds 10% of the tax required to be shown on the return for that year.

Normally, the understatement is reduced by the portion attributable to a particular item if there is either substantial authority supporting its treatment or adequate disclosure. An item is adequately disclosed when (1) the facts affecting the tax treatment of an item are disclosed on the taxpayer's return or on a statement attached to the return and (2) a reasonable basis exists for the taxpayer's treatment of that item.

A taxpayer can make disclosure on Form 8275, Disclosure Statement, or Form 8275-R, Regulation Disclosure Statement. However, in certain circumstances, disclosure on the tax return constitutes adequate disclosure. Disclosure is considered adequate if the taxpayer (1) clearly furnished all information required by the applicable forms and instructions, (2) disclosed the information on the return in an appropriate manner, (3) listed the items separately (rather than combining them) and (4) can verify the amounts entered on the forms. An amount is verifiable if, on audit, the taxpayer can demonstrate its origin and show that it acted in good faith in entering that amount on the form.

Under Rev. Proc. 2001-5, merely completing certain tax return schedules or providing other return information is sufficient. This includes (1) Schedule A, Itemized Deductions, (2) certain trade or business expenses consisting of casualty and theft losses, specific bad debt charge-off, reasonableness of officers' compensation, repair expenses and taxes and (3) Schedule M-1 items, Reconciliation of Income (Loss) per Books With Income per Return, given that "the information provided reasonably may be expected to apprise the Internal Revenue Service of the nature of the potential controversy concerning the tax treatment of the item." The revenue procedure also covers certain foreign tax items, moving expenses, employee business expenses and certain credits (when the taxpayer completes the appropriate form).

According to the IRS, disclosure is available when the appropriate forms "are completed in a clear manner and in accordance with their instructions. The money amounts entered on the forms must be verifiable, and the information on the return must be properly disclosed." For further information, see "Tax Trends," TTA, January 2002, p. 66.

From Jian Wu, New York, NY