IRS Releases 2006 "Adequate Disclosure" Guidelines

In general, Rev. Proc. 2006-48 provides guidance in determining when disclosure is adequate for purposes of reducing a tax understatement under Secs. 6662(d)(2) and 6694(a)(3). It does not apply to any other penalty provisions, such as the disregard provision, which are subject to an adequate disclosure exception. Taxpayers must furnish all required information in accordance with the applicable forms and instructions, and the amounts entered on the forms must be verifiable.

Law

If Sec. 6662 applies to any portion of a tax underpayment required to be shown on a return, 20% of the portion of the underpayment to which the section applies is added to the tax; the penalty rate is 40% for certain gross valuation misstatements. Under Sec. 6662(b)(2), Sec. 6662 applies to the portion of an underpayment attributable to a substantial income tax understatement.

Under Sec. 6662(d)(1), an income tax understatement is substantial if it exceeds the greater of 10% of the tax required to be shown on the return for the tax year, or $5,000. Under Sec. 6662(d)(1)(B), a corporation’s (other than an S corporation’s or a personal holding company’s) understatement is substantial if the understatement exceeds the lesser of 10% of the tax required to be shown on the return (or $10,000, if greater) or $10 million.

Sec. 6662(d)(2) defines an understatement as the excess of the tax required to be shown on the return for the tax year, over the tax shown on the return, reduced by any rebate (within the meaning of Sec. 6211(b)(2)).

For an item not attributable to a tax shelter, Sec. 6662(d)(2)(B)(ii) provides that the understatement is reduced by the portion attributable to any item if the relevant facts affecting the item’s tax treatment are adequately disclosed on the return or on a statement attached to the return, and a reasonable basis exists for the item’s tax treatment.

Sec. 6694 imposes a $250 penalty on a return preparer for filing a return or refund claim that results in an understatement of liability due to a position for which the preparer knew, or should have known, that there was not a realistic possibility of being sustained on the merits, and did not disclose the position in accordance with Sec. 6662(d)(2)(B)(ii).

Fiscal- and short-tax year returns: In general, Rev. Proc. 2006-48 could apply to a return for a fiscal tax year that begins in 2006 and ends in 2007. It could also apply to a short-year return for a period beginning in 2007 when the return is to be filed before the 2007 forms are available. (Individuals are generally not in this position. For example, a decedent’s final return for a fractional part of a year is due the 15th day of the fourth month following the close of the 12-month period beginning with the first day of such fractional part of the year.) For fiscal- and short-year returns, the taxpayer must take into account any tax law changes effective for tax years beginning after 2006, even though such changes are not reflected on the form.

Rev. Proc. 2006-48 does not take into account tax law changes effective for tax years beginning after 2006. If a line referred to in the procedure is affected and requires additional reporting, a taxpayer may have to file Form 8275, Disclosure Statement, or 8275-R, Regulation Disclosure Statement, until the Service prescribes criteria for complying with the requirement.

Procedure

Additional disclosure of facts relevant to, or positions taken with respect to, issues involving any of the items set forth below is unnecessary for purposes of reducing any income tax understatement under Sec. 6662(d), provided the forms and attachments 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 disclosed in the manner described below. An amount is verifiable if, on audit, the taxpayer can demonstrate its origin (even if the IRS does not ultimately accept that amount) and can show good faith in entering that number.

The disclosure of an amount as provided below is not adequate when the understatement arises from a transaction between related parties. If an entry may present a legal issue or controversy because of a related-party transaction, that transaction and the relationship must be disclosed on Form 8275 or 8275-R.

Taxpayers must clearly identify an item entered on a line with no preprinted description (such as “other expenses”). For example, to disclose a bad debt for a sole proprietorship, the words “bad debt” should be printed on the line of Schedule C that shows the bad debt.

Also, for Schedule M-3, Net Income (Loss) Reconciliation for Corporations with Total Assets of $10 Million or More, Part II, line 25, Other income (loss) items with differences, or Part III, line 35, Other expense/deduction items with differences, the entry must provide descriptive language (e.g., “Cost of noncompete agreement deductible, not capitalizable”). If space limitations on a form do not allow an adequate description, the description must be continued on an attachment.

Although a taxpayer may literally meet the procedure’s disclosure requirements, the disclosure will have no effect on the Sec. 6662 accuracy-related penalty if the item or position on the return:

1. Does not have a reasonable basis, as defined in Regs. Sec. 1.6662-3(b)(3);

2. Is attributable to a tax-shelter item as defined in Sec. 6662(d)(2) and Regs. Sec. 1.6662-4(g); or

3. Is not properly substantiated or the taxpayer failed to keep adequate books and records as to the item or position; see Regs. Sec. 1.6694-2(c) for limits on the effectiveness of a disclosure on the Sec. 6694 return preparer penalty.

(1) Form 1040, Schedule A, Itemized Deductions:

(a) Medical and dental expenses: Complete lines 1–4, supplying all required information.

(b) Taxes: Complete lines 5–9, supplying all required information. Line 8 must list each type of tax and the amount paid.

(c) Interest expense: Complete lines 10–14, supplying all required information. This section does not apply to amounts disallowed under (1) Sec. 163(d) unless Form 4952, Investment Interest Expense Deduction, is completed or (2) Sec. 265.

(d) Contributions: Complete lines 15–18, supplying all required information. Merely entering the amount of a donation on Schedule A, however, will not constitute adequate disclosure if the taxpayer receives a substantial benefit from the donation shown. If a contribution of property other than cash is made and the amount claimed as a deduction exceeds $500, the taxpayer must attach a properly completed Form 8283, Noncash Charitable Contributions, to the return. This section will not apply to any contribution of $250 or more unless the contemporaneous-written-acknowledgment requirement of Sec. 170(f)(8) is satisfied.

In addition, for a contribution of a qualified motor vehicle, boat or airplane having a value of more than $500, this section will not apply unless a contemporaneous written acknowledgment, as required by Sec. 170(f)(12), is obtained from the donee organization and attached to the return. A Sec. 170(f)(8) acknowledgement is not required if a Sec. 170(f)(12) acknowledgment is required.

(e) Casualty and theft losses: Complete Form 4684, Casualties and Thefts, and attach to the return. Each item or article for which the taxpayer claims a casualty or theft loss must be listed on Form 4684.

(2) Certain trade or business expenses (including the following six expenses as they relate to the rental of property):

(a) Casualty and theft losses: The procedure outlined above must be followed.

(b) Legal expenses: The amount claimed must be stated. This section does not apply, however, to amounts properly characterized as capital expenditures, personal expenses or nondeductible lobbying or political expenditures, including amounts required to be (or that are) amortized over a period of years.

(c) Specific bad debt charge-off: The amount written off must be stated.

(d) Reasonableness of officers’ compensation: Form 1120, Schedule E, Compensation of Officers, must be completed when required by its instructions. The time devoted to business must be expressed as a percentage, as opposed to “part” or “as needed.” This section does not apply to “golden parachute” payments, as defined under Sec. 280G. It does not apply to the extent that remuneration paid or incurred exceeds the $1 million-per-employee-remuneration limit, if applicable.

(e) Repair expenses: The amount claimed must be stated. This section does not apply, however, to any repair expenses properly characterized as capital expenditures or personal expenses.

(f) Taxes (other than foreign taxes): The amount claimed must be stated.

(3) Differences in book and income tax reporting:

(a) Form 1065, U.S. Return of Partnership Income: Schedule M-3 (Form 1065), Net Income (Loss) Reconciliation for Certain Partnerships:

• Part II, Column (b), Temporary Difference, and Column (c), Permanent Difference, of Part II, (reconciliation of income (loss) items); and

• Part III (reconciliation of expense/deduction items).

(b) Form 1120: Schedule M-1, Reconciliation of Income (Loss) per Books With Income per Return, and Schedule M-3 (Form 1120), Net Income (Loss) Reconciliation for Corporations With Total Assets of $10 Million or More:

• Column (b), Temporary Difference, and Column (c), Permanent Difference, of Part II, (reconciliation of income (loss) items); and

• Part III (reconciliation of expense/deduction items).

(c) Form 1120-L, U.S. Life Insurance Company Income Tax Return: Schedule M-3 (Form 1120-L), Net Income (Loss) Reconciliation for U.S. Life Insurance Companies With Total Assets of $10 Million or More:

• Column (b), Temporary Difference, and Column (c), Permanent Difference, of Part II, (reconciliation of income (loss) items); and

• Part III (reconciliation of expense/deduction items).

(d) Form 1120-PC, U.S. Property and Casualty Insurance Company Income Tax Return: Schedule M-3 (Form 1120-PC), Net Income (Loss) Reconciliation for U.S. Property and Casualty Insurance Companies With Total Assets of $10 Million or More:

• Column (b), Temporary Difference, and Column (c), Permanent Difference, of Part II, (reconciliation of income (loss) items); and

• Part III (reconciliation of expense/deduction items).

(e) Form 1120-S, U.S. Income Tax Return for an S Corporation: Schedule M-3 (Form 1120-S), Net Income (Loss) Reconciliation for S Corporations With Total Assets of $10 Million or More:

• Column (b), Temporary Difference, and Column (c), Permanent Difference, of Part II, (reconciliation of income (loss) items); and

• Part III (reconciliation of expense/deduction items).

For Schedule M-1 and all Schedules M-3, the information provided reasonably must be expected to apprise the Service of the nature of the potential controversy concerning the tax treatment of the item. If the information provided does not so apprise the Service, a Form 8275 or Form 8275-R must be used to adequately disclose the item (see Part II of the instructions for those forms).

An item reported on a line with a preprinted description, shown on an attached schedule, or “itemized” on Schedule M-1, may represent the aggregate amount of several transactions producing that item (i.e., a group of similar items, such as amounts paid or incurred for supplies by a taxpayer engaged in business). In some instances, the potentially controversial item may involve a portion of the amount disclosed on the schedule. In these instances, the IRS will not be reasonably apprised of the potential controversy by the amount disclosed; the taxpayer must use Form 8275 or 8275-R regarding that portion of the item. Also, combining unlike items will not constitute adequate disclosure, whether on Schedule M-1 or M-3, or on an attachment as directed by the instructions.

(4) Foreign tax items:

(a) International Boycott Transactions: Transactions disclosed on Form 5713, International Boycott Report:

• Schedule A, International Boycott Factor ( Section 999(c)(1));

• Schedule B, Specifically Attributable Taxes and Income (Section 999(c)(2)); and

• Schedule C, Tax Effect of the International Boycott Provisions, must be completed when required by their instructions.

(b) Treaty-Based Return Position: Transactions and amounts under Sec. 6114 or 7701(b), as disclosed on Form 8833, Treaty-Based Return Position Disclosure Under Section 6114 or 7701(b).

(5) Other:

(a) Moving expenses: Complete Form 3903, Moving Expenses, and attach to the return.

(b) Employee business expenses: Complete Form 2106, Employee Business Expenses, or Form 2106-EZ, Unreimbursed Employee Business Expenses, and attach to the return. This section does not apply to club dues or to travel expenses for any nonemployee accompanying the taxpayer on the trip.

(c) Fuels credit: Complete Form 4136, Credit for Federal Tax Paid on Fuels, and attach to the return.

(d) Investment credit: Complete Form 3468, Investment Credit, and attach to the return.

Rev. Proc. 2006-48, IRB 2006-47, 934

REFLECTIONS: In general, Rev. Proc. 2006-48 applies to any return filed on 2006 forms for a tax year beginning in 2006, and to any return filed on 2006 tax forms in 2007 for short tax years beginning in 2007. It has been expanded by adding new Schedules M-3 for Forms 1065, 1120-L, 1120-PC and 1120S, which reconcile net income (loss) in the financial statements to that shown on an entity’s return. Guidance for returns filed for 2005 is provided in Rev. Proc. 2005-75.