At least once in their career most tax return preparers have faced the dilemma of whether and how to make a disclosure with a tax return. A disclosure is an extra explanation beyond the usual income and expenses shown on a tax return. Not surprisingly, most taxpayers do not want to disclose anything more than necessary to the IRS. There may be privacy concerns or they just don’t want the IRS to know anything more than necessary about them or their business. They also may be concerned that a disclosure is a red flag and will increase the chances of an IRS audit. All of these are legitimate concerns, but a disclosure can protect the taxpayer -- and maybe more importantly the tax return preparer -- from penalties.
Pursuant to IRC Section 6662(d)(2)(B), a taxpayer can avoid accuracy-related penalties related to any substantial understatement if the taxpayer (1) had “substantial authority” for the item, or (2) both (i) the relevant facts affecting the item’s treatment are adequately disclosed in the return or in a statement attached to the return and (ii) there is a reasonable basis for the tax treatment. According to Treas. Reg. Sec. 1.6662-4(f), disclosure is adequate if it is “made on a properly completed form attached to the return or to a qualified amended return … for the taxable year. In the case of an item or position, other than one that is contrary to a regulation, disclosure must be made on Form 8275 (Disclosure Statement); in the case of a position contrary to a regulation, disclosure must be made on Form 8275-R (Regulation Disclosure Statement).”
The IRS issues an annual Revenue Procedure which prescribes the circumstances under which disclosure of information, on a return or qualified amended return, in accordance with the applicable forms and instructions is adequate. For the 2018 tax year, that is Rev. Proc. 2019-9. According to the annual revenue procedure, additional disclosure of facts relevant to, or positions taken with respect to, issues involving any of the listed items is not necessary, although many tax returns will contain footnotes or attach explanations as an extra precaution. If the annual revenue procedure does not include an item, disclosure is adequate with respect to that item only if it is made on a properly completed Form 8275 or Form 8275-R attached to the tax return.
Form 8275 is used by taxpayers and tax return preparers to disclose items or positions, except those taken contrary to a regulation, that are not otherwise adequately disclosed on a tax return to avoid certain penalties. A Form 8275 is attached to a tax return to avoid the portions of the accuracy-related penalty due to disregard of rules or to a substantial understatement of income tax for non-tax shelter items if the return position has a reasonable basis. In addition, a properly filed Form 8275 can be used for disclosures relating to the economic substance penalty and the preparer penalties for tax understatements due to unreasonable positions or disregard of rules. The IRS receives countless Forms 8275 each year and attaching a Form 8275 to a tax return does not automatically trigger an audit. Most tax returns with a Form 8275 are not audited.
Form 8275-R is used by taxpayers and tax return preparers to disclose positions taken on a tax return that are contrary to Treasury regulations. The form is filed to avoid the portions of the accuracy-related penalty due to disregard of regulations or to a substantial understatement of income tax for non-tax shelter items if the return position has a reasonable basis. It can also be used for disclosures relating to the economic substance penalty and the preparer penalties for tax understatements due to positions taken contrary to regulations. Not surprisingly, there are substantially fewer Forms 8275-R filed than Forms 8275 and the chances of an IRS audit are greater.
If a Form 8275 or 8275-R is needed, the next question is how much detail and explanation to provide. I have seen explanations that range from one sentence to pages of explanation and legal arguments, attaching transactional documents and even opinion letters. The disclosure only needs to include enough information to apprise the IRS of what the taxpayer is doing. If the IRS needs further explanation or documents, they will request them.
During my career, I have been contacted numerous times by tax return preparers about whether a disclosure should be made. My typical response is if the tax return preparer has concerns and is considering a disclosure, it should be made. If the client disagrees, maybe they need to find a new return preparer. Don’t make the client’s problem your problem.
For any questions on this or any other tax-related matters, please feel free to contact me at (214) 749-2456 or firstname.lastname@example.org.