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IRS Updates Guidance on Disclosures and Accuracy Related Penalties

By Joel N. Crouch on January 3, 2019

On December 20th, the IRS released Revenue Procedure 2019-9 providing guidance on whether disclosure of an item or position taken on a tax return is adequate for purposes of reducing or eliminating the Substantial Understatement of Income Tax Penalty (IRC Section 6662(d)) and the Return Preparer Penalty (IRC Section 6694(a)).    Rev. Proc. 2019-9 updates Rev. Proc. 2018-11 and makes editorial but “no additional substantive changes”. Rev. Proc. 2019-9 applies to any income tax return filed on 2018 tax forms for a tax year beginning in 2018, and to any income tax return filed in 2019 on 2018 tax forms for short tax years beginning in 2019.

There is a substantial understatement of income tax if the amount of the understatement exceeds the greater of (i) 10 percent of the amount of tax required to be shown on the return for the taxable year or (ii) $5,000.  A corporation, other than an S corporation or a personal holding company, has a substantial understatement of income tax if the amount of the understatement exceeds the lesser of (i) 10 percent of the tax required to be shown on the return for a taxable year (or, if greater, $10,000) or (ii) $10,000,000. An understatement is the excess of the amount of tax required to be shown on the return for the taxable year over the amount of the tax that is shown on the return.  The penalty is 20% of the underpayment of tax. The penalty rate increases to 40 percent in the case of gross valuation misstatements under section 6662(h), nondisclosed noneconomic substance transactions under section 6662(i), or undisclosed foreign financial asset understatements under section 6662(j).  Section 6662(b)(2) applies to the portion of an underpayment of tax that is attributable to a substantial understatement of income tax.

Section 6694(a) imposes a penalty on a tax return preparer who prepares a return or claim for refund reflecting an understatement of liability due to an “unreasonable position” if the tax return preparer knew (or reasonably should have known) of the position. A position (other than a position with respect to a tax shelter or a reportable transaction to which section 6662A applies) is generally treated as unreasonable unless (i) there is or was substantial authority for the position, or (ii) the position was properly disclosed in accordance with section 6662(d)(2)(B)(ii)(I) and had a reasonable basis. The section 6694 penalty is the greater of $1000 or 50% of the income derived by the tax return preparer with respect to the return or claim.  The penalty is increased to the greater of $5000 or 75% of the income derived where the understatement is due to willful or reckless conduct.

If the disputed item or position is adequately disclosed on the return the substantial understatement penalty and the preparer penalty can be eliminated with respect to the disclosed item or position.  A disclosure is generally made on a Form 8275, Disclosure Statement.  However, in the case of a position contrary to a regulation, disclosure must be made on Form 8275-R, Regulation Disclosure Statement. Revenue Procedure 2019-9  provides guidance for determining when a disclosure is adequate to eliminate the substantial understatement and preparer penalties.  For purposes of the revenue procedure, the taxpayer must furnish all required information in accordance with the applicable disclosure forms and instructions, and the money amounts entered on these forms must be verifiable.  In other words, an incomplete or inaccurate disclosure will not protect the taxpayer or return preparer from the substantial understatement and preparer penalties.

A proper disclosure on either Form 8275 or Form 8275-R will only provide a defense to the substantial understatement penalty, Section 6662(d).  A disclosure does not apply with respect to any other penalty provisions—including the disregard provisions of the section 6662(b)(1) accuracy-related penalty, the section 6662(b)(6) accuracy-related penalty and the section 6662(i) increased accuracy-related penalty in the case of nondisclosed noneconomic substance transactions, and the section 6662(j) increased accuracy-related penalty in the case of undisclosed foreign financial asset understatements.  In such cases, a taxpayer must rely on reasonable cause and other defenses to penalties.

For any questions on this or any other tax-related matter, please feel free to contact Joel Crouch at (214) 749-2456 or jcrouch@meadowscollier.com.