When a taxpayer or tax professional discovers an error on a previously filed tax return, the taxpayer usually asks whether and how the error should be corrected. While there is nothing in the Internal Revenue Code or Regulations requiring a taxpayer to amend a tax return, CPAs and other tax professionals have a duty under Circular 230 and ethical rules to advise a taxpayer that an amended tax return should be filed and that failure to do so could result in imposition of penalties. If a taxpayer chooses not to file an amended return, he or she could be subject to an accuracy-related penalty pursuant to IRC Section 6662. However, by filing a Qualified Amended Return (QAR), the taxpayer can avoid an accuracy-related penalty.
IRS Section 6662 provides for the imposition of an accuracy-related penalty on any underpayment of tax. IRS Section 6662(b) says that an accuracy related penalty will apply to an underpayment which is attributable to (1) negligence or disregard of rules or regulations; (2) any substantial understatement of income tax; (3) Any substantial valuation misstatement (4) any substantial overstatement of pension liabilities (5) any substantial estate or gift tax valuation understatement; (6) any disallowance of claimed benefits by reason of a transaction lacking economic substance or failing to meet the requirements of any similar rule of law; or (7) any undisclosed foreign financial asset understatement. Depending on the circumstances the amount of the penalty can be either 20% or 40% of the amount of the underpayment.
IRS Section 6664 defines “underpayment” as the difference between the correct amount of tax and the tax reported on the taxpayer’s tax return. In a simple example, if the taxpayer reports $1000 of tax and the IRS determines the tax should have been $1500, the underpayment for purposes of the accuracy related penalty is the difference between $1500 and $1000, ie, $500. Assuming a 20% penalty, the accuracy-related penalty would be $100.
A taxpayer who is aware of an underpayment on his or her tax return can avoid the imposition of an accuracy related penalty by filing a QAR. If the taxpayer files a QAR, the amount of tax reported on the QAR is treated as if it were reported on the original tax return. Thus, there is no underpayment for purposes of the accuracy-related penalty. A QAR is defined in Treas. Reg. Section 6664-2(c)(3) as an amended return filed after the due of the original return (determined with regard to extensions) and before:
- The date the taxpayer is first contacted by the IRS regarding an examination or criminal investigation with respect to the return;
- In the case of a promoted transaction, the date the tax shelter promoter is first contacted concerning an IRS examination;
- In the case of a pass-through item, the date the pass-through entity is first contacted by the IRS in connection with an examination of the return to which the pass-through item relates;
- The date a John Doe summons is served on a third party with respect to an activity of the taxpayer for which the taxpayer directly or indirectly claimed a tax benefit; and
- The date on which the IRS announces, by revenue ruling, revenue procedure, notice or announcement, to be published in the Internal Revenue Bulletin, a settlement initiative to waive or compromise penalties with respect to a listed transaction.
In the case of an undisclosed Listed Transaction, an amended return will only be treated as a QAR if it is filed before:
- The dates described above for filing a QAR generally;
- The date the IRS first contacts a person regarding an examination of that person’s liability for penalties under IRC Section 6707(a) with respect to the undisclosed listed transaction of the taxpayer; and
- The date on which the IRS requests from the taxpayer’s material advisor (or any person who made a tax statement for the benefit of the taxpayer) the information required to be included in a list under IRC Section 6112 related to a transaction that is the same, or substantially similar to, the undisclosed listed transaction.
Like a “voluntary disclosure” in the criminal tax arena, a QAR in the civil tax arena is intended to encourage taxpayers to voluntarily come into compliance. However, when considering whether to file an amended return, it is important to keep in mind that an amended return does not qualify as a QAR if the tax deficiency corrected on the amended return relates to a fraudulent position on the original return. In such circumstances, the taxpayer still may be subject to a 75% civil fraud penalty pursuant to IRC Section 6663. However, by coming into compliance with regard to a fraudulent position, the taxpayer will be able to avoid a potential criminal investigation.
Taxpayers who are aware of issues on their tax returns and are not under examination by the IRS should seriously consider coming into compliance by filing a QAR to avoid potential liability for accuracy-related penalties. However, due diligence must be conducted to confirm not only is the amended return timely, but there is no exposure for a 75% civil fraud penalty.