The enactment of the Revenue Reconciliation Act of 1993 has made it significantly easier for the IRS to impose accuracy-related penalties against taxpayers. The penalty for substantial understatement of income tax is one of five accuracy-related penalties found in the Code.
The accuracy-related penalties are in turn one of three classes of penalties, the other two being the delinquency penalties (e.g., failure to timely file or failure to timely pay income tax liabilities shown on a return) and the penalty for fraud, which requires a willful attempt to deceive the government.
Having decided to assess an accuracy-related penalty, the IRS thereby forgoes any opportunity it might otherwise have to impose either a delinquency penalty or a fraud penalty. Similarly, the IRS may impose but one of the five accuracy-related penalties, even though more than one might apply.
Each of the five accuracy-related penalties imposes a penalty equal to 20 percent of the amount of the “underpayment” attributable to the specific penalty. An “underpayment” is the amount by which the tax owed exceeds the tax paid. The “understatement,” from which the “underpayment” derives, is reduced to the extent that the taxpayer’s position is (1) adequately disclosed on the face of the return or on an attached statement, or for which there is (2) “substantial authority.”
Treas. Reg. § 1.6662-4(d)(2) provides that “substantial authority” only exists if “the weight of authorities supporting the treatment is substantial in relation to the weight of authorities supporting contrary positions.” “Authoritative” sources include cases, rulings, regulations, treaties and Congressional Reports. Opinions of tax counsel or of tax experts writing in journals or law review articles are not, however, considered authoritative for purposes of determine whether there exists “substantial authority.”
The new tax law, enacted as the Revenue Reconciliation Act of 1993, redefines the element of adequate disclosure. Under prior law, if disclosure were not made, an asserted understatement could be defeated by a showing of reasonableness. Under prior law, if disclosure was made, a nonfrivolous position taken by the taxpayer was sufficient to defeat the imposition of the understatement penalty. Under the new law, the taxpayer’s position must be reasonable, even if disclosed, in order to avoid the understatement penalty.
Thus, under the new law, even a disclosed position must be “reasonable” in order to defeat the imposition of the substantial understatement of income penalty. Although the term “reasonable” is not defined in Code § 6662 (i.e., which enumerates the accuracy-related penalties), or anywhere else in the Code, the Conference Committee Report stipulates that “reasonable basis” comprehends a “relatively high standard of tax reporting, that is, significantly higher than ‘not patently improper’.” The Report continues, and states that the reasonableness standard is not satisfied by a return position that is “merely arguable or that is merely a colorable claim.”