For many items reported on a tax return, the correct tax treatment is clear under the law. When the correct tax treatment is not so clear, a decision must be made on how the item will be reported, taking into account the relevant authorities for and against the desired tax position. If the IRS is likely to disagree with the tax position ultimately taken on the return, a further decision is whether to notify the IRS of the potential disagreement through an “adequate disclosure” on the return.
For example, assume there’s a deduction you want to take on your tax return, but there’s uncertainty as to whether the deduction is allowed under the law. Do you take the deduction and flag the issue with an adequate disclosure notifying the IRS of the potential controversy? Or, do you take the deduction without the disclosure?
Let’s consider some of the risks of taking the deduction without adequate disclosure. A 20 percent penalty applies to a tax underpayment attributable to a “substantial understatement of income tax.” For individuals, a substantial understatement of income tax is the greater of 10 percent of the tax required to be shown on the return (5 percent if the return reports a Section 199A qualified business income deduction) or $5,000. For corporations, it’s the lesser of 10 percent of the tax required to be shown on the return (or, if greater, $10,000) or $10 million. The 20 percent penalty also applies to a tax underpayment attributable to negligence or disregard of rules or regulations. If the IRS later disallows the deduction on audit, a 20 percent penalty could be charged for substantial understatement of tax—if mathematically applicable—or for negligence or disregard of rules or regulations.
To avoid these penalties without disclosure on the tax return, there must be “substantial authority” for the deduction. There is substantial authority when the weight of authorities supporting the deduction is substantial in relation to the weight of authorities supporting contrary treatment. Disclosure on the tax return generally is not necessary for tax positions with substantial authority. However, to establish the existence of substantial authority for a tax position, written documentation of the relevant facts and tax analysis should be prepared and retained in the tax return file.
If a tax position does not have substantial authority but has at least a “reasonable basis,” penalties generally can be avoided if the position is adequately disclosed on the tax return. A return position satisfies the reasonable basis standard if it’s reasonably based on at least one of the authorities set forth in Treas. Reg. Section 1.6662-4(d)(3)(iii), such as a statute, regulation, court case, revenue ruling, revenue procedure or other listed authority, taking into account the relevance and persuasiveness of the authority and subsequent developments. The reasonable basis standard is significantly higher than “not frivolous” or “not patently improper” but lower than substantial authority. If a tax position has a reasonable basis but is not supported by substantial authority, then adequate disclosure on the tax return is required to avoid the penalties described above.
Form 8275, Disclosure Statement, is used to disclose items or tax positions that aren’t otherwise adequately disclosed on a tax return. Form 8275-R, Regulation Disclosure Statement, is used to disclose tax positions taken on a return that are contrary to a regulation. If the disclosure is adequate, the penalty for a substantial understatement of income tax or negligent disregard of rules or regulations (and certain other penalties) can be avoided, even if the IRS disagrees with the tax position.
A common question is how much disclosure is enough to avoid penalties? According to the Form 8275 and 8275-R instructions, the disclosure must include information that reasonably can be expected to apprise the IRS of the identity of the item, its amount and the controversy or potential controversy. For disclosures on Form 8275-R, the statement also must include an explanation of why the taxpayer believes the regulation to be invalid.
Bear in mind the purpose of the disclosure is to put the IRS on notice of a potential controversy concerning the item or tax position. The disclosure should be carefully crafted to meet the requirement without providing unnecessary information or legal argument. Going back to our deduction example, a disclosure on Form 8275 generally would be adequate if it identifies the item being deducted, the amount of the deduction, the rule under which the item is being deducted and the issue the IRS could raise as to whether the item is properly deducted.
No taxpayer wants to draw IRS attention to uncertain tax positions reported on a tax return, especially when disclosure generally is not mandatory. However, adequate disclosure and consultation with tax advisors on how and what to disclose may reduce a taxpayer’s exposure to penalties for a tax underpayment.
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