Thursday, December 30, 2010

IRS Updates Disclosure Rules To Lessen Understatement And Preparer Penalties — Rev Proc 2011-13, 2011-3 IRB

A revised revenue procedure identifies when disclosure on a taxpayer's return for an item or a position is adequate to reduce a Code Sec. 6662(d) understatement of income tax under the accuracy-related penalty, and to avoid the Code Sec. 6694(a) preparer penalty for understatements due to unreasonable positions. It applies to any income tax return filed on 2010 tax forms for tax years beginning in 2010, and to any income tax return filed on 2010 tax forms in 2011 for short tax years beginning in 2011.

Background. Under Code Sec. 6662, a 20% penalty applies to the portion of a tax underpayment that is attributable to a substantial understatement of income tax. The penalty rate is 40% in the case of gross valuation misstatements under Code Sec. 6662(h), nondisclosed noneconomic substance transactions under Code Sec. 6662(i), or undisclosed foreign financial asset understatements under section Code Sec. 6662(j). An understatement is “substantial” if it exceeds the greater of 10% of the amount of tax required to be shown on the return for the tax year or $5,000. However, a corporation (other than an S corporation or personal holding company) has a substantial tax understatement if the understatement exceeds the lesser of (1) 10% of the tax required to be shown on the return for a tax year (or, if greater, $10,000), or (2) $10 million. (Code Sec. 6662(d))

For a non-tax shelter item, the understatement is reduced to the extent the relevant facts affecting the item's tax treatment are adequately disclosed in the return or in a statement attached to the return, and there is a reasonable basis for the taxpayer's tax treatment. (Code Sec. 6662(d)(2)(B)(ii))

Under Code Sec. 6694(a), a penalty is imposed on a tax return preparer who prepares a return or refund claim reflecting an understatement of liability due to an “unreasonable position” if he knew (or reasonably should have known) of the position. A position (other than for a tax shelter or a reportable transaction) is generally treated as unreasonable unless (1) there is or was substantial authority for the position; or (2) the position was properly disclosed under Code Sec. 6662(d)(2)(B)(ii)(I) and had a reasonable basis. If the position is with respect to a tax shelter or a reportable transaction, the position is treated as unreasonable unless it is reasonable to believe that the position would more likely than not be sustained on the merits. (Notice 2009-5, 2009-1 CB 309)

Revised procedure. In Rev Proc 2011-13, IRS sets out the circumstances under which disclosure of information on a return is considered to be adequate to avoid the substantial understatement penalty under Code Sec. 6662(d) and the preparer penalty under Code Sec. 6694(a) for understatements due to unreasonable positions. A corporation making a complete and accurate disclosure of a tax position on the appropriate year's Schedule UTP (Uncertain Tax Position Statement), will be treated as if it had filed a Form 8275 (Disclosure Statement) or Form 8275-R (Regulation Disclosure Statement) regarding the tax position. However, the filing of a Form 8275 or Form 8275-R, will not be treated as if the corporation filed a Schedule UTP.

Additional disclosure of relevant facts or positions taken with respect to issues involving any of the items listed in Rev Proc 2011-13 is unnecessary for purposes of reducing any understatement of income tax under Code Sec. 6662(d) (except as otherwise provided in Rev Proc 2011-13, Sec. 4.02(3), concerning Schedules M-1 and M-3), if forms and attachments are completed in a clear manner and in accordance with instructions.

Although a taxpayer may literally meet Rev Proc 2011-13’s disclosure requirements, the disclosure won't have an effect for purposes of the Code Sec. 6662 accuracy-related penalty if the item or position on the return: (1) doesn't have a reasonable basis as defined in Reg. § 1.6662-3(b)(3); (2) is attributable to a tax shelter item as defined in Code Sec. 6662(d)(2); or (3) isn't properly substantiated or the taxpayer failed to keep adequate books and records with respect to the item or position. Disclosure will have no effect for purposes of the Code Sec. 6694(a) penalty as applicable to tax return preparers if the position is with respect to a tax shelter (as defined in Code Sec. 6662(d)(2)(C)(ii)) or a reportable transaction to which Code Sec. 6662A applies.

Rev Proc 2011-13, Sec. 4.01(2), provides that money amounts entered on forms must be verifiable, and the information on the return must be disclosed in the manner described in Rev Proc 2011-13, Sec. 4.02(3). A number is verifiable if, on audit, the taxpayer can prove the origin of the amount (even if that number is not ultimately accepted by IRS) and can show good faith in entering that number on the applicable form. Further, the disclosure of an amount as provided in Rev Proc 2011-13, Sec. 4.02, isn't adequate when the understatement arises from a transaction between related parties. If an entry may present a legal issue or controversy because of a related-party transaction, then that transaction and the relationship must be disclosed on Form 8275 or Form 8275-R.

When the amount of an item is shown on a line that doesn't have a preprinted description identifying that item, the taxpayer must clearly identify the item by including the description on that line. For example, to disclose a sole proprietorship's bad debt, the words “bad debt” must be written or typed on the line of Schedule C that shows the amount of the bad debt. Also, for Schedule M-3 (Form 1120), Part II, line 25, Other income (loss) items with differences, or Part III, line 35, Other expense/deduction items with differences, the entry must provide descriptive language (e.g., “Cost of non-compete agreement deductible not capitalizable”). If space limitations on a form do not allow for an adequate description, the description must be continued on an attachment.

References: For the substantial understatement penalty, see FTC 2d/FIN ¶V-2151; United States Tax Reporter ¶66,624.03; TaxDesk ¶863,014; TG ¶71638. For the preparer penalty, see FTC 2d/FIN ¶V-2631; United States Tax Reporter ¶66,944; TaxDesk ¶867,019; TG ¶71769.

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