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During a webinar the other week regarding the impact of the Mayo Foundation decision on taxpayers, I discussed the effect of Mayo on taxpayers’ decisions to take positions that are contrary to IRS rules or regulations. Part of that discussion examined the 20-percent accuracy-related penalty that can be imposed on such positions under Code section 6662.
As our readers may know, if a taxpayer takes a position on a return that is contrary to an IRS rule or regulation, the taxpayer may avoid the imposition of the accuracy-related penalty by following the requirements of Treas. Reg. § 1.6662-3. In general, that regulation provides that, when a taxpayer takes a position contrary to a regulation, the penalty for disregarding rules or regulations does not apply if (i) the position is disclosed on “a properly completed and filed Form 8275-R,” (ii) the position represents a “good faith challenge” to the validity of the regulation, and (iii) the taxpayer has a reasonable basis for the position. Treas. Reg. § 1.6662-3(a), (c)(1), (c)(2).
At the end of the webinar, an audience member asked whether the requirement to disclose a position on Form 8275-R included a position that was contrary to a revenue ruling. As so often happens in tax law, the answer creates as many questions as it resolves. Because one person’s question is likely shared by others, it seems appropriate to discuss the issue in a blawg post.
Although Disclosure On Form 8275-R Is Not Required…
As discussed in the webinar, the plain text of Treas. Reg. § 1.6662-3(a) seems to give a fairly simple answer: no such disclosure is required. The regulation states:
The penalty for disregarding rules or regulations does not apply… if the requirements of paragraph (c)(1) of this section are satisfied and the position in question is adequately disclosed as provided in paragraph (c)(2)…. In addition, if a position with respect to an item… is contrary to a revenue ruling or notice…, this penalty does not apply if the position has a realistic possibility of being sustained on its merits.
The quoted text makes clear that, to avoid a penalty for taking a position that is contrary to a revenue ruling, a taxpayer need only have a realistic possibility of being sustained on its merits. The first sentence explains how to avoid the penalty for “rules and regulations” generally, and the second sentence explains how to avoid the penalty for revenue rulings or notices specifically. Although the regulations define the phrase “rules and regulations” to include revenue rulings, the textual separation of the two categories and the separate specification of a requirement for positions contrary to revenue rulings suggest that no disclosure is required in that context.
The regulation further supports this distinction by providing, “a taxpayer who takes a position… contrary to a revenue ruling or notice has not disregarded the ruling or notice if the contrary position has a realistic possibility of being sustained on its merits.” Treas. Reg. § 1.6662-3(b)(2). In other words, if the taxpayer’s position has a “realistic possibility of being sustained,” the position is not even considered to be contrary to the ruling or notice. In such a case, the requirements to avoid a penalty that are described in paragraph (a) are not even relevant.
...Disclosure On Form 8275 May Be.
On the other hand, because the 6662 regulations define the phrase “rules or regulations” to include revenue rulings, this broad definition could be interpreted to mean that the general disclosure requirement for positions that are contrary to “rules or regulations” applies to revenue rulings as well. This interpretation is supported by Form 8275 and its accompanying instructions, which state:
If you are disclosing a position contrary to a rule (such as a statutory provision or IRS revenue ruling), you must identify the rule in column (a).
Although this instruction does not mandate that taxpayers file the form for positions that are contrary to revenue rulings, it certainly presumes that the form should be filed for such positions. (Form 8275-R is used to disclose positions that are contrary to regulations, and Form 8275 is used to disclose other positions generally.)
So, how do we reconcile the instructions to Form 8275 with the 6662 regulations? The answer seems lie elsewhere - specifically, the provisions regarding substantial understatements of income tax.
Code section 6662 also imposes a 20-percent penalty for “any substantial understatement of income tax.” Without getting too far into the weeds, an understatement exists where a taxpayer’s return shows less tax owed than is legally required. Treas. Reg. § 1.6662-4(b)(2). Such an understatement is “substantial” if it exceeds the greater of (i) 10 percent of the tax required to be shown on the return or (ii) $5,000 for an individual taxpayer ($10,000 in the case of a non-S corporate taxpayer). Treas. Reg. § 1.6662-4(b)(1).
A taxpayer may avoid the substantial understatement penalty generally if (i) the taxpayer has “substantial authority” for the position giving rise to the understatement or (ii) the taxpayer adequately discloses the position on Form 8275. Treas. Reg. § 1.6662-4(a), (f)(1). Perhaps positions that are contrary to revenue rulings need to be disclosed on Form 8275 to avoid the potential imposition of a penalty for a substantial understatement of income tax. Then again, the disclosure exception to the substantial understatement penalty applies to a variety of tax positions – not just those that are contrary to revenue rulings. Thus, any return position that risks the imposition of a substantial understatement penalty would implicate this disclosure requirement.
Also, if the regulations require per se disclosure of a position that is contrary to a revenue ruling to avoid the substantial understatement penalty, it would seem to eviscerate the meaning of the second sentence of Treas. Reg. § 1.6662-3(a) quoted above. After all, if a taxpayer chose not disclose a position contrary to a revenue ruling on Form 8275, the IRS could simply disallow the item and then assert a substantial understatement penalty.
Recall that, to avoid a substantial understatement penalty, a taxpayer must have “substantial authority” for an undisclosed position. Because that standard is higher than the “realistic possibility” required by Treas. Reg. § 1.6662-3(a), (b)(2), a taxpayer could conceivably avoid a penalty for taking a position contrary to a revenue ruling but still be subject to a penalty for a substantial understatement of income tax. Thus, when confronted with a position that is contrary to a revenue ruling, the IRS could simply assert a substantial understatement penalty, rather than a disregard-of-rules-or-regulations penalty, and subject that position to the “substantial authority” standard rather than the “realistic possibility” standard.
From a policy perspective, it is worth asking whether anyone, in the government or otherwise, can provide a meaningful and practical distinction between the “substantial authority” and “realistic possibility” standards. Nevertheless, the language of the regulations, accepted at face value, creates a dilemma for taxpayers, either: (i) disclose a position contrary to a revenue ruling and invite a challenge from the IRS, or (ii) do not disclose the position and face a higher standard to avoid the imposition of a 20-percent penalty.
Taxpayers can also avoid these penalties by demonstrating reasonable cause and good faith; however, as the Tax Court’s decision last year in Canal Corp. v. Comm’r suggests, the bar for satisfying that standard (particularly for corporate taxpayers involved in complex tax planning) may be rising. As a result, taxpayers should not take for granted that reasonable cause and good faith can be shown any more easily than “substantial authority” or a “realistic possibility”.
If nothing else, the dilemma discussed above simply reflects one more area in which federal tax law has grown overly complex. Taxpayers already confront substantive rules that require many volumes of opinions, statutes, regulations, rulings, and other guidance. Increasingly, they face a similarly extensive minefield when it comes to the procedural requirements associated with the implementation of those substantive rules. If, as recent headlines suggest, meaningful tax reform is on the table, lawmakers should not forget that any reform should encompass both substantive and procedural aspects of the law.