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Part 20. Penalty and Interest

Chapter 1. Penalty Handbook

Section 5. Return Related Penalties (Cont. 1)

20.1.5  Return Related Penalties (Cont. 1)

20.1.5.8 
IRC Section 6662(d): Substantial Understatement

20.1.5.8.5  (07-01-2008)
Penalty Relief

  1. See IRM 20.1.5.6.of this manual.

20.1.5.9  (07-01-2008)
IRC Section 6662(e): Substantial Valuation Misstatement

  1. For the accuracy-related penalty to apply in the case of a substantial valuation misstatement, the portion of the underpayment attributable to a substantial valuation misstatement must exceed $5,000 ($10,000 in the case of a corporation other than an S corporation or a personal holding company).

  2. The amount of the penalty is 20 percent of the underpayment attributable to a substantial valuation misstatement and 40 percent in the case of a gross valuation misstatement.

20.1.5.9.1  (07-01-2008)
Penalty Assertion

  1. The examining officer is responsible for the assertion of the accuracy-related penalty attributable to a valuation misstatement.

  2. See IRC section 6662(e)(1)(B) relating to substantial valuation misstatements under IRC section 482 transactions.

  3. If the value or adjusted basis of any property claimed on a return is 200 percent or more of the amount determined to be the correct amount of such value or adjusted basis, the valuation misstatement constitutes a " gross valuation misstatement." See IRC section 6662(h)(2)(A). If there is a gross valuation misstatement, then the 20 percent penalty under IRC section 6662(a) is increased to 40 percent. See IRC section 6662(h)(1).

  4. There is no disclosure exception to this penalty. See Treas. Reg. 1.6662-5(a). The only exception is reasonable cause and good faith under IRC section 6664.

  5. The substantial valuation misstatement penalty does not apply to any understatement upon which a penalty under IRC section 6662A is imposed. IRC section 6662A does not apply to any understatement upon which the gross valuation misstatement penalty is imposed.

20.1.5.9.2  (07-01-2008)
IRC Section 6662(e)(1)(A): Substantial Valuation Misstatement

  1. A substantial valuation misstatement exists if the value or adjusted basis of any property claimed on a return is 150 percent or more of the amount determined to be the correct amount of such value or adjusted basis. IRC section 6662(e)(1)(A).

20.1.5.9.3  (10-25-2005)
IRC Section 6662(e)(1)(B): Valuation Misstatement Penalties for Transfer Pricing Transactions Under IRC Section 482

  1. IRC section 6662(e)(1)(B) imposes transfer pricing penalties on any underpayment attributable to a substantial valuation misstatement pertaining to transfer pricing under IRC section 482. These penalties are identified as the transactional penalty and the net adjustment penalty.

  2. The Transactional Penalty. This penalty applies when the price reported for any property or services is 200 percent or more (or 50 percent or less) of the amount determined under IRC section 482 to be the correct price.

  3. The Net Adjustment Penalty. This penalty applies when the net section 482 adjustment exceeds the lesser of $5 million or 10 percent of the taxpayer’s gross receipts.

  4. The term "price for any property or services" encompasses all kinds of adjustments under IRC section 482, including purchase prices, fees, services, rents, interest, and advances.

  5. For the net IRC section 482 adjustments that are excluded from the penalty, see IRC section 6662(e)(3)(B) and Treas. Reg. 1.6662-6(d). For calculation examples see Treas. Reg. 1.6662-6(c)(7).

  6. In order to monitor and gather information on the application of the transfer pricing penalty, the Service formed the Transfer Pricing Penalty Oversight Committee to review these cases. See Announcement 96-16, 1996-13 I.R.B. 22 (March 25, 1996).

  7. See Exhibit 20.1.5-4 flow chart for the IRC section 6662(e) Transfer Pricing Penalty.

20.1.5.9.4  (07-01-2008)
IRC Section 6662(h): Gross Valuation Misstatement

  1. A gross valuation misstatement exists:

    1. If the value or adjusted basis of any property claimed on a return is 200 percent or more of the corrected amount, or

    2. If the price for any property or service (or for the use of property) claimed on a return is 400 percent or more (or 25 percent or less) of the amount determined under IRC section 482 to be the correct price, or

    3. If the net section 482 adjustment exceeds the lesser of $20,000,000 or 20 percent of the taxpayer’s gross receipts.

20.1.5.9.5  (07-01-2008)
Penalty Calculation

  1. In the example below the substantial valuation misstatement penalty applies to the individual income tax return because both conditions for assertion are met (no exceptions to the penalty apply and the amount of the understatement and underpayment are equal):

    Example:

      a) Price of property (or adjusted basis) as reported on the return $46,000
      b) Price as adjusted by examination $20,000
      c) 150 percent times the amount in (b) $30,000
      d) Note: Condition #1 is met. The value reported on the return of $46,000 is more than 150 percent of the adjusted amount of $20,000 ($46,000 divided by $20,000 = 230 percent).
      e) Amount adjusted (line "a" less line " b" ) $26,000
      f) Underpayment on $26,000 $ 7,000
      g) Penalty (20 percent times $7,000) $ 1,400
      h) Note: Condition #2 is met. The underpayment of $7,000 attributable to the misstatement of $26,000 exceeds the required $5,000.

  2. If the adjusted value in (b) above were $10,000, the amount reported of $46,000 would then exceed the adjusted amount ($10,000) by more than 200 percent ($46,000 divided by $10,000 = 460 percent). The gross valuation misstatement penalty would then apply at 40 percent of the applicable underpayment.

  3. For calculation examples, involving carryovers and flow through entities, See IRM 20.1.5.2.3. and Treas. Regs. 1.6662-5(d) and (h).

  4. The penalty is considered separately for each property adjusted. To distinguish between a substantial and a gross valuation misstatement requires a property-by-property calculation.

  5. With regard to the transfer pricing penalty under IRC section 6662(e), please refer to the rules for coordinating between the transactional penalty and the net adjustment penalty illustrated by examples in Treas. Reg. 1.6662-6(f).

20.1.5.9.6  (07-01-2008)
Penalty Assessment

  1. See IRM 20.1.5.3.2 of this manual.

20.1.5.9.7  (07-01-2008)
Penalty Relief

  1. See IRM 20.1.5.6 of this manual.

20.1.5.9.7.1  (07-01-2008)
Reasonable Cause

  1. IRC section 6664(c) provides an exception to the penalty if the taxpayer has reasonable cause and acted in good faith.

  2. The reasonable cause exception applies to the transfer pricing penalties (IRC section 6662(e) and Treas. Reg. 1.6662-6) only under certain circumstances.

    1. For the Transactional Penalty. See IRM 20.1.5.9.3 and IRC section 6662(e)(1)(B)(i). A taxpayer must meet the reasonable cause requirements of Treas. Reg. 1.6664-4 to avoid the penalty.

    2. For the Net Adjustment Penalty, see IRM 20.1.5.9.3. The reasonable cause requirements under IRC section 6664(c) are met only if the taxpayer meets the requirements of Treas. Reg. 1.6662-6(d).

  3. In applying the provisions of Treas. Reg. 1.6664-4 where a taxpayer has relied on a professional analysis in determining its transfer pricing, whether the professional is an employee of, or related to, the taxpayer is not determinative in evaluating whether the taxpayer reasonably relied in good faith on advice.

20.1.5.9.7.2  (07-01-2008)
Charitable Deduction Property

  1. No penalty may be imposed under section 6662 with respect to any portion of an underpayment upon a showing by the taxpayer that there was a reasonable cause for, and the taxpayer acted in good faith with respect to, such portion.

  2. The taxpayer will not satisfy the good faith test by merely relying on an appraisal. The taxpayer will not be considered to have reasonably relied in good faith on advice unless the requirements of Treas. Reg. 1.6664-4(b) and (c) are met.

  3. In addition, the taxpayer must meet the specific requirements in Treas. Reg. 1.6664-4(h) where charitable deduction property is involved.

  4. When there is an underpayment due to overstated charitable deduction property, the reasonable cause exception under IRC section 6664(c)(2) applies only if the following two conditions are first met:

    1. The claimed value of the property was based on a "qualified appraisal" made by a "qualified appraiser," and

    2. The taxpayer made a good faith investigation of the value of the contributed property. See Treas. Reg. 1.6664-4(h).

  5. The Pension Protect Act of 2006 added a penalty provision under IRC section 6695A. If the claimed value of property based on an appraisal results in a substantial or gross valuation misstatement under IRC section 6662, a 6695A penalty is imposed on any person who prepared the appraisal and who knew, or reasonably should have known, the appraisal would be used in connection with a return or claim for refund. See IRM 20.1.6.

20.1.5.10  (10-01-2005)
IRC Sections 6662(f): Substantial Overstatement of Pension Liabilities

  1. The amount of the penalty is 20 percent of the underpayment attributable to a substantial overstatement of pension liabilities and 40 percent of the underpayment attributable to a gross valuation misstatement.

  2. An overstatement of pension liabilities occurs when the actuarial determination of the liabilities taken into account for purposes of computing the employer contribution deduction under IRC section 404(a) is 200 percent or more of the correct amount (400 percent or more in the case of a gross valuation misstatement).

  3. The penalty does not apply unless the underpayment attributable to the substantial overstatement of pension liabilities (or gross valuation misstatement, if applicable) exceeds $1,000.

20.1.5.10.1  (10-01-2005)
Penalty Calculation

  1. The following example illustrates the penalty criteria and calculation:

    a) The taxpayer’s 1990 return had taxable income of $300,000 and tax of $98,000.
    b) In determining the amount of taxable income, the taxpayer deducted $80,000 for contributions to a defined benefit pension plan maintained for its employees.
    c) Upon examination of the taxpayer’s return, the Service adjusted the interest assumption in valuing the pension liabilities for calculating the deduction.
    d) The taxpayer’s maximum deduction for contributions to its plan was accordingly adjusted from $80,000 to $35,000.

    Note:

    The 200 percent requirement is met when the amount deducted on the return ($80,000) exceeds the correct amount ($35,000) by more than 200 percent ($80,000 divided by $35,000 = 229 percent). The penalty is calculated as follows:

    a) Taxable income as adjusted ($300,000 + $45,000) $345,000
    b) Tax liability as adjusted $111,500
    c) Tax liability as filed $98,000
    d) Underpayment ("b" less "c" ) $13,500
    e) Penalty rate 20%
    f) Penalty ("d" times "e" ) $2,700

    Note:

    Since the deduction claimed exceeds the corrected amount by more than 200 percent, but is less than 400 percent, the penalty applies at the 20 percent rate. If the corrected deduction were $18,000, the percentage of the overstatement would be 444 percent ($80,000 divided by $18,000) and the penalty would apply at the 40 percent rate.

  2. See Notice 89-47, 1989-1 C.B. 687, for guidance on the calculation of the penalty. While this notice applies to IRC section 6659A, which is repealed, the examples contained in the notice still provide guidance on the mechanics of calculating the penalty.

20.1.5.10.2  (07-01-2008)
Penalty Relief

  1. The penalty will not apply if the taxpayer shows that there was a reasonable cause for the valuation or assumptions used in deriving the deduction on the return and that the taxpayer acted in good faith.

  2. See IRM 20.1.5.6. of this manual.

20.1.5.11  (10-01-2005)
IRC Section 6662(g): Substantial Estate or Gift Tax Valuation Understatement

  1. The amount of the penalty is 20 percent of the underpayment attributable to a substantial estate or gift tax valuation understatement or 40 percent of the underpayment attributable to a gross valuation misstatement.

  2. The penalty applies only to returns of tax imposed under Subtitle B.

20.1.5.11.1  (07-01-2008)
Penalty Assertion

  1. There is a substantial estate or gift tax valuation understatement if the value of the property claimed on an estate or gift tax return is 65 percent or less of the corrected amount (or 40 percent or less in the case of a gross valuation misstatement). See IRC section 6662(g)(1) and IRC section 6662(h)(2)(C) respectively.

  2. The penalty does not apply unless the underpayment attributable to the substantial estate or gift tax valuation understatement (or gross valuation misstatement, if applicable) exceeds $5,000.

20.1.5.11.2  (07-01-2008)
Penalty Calculation

  1. The determination of whether the percentage threshold for a substantial or gross valuation misstatement is reached is made on a property-by-property basis.

  2. To calculate the valuation understatement percentage, divide the value of the property reported on the return by the corrected value of the property.

  3. The following example illustrates the calculation of the understatement percentage for three adjustments (assuming the $5,000 requirement is met and no exceptions to the penalty apply).

  4. Example: The decedent’s estate tax return included stock in three closely held corporations: A, B and C. On the return, the stock in each corporation was valued at $80,000. On examination, the corrected stock values were determined to be $150,000 for A, $190,000 for B, and $330,000 for C. The following determinations were made:

    1. Stock A: The amount on the return ($80,000), divided by the corrected amount ($150,000) is 53 percent. The penalty does not apply to this adjustment because the value of the stock is not 50 percent or less of the corrected amount.

    2. Stock B: The amount on the return ($80,000), divided by the corrected amount ($190,000) is 42 percent. The accuracy-related penalty attributable to a substantial estate or gift tax valuation understatement applies to this adjustment because the value of Stock B is 50 percent or less (but more than 25 percent) of the corrected amount. The penalty amount is 20 percent of the underpayment attributable to the adjustment for Stock B.

    3. Stock C: The amount on the return ($80,000), divided by the corrected amount ($330,000) is 24 percent. The accuracy-related penalty attributable to a gross valuation misstatement applies to this adjustment because the value of Stock C is 25 percent or less of the corrected amount. The penalty amount is 40 percent of the underpayment attributable to the adjustment for Stock C.

  5. For calculation examples that relate to the above adjustments, see Exhibit 20.1.5-5.

20.1.5.11.3  (07-01-2008)
Penalty Assessment

  1. See IRM 20.1.5.3.2 of this manual.

20.1.5.11.4  (07-01-2008)
Penalty Relief

  1. See IRM 20.1.5.6 of this manual.

20.1.5.12  (07-01-2008)
IRC Section 6663: Civil Fraud Penalty

  1. IRC section 6663(a) provides that if any underpayment of tax is due to fraud, a penalty is imposed equal to 75 percent of the portion of the underpayment due to fraud.

  2. For purposes of Section 6663, a portion of the underpayment will be considered to be due to fraud where it is the result of intent to evade tax.

  3. For common features of the civil fraud penalty and the accuracy-related penalties, See IRM 20.1.5.2 of this manual.

20.1.5.12.1  (07-01-2008)
Indications of Fraud

  1. IRC section 6663 does not define "fraud" Courts have long recognized that the essence of the fraud penalty is the taxpayer’s state of mind. The state of mind required has been described in various ways, but most definitions require "intent to evade tax." Intent is distinguished from inadvertence, reliance on incorrect professional advice, honest difference of opinion, negligence or carelessness.

  2. Since direct proof of a taxpayer’s fraudulent intent is rarely available, fraud may be proven by circumstantial evidence and reasonable inferences. Fraud will generally involve one or more of the following elements:

    • Deception,

    • Misrepresentation of material facts,

    • False or altered documents,

    • Evasion (i.e., diversion or omission), or

    • Conspiracy.

  3. Some common "badges of fraud" include:

    1. Understatement of income (e.g., by omissions of specific items or entire sources of income, failure to report substantial amounts of income received),

    2. Fictitious or improper deductions (e.g., overstatement of deductions, personal items deducted as business expenses),

    3. Accounting irregularities (e.g., two sets of books, false entries on documents),

    4. Acts of the taxpayer evidencing an intention to evade tax (e.g., false statements, destruction of records, transfer of assets),

    5. A consistent pattern over several years of underreporting taxable income,

    6. Implausible or inconsistent explanations of behavior,

    7. Failure to cooperate with the examining agent,

    8. Concealment of assets,

    9. Engaging in illegal activities (e.g., drug dealing), or attempting to conceal illegal activities,

    10. Inadequate records, and

    11. Dealing in cash.

  4. Recommendations for asserting the civil fraud penalty should be carefully reviewed to fully establish that the evidence supports the assertion. Fraud must be proven by clear and convincing evidence

  5. All statutory notices of deficiency asserting the fraud penalty must be reviewed by Area Counsel.

20.1.5.12.2  (07-01-2008)
Penalty Assertion

  1. Civil fraud penalty will be asserted when there is clear and convincing evidence to prove that some part of the underpayment of tax was due to civil fraud. Such evidence must show the taxpayer’s intent to evade tax which the taxpayer believed to be owing.

  2. To assert the civil fraud penalty in a tax case, it is necessary to establish that a part of the deficiency is due to a knowingly false representation of facts by the taxpayer. The Service bears the burden of proving civil fraud by clear and convincing evidence in the Tax Court. See IRC section 7454(a). The Service must show that:

    • The taxpayer knew the content of the return was false; and

    • Made the return with the intent to evade tax.

  3. The civil fraud penalty should be asserted on a case-by-case basis giving consideration to all factors which have a bearing on the taxpayer’s fraudulent intent.

  4. If a taxpayer submits an amended return, it does not cure the defects on the previously filed fraudulent return and the fraud penalty would apply.

  5. The civil fraud penalty cannot be asserted on the same underpayment (or portion of an underpayment) on which accuracy-related penalties are asserted under IRC sections 6662 and 6662A (where the reportable transaction understatement is treated as an underpayment). Only one penalty can be applied to any portion of an underpayment of tax.

  6. The criteria for proving fraudulent failure to file under IRC section 6651(f) and civil fraud under IRC section 6663 are the same. Generally, if a fraudulent return is filed, but filed late, the civil fraud penalty under IRC section 6651(f) is the appropriate penalty to assert. Although there is no specific prohibition against asserting penalties under both IRC sections 6651(f) and 6663, the examiner should exercise caution. The court is not likely to sustain the assertion of both penalties unless compelling facts support the Service’s position. Area Counsel should be consulted before asserting both these penalties on the same return. For more information regarding restrictions on the assertion of the civil fraud penalty with respect to the failure to file and fraudulent failure to file penalties, see IRM 20.1.2.7 for additional information on the fraudulent failure to file penalty under IRC section 6651(f).

  7. On a joint return, the civil fraud penalty does not apply to a spouse unless some part of the underpayment is due to civil fraud on the part of that spouse. See IRC section 6663(c).

    1. For taxpayers filing a joint return after having filed separate returns, see IRC section 6013(b)(5).

    2. The civil fraud penalty follows the Code provision that allows a married couple to file a joint return after separate returns have been filed.

    3. If the sum of the amounts shown as tax on the two separate returns (for example, $150 plus $100 = $250) is less than the amount shown as tax on the joint return (for example, $300), then for the purpose of computing the civil fraud penalty, the sum of the amounts shown on the separate returns is treated as the amount shown on the joint return.

    4. Any fraud on either separate return will be deemed to be fraud on the joint return.

  8. As a general rule, neither Collection employees nor Customer Service employees are authorized to assess the civil fraud penalty. When fraud is identified by one of these functions, the case must be discussed with the group manager and the Fraud Technical Advisor (FTA) for referral consideration. IRM 25.1.11.

  9. In cases closing as unagreed with the civil fraud penalty, the report must include the alternative IRC section 6662 penalty positions that are most applicable. Closing an unagreed case without including an explanation of the alternative penalty positions in the report may hamper the government’s litigating position because the basis for the alternative penalty positions may be unclear to either Appeals or Area Counsel.

  10. The examiner’s report will reflect the civil fraud penalty by IRC section and identify the adjustments attributable to fraud. The examiner will attach Form 3198, Special Handling Notice for Examination Case Processing or Form 3198-A, TE/GE Special Handling Notice to the case file.

  11. For additional information on the Civil Fraud Process, see IRM 25.1, Fraud Handbook.

20.1.5.12.3  (07-01-2008)
Penalty Referral

  1. When an examiner determines that only the civil fraud penalty would apply, a referral to Criminal Investigation (CI) is not required.

  2. Determination of the civil fraud penalty is a shared responsibility of the examiner, the examiner’s group manager and the Fraud Technical Advisor.

  3. Referral guidelines to CI are contained in IRM 25.1.3, Criminal Referrals.

20.1.5.12.4  (07-01-2008)
Civil and Criminal Fraud

  1. The major difference between civil and criminal fraud is the degree of proof required to establish fraud on the part of the taxpayer.

    1. Criminal fraud requires sufficient evidence to prove guilt beyond a reasonable doubt.

    2. Civil fraud requires clear and convincing evidence of fraud with intent to evade tax.

  2. Due to the lower standard of proof in civil cases, the civil fraud penalty may be imposed upon a taxpayer who was not convicted of criminal tax evasion. If the taxpayer is convicted of criminal tax evasion under IRC section 7201, the civil fraud penalty should be asserted for the same tax year.

  3. However, criminal conviction does not mean the civil penalty will be automatically sustained.

  4. Examiners and managers should be aware of collateral estoppel and the important distinction it can have in civil tax fraud penalty cases. Collateral estoppel is a legal doctrine that prevents a taxpayer, who has been previously convicted of criminal tax evasion under 7201, from asserting a defense to the civil fraud penalty. See IRM 25.1.6.3.

  5. Examiners should coordinate closely with the group manager and local counsel on cases involving potential fraud.

20.1.5.12.5  (07-01-2008)
Penalty Calculation

  1. The civil fraud penalty is derived by multiplying the 75 percent penalty rate times the underpayment attributable to civil fraud.

  2. If any part of an underpayment is due to civil fraud, then the entire underpayment shall be treated as attributable to civil fraud unless the taxpayer establishes otherwise. The examiner will make a good faith effort to objectively weigh the evidence provided and eliminate those items that are inaccurate, but not fraudulent from the penalty calculation. See IRC section 6663(b).

  3. For a calculation example involving the accuracy-related penalty and the civil fraud penalty, see Exhibit 20.1.5-1 .

  4. For a calculation example involving civil fraud when Schedule C gross receipts cause an adjustment to self-employment tax under IRC section 1401, with a related change in the income tax deduction allowed under IRC section 164(f), see Exhibit 20.1.5-6.

20.1.5.12.6  (07-01-2008)
Civil Fraud Development

  1. If it is determined that a fraud case has firm indications of fraud, but does not meet criminal criteria, Form 11661, Request for Fraud Development, must be prepared.

  2. The examiner should contact the local FTA when the initial indicators of fraud are uncovered for assistance in completing Form 11661.

  3. See IRM 25.1.2, Recognizing and Developing Fraud for procedures on developing and processing a civil fraud case.

20.1.5.12.7  (07-01-2008)
Penalty Assessment

  1. The examiner will compute the penalty and provide any special closing instructions for CCP on the appropriate special handling notice, Form 3198 or Form 3l98A.

  2. The total civil fraud penalty will be assessed to the Master File with TC 320using:

    • Form 5344, Examination Closing Record,

    • Form 5403, Appeals Closing Record, or

    • Form 5599, TE/GE Examined Closing Record.

  3. The fraud penalty is assessed to the Non-Master File with TC 320 using:

    • Form 4720, Return of Certain Excise Taxes on Charities and Other Persons Under Chapters 41 and 42 of the IRC or

    • Form 5734, Non-Master File Assessment Voucher.

  4. The Form 5734 will be processed with the tax return using established functional guidelines.

  5. See IRM 20.1.2.7 for assessments relating to fraudulent failure to file penalty under IRC section 6651(f).

20.1.5.13  (07-01-2008)
IRC Section 6662A: Accuracy-Related Penalty on Understatements with Respect to Reportable Transactions

  1. Internal Revenue Code section 6662A generally imposes an accuracy-related penalty on any reportable transaction understatement for tax years ending after October 22, 2004. The IRC section 6662A penalty applies to:

    1. Any listed transaction (which is one category of reportable transactions); and

    2. Any other reportable transaction if a significant purpose of the transaction is the avoidance or evasion of federal income tax.

  2. As described below, a reportable transaction understatement under IRC section 6662A differs from an underpayment for IRC section 6662(a) and (b), accuracy-related penalty, purposes. IRC section 6662A penalty does not apply to reportable transaction understatements attributable to transactions settled under Announcement 2005-80 settlement initiative.

  3. The computation of the IRC section 6662A penalty is 20 percent of the reportable transaction understatement for tax years ending after October 22, 2004, where the reportable transaction was properly disclosed, and 30 percent of the reportable transaction understatement where the transaction was not properly disclosed. The disclosure requirements are explained in the section below, Adequate Disclosure and Rescission of IRC section 6707A Penalty.

20.1.5.13.1  (07-01-2008)
Adequate Disclosure and Rescission of IRC section 6707A Penalty

  1. A taxpayer uses Form 8886, Reportable Transaction Disclosure Statement, to make the disclosure required under IRC section 6011 and the regulations. Under Treas. Reg. 1.6011-4(e), the Form 8886 must be attached to the taxpayer's tax return (or amended return) for each taxable year for which a taxpayer participates in a reportable transaction. In addition, when the taxpayer files its first Form 8886, a duplicate form must be sent to the Office of Tax Shelter Analysis (OTSA).

  2. Generally, a taxpayer should first file a Form 8886 beginning with the first year that it has participated in the reportable transaction. Thus, the requirement to file a duplicate Form 8886 should arise during the first year of participation in the reportable transaction.

  3. If, however, the taxpayer fails to file any Form 8886 in its first year of participation, the requirement to send a duplicate Form 8886 to OTSA will arise whenever the taxpayer first submits a Form 8886, regardless of how many years it has been engaged in the reportable transaction at issue.

  4. A failure to submit either filing is a failure to satisfy the disclosure requirements. If a taxpayer has entered into more than one reportable transaction, the taxpayer is required to meet the disclosure requirements with respect to each transaction.

  5. A taxpayer is treated as meeting the disclosure requirements of IRC section 6011 and the associated regulations if the Commissioner (or the Commissioner’s delegate) rescinds the penalty under IRC section 6707A.

  6. IRC section 6707A provides a monetary penalty for the failure to include on any return or statement any information required to be disclosed under IRC §6011 with respect to a reportable transaction.

  7. IRC section 6707A authorizes the Commissioner to rescind the imposition of the penalty with respect to reportable non-listed transactions if it would promote compliance with the tax laws and effective tax administration. The penalty cannot be rescinded with respect to a listed transaction.

  8. The Commissioner’s refusal to rescind the penalty may not be reviewed by Appeals or in any court proceeding.

  9. The examiner should question the taxpayer or otherwise determine whether the taxpayer successfully sought rescission of an IRC section 6707A penalty with respect to the reportable transaction at issue, because such rescission could directly impact the application of IRC section 6662A.

  10. If the transaction at issue is a listed transaction, however, IRC section 6707A does not permit rescission and, therefore, the potential rescission of an IRC section 6707A penalty and its impact on IRC section 6662A is not an issue.

20.1.5.13.2  (07-01-2008)
Penalty Calculation

  1. The reportable transaction understatement is the sum of:

    1. The increase in taxable income that results from a difference between the proper tax treatment of the item related to the transaction and the taxpayer’s treatment of the item multiplied by the highest tax rate imposed by IRC section 1 for individuals or IRC section 11 for corporations, and

    2. The decrease in the aggregate amount of credits which results from the difference between the credits the taxpayer claimed and the proper amount. This is illustrated in the following example.

  2. Example:

    • Corporation Z is a C corporation. In Tax year (TY) 2005, Z had a net operating loss of $300,000. During TY 2005, Z participated in a reportable transaction that had a significant purpose of tax avoidance and generated a $250,000 loss. As required under Treas. Reg. 1.6011-4, Z filed a completed Form 8886 with its timely filed TY 2005 tax return and also filed a copy with the Office of Tax Shelter Analysis (OTSA).

    • Upon audit, the IRS disallowed Z’s $300,000 net operating loss, but determined that Z’s tax liability for TY 2005 remains $0. The adjustments consist of: disallowance of the $250,000 loss attributable to the reportable transaction and disallowance of a $50,000 deduction. The IRS determines that the disallowed $50,000 deduction was taken by Z in disregard of the rules or regulations. In addition, Z’s position did not have a realistic possibility of being sustained on its merits and was not adequately disclosed on Form 8275 pursuant to Treas. Reg. 1.6662-3(c).

    • Although Z disregarded the rules or regulations, Z will not owe an accuracy-related penalty on the underpayments under IRC section 6662 because Z’s corrected tax liability for TY 2005 is $0 and no underpayment exists. Without an underpayment, there is no liability for a penalty under IRC section 6662. Z, however, is subject to the penalty on a reportable transaction understatement under IRC section 6662A for TY 2005 because Z participated in a reportable transaction with a significant purpose of tax avoidance and there is a reportable transaction understatement resulting from the taxpayer’s tax treatment of that transaction. The penalty rate is 20 percent because Z properly disclosed participation in the reportable transaction. Z’s penalty is calculated as follows:

    • The reportable transaction understatement = ($250,000 x .35) + (0) = $87,500

      $250,000 = Increase in taxable income resulting from the difference between the proper tax treatment and the taxpayer's treatment of the loss attributable to the reportable transaction.
      35% = Highest corporate income tax rate imposed by IRC section 11.
      $0 = Decrease in aggregate amount of credits that results from the difference between the taxpayer's treatment of the reportable transaction and the proper tax treatment of that transaction.

    • Z’s reportable transaction understatement is $87,500, upon which a 20 percent penalty is applied because Z properly disclosed the transaction under Treas. Reg 1.6011-4. Z’s accuracy-related penalty on the reportable transaction understatement under IRC section 6662A is $17,500 for TY 2005 ($87,500 x .20).

  3. If the taxpayer files an amended return after the IRS first contacts the taxpayer regarding an examination of the return, or any other dates specified by the Secretary, the tax treatment of an item on the amended return is not taken into account in determining the reportable transaction understatement, see IRC section 6662A(e)(3), and Treas. Reg. 1.6664-2(c)(3).

    Note:

    Due to the definition of "reportable transaction understatement," the IRC section 6662A penalty, unlike the IRC section 6662 penalty, will apply even if there is no underpayment of tax on the taxpayer’s return, as shown in the example above.

  4. In the case of a reportable transaction other than a listed transaction, the IRC section 6662A penalty will not be imposed if the taxpayer:

    1. Adequately disclosed its reportable transaction as required under IRC section 6011 and the associated regulations, and

    2. Meets other criteria to establish reasonable cause and good faith.

20.1.5.13.3  (07-01-2008)
Coordination with Other Penalties

  1. Generally, the IRC section 6662A penalty is in addition to any other penalty that may be imposed. The following penalties, however, may not be assessed if the IRC section 6662A penalty is assessed: IRC section 6662 penalty, Accuracy-Related Penalty on Underpayments; IRC section 6663 penalty, Fraud Penalty; and IRC section 6676 penalty, Erroneous Claim for Refund or Credit. Also, the IRC section 6662A penalty does not apply to any portion of an understatement on which the IRC section 6662(h), accuracy-related penalty for a gross valuation misstatement or IRC section 6663, fraud penalty, is assessed.

  2. For purposes of determining whether the taxpayer has a substantial understatement of income tax under IRC section 6662(d), e.g., determining whether an individual has an understatement in excess of the lesser of:

    1. 10 percent of tax required to be shown on the return, or ,

    2. $5,000.

  3. The understatement attributable to the IRC section 6662A reportable transaction is included in the IRC section 6662(d) understatement calculation. However, the reportable transaction understatement upon which the IRC section 6662A penalty is asserted, is not included in the amount of the understatement used to determine the underpayment upon which the 20 percent under IRC section 6662(d) penalty is asserted. These calculations are illustrated in the following example.

  4. Example:

    • A and B, husband and wife, filed a joint federal income tax return for Tax Year (TY) 2005, reporting taxable income of $15,800 and a tax liability of $1,644. A and B participated in a reportable transaction a significant purpose of which was the avoidance or evasion of Federal income tax, which was not disclosed pursuant to IRC section 6011. A and B had no amounts previously assessed (or collected without assessment) and no rebates had been made. Subsequently, the return was examined and the following adjustments and penalties were agreed to:

      Adjustment 1 (no penalty)