The IRS can impose a twenty percent (20%) accuracy-related penalty on the portion of an underpayment in taxes attributable to misconduct identified in IRC § 6662(b). Specifically, the 20% accuracy-related penalty is imposed if the underpayment in taxes is attributable to negligence or disregard of tax rules or regulations.
Note – the accuracy related penalty can also be imposed for a substantial understatement of income tax (IRC §6662(b)(2)) and any other reason stated in IRC § 6662(b), but many accuracy related penalties are assessed on the basis of negligence or disregard of tax rules and regulations.
NEGLIGENCE OR DISREGARD OF RULES OR REGULATIONS
One type of misconduct that triggers the accuracy-related penalty under IRC § 6662 is “negligence or disregard of rules or regulations.”
IRC § 6662(c) defines negligence as the failure to reasonably attempt to comply with the Internal Revenue Code, and disregard as careless, reckless, or intentional disregard.
Courts have defined negligence as the lack of due care or failure to do what is reasonable and ordinarily prudent under the circumstance. It includes acts of omission or commission that a reasonable person would or would not do. Hence, it covers a broad range of conduct that results in an underpayment of tax.
Acts that Constitute Negligence
Negligence frequently takes the form of a failure to report income or an overstatement of deductions. The act of understating income is not by itself proof of negligence, but significant discrepancies between actual and reported net income are strong evidence of negligence. A taxpayer through their tax attorney must be able to explain the large discrepancies between actual and reported income.
The following are examples of negligence warranting the accuracy-related penalty.
- Failure of the taxpayer to include an amount of income shown on an information return on the income tax return
- Failure of the taxpayer to make a reasonable attempt to ascertain the correctness of a deduction, credit, or exclusion on a return, which, under the circumstances, for a reasonable and prudent person would be “too good to be true”
- Failure of a partner to comply with IRC § 6222 requirements (regarding a partner’s treatment of partnership items on its return in a manner that is consistent with the treatment of such items on the partnership return).
- Failure of a shareholder to comply with IRC § 6242 (regarding the treatment of an S corporation shareholder of subchapter S items on its return that is consistent with the treatment of such items on the corporation’s return)
DISREGARD OF RULES OR REGULATIONS
The IRS will assess a penalty when a taxpayer disregards IRS rules and regulations. Disregard arises when a taxpayer is aware of a rule or regulation, yet still chooses to ignore the requirements. However, a penalty for disregard of rules and regulations does not apply if:
- The position has a reasonable basis.
- The position is disclosed on Form 8275, and a good faith challenge to the validity of regulation is made on Form 8275-R.
- The taxpayer maintains adequate books and records or can substantiate items properly.
The regulations define three types of disregard: careless disregard, reckless disregard, and intentional disregard.
Careless disregard is defined as not exercising reasonable diligence to determine the correctness of a return position that is contrary to the rules or regulations. On the other hand, reckless disregard is the making of little or no effort at all to determine substantial deviation from the standard of conduct that a reasonable person would observe. Finally, intentional disregard is defined as the knowledge of a rule or regulation that is disregarded.
Rules and Regulations
Rules and regulations are provisions of the Internal Revenue Code (IRC), temporary or final Treasury regulations issued under the Code, and revenue rulings of notices issued by the Internal Revenue Service (IRS) and published in the Internal Revenue Bulletin. Of the three, the revenue rulings are not “rules” in the administrative law sense. They are generally given a lower degree of deference than regulations in a judicial proceeding. Nonetheless, a return position contrary to a revenue ruling will be subject to the accuracy-related penalty unless it has a realistic possibility of being sustained on the merits. Therefore, even if a revenue ruling is merely a position of the IRS, a taxpayer nevertheless will be considered guilty of intentional disregard if he adopts a return position that, in the IRS’ opinion, would probably not succeed in court.
Defense: Reasonable Basis Standard
A position is not negligent if there is a reasonable basis for that position. For purposes of the regulations, a return position will generally satisfy the reasonable basis standard if it is reasonable based on one or more of the authorities outlined in Regulations Section 1.6662-4(d)(3)(iii). Therefore, even if a return position does not satisfy the reasonable basis standard, the reasonable cause and good faith exception of IRC Section 6664, can still avoid the accuracy-related penalty for negligence or disregard of rules and regulations.
For tax reporting, the Regulations interpret reasonable basis as one significantly higher than not frivolous or not patently improper. Being reasonable is not satisfied by a return position that is merely arguable or merely a colorable claim. Still, it need not satisfy the substantial authority standard as the regulations define that standard.