The Art of the Tax Disclosure: How to Avoid Tax Penalties By Disclosing a Return Position
There are at least three questions when it comes to IRS tax disclosures: (1) Should a taxpayer disclose; (2) How should a taxpayer disclose; and (3) How much detail should be disclosed? Should a taxpayer simply append a statement or footnote to the return, or should the taxpayer utilize a Form 8275, Form 8275-R, or Form 8886? This article addresses these questions, drawing on experience with hundreds of tax return disclosures. We also explore outstanding questions in the context of IRS disclosures.
To Disclose or Not To Disclose, That is the Question
The Internal Revenue Code (IRC) imposes penalties for tax-reporting positions that result in an underpayment of tax or an understatement of liability and (1) lack the appropriate level of authority and/or (2) are not adequately disclosed. The Accuracy-Related Penalty imposed by Section 6662 (taxpayer) and Section 6694 (preparer) are two examples.
Section 6662 imposes a 20% penalty for an underpayment resulting from: negligence or disregard of Rules or Regulations; a substantial understatement of income tax; a substantial valuation misstatement under Chapter 1; and other violations. In some cases, the underpayment penalty is increased to 40%.
In addition, Section 6694 imposes a penalty against a tax preparer when (1) he or she prepares a return or claim that reflects an understatement of liability based on an unreasonable position and (2) the individual knew or reasonably should have known of the unreasonable position.
A tax disclosure, however, provides a potential defense against IRS penalties. In fact, in many circumstances, a failure to adequately disclose can result in penalties against both a taxpayer and a tax-return preparer.
How To Disclose
The IRS provides three potential methods of formal disclosure: Form 8275, Form 8275-R, and Form 8886.
Form 8275, Disclosure Statement, allows a taxpayer to disclose certain items or positions that are not contrary to IRS regulations and that are not otherwise adequately disclosed on a tax return. This form is available to individuals, corporations, pass-through entities, and tax return preparers.
Form 8275-R, Regulation Disclosure Statement, allows a taxpayer to disclose reporting positions that are contraryto Treasury Regulations. In other words, if a position is not contrary to the Regulations, an individual must use Form 8275—not Form 8275-R. Like Form 8275, a Form 8275-R may be filed by individuals, corporations, pass-through entities, and tax return preparers.
Finally, Form 8886, Reportable Transaction Disclosure Statement, is available to disclose information with respect to reportable transactions. Reportable Transactions include Listed Transactions, Confidential Transactions, Transactions with Contractual Protections, Loss Transactions, and Transactions of Interest.
A taxpayer generally must use separate forms 8886 for each reportable transaction unless the transactions are the same or substantially similar. A transaction is substantially similar if (1) it is expected to obtain the same or similar types of tax consequences and (2) is either factually similar or based on the same or similar tax strategy.According to the IRS, determinations of substantial similarity should be construed in favor of disclosure.
How Much To Disclose?
The information that is necessary to satisfy the detailed IRS regulations, case law, and administrative authorities is generally a question for a qualified tax attorney. Failing to have a tax attorney review or draft a sensitive disclosure may expose a taxpayer to or the tax-return preparer to substantial penalties. In some circumstances, a non-compliant disclosure (or failure to disclose when required) can leven ead to a criminal prosecution.
A proper tax disclosure generally requires knowledge of the tax provisions at issue and an understanding of the nuance of the positions available. The amount of information and detail needed is a function of the facts and circumstances and the particular IRS regulations at issue.
Believe it or not, the most common mistake is likely “over” disclosure or a failure to properly tailor the disclosure. A taxpayer, remember, is only required to disclose enough detail to indicate to the IRS what is at issue. As such, the disclosure should generally to be concise—and precise. Extraneous disclosures can expose a taxpayer to additional risk.
Is it possible to reduce the amount of an underpayment?
Yes, it is possible to reduce the amount of an underpayment both with respect to taxpayers and preparers.
Section 6662(d)(2)(B) allows for the reduction by the portion of an understatement attributable to:
i. The tax treatment of an item by the taxpayer if there is or was substantial authority for such treatment; or
ii. Any item if—
I. The relevant facts affecting the item’s tax treatment are adequately disclosed in the return or in a statement attached to the return, and
II. There is a reasonable basis for the tax treatment of such item by the taxpayer.
Substantial authority exists when the authorities permitting a particular treatment are substantial compared to the sources not supporting that treatment. Keep in mind, however, that the IRS regulations only allow certain types of authorities to factor into the equation, and those tax-law authorities have well-established hierarchies in the tax law. Whether or not substantial authority exists is a legal question—generally, a tax attorney may be able to provide a tax opinion addressing the issue. Adequate disclosure exists when the disclosure is on a proper form or amended return. Likewise, “reasonable basis” is a term of art in the tax law, and whether a reasonable basis exists for a tax-return position often requires analysis by a tax attorney.
Similarly, preparer penalties may be reduced. Section 6694(b)(3) reduces the amount of an understatement by the amount paid by a preparer under subsection (a).
Is it possible to amend a disclosure?
Yes. An individual can file an amended return or request for administrative adjustment under Section 6227. If the return constitutes a Qualified Amended Return and is timely filed, it will reduce accuracy-related penalties.
 26 U.S.C. § 6662.
 26 U.S.C. § 6694.
 26 U.S.C. § 6694.
 26 C.F.R. § 1.6664-2.
 26 U.S.C. § 6227.