IRS Updated Revenue Procedure for Reducing or Avoiding Understatement Penalties and Tax Return Preparer Penalties
Recently, the IRS issued Revenue Procedure 2020-54, which updated Revenue Procedure 2019-42. Specifically, this new Revenue Procedure identifies circumstances under which the taxpayer makes an adequate disclosure on a taxpayer’s income tax return regarding an item or position for the purpose of reducing the understatement of income tax under section 6662(d) of the Internal Revenue Code (relating to the substantial understatement aspect of the accuracy-related penalty), and for the purpose of avoiding the tax return preparer penalty under section 6694(a) (relating to understatements due to unreasonable positions) with respect to income tax returns.
To give some context, the IRS may charge a 20% addition to tax for any “substantial understatement of tax” under section 6662. Generally, a substantial understatement of tax exists if the amount of the understatement exceeds the greater of (i) 10% of the amount of tax required to be shown on the return for the tax year or (ii) $5,000. I.R.C. § 6662(d)(1)(A). An “understatement” is the excess of (i) the amount of the tax required to be shown on a return for the tax year, over (ii) the amount of the tax imposed which is shown on the return, reduced by any rebate (within the meaning of I.R.C. § 6211(b)(2)). I.R.C. § 6662(d)(2)(A). Special rules for determining understatements apply to corporations and individuals utilizing § 199A QBI deductions. See I.R.C. § (d)(1)(B), (d)(1)(C).
Additionally, the IRS may impose a return preparer penalty under I.R.C. § 6694 on a tax return preparer who prepares a return or claim for refund reflecting an understatement of tax liability due to an “unreasonable position” if the tax return preparer knew (or reasonably should have known) of the position. Notably, any tax shelter or reportable transaction is considered per se unreasonable, unless it is reasonable for the return preparer to believe that the position would more likely than not be sustained on the merits. I.R.C. §6694(a)(2).
However, if the taxpayer has a “reasonable basis” for the tax treatment of the item, then the amount of the understatement is reduced by the portion of the understatement attributable to the item if (i) there was or is substantial authority for such treatment, or (2) 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 tax treatment of such item by the taxpayer. I.R.C. § 6662(d)(2)(B). Revenue Procedure 2020-54 sets forth guidance with respect to what constitutes “adequate disclosure” for the purposes of avoiding these penalties.
Generally, a taxpayer must furnish all required information in accordance with the applicable forms and instructions, and the amounts entered on these forms must be verifiable to be “adequate.” However, there are limitations. See e.g. Rev. Proc. 2020-54 (“Although a taxpayer may literally meet the disclosure requirements of this revenue procedure, the disclosure will have no effect for purposes of the section 6662 accuracy-related penalty if the item or position on the return (1) does not have a reasonable basis as defined in Treas. Reg. § 1.6662-3(b)(3) . . .”). Notably, this new Revenue Procedure updated the tax years and tax forms to which the Revenue Procedure applies but has not made any substantive changes to the previously release guidance in Rev Proc 2019-42. The requirements under these Revenue Procedures are somewhat complex, and the advice of a tax attorney may be needed to ensure that adequate disclosure is provided to avoid the imposition of these severe penalties.