INSIGHT: IRS LB&I Concept Unit on Accuracy-Related Penalties Contains Significant Errors

On July 29, 2020, the IRS Large Business and International (LB&I) Division publicly released a “concept unit” on accuracy-related penalties under Internal Revenue Code Section 6662, which is meant to provide instruction to IRS examiners dealing with penalty issues. Unfortunately, this concept unit contains significant errors. Taxpayers and tax practitioners should not rely on this concept unit when it comes to the application of accuracy-related penalties. While the concept unit appears to have been removed from the LB&I website as of August 3, many taxpayers, tax practitioners, and IRS examiners may have already downloaded and saved the concept unit, and should be aware of the errors noted below.

Accuracy-related penalties include penalties for negligence or disregard of rules or regulations, substantial understatements of income tax, transactions lacking economic substance, and valuation misstatement penalties (including transfer pricing penalties), among others. These penalties are imposed in the amount of 20% or 40% (depending on the penalty) of any underpayment of tax to which IRC Section 6662 applies.

Reasonable Basis

The most significant error is the concept unit’s misstatement of the reasonable basis standard. Under Treasury Regulation Section 1.6662-3(b)(3), satisfaction of the reasonable basis standard may provide a defense against the application of certain accuracy-related penalties. The tax return preparer penalties under IRC Section 6694 and Circular 230’s rules governing practice before the IRS also incorporate the reasonable basis standard. Treas. Reg. Section 1.6662-3(b)(3) defines reasonable basis as a standard significantly higher than frivolous but lower than substantial authority, and specifies that reasonable basis exists when a return position is reasonably based on one or more specified authorities. The AICPA’s interpretation of its Statements on Standards for Tax Services, which likewise incorporate the reasonable basis standard, states that the standard “generally is interpreted as requiring that there be approximately a 20 percent likelihood that the position will be upheld on its merits if it is challenged.”

By contrast, the concept unit erroneously states that “[t]he reasonable basis standard is usually met when the position: (1) Has a greater than 50% likelihood of being sustained if litigated, and (2) Is based on substantial authority.” That is, the concept unit mistakenly defines reasonable basis as equivalent to more likely than not, which is a higher standard than both reasonable basis and substantial authority. Given the settled nature of the law and guidance in this area, this appears to be a misstatement on the part of the IRS, rather than an attempt to redefine the reasonable basis standard.

Underpayment Computation

Under IRC Section 6664(a), the amount of an underpayment is determined by comparing the amount of tax due to the amount of tax shown on the taxpayer’s return, taking into account any rebates of tax and any amounts that were not shown on the return but were previously assessed or collected. The concept unit misstates the formula for computing an underpayment. Specifically, it adds amounts previously assessed or collected to the amount of the underpayment, whereas such amounts reduce the amount of an underpayment when applying the statutory computation. The erroneous guidance would result in examiners computing larger underpayments (and thus larger penalties) in cases when there are amounts that were not shown on the return but were previously assessed or collected.

Conclusion

Based on the errors noted above, the concept unit should not be relied on when it comes to the application of accuracy-related penalties. The errors discussed above are particularly unfortunate as examiners following this incorrect guidance might refuse to accept valid taxpayer defenses and/or apply penalties based on an inflated underpayment amount.

In 2019, the Treasury Inspector General for Tax Administration (TIGTA) released a report critical of LB&I’s application of penalties. In response to the TIGTA report, LB&I agreed with the recommendation to ensure that its examiners and supervisors were properly trained to consider and, when appropriate, apply accuracy-related penalties. Specifically, LB&I noted that its Penalty Concept Network would provide materials for examiners in this area. It appears likely that this concept unit is part of that effort, and it is to be hoped that swift remediation of these errors, as well as a review of the concept unit as a whole, will enable LB&I to achieve its aim of improving penalty administration.
This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.

Author Information

Thomas D. Bettge is a senior associate in the Economic Valuation Services (EVS) group with KPMG LLP in Houston. Thomas Kane is a director, Mark R. Martin is a principal in the EVS group, and Michael Dolan is National Director of IRS Policies and Dispute Resolution with KPMG LLP’s Washington National Tax practice.

The preceding information is not intended to be “written advice concerning one or more Federal tax matters” subject to the requirements of section 10.37(a)(2) of Treasury Department Circular 230. The information contained herein is of a general nature and based on authorities that are subject to change. Applicability of the information to specific situations should be determined through consultation with your tax adviser. This article represents the views of the author(s) only, and does not necessarily represent the views or professional advice of KPMG LLP.