IRS MODIFIES PENALTY-AVOIDANCE PROCEDURES FOR CEP TAXPAYERS.

Rev. Proc. 94-69

SECTION 1. PURPOSE

.01 The purpose of this revenue procedure is to modify, update, and restate Rev. Proc. 85-26, 1985-1 C.B. 580, to reflect the repeal of section 6661 of the Internal Revenue Code and the amendment of section 6662 by the Omnibus Budget Reconciliation Act of 1989, Pub. L. 101-239, 103 Stat. 2106 ("OBRA 1989"), effective for returns due after December 31, 1989 (determined without regard to extensions).

.02 This revenue procedure provides special procedures for taxpayers that are subject to the Coordinated Examination Program ("CEP") to show additional tax due or make adequate disclosure with respect to an item or a position to avoid imposition of the substantial understatement penalty imposed under former section 6661 and the accuracy-related penalty currently described in sections 6662(b)(1) and 6662(b)(2).

.03 This revenue procedure also provides safe harbor rules for CEP taxpayers to avoid the former section 6661 substantial understatement penalty and the accuracy-related penalty described in sections 6662(b)(1) and 6662(b)(2) with respect to returns already filed by CEP taxpayers that are notified of their removal (decontrol) from the CEP.

SECTION 2. BACKGROUND

.01 Former section 6661(a) provided for an addition to tax equal to 25 percent of the amount of any underpayment attributable to a substantial understatement of income tax for a taxable year. Former section 6661 was repealed by OBRA 1989 and applies only to returns due on or before December 31, 1989 (determined without regard to extensions).

.02 Under section 1.6661-2(d)(2) of the Income Tax Regulations, a substantial understatement of income tax for purposes of the section 6661 penalty is computed without regard to any amount of additional tax shown on an amended return. In the case of additional tax shown or adequate disclosure made on a "qualified amended return," however, section 1.6661-6(c) provides for an automatic waiver of any penalty that would not have been imposed if the additional tax shown or the adequate disclosure made had been included on the taxpayer's original return. Section 1.6661-4 describes what constitutes adequate disclosure.

.03 Current section 6662 imposes an accuracy-related penalty equal to 20 percent of the portion of any underpayment that is attributable to (1) negligence or disregard of rules or regulations, or (2) any substantial understatement of income tax. Section 6662 was amended by OBRA 1989, and, as amended, applies to returns due after December 31, 1989 (determined without regard to extensions).

.04 Section 1.6662-3(b)(1) defines "negligence" to include any failure to make a reasonable attempt to comply with the provisions of the internal revenue laws or to exercise ordinary and reasonable care in the preparation of a tax return. "Negligence" also includes any failure by the taxpayer to keep adequate books and records or to substantiate items properly.

.05 Section 1.6662-3(b)(2) defines "disregard" to include any careless, reckless, or intentional disregard of rules or regulations. "Rules or regulations" includes the provisions of the Internal Revenue Code, temporary or final regulations issued under the Code, and revenue rulings or notices issued by the Internal Revenue Service.

.06 Section 1.6662-3(c) provides, generally, that no penalty for negligence or disregard of rules or regulations will be imposed on any underpayment attributable to an item or position that is adequately disclosed.

.07 Section 6662(d)(1) generally defines "substantial understatement" of income tax to be an understatement for the taxable year that exceeds the greater of 10 percent of the tax required to be shown on the return or $5,000 ($10,000 in the case of a corporation other than an S corporation or a personal holding company).

.08 Under sections 6662(d)(2)(B)(ii) and 1.6662-4(e), prior to the amendment of section 6662 in 1993, the tax treatment of an item (other than a tax shelter item) that is not frivolous and is adequately disclosed is not taken into account in computing the amount of an understatement of income tax for purposes of the substantial understatement penalty.

.09 Sections 1.6662-3(c) and 1.6662-4(f) provide the methods for making adequate disclosure for purposes of the (1) penalty for negligence or disregard of rules or regulations, and (2) the substantial understatement penalty, respectively. These methods include attaching a properly completed Form 8275, Disclosure Statement, to an original return or to a qualified amended return in the case of an item or position other than one that is contrary to a regulation. In the case of a position contrary to a regulation, disclosure must be made on Form 8275-R (Regulation Disclosure Statement).

.10 Sections 1.6661-6(c)(2) and 1.6664-2(c)(3) generally provide that for purposes of the substantial understatement penalty and the accuracy-related penalty, respectively, a "qualified amended return" is an amended return that is filed after the due date of the return for the taxable year and before the time the taxpayer is first contacted regarding an examination of the return. A qualified amended return also includes an amended return that is filed within such time frame solely to disclose information but does not report any additional tax liability. In addition, sections 1.6661-6(c)(4) and 1.6664-2(c)(4) provide that the Commissioner may prescribe by revenue procedure the manner in which the rules governing qualified amended returns apply to particular classes of taxpayers.

.11 Section 13251 of the Omnibus Budget Reconciliation Act of 1993 ("OBRA 1993") amended section 6662(d)(2)(B)(ii), pertaining to the substantial understatement penalty, to provide that the taxpayer must have a reasonable basis for the tax treatment of an item on a tax return to meet the standard for adequate disclosure with respect to that item for tax returns with due dates after December 31, 1993 (without regard to extensions). The Conference Report accompanying section 13251 of OBRA 1993 states that the "reasonable basis" disclosure standard also applies to the penalty for disregarding rules or regulations and that there is no longer a disclosure exception for the negligence penalty. See H.R. Conf. Rep. No. 213, 103d Cong., 1st Sess. 669 (1993). These provisions in the Conference Report were implemented by section 1.6662-7T of the temporary Income Tax Regulations, issued on March 14, 1994, for returns and qualified amended returns filed after that date.

SECTION 3. QUALIFIED AMENDED RETURN

.01 For purposes of avoiding imposition of the penalty under section 6662(b)(1) for negligence or disregard of rules or regulations for tax returns due after December 31, 1989, and the substantial understatement penalty under former section 6661 or section 6662(b)(2), a written statement furnished by a CEP taxpayer to the Service personnel requesting the statement is treated as a qualified amended return if the written statement is:

(1) described in section 3.02 below, and

(2) furnished after the tax return has been filed but no later than 15 days (or any later date agreed to in writing by the appropriate District official upon a showing of reasonable cause) from the date of written notice from the Service to the taxpayer requesting that such statement be furnished with respect to the taxable year(s) involved.

.02 A written statement is described in this section 3.02 if it includes:

(1) the caption "Furnished under Rev. Proc. 94-69 ";

(2) a description of all items that would result in adjustments if the taxpayer, in lieu of furnishing a written statement, filed a properly completed amended return. The description of an item is adequate if it consists of information that reasonably may be expected to apprise the Internal Revenue Service of the identity of the item, its amount, and the nature of the controversy or potential controversy. For example, the statement that certain amounts deducted as expenses should instead have been capitalized is adequate only if it refers to specific accounts and amounts recorded in invoices or journal entries. Further, if a position contrary to a rule or regulation has been taken with respect to an item, the statutory or regulatory provision or the ruling in question must be adequately identified; and

(3) The following declaration signed by a person authorized to sign the return of the taxpayer: "Under penalties of perjury, I declare that I have examined this written statement, and to the best of my knowledge and belief this written statement is true, correct, and complete."

.03 A written statement need not include a recomputation of tax liability. Similarly, if an item automatically affects another item, the written statement need not include a recomputation of the affected item. For example, if the taxpayer's written statement identifies with specificity an increase in ending inventory and states the amount of the increase, an item resulting in adjustments has been described as required in section 3.02(2) above. The written statement need not include a recomputation of tax liability resulting from the increase in ending inventory. Similarly, the written statement need not identify the existence and amount of the decrease in the cost of goods sold that results from the increase in ending inventory.

.04 Any additional tax liability resulting from the adjustments identified in a written statement described in sections 3.01 through 3.03 above shall be treated as an additional amount of tax shown on a qualified amended return.

.05 The Service representative will not specify whether the statements furnished satisfy adequate disclosure standards when the statements are submitted.

SECTION 4. DISCLOSURE ON QUALIFIED AMENDED RETURN

.01 Returns due on or before December 31, 1989. In the case of returns due on or before December 31, 1989, if, in a written statement described in sections 3.01 through 3.03 above, the taxpayer makes adequate disclosure with respect to an item in the manner prescribed in section 1.6661-4, such disclosure shall be treated as adequate disclosure made in a statement attached to a qualified amended return.

.02 Returns due after December 31, 1989, and before January 1, 1994. In the case of returns due after December 31, 1989, and before January 1, 1994, if, in a written statement described in sections 3.01 through 3.03 above, the taxpayer provides the information that would have been reported on a properly completed Form 8275 or Form 8275-R and otherwise satisfies the applicable requirements of the regulations under section 6662, such disclosure shall be treated as adequate disclosure made on a Form 8275 or Form 8275-R attached to a qualified amended return.

.03 Returns due after December 31, 1993. In the case of returns due after December 31, 1993, if, in a written statement described in sections 3.01 through 3.03 above, the taxpayer provides the information that would have been reported on a properly completed Form 8275 or Form 8275-R and otherwise satisfies the applicable requirements of the regulations under section 6662, such disclosure shall be treated as adequate disclosure made on a Form 8275 or Form 8275-R attached to a qualified amended return. Accordingly, a taxpayer may disclose to avoid the substantial understatement of income tax penalty only if the taxpayer's position had a reasonable basis. In addition, for returns filed after March 14, 1994, the effective date of section 1.6662-7T, a taxpayer may not disclose to avoid the negligence penalty and may disclose to avoid the disregard of rules or regulations penalty only if the taxpayer's position had a reasonable basis.

SECTION 5. SAFE HARBOR RULE

The provisions of this revenue procedure will continue to apply for a period of 15 days (or until any later date agreed to in writing by the appropriate District official upon a showing of reasonable cause) from the date of written notice to the taxpayer that it no longer meets the criteria for a CEP taxpayer. Thus, with respect to returns that have already been filed but are not yet under examination, the written statements described in sections 3.01 through 3.03 above will be treated as qualified amended returns or disclosure statements, as the case may be, only if received no later than 15 days (or any later date agreed to in writing by the appropriate District official upon a showing of reasonable cause) from the date of such written notice. Returns of the taxpayer filed after the date of such written notice are not subject to the provisions of this revenue procedure.

SECTION 6. EFFECT ON OTHER DOCUMENTS

Rev. Proc. 85-26, 1985-1 C.B. 580, is superseded.

SECTION 7. EFFECTIVE DATE

This revenue procedure is effective October 31, 1994.

DRAFTING INFORMATION

The principal author of this revenue procedure is Gerald A. Consalvi of the Office of Assistant Chief Counsel (Income Tax and Accounting). For further information regarding this revenue procedure, contact Mr. Consalvi on (202) 622-4940 (not a toll-free call).