Final Regs Issued on Accuracy-Related Penalties

 [4830-01]

 ACTION: Final Regulations.

 SUMMARY: This document contains final regulations relating to the accuracy-related penalty for negligence or disregard of rules or regulations, substantial understatement of income tax, and substantial (or gross) valuation misstatement under chapter 1 of the Internal Revenue Code. The applicable tax law was amended by the Omnibus Budget Reconciliation Act of 1989. The regulations affect all taxpayers that file returns of income tax and provide guidance necessary to comply with these changes.

 EFFECTIVE DATES: Except for sections 1.6662-3(c) and 1.6662-4(e) and (f), these final regulations are effective for income tax returns due after December 31, 1989 (determined without regard to extensions of time for filing). Sections 1.6662-3(c) and 1.6662-4(e) and (f) are effective for income tax returns due after December 31, 1991 (determined without regard to extensions of time for filing).

 FOR FURTHER INFORMATION CONTACT: Gail M. Winkler of the Office of Assistant Chief Counsel (Income Tax and Accounting), Internal Revenue Service, 1111 Constitution Avenue, N.W., Washington, D.C. 20224 (Attention: CC:IT&A:4) or telephone (202) 566-5985 (not a toll- free call).

SUPPLEMENTARY INFORMATION:

PAPERWORK REDUCTION ACT

The collection of information contained in these final regulations has been reviewed and approved by the Office of Management and Budget in accordance with the Paperwork Reduction Act of 1980 (44 U.S.C. 3504(h)) under control number 1545-0889. The estimated average annual burden per respondent is 4.79 hours.

 This estimate is an approximation of the average time expected to be necessary for a collection of information. It is based on such information as is available to the Internal Revenue Service. Individual respondents may require greater or less time, depending on their particular circumstances.

 Comments concerning the accuracy of this burden estimate and suggestions for reducing this burden should be directed to the Internal Revenue Service, Attn: IRS Reports Clearance Officer T:FP, Washington D.C. 20224, and to the Office of Management and Budget, Attention: Desk Officer for the Department of the Treasury, Office of Information and Regulatory Affairs, Washington, D.C. 20503.

BACKGROUND

 On March 4, 1991, the Federal Register (56 FR 8943) published a notice of proposed rulemaking regarding the accuracy-related penalty under section 6662 of the Internal Revenue Code and definitions and rules for purposes of this penalty (and the fraud penalty under section 6663) under section 6664. A public hearing was held on June 3, 1991. After consideration of the public comments regarding the proposed regulations, the regulations are adopted as revised by this Treasury decision. Descriptions of the revisions to the proposed regulations are included in the discussion of the public comments below.

EXPLANATION OF STATUTORY PROVISIONS

 Section 6662(a) provides for an accuracy-related penalty of 20 percent of any portion of an underpayment of tax required to be shown on a return that is attributable to any of the types of misconduct specified in section 6662(b), i.e., (1) negligence or disregard of rules or regulations; (2) a substantial understatement of income tax; (3) a substantial valuation misstatement under chapter 1; (4) a substantial overstatement of pension liabilities; or (5) a substantial estate or gift tax valuation understatement. The accuracy-related penalty is not imposed on any portion of an underpayment on which the fraud penalty is imposed. These final regulations provide rules only for the first three types of misconduct and, in the case of negligence or disregard of rules or regulations, only in the context of income taxes imposed under subtitle A of the Code.

 Section 6662(c) defines "negligence" for purposes of the negligence and disregard component of the accuracy-related penalty to include any failure to make a reasonable attempt to comply with the provisions of the internal revenue laws and "disregard" for purposes of this component to include any careless, reckless or intentional disregard.

 Section 6662(d) provides for purposes of the substantial understatement component of the accuracy-related penalty that an understatement of tax is substantial if it exceeds the greater of 10 percent of the tax required to be shown on the return for the taxable year, or $5,000 ($10,000 in the case of a corporation other than an S corporation or personal holding company). The term "understatement" means the excess of (i) the amount of tax required to be shown on the return, over (ii) the amount of tax imposed which is shown on the return, reduced by any rebate. Except in the case of an item attributable to a tax shelter, an understatement is reduced by the portion of the understatement that is attributable to the tax treatment of an item for which there is substantial authority or that was adequately disclosed.

 Section 6662(e) provides that there is a substantial valuation misstatement for purposes of the substantial valuation misstatement component of the accuracy-related penalty if the value or adjusted basis of any property claimed on any return of tax imposed by chapter 1 is 200 percent or more of the correct amount. The valuation misstatement is "gross" (and the penalty rate is 40 percent) when the value or adjusted basis of property claimed on the return is 400 percent or more of the correct amount.

 This component of the accuracy-related penalty only applies if the portion of an underpayment attributable to substantial (and gross) valuation misstatements under chapter 1 for a year exceeds $5,000 ($10,000 in the case of a corporation other than an S corporation or personal holding company). These final regulations do not address substantial (or gross) valuation misstatements in connection with transactions between persons described in section 482 or net section 482 transfer price adjustments as described in section 6662(e)(1)(B).

 Section 6664 provides that an "underpayment" for purposes of the accuracy-related (and fraud) penalty means the amount by which the tax imposed exceeds the excess of (i) the sum of (A) the amount of tax shown on the return, plus (B) amounts not so shown previously assessed (or collected without assessment), over (ii) the amount of rebates made. The accuracy-related penalty applies only where a return is filed (other than a return prepared by the Secretary under section 6020(b)).

 Section 6664(c) provides that no accuracy-related penalty will be imposed with respect to any portion of an underpayment if it is shown that there was reasonable cause for such portion and that the taxpayer acted in good faith. Special rules apply for the reasonable cause and good faith exception in the case of any underpayment attributable to a substantial (or gross) valuation misstatement under chapter 1 with respect to charitable deduction property.

PUBLIC COMMENTS

IN GENERAL

 The proposed regulations provide that both an accuracy-related penalty and a penalty under section 6651 for failure to timely file a return may be imposed on the same portion of an underpayment if a return is filed, but is filed late. Prop. Reg. section 1.6662-2(a). In response to a comment, the final regulations provide that the fact that a return is filed late will not be taken into account in determining whether an accuracy-related penalty should be imposed.

NEGLIGENCE OR DISREGARD OF RULES OR REGULATIONS

MEANING OF "NEGLIGENCE"

The proposed regulations provide that the term "negligence" includes 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. Under the proposed regulations, negligence is strongly indicated if a taxpayer fails to make a reasonable attempt to ascertain the correctness of a deduction, credit or exclusion on a return which would seem to a reasonable and prudent person to be "too good to be true" under the circumstances. Prop. Reg. section 1.6662-3(b)(1).

 Several commentators stated that the "too good to be true" formulation is too subjective and should be eliminated from the final regulations. The final regulations retain the "too good to be true" formulation as a strong indicator of negligence because it expresses in understandable terms a typical form of negligent behavior and has been used a number of times by courts in describing negligence. See, e.g., McCrary v. Commissioner, 92 T.C. 827 (1989); Elliott v. Commissioner, 90 T.C. 960 (1988); and Starrett v. Commissioner, 59 T.C.M. (CCH) 334 (1990).

 The proposed regulations provide that a position is attributable to negligence if it is frivolous, or is not frivolous, but lacks a reasonable basis. Because reasonable basis is a higher standard than frivolous, the final regulations simply provide that a position is attributable to negligence if it lacks a reasonable basis.

DISREGARD OF RULES OR REGULATIONS

The disregard prong of the negligence or disregard penalty applies to a careless, reckless or intentional disregard of "rules or regulations." The proposed regulations define "rules" to include revenue rulings issued by the Internal Revenue Service. Prop. Reg. section 1.6662-3(b)(2). One commentator stated that a revenue ruling should not be treated as a "rule" because (1) a revenue ruling does not constitute a rule under the Administrative Procedure Act (5 U.S.C. sections 500, et seq.) and (2) a revenue ruling is only the contention of one party and is not subjected to the give and take of a public comment process.

 The legislative history to the Tax Reform Act of 1976 (which enacted section 6694 relating to income tax return preparers) expressly provides that rules and regulations include regulations and "IRS rulings." See S. Rep. No. 938, 94th Cong., 2d Sess. 355 (1976). Moreover, revenue rulings were expressly listed as "rules" under former section 1.6694-1(a)(3) (concerning the understatement of a taxpayer's liability by an income tax return preparer). Therefore, the final accuracy-related penalty regulations, in providing that revenue rulings are "rules," merely reflect a continuation of prior law.

 Notices published in the Internal Revenue Bulletin by the Service also contain substantive interpretations of Federal tax law. In addition, these notice's generally are subject to a level of review that is the same or higher than that accorded revenue rulings. Accordingly, the final regulations also provide that the term "rules or regulations" includes notices (other than notices of proposed rulemaking) that are issued by the Service and published in the Internal Revenue Bulletin. Revenue procedures are not listed, as they may or may not be treated as "rules or regulations" depending on all facts and circumstances.

 The proposed regulations provide that a taxpayer will not be considered to have disregarded a revenue ruling for purposes of the disregard prong of the negligence or disregard penalty if the position that is contrary to the ruling has at least a realistic possibility of being sustained on its merits. Prop. Reg. section 1.6662-3(b)(2). One commentator objected to employing the realistic possibility standard in the accuracy-related penalty context and another commentator stated that a taxpayer should not be considered to have disregarded a revenue ruling if the position contrary to the ruling has at least a reasonable basis.

 This provision in the proposed regulations is a taxpayer- favorable rule, as there is no statutory requirement that an exception be made from the general definition of "disregard" for positions contrary to revenue rulings. Framing this exception in terms of a standard that exists in the preparer penalty context helps coordinate the accuracy and preparer penalty regimes. Accordingly, the final regulations retain this "realistic possibility" exception to the disregard prong of the penalty for positions contrary to revenue rulings (as well as notices).

DISCLOSURE OF POSITIONS CONTRARY TO A REGULATION

The proposed regulations provide that a taxpayer will not be considered to have disregarded a regulation if the position contrary to the regulation is not frivolous and is adequately disclosed. Prop. Reg. section 1.6662-3(c). A commentator stated that the legislative history of OBRA 1989 suggests that disclosure should only be a safe harbor and not the sole means of avoiding a penalty for intentional disregard of a regulation.

 There is no indication in the legislative history of OBRA 1989 that Congress intended disclosure to be only a safe harbor. The taking of a position contrary to a regulation is of sufficient importance to the self-assessment nature of the Federal tax system that it is appropriate to require that the Service be notified of such positions. Therefore, the final regulations adopt the rule of the proposed regulations requiring adequate disclosure of a position contrary to a regulation.

 In addition, because of the importance to the self-assessment system of disclosing positions contrary to regulations, the final regulations make two changes to the rules concerning positions contrary to regulations. First, the final regulations provide that disclosure of such positions is adequate only if the disclosure is separately made on a Form 8275-R. Until Form 8275-R is available, taxpayers must disclose positions contrary to regulations on a separate Form 8275 with the caption "REGULATIONS" appearing in the upper right corner of the form. (A similar disclosure rule is provided in the final preparer penalty regulations.) Second, because the legislative history of OBRA 1989 provides that the penalty for reckless or intentional disregard of a regulation may be avoided through disclosure only if the position represents a good faith challenge to the validity of the regulation, the final regulations incorporate this standard. See H.R. Rep. No. 247, 101st Cong., 1st Sess. 1393 (1989).

ALTERNATIVE METHODS OF DISCLOSURE

A number of commentators also criticized the requirement in the proposed regulations that disclosure be made on a Form 8275 for purposes of the negligence or disregard penalty. Commentators argued that disclosure on a return in accordance with an annual revenue procedure should be adequate.

 There is no indication in the legislative history of OBRA 1989 that Congress intended to permit disclosure to be made on the return itself in accordance with an annual revenue procedure for purposes of the negligence or disregard penalty. It is in the interest of both taxpayers and the Service to have a relatively uniform disclosure regime that provides certainty as to whether adequate disclosure has been made. Thus, the final regulations do not relax the requirements for making adequate disclosure for purposes of the negligence or disregard penalty.

MEANING OF "FRIVOLOUS"

The proposed regulations define a "frivolous" position as one that is "patently improper." Prop. Reg. section 1.6662-3(b)(3). Commentators recommended that this definition be changed, for example, to require that the position be both patently improper and knowingly advanced in bad faith, or that a frivolous position be defined as one that is "not litigable."

 The "patently improper" definition was included in the proposed regulations because it represents an objective standard. Thus, neither the good nor the bad intentions of a person taking a position are relevant to a determination of whether that position is frivolous within the meaning of the regulations. The Service continues to believe that an objective standard is appropriate. The recommendation that a frivolous position be defined as one that is not litigable would place taxpayers who are not attorneys (or who are not represented by attorneys) at a disadvantage in assessing the effectiveness of disclosure in relation to taxpayers who are. Accordingly, the final regulations retain the definition of a frivolous position as one that is patently improper.

FAILURE TO MAINTAIN BOOKS AND RECORDS

The proposed regulations provide that a taxpayer may not avoid a negligence or disregard penalty by disclosure if the taxpayer fails to maintain adequate books and records or to substantiate items properly. Prop. Reg. section 1.6662-3(c)(1). One commentator stated that a taxpayer should be able to avoid this penalty even if the taxpayer did not maintain adequate books and records, if the taxpayer discloses that he or she did not maintain adequate books and records. Such a rule would be inconsistent with the legislative history of OBRA 1989. See H.R. Rep. No. 247, 101st Cong., 1st Sess. 1393 (1989). Thus, the final regulations do not incorporate this rule. In response to another comment, the final regulations substitute the term "adequate books and records" for the term "proper books and records" wherever the latter term was used in the proposed regulations so that the former term is used consistently throughout the regulations.

SUBSTANTIAL UNDERSTATEMENT OF INCOME TAX

AUTHORITIES

The proposed regulations provide that "authorities" for purposes of determining whether substantial authority is present include, among other items, applicable provisions of the Internal Revenue Code and other statutory provisions, Federal court cases interpreting such statutes, private letter rulings and technical advice memoranda issued after October 31, 1976, and actions on decisions and general counsel memoranda issued after March 12, 1981. The proposed regulations further provide that an authority ceases to be an authority once it is overruled or modified, implicitly or explicitly, by an authority of the same or higher source. For example, a district court opinion on an issue is not an authority if overruled or reversed. Similarly, a private letter ruling is not authority if revoked or if inconsistent with a subsequent proposed regulation, revenue ruling or other administrative pronouncement published in the Internal Revenue Bulletin. The proposed regulations provide that in weighing authorities to determine whether substantial authority is present, an older private letter ruling, technical advice memorandum, general counsel memorandum or action on decision generally must be accorded less weight than a more recent one. Any such document that is more than ten years old generally is accorded very little weight. Prop. Reg. section 1.6662-4(d)(3).

 COURT CASES. Several commentators stated that court cases in addition to Federal court cases interpreting the Internal Revenue Code and other statutory provisions should constitute authorities. The final regulations adopt this comment by listing "court cases" as one of the types of authority.

 SERVICE RULINGS AND MEMORANDA. Commentators argued that all private letter rulings, technical advice memoranda, actions on decisions, and general counsel memoranda should constitute authorities, not just those issued after a certain date. Private letter rulings and technical advice memoranda first became available to the public after October 31, 1976. Except for certain general counsel memoranda published in the pre-1955 volumes of the Cumulative Bulletin, actions on decisions and general counsel memoranda first became available to the public after March 12, 1981.

 The Service believes that treating its private rulings and similar memoranda as authorities for purposes of the substantial understatement penalty is appropriate only to the extent these documents were prepared and internally reviewed in anticipation of the documents being made available to the public. The 1976 and 1981 cut-off dates in the proposed regulations are also consistent with the legislative history of OBRA 1989. See H.R. Rep. No. 247, 101st Cong., 1st Sess. 1390 n.79 (1989). Accordingly, the final regulations preserve the rule that only private letter rulings and technical advice memoranda issued after October 31, 1976 and only actions on decisions issued after March 12, 1981 are authorities. The proposed regulations are modified, however, to provide that general counsel memoranda published in the pre-1955 volumes of the Cumulative Bulletin are also authorities.

 Commentators also contended that the age of a document should not be taken into account in testing for substantial authority and that in no event should the regulations contain a ten-year rule. It was argued that the relevance and persuasiveness of a document are more important than its age.

 Older private letter rulings, technical advice memoranda, general counsel memoranda and actions on decisions are less likely to reflect the current state of the law and position of the Service than more recent ones. In view of this and the level of review for these administrative pronouncements, the ten-year rule is appropriate. However, in response to the comments, the final regulations clarify that the persuasiveness and relevance of any of these documents, viewed in light of subsequent developments, should be taken into account as well as the document's age.

 OVERRULED OR MODIFIED AUTHORITIES. Several commentators objected to the statement in the proposed regulations that an authority ceases to be an authority once it is overruled or modified, implicitly or explicitly, by an authority of the same or higher source. In particular, there was concern that this language could be read to mean that a district court opinion could lose its status as an authority as a result of a contrary opinion by a United States Court of Appeals not located in the same circuit as the district court. In general, these commentators maintained that any rule attempting to nullify an authority is inconsistent with the notion that all authorities are to be taken into account and weighed in determining whether substantial authority is present.

 In response to these comments, the final regulations clarify that an authority ceases to be an authority only to the extent that it is overruled or modified, implicitly or explicitly, by a body with the power to overrule or modify the earlier authority. For example, a district court opinion on an issue is not an authority if overruled, implicitly or explicitly, by the United States Court of Appeals for that district. Similarly, an opinion of the United States Tax Court is not considered to be overruled or modified by a United States Court of Appeals to which the taxpayer does not have a right of appeal, unless the Tax Court adopts the holding of the Court of Appeals.

 Commentators also argued that the Service's position in a proposed regulation is too tentative to justify the rule that proposed regulations supersede prior, inconsistent private letter rulings. Proposed regulations are subject to a higher level of review than private letter rulings and, therefore, reflect the current position of the Service more accurately than previously issued private letter rulings. Proposed regulations also reflect intervening changes in the law. It is not appropriate to retain as an authority a document that does not accurately reflect the current status of the law and position of the Service. Thus, the final regulations retain the rule that a proposed regulation (or a revenue ruling or other administrative pronouncement published in the Internal Revenue Bulletin) supersedes a previously issued private letter ruling.

NATURE OF SUBSTANTIAL AUTHORITY ANALYSIS

One commentator argued that the final regulations should state that the substantial authority analysis is similar to the analysis a court would follow. The final regulations, like the proposed regulations, do not contain this statement because the regulations already provide sufficient guidance as to the nature of the substantial authority analysis and the statement may be confusing to taxpayers who are not attorneys.

WRITTEN DETERMINATIONS

Two commentators requested clarification on the date that a written determination issued to a taxpayer by the Service ceases to constitute substantial authority for the tax treatment of an item on the taxpayer's return. In response to these comments, the final regulations clarify that written determinations (other than those based on inaccurate facts) cease to be authority on the date, and to the extent, that such determinations are modified or revoked by a notice to the taxpayer, the enactment of legislation, or other enumerated events.

DISCLOSURE

Commentators also advocated additional methods of disclosure out of the substantial understatement penalty. For the reasons discussed above concerning methods of disclosure for purposes of the negligence or disregard penalty, the final regulations do not relax the requirements for making adequate disclosure for purposes of the substantial understatement penalty. The final regulations also provide that a position contrary to a regulation must be disclosed on a Form 8275-R for purposes of both penalties. Thus, the final regulations provide that disclosure is adequate for purposes of the substantial understatement penalty if made on a Form 8275 or 8275-R, as appropriate, or in accordance with an annual revenue procedure.

AGGREGATION OF UNDERSTATEMENTS

The proposed regulations contain special rules in the case of carrybacks and carryovers for determining whether an understatement of income tax is substantial. Prop. Reg. section 1.6662-4(c). Under the aggregation rule of the proposed regulations, the determination of whether an understatement is substantial for a year in which a loss, deduction or credit arises (a "loss or credit year") is to be made by treating any understatement that is attributable to a carryback or carryover item as an understatement with respect to the return of the loss or credit year.

 Commentators criticized this approach as being too complicated and inconsistent with the prior regulations. In response to comments, the final regulations do not contain the aggregation rule contained in the proposed regulations. Instead, the final regulations include rules providing that the determination of whether an understatement is substantial is to be made on a year-by-year basis, without aggregation.

SUBSTANTIAL (OR GROSS) VALUATION MISSTATEMENTS

 There is a substantial (or gross) valuation misstatement if the value or adjusted basis of property claimed on a return is 200 percent (400 percent in the case of a gross valuation misstatement) or more of the correct amount. The proposed regulations provide that a valuation misstatement is a gross valuation misstatement if the correct value or adjusted basis of property claimed on a return is zero. Prop. Reg. section 1.6662-5(g).

 Some commentators argued that treating all valuation misstatements with respect to zero value or basis property as gross valuation misstatements is too harsh. However, this approach is consistent with the principle inherent in the statute that relatively greater misstatements are subject to penalty at a higher rate, as well as with the statutory language, and is, therefore, retained in the final regulations.

 The proposed regulations also provide that the substantial (or gross) valuation misstatement penalty applies to an underpayment with respect to a return due after December 31, 1989 that is attributable to a valuation misstatement (e.g., of the adjusted basis of property for which depreciation is claimed) on that return, even if the original misstatement (e.g., of the adjusted basis of the property in the year it is placed in service) was claimed on a return due before January 1, 1990. Prop. Reg. section 1.6662-5(k). One commentator objected to this rule on the ground that the statute does not apply to misstatements of property first occurring on returns filed before its January 1, 1990 effective date.

 There is no indication that Congress intended to exclude an underpayment attributable to a misstatement of value or adjusted basis on a return filed after December 31, 1989 from the ambit of section 6662(e) simply because the initial misstatement was made on a return filed prior to 1990. Such an approach would enable a taxpayer to continue to benefit from past misstatements and would violate the general rule that each tax year stands on its own. Thus, the final regulations adopt the rule contained in the proposed regulations.

 The proposed regulations also state that there is no disclosure exception to the valuation misstatement penalty. Prop. Reg. section 1.6662-5(a). Commentators argued that a disclosure exception similar to that provided for the negligence or disregard and substantial understatement penalties should be provided for the valuation misstatement penalty or, alternatively, that a disclosure exception should be provided for valuation misstatements due to legal errors.

 Congress did not, by statute or legislative history, provide a disclosure exception from the valuation misstatement penalty and, accordingly, there is no basis for applying such an exception under the regulations. Moreover, the courts have consistently applied the penalty without regard to whether the valuation misstatements were based on legal or factual errors. Accordingly, the final regulations continue to provide that there is no disclosure exception to the valuation misstatement penalty.

DEFINITION OF UNDERPAYMENT

 The proposed regulations take overstated prepayment credits, such as overstated withholding credits and estimated tax payments, into account in computing the amount of an underpayment for purposes of the accuracy-related penalty. Prop. Reg. section 1.6664-2(c). Some commentators objected to this rule on the ground that overstated prepayment credits are not taken into account in computing the amount of a deficiency under section 6211.

 There are differences in the section 6664 definition of "underpayment" and the section 6211 definition of "deficiency" that warrant taking overstated prepayment credits into account for purposes of the accuracy-related penalty. If a taxpayer's overstatement of withholding credits or estimated tax payments is inadvertent, the taxpayer may qualify for the reasonable cause and good faith exception to the accuracy-related penalty. Accordingly, the final regulations adopt the rule set forth in the proposed regulations.

ORDERING RULES

 The proposed regulations provide ordering rules for taking adjustments to a return into account in calculating the total amount of accuracy-related and fraud penalties that are imposed by sections 6662 and 6663 with respect to a return for a taxable year. Similar rules are provided for allocating unclaimed prepayment credits to adjustments on a return. Prop. Reg. section 1.6664-3.

 One commentator suggested that these ordering rules be replaced by a rule that would allocate portions of an underpayment to adjustments on the basis of each adjustment's contribution to the amount of the underpayment. The suggestion is not dictated by OBRA 1989, is inconsistent with the established practice of the Service, and could raise substantial controversies as to the proper allocations. Accordingly, the final regulations retain the ordering rules of the proposed regulations.

REASONABLE CAUSE AND GOOD FAITH EXCEPTION

 No accuracy-related penalty will be imposed on any portion of an underpayment of tax if the taxpayer demonstrates that there was reasonable cause for such portion and that the taxpayer acted in good faith. The determination of whether a taxpayer acted with reasonable cause and in good faith is to be made on the basis of all facts and circumstances. Prop. Reg. section 1.6664-4.

 Some commentators recommended that special reasonable cause and good faith rules be drafted for particular categories of taxpayers and that reasonable cause and good faith be presumed under certain circumstances. In particular, it was suggested that reliance on professional advice limited to the conclusion that there is substantial authority for a position should qualify for the reasonable cause and good faith exception.

 A facts and circumstances approach to determining reasonable cause and good faith provides the greatest degree of flexibility in evaluating a taxpayer's situation. Special rules and presumptions, to the extent that they require that certain facts and circumstances be disregarded, are inconsistent with this flexible approach. Thus, the final regulations do not adopt these suggestions.

SPECIAL ANALYSES

It has been determined that these final rules are not major rules as defined in Executive Order 12291. Therefore, a final Regulatory Impact Analysis is not required. It has also been determined that section 553(b) of the Administrative Procedure Act (5 U.S.C. chapter 5) and the Regulatory Flexibility Act (5 U.S.C. chapter 6) do not apply to these regulations, and, therefore, a final Regulatory Flexibility Analysis is not required. Pursuant to section 7805(f) of the Internal Revenue Code, the notice of proposed rulemaking was submitted to the Chief Counsel for Advocacy of the Small Business Administration for comment on its impact on small business.

DRAFTING INFORMATION

 The principal author of these regulations is Gail M. Winkler, Office of the Assistant Chief Counsel (Income Tax and Accounting), Internal Revenue Service. However, personnel from other offices in the Internal Revenue Service and Treasury Department participated in their development.

LIST OF SUBJECTS

26 CFR 1.6654-1 through 1.6709-1T

 Income taxes, Penalties, Reporting and recordkeeping requirements.

26 CFR Part 602

 Reporting and recordkeeping requirements.

Treasury Decision 8381

ADOPTION OF AMENDMENTS TO THE REGULATIONS

Accordingly, 26 CFR parts 1 and 602 are amended as follows:

PART 1 -- INCOME TAX; TAXABLE YEARS BEGINNING AFTER DECEMBER 31, 1953

Paragraph 1. The authority for part 1 continues to read in part:

Authority: Sec. 7805, 68A Stat. 917; sec. 26 U.S.C. 7805, 26 U.S.C. 7805 * * *

Par. 2. The following new sections 1.6662-0 through 1.6662-5 and 1.6664-0 through 1.6664-4 are added to read as follows:

SECTION 1.6662-0 TABLE OF CONTENTS.

This section lists the captions that appear in sections 1.6662-1 through 1.6662-5.

 SECTION 1.6662-1 OVERVIEW OF THE ACCURACY-RELATED PENALTY.

Section 6662 imposes an accuracy-related penalty on any portion of an underpayment of tax required to be shown on a return that is attributable to one or more of the following:

(a) Negligence or disregard of rules or regulations;

(b) Any substantial understatement of income tax;

(c) Any substantial valuation misstatement under chapter 1;

(d) Any substantial overstatement of pension liabilities; or

(e) Any substantial estate or gift tax valuation understatement.

Sections 1.6662-1 through 1.6662-5 address only the first three components of the accuracy-related penalty, i.e., the penalties for negligence or disregard of rules or regulations, substantial understatements of income tax, and substantial (or gross) valuation misstatements under chapter 1. The penalties for negligence or disregard of rules or regulations and for a substantial understatement of income tax may be avoided by adequately disclosing certain information as provided in section 1.6662-3(c) and section 1.6662-4(e) and (f), respectively. The penalty for a substantial (or gross) valuation misstatement under chapter 1 may not be avoided by disclosure. No accuracy-related penalty may be imposed on any portion of an underpayment if there was reasonable cause for, and the taxpayer acted in good faith with respect to, such portion. The reasonable cause and good faith exception to the accuracy-related penalty is set forth in section 1.6664-4.

SECTION 1.6662-2 ACCURACY-RELATED PENALTY.

(a) IN GENERAL. Section 6662(a) imposes an accuracy-related penalty on any portion of an underpayment of tax (as defined in section 6664(a) and section 1.6664-2) required to be shown on a return if such portion is attributable to one or more of the following types of misconduct:

(1) Negligence or disregard of rules or regulations (see section 1.6662-3);

(2) Any substantial understatement of income tax (see section 1.6662-4); or

(3) Any substantial (or gross) valuation misstatement under chapter 1 ("substantial valuation misstatement" or "gross valuation misstatement"), provided the applicable dollar limitation set forth in section 6662(e)(2) is satisfied (see section 1.6662-5).

The accuracy-related penalty applies only in cases in which a return of tax is filed, except that the penalty does not apply in the case of a return prepared by the Secretary under the authority of section 6020(b). The accuracy-related penalty under section 6662 and the penalty under section 6651 for failure to timely file a return of tax may both be imposed on the same portion of an underpayment if a return is filed, but is filed late. The fact that a return is filed late, however, is not taken into account in determining whether an accuracy-related penalty should be imposed. No accuracy-related penalty may be imposed on any portion of an underpayment of tax on which the fraud penalty set forth in section 6663 is imposed.

(b) AMOUNT OF PENALTY -- (1) IN GENERAL. The amount of the accuracy-related penalty is 20 percent of the portion of an underpayment of tax required to be shown on a return that is attributable to any of the types of misconduct listed in paragraphs (a)(1) through (a)(3) of this section, except as provided in paragraph (b)(2) of this section.

(2) INCREASE IN PENALTY FOR GROSS VALUATION MISSTATEMENT. In the case of a gross valuation misstatement, as defined in section 6662(h)(2) and section 1.6662-5(e)(2), the amount of the accuracy- related penalty is 40 percent of the portion of an underpayment of tax required to be shown on a return that is attributable to the gross valuation misstatement, provided the applicable dollar limitation set forth in section 6662(e)(2) is satisfied.

(c) NO STACKING OF ACCURACY-RELATED PENALTY COMPONENTS. The maximum accuracy-related penalty imposed on a portion of an underpayment may not exceed 20 percent of such portion (40 percent of the portion attributable to a gross valuation misstatement), notwithstanding that such portion is attributable to more than one of the types of misconduct described in paragraph (a) of this section. For example, if a portion of an underpayment of tax required to be shown on a return is attributable both to negligence and a substantial understatement of income tax, the maximum accuracy- related penalty is 20 percent of such portion. Similarly, the maximum accuracy-related penalty imposed on any portion of an underpayment that is attributable both to negligence and a gross valuation misstatement is 40 percent of such portion.

(d) EFFECTIVE DATE. Section 1.6662-3(c) and section 1.6662-4(e) and (f) (relating to methods of making adequate disclosure) will apply to returns the due date for which (determined without regard to extensions of time for filing) is after December 31, 1991. Except as provided in the preceding sentence, sections 1.6662-1 through 1.6662-5 apply to returns the due date for which (determined without regard to extensions of time for filing) is after December 31, 1989. To the extent the provisions of these regulations were not reflected in the statute as amended by the Omnibus Budget Reconciliation Act of 1989 (OBRA 1989), in Notice 90-20, 1990-1 C.B. 328, or in rules and regulations in effect prior to March 4, 1991 (to the extent not inconsistent with the statute as amended by OBRA 1989), these regulations will not be adversely applied to a taxpayer who took a position based upon such prior rules on a return filed before January 1, 1992.

SECTION 1.6662-3 NEGLIGENCE OR DISREGARD OF RULES OR REGULATIONS.

(a) IN GENERAL. If any portion of an underpayment, as defined in section 6664(a) and section 1.6664-2, of any income tax imposed under subtitle A of the Code that is required to be shown on a return is attributable to negligence or disregard of rules or regulations, there is added to the tax an amount equal to 20 percent of such portion. This penalty does not apply, however, if the requirements of section 1.6662-3(c)(1) are satisfied and the position in question is adequately disclosed as provided in section 1.6662-3(c)(2), or to the extent that the reasonable cause and good faith exception to this penalty set forth in section 1.6664-4 applies. In addition, if a position with respect to an item is contrary to a revenue ruling or notice (other than a notice of proposed rulemaking) issued by the Internal Revenue Service and published in the Internal Revenue Bulletin, this penalty does not apply if the position has a realistic possibility of being sustained on its merits. See section 1.6694-2(b) of the preparer penalty regulations for a description of the realistic possibility standard.

(b) DEFINITIONS AND RULES -- (1) NEGLIGENCE. The term "negligence" includes 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. A position with respect to an item is attributable to negligence if it lacks a reasonable basis. Negligence is strongly indicated where --

(i) A taxpayer fails to include on an income tax return an amount of income shown on an information return, as defined in section 6724(d)(1);

(ii) A taxpayer fails to make a reasonable attempt to ascertain the correctness of a deduction, credit or exclusion on a return which would seem to a reasonable and prudent person to be "too good to be true" under the circumstances;

(iii) A partner fails to comply with the requirements of section 6222, which requires that a partner treat partnership items on its return in a manner that is consistent with the treatment of such items on the partnership return (or notify the Secretary of the inconsistency); or

(iv) A shareholder fails to comply with the requirements of section 6242, which requires that an S corporation shareholder treat subchapter S items on its return in a manner that is consistent with the treatment of such items on the corporation's return (or notify the Secretary of the inconsistency).

(2) DISREGARD OF RULES OR REGULATIONS. The term "disregard" includes any careless, reckless or intentional disregard of rules or regulations. The term "rules or regulations" includes the provisions of the Internal Revenue Code, temporary or final Treasury regulations issued under the Code, and revenue rulings or notices (other than notices of proposed rulemaking) issued by the Internal Revenue Service and published in the Internal Revenue Bulletin. A disregard of rules or regulations is "careless" if the taxpayer does not exercise reasonable diligence to determine the correctness of a return position that is contrary to the rule or regulation. A disregard is "reckless" if the taxpayer makes little or no effort to determine whether a rule or regulation exists, under circumstances which demonstrate a substantial deviation from the standard of conduct that a reasonable person would observe. A disregard is "intentional" if the taxpayer knows of the rule or regulation that is disregarded. Nevertheless, a taxpayer who takes a position contrary to a revenue ruling or a notice has not disregarded the ruling or notice if the contrary position has a realistic possibility of being sustained on its merits.

(3) FRIVOLOUS. A "frivolous" position with respect to an item is one that is patently improper.

(c) EXCEPTION FOR ADEQUATE DISCLOSURE -- (1) IN GENERAL. No penalty under section 6662(b)(1) may be imposed on any portion of an underpayment that is attributable to negligence or a position contrary to a rule or regulation if the position is disclosed in accordance with the rules of paragraph (c)(2) of this section and, in the case of a position contrary to a regulation, the position represents a good faith challenge to the validity of the regulation. This disclosure exception does not apply, however, in the case of a position that is frivolous or where the taxpayer fails to keep adequate books and records or to substantiate items properly.

(2) METHOD OF DISCLOSURE. Disclosure is adequate for purposes of this section if made in accordance with the provisions of sections 1.6662-4(f)(1), (3), (4) and (5), which permit disclosure on a properly completed and filed Form 8275 or 8275-R, as appropriate. In the case of a position contrary to a rule or regulation, disclosure is adequate only if the preceding sentence is satisfied and the statutory or regulatory provision or ruling in question is adequately identified on the Form 8275 or 8275-R, as appropriate. The provisions of section 1.6662-4(f)(2), which permit disclosure in accordance with an annual revenue procedure for purposes of the substantial understatement penalty, do not apply for purposes of the penalty for negligence or disregard of rules or regulations.

(d) SPECIAL RULES IN THE CASE OF CARRYBACKS AND CARRYOVERS -- (1) IN GENERAL. The penalty for negligence or disregard of rules or regulations applies to any portion of an underpayment for a year to which a loss, deduction or credit is carried, which portion is attributable to negligence or disregard of rules or regulations in the year in which the carryback or carryover of the loss, deduction or credit arises (the "loss or credit year").

(2) TRANSITION RULE FOR CARRYBACKS TO PRE-1990 YEARS. A 20 percent penalty under section 6662(b)(1) is imposed on any portion of an underpayment for a carryback year, the return for which is due (without regard to extensions) before January 1, 1990, if --

(i) That portion is attributable to negligence or disregard of rules or regulations in a loss or credit year; and

(ii) The return for the loss or credit year is due (without regard to extensions) after December 31, 1989.

(3) EXAMPLE. The following example illustrates the provisions of paragraph (d) of this section. This example does not take into account the reasonable cause exception under section 1.6664-4.

EXAMPLE. Corporation M is a C corporation. In 1990, M had a loss of $200,000 before taking into account a deduction of $350,000 that M claimed as an expense in careless disregard of the capitalization requirements of section 263 of the Code. M failed to make adequate disclosure of the item for 1990. M reported a $550,000 loss for 1990 and carried back the loss to 1987 and 1988. M had reported taxable income of $400,000 for 1987 and $200,000 for 1988, before application of the carryback. The carryback eliminated all of M's taxable income for 1987 and $150,000 of taxable income for 1988. After disallowance of the $350,000 expense deduction and allowance of a $35,000 depreciation deduction with respect to the capitalized amount, the correct loss for 1990 was determined to be $235,000. Because there is no underpayment for 1990, the penalty for negligence or disregard of rules or regulations does not apply for 1990. However, as a result of the 1990 adjustments, the loss carried back to 1987 is reduced from $550,000 to $235,000. After application of the $235,000 carryback, M has taxable income of $165,000 for 1987 and $200,000 for 1988. This adjustment results in underpayments for 1987 and 1988 that are attributable to the disregard of rules or regulations on the 1990 return. Therefore, the 20 percent penalty rate applies to the 1987 and 1988 underpayments attributable to the disallowed carryback.

SECTION 1.6662-4 SUBSTANTIAL UNDERSTATEMENT OF INCOME TAX.

(a) IN GENERAL. If any portion of an underpayment, as defined in section 6664(a) and section 1.6664-2, of any income tax imposed under subtitle A of the Code that is required to be shown on a return is attributable to a substantial understatement of such income tax, there is added to the tax an amount equal to 20 percent of such portion. Except in the case of any item attributable to a tax shelter (as defined in paragraph (g)(2) of this section), an understatement is reduced by the portion of the understatement that is attributable to the tax treatment of an item for which there is substantial authority, or with respect to which there is adequate disclosure. General rules for determining the amount of an understatement are set forth in paragraph (b) of this section and more specific rules in the case of carrybacks and carryovers are set forth in paragraph (c) of this section. The rules for determining when substantial authority exists are set forth in section 1.6662-4(d). The rules for determining when there is adequate disclosure are set forth in section 1.6662-4(e) and (f). This penalty does not apply to the extent that the reasonable cause and good faith exception to this penalty set forth in section 1.6664-4 applies.

(b) DEFINITIONS AND COMPUTATIONAL RULES -- (1) SUBSTANTIAL. An understatement (as defined in paragraph (b)(2) of this section) is "substantial" if it exceeds the greater of --

(i) 10 percent of the tax required to be shown on the return for the taxable year (as defined in paragraph (b)(3) of this section); or

(ii) $5,000 ($10,000 in the case of a corporation other than an S corporation (as defined in section 1361(a)(1)) or a personal holding company (as defined in section 542)).

(2) UNDERSTATEMENT. Except as provided in paragraph (c)(2) of this section (relating to special rules for carrybacks), the term "understatement" means the excess of --

(i) The amount of the tax required to be shown on the return for the taxable year (as defined in paragraph (b)(3) of this section), over

(ii) The amount of the tax imposed which is shown on the return for the taxable year (as defined in paragraph (b)(4) of this section), reduced by any rebate (as defined in paragraph (b)(5) of this section).

The definition of understatement also may be expressed as --

UNDERSTATEMENT = X - (Y - Z)

where X = the amount of the tax required to be shown on the return; Y = the amount of the tax imposed which is shown on the return; and Z = any rebate.

(3) AMOUNT OF THE TAX REQUIRED TO BE SHOWN ON THE RETURN. The "amount of the tax required to be shown on the return" for the taxable year has the same meaning as the "amount of income tax imposed" as defined in section 1.6664-2(b).

(4) AMOUNT OF THE TAX IMPOSED WHICH IS SHOWN ON THE RETURN. The "amount of the tax imposed which is shown on the return" for the taxable year has the same meaning as the "amount shown as the tax by the taxpayer on his return," as defined in section 1.6664-2(c), except that --

(i) There is no reduction for the excess of the amount described in section 1.6664-2(c)(1)(i) over the amount described in section 1.6664-2(c)(1)(ii), and

(ii) The tax liability shown by the taxpayer on his return is recomputed as if the following items had been reported properly:

(A) Items (other than tax shelter items as defined in section 1.6662-4(g)(3)) for which there is substantial authority for the treatment claimed (as provided in section 1.6662-4(d)).

(B) Items (other than tax shelter items as defined in section 1.6662-4(g)(3)) with respect to which there is adequate disclosure (as provided in section 1.6662-4(e) and (f)).

(C) Tax shelter items (as defined in section 1.6662-4(g)(3)) for which there is substantial authority for the treatment claimed (as provided in section 1.6662-4(d)), and with respect to which the taxpayer reasonably believed that the tax treatment of the items was more likely than not the proper tax treatment (as provided in section 1.6662-4(g)(4)).

(5) REBATE. The term "rebate" has the meaning set forth in section 1.6664-2(e), except that --

(i) "Amounts not so shown previously assessed (or collected without assessment)" includes only amounts not so shown previously assessed (or collected without assessment) as a deficiency, and

(ii) The amount of the rebate is determined as if any items to which the rebate is attributable that are described in paragraph (b)(4) of this section had received the proper tax treatment.

(6) EXAMPLES. The following examples illustrate the provisions of paragraph (b) of this section. These examples do not take into account the reasonable cause exception under section 1.6664-4:

EXAMPLE 1. In 1990, Individual A, a calendar year taxpayer, files a return for 1989, which shows taxable income of $18,200 and tax liability of $2,734. Subsequent adjustments on audit for 1989 increase taxable income to $51,500 and tax liability to $12,339. There was substantial authority for an item resulting in an adjustment that increases taxable income by $5,300. The item is not a tax shelter item. In computing the amount of the understatement, the amount of tax shown on A's return is determined as if the item for which there was substantial authority had been given the proper tax treatment. Thus, the amount of tax that is treated as shown on A's return is $4,176, i.e., the tax on $23,500 ($18,200 taxable income actually shown on A's return plus $5,300, the amount of the adjustment for which there was substantial authority). The amount of the understatement is $8,163, i.e., $12,339 (the amount of tax required to be shown) less $4,176 (the amount of tax treated as shown on A's return after adjustment for the item for which there was substantial authority). Because the $8,163 understatement exceeds the greater of 10 percent of the tax required to be shown on the return for the year, i.e., $1,234 ($12,339 X .10) or $5,000, A has a substantial understatement of income tax for the year.

EXAMPLE 2. Individual B, a calendar year taxpayer, files a return for 1990 that fails to include income reported on an information return, Form 1099, that was furnished to B. The Service detects this omission through its document matching program and assesses $3,000 in unreported tax liability. B's return is later examined and as a result of the examination the Service makes an adjustment to B's return of $4,000 in additional tax liability. Assuming there was neither substantial authority nor adequate disclosure with respect to the items adjusted, there is an understatement of $7,000 with respect to B's return. There is also an underpayment of $7,000. (See section 1.6664-2.) The amount of the understatement is not reduced by imposition of a negligence penalty on the $3,000 portion of the underpayment that is attributable to the unreported income. However, if the Service does impose the negligence penalty on this $3,000 portion, the Service may only impose the substantial understatement penalty on the remaining $4,000 portion of the underpayment. (See section 1.6662-2(c), which prohibits stacking of accuracy-related penalty components.)

(c) SPECIAL RULES IN THE CASE OF CARRYBACKS AND CARRYOVERS --(1) IN GENERAL. The penalty for a substantial understatement of income tax applies to any portion of an underpayment for a year to which a loss, deduction or credit is carried that is attributable to a "tainted item" for the year in which the carryback or carryover of the loss, deduction or credit arises (the "loss or credit year"). The determination of whether an understatement is substantial for a carryback or carryover year is made with respect to the return of the carryback or carryover year. "Tainted items" are taken into account with items arising in a carryback or carryover year to determine whether the understatement is substantial for that year.

(2) UNDERSTATEMENTS FOR CARRYBACK YEARS NOT REDUCED BY AMOUNT OF CARRYBACKS. The amount of an understatement for a carryback year is not reduced on account of a carryback of a loss, deduction or credit to that year.

(3) TAINTED ITEMS DEFINED. (i) IN GENERAL. Except in the case of a tax shelter item (as defined in paragraph (g)(3) of this section), a "tainted item" is any item for which there is neither substantial authority nor adequate disclosure with respect to the loss or credit year.

(ii) TAX SHELTER ITEMS. In the case of a tax shelter item (as defined in paragraph (g)(3) of this section), a "tainted item" is any item for which there is not, with respect to the loss or credit year, both substantial authority and a reasonable belief that the tax treatment is more likely than not the proper treatment.

(4) TRANSITION RULE FOR CARRYBACKS TO PRE-1990 YEARS. A 20 percent penalty under section 6662(b)(2) is imposed on any portion of an underpayment for a carryback year, the return for which is due (without regard to extensions) before January 1, 1990, if --

(i) That portion is attributable to one or more "tainted items" (as defined in paragraph (c)(3) of this section) arising in a loss or credit year; and

(ii) The return for the loss or credit year is due (without regard to extensions) after December 31, 1989.

The preceding sentence applies only if the understatement in the carryback year is substantial. See Example 2 in paragraph (c)(5) of this section.

(5) EXAMPLES. The following examples illustrate the rules of paragraph (c) of this section regarding carrybacks and carryovers. These examples do not take into account the reasonable cause exception under section 1.6664-4.

EXAMPLE 1. (i) Corporation N, a calendar year taxpayer, is a C corporation. N was formed on January 1, 1987, and timely filed the following income tax returns:

 Tax Year       1987           1988           1989           1990

(iii) For tax year 1990, N carries over $50,000 of the 1989 loss to offset $50,000 of income earned in 1990 and reduce taxable income to zero. N would have reported $7,500 of tax liability for 1990 if it were not for use of the net operating loss carryover (NOLCO). N assumes there is a remaining NOLCO of $120,000 to be applied for tax year 1991.

(iv) In June 1991, the Service completes its examination of the 1989 loss year return and makes the following adjustment:

 Taxable income per 1989 return          ($300,000)

(vi) As a result of the adjustment to the 1989 return, N had an understatement of $4,575 for tax year 1987; an understatement of $22,250 for tax year 1988; an understatement of $1,500 for tax year 1989; and an understatement of $7,500 for tax year 1990. Only the $22,250 understatement for 1988 is a substantial understatement, i.e., it exceeds the greater of (a) $2,225 (10 percent of the tax required to be shown on the return for the taxable year (.10 X $22,250)) or (b) $10,000. The underpayment for 1988 is subject to a penalty rate of 20 percent.

EXAMPLE 2. The facts are the same as in Example 1, except that in addition to examining the 1989 return, the Service also examines the 1987 return and makes an adjustment that results in an understatement. (This adjustment is unrelated to the adjustment on the 1987 return for the disallowance of the NOLCB from 1989.) If the understatement resulting from the adjustment to the 1987 return, when combined with the understatement resulting from the disallowance of the NOLCB from 1989, exceeds the greater of (a) 10 percent of the tax required to be shown on the return for 1987 or (b) $10,000, the underpayment for 1987 will also be subject to a substantial understatement penalty. The portion of the underpayment attributable to the adjustment unrelated to the disallowance of the NOLCB will be subject to a penalty rate of 25 percent under former section 6661. The portion of the underpayment attributable to the disallowance of the NOLCB will be subject to a penalty rate of 20 percent under section 6662.

EXAMPLE 3. Individual P, a calendar year single taxpayer, files his 1990 return reporting taxable income of $10,000 and a tax liability of $1,504. An examination of the 1990 return results in an adjustment for unreported income of $25,000. There was not substantial authority for P's failure to report the income, and P did not make adequate disclosure with respect to the unreported income. P's correct tax liability for 1990 is determined to be $7,279, resulting in an understatement of $5,775 (the difference between the amount of tax required to be shown on the return ($7,279) and the tax shown on the return ($1,504)). Because the understatement exceeds the greater of (a) $728 (10 percent of the tax required to be shown on the return (.10 X $7,279)) or (b) $5,000, the understatement is substantial. Subsequently, P files his 1993 return showing a net operating loss. The loss is carried back to his 1990 return, reducing his taxable income for 1990 to zero. However, the amount of the understatement for 1990 is not reduced on account of the NOLCB to that year. P is subject to the 20 percent penalty rate under section 6662 on the underpayment attributable to the substantial understatement for 1990, notwithstanding that the tax required to be shown on the return for that year, after application of the NOLCB, is zero.

(d) SUBSTANTIAL AUTHORITY -- (1) EFFECT OF HAVING SUBSTANTIAL AUTHORITY. If there is substantial authority for the tax treatment of an item, the item is treated as if it were shown properly on the return for the taxable year in computing the amount of the tax shown on the return. Thus, for purposes of section 6662(d), the tax attributable to the item is not included in the understatement for that year. (For special rules relating to tax shelter items see section 1.6662-4(g).)

(2) SUBSTANTIAL AUTHORITY STANDARD. The substantial authority standard is an objective standard involving an analysis of the law and application of the law to relevant facts. The substantial authority standard is less stringent than the "more likely than not" standard (the standard that is met when there is a greater than 50- percent likelihood of the position being upheld), but more stringent than the reasonable basis standard (the standard which, if satisfied, generally will prevent imposition of the penalty under section 6662(b)(1) for negligence). A return position that is arguable, but fairly unlikely to prevail in court, satisfies the reasonable basis standard, but not the substantial authority standard. The possibility that a return will not be audited or, if audited, that an item will not be raised on audit, is not relevant in determining whether the substantial authority standard (or the reasonable basis standard) is satisfied.

(3) DETERMINATION OF WHETHER SUBSTANTIAL AUTHORITY IS PRESENT -- (i) EVALUATION OF AUTHORITIES. There is substantial authority for the tax treatment of an item only if the weight of the authorities supporting the treatment is substantial in relation to the weight of authorities supporting contrary treatment. All authorities relevant to the tax treatment of an item, including the authorities contrary to the treatment, are taken into account in determining whether substantial authority exists. The weight of authorities is determined in light of the pertinent facts and circumstances in the manner prescribed by paragraph (d)(3)(ii) of this section. There may be substantial authority for more than one position with respect to the same item. Because the substantial authority standard is an objective standard, the taxpayer's belief that there is substantial authority for the tax treatment of an item is not relevant in determining whether there is substantial authority for that treatment.

(ii) NATURE OF ANALYSIS. The weight accorded an authority depends on its relevance and persuasiveness, and the type of document providing the authority. For example, a case or revenue ruling having some facts in common with the tax treatment at issue is not particularly relevant if the authority is materially distinguishable on its facts, or is otherwise inapplicable to the tax treatment at issue. An authority that merely states a conclusion ordinarily is less persuasive than one that reaches its conclusion by cogently relating the applicable law to pertinent facts. The weight of an authority from which information has been deleted, such as a private letter ruling, is diminished to the extent that the deleted information may have affected the authority's conclusions. The type of document also must be considered. For example, a revenue ruling is accorded greater weight than a private letter ruling addressing the same issue. An older private letter ruling, technical advice memorandum, general counsel memorandum or action on decision generally must be accorded less weight than a more recent one. Any document described in the preceding sentence that is more than 10 years old generally is accorded very little weight. However, the persuasiveness and relevance of a document, viewed in light of subsequent developments, should be taken into account along with the age of the document. There may be substantial authority for the tax treatment of an item despite the absence of certain types of authority. Thus, a taxpayer may have substantial authority for a position that is supported only by a well-reasoned construction of the applicable statutory provision.

(iii) TYPES OF AUTHORITY. Except in cases described in paragraph (d)(3)(iv) of this section concerning written determinations, only the following are authority for purposes of determining whether there is substantial authority for the tax treatment of an item: applicable provisions of the Internal Revenue Code and other statutory provisions; proposed, temporary and final regulations construing such statutes; revenue rulings and revenue procedures; tax treaties and regulations thereunder, and Treasury Department and other official explanations of such treaties; court cases; congressional intent as reflected in committee reports, joint explanatory statements of managers included in conference committee reports, and floor statements made prior to enactment by one of a bill's managers; General Explanations of tax legislation prepared by the Joint Committee on Taxation (the Blue Book); private letter rulings and technical advice memoranda issued after October 31, 1976; actions on decisions and general counsel memoranda issued after March 12, 1981 (as well as general counsel memoranda published in pre-1955 volumes of the Cumulative Bulletin); Internal Revenue Service information or press releases; and notices, announcements and other administrative pronouncements published by the Service in the Internal Revenue Bulletin. Conclusions reached in treatises, legal periodicals, legal opinions or opinions rendered by tax professionals are not authority. The authorities underlying such expressions of opinion where applicable to the facts of a particular case, however, may give rise to substantial authority for the tax treatment of an item. Notwithstanding the preceding list of authorities, an authority does not continue to be an authority to the extent it is overruled or modified, implicitly or explicitly, by a body with the power to overrule or modify the earlier authority. In the case of court decisions, for example, a district court opinion on an issue is not an authority if overruled or reversed by the United States Court of Appeals for such district. However, a Tax Court opinion is not considered to be overruled or modified by a court of appeals to which a taxpayer does not have a right of appeal, unless the Tax Court adopts the holding of the court of appeals. Similarly, a private letter ruling is not authority if revoked or if inconsistent with a subsequent proposed regulation, revenue ruling or other administrative pronouncement published in the Internal Revenue Bulletin.

(iv) SPECIAL RULES -- (A) WRITTEN DETERMINATIONS. There is substantial authority for the tax treatment of an item by a taxpayer if the treatment is supported by the conclusion of a ruling or a determination letter (as defined in section 301.6110-2(d) and (e)) issued to the taxpayer, by the conclusion of a technical advice memorandum in which the taxpayer is named, or by an affirmative statement in a revenue agent's report with respect to a prior taxable year of the taxpayer ("written determinations"). The preceding sentence does not apply, however, if --

(1) There was a misstatement or omission of a material fact or the facts that subsequently develop are materially different from the facts on which the written determination was based, or

(2) The written determination was modified or revoked after the date of issuance by --

(i) A notice to the taxpayer to whom the written determination was issued,

(ii) The enactment of legislation or ratification of a tax treaty,

(iii) A decision of the United States Supreme Court,

(iv) The issuance of temporary or final regulations, or

(v) The issuance of a revenue ruling, revenue procedure, or other statement published in the Internal Revenue Bulletin.

Except in the case of a written determination that is modified or revoked on account of section 1.6662-4(d)(3)(iv)(A)(l), a written determination that is modified or revoked as described in section 1.6662-4(d)(3)(iv)(A)(2) ceases to be authority on the date, and to the extent, it is so modified or revoked. See section 6404(f) for rules which require the Secretary to abate a penalty that is attributable to erroneous written advice furnished to a taxpayer by an officer or employee of the Internal Revenue Service.

(B) TAXPAYER'S JURISDICTION. The applicability of court cases to the taxpayer by reason of the taxpayer's residence in a particular jurisdiction is not taken into account in determining whether there is substantial authority for the tax treatment of an item. Notwithstanding the preceding sentence, there is substantial authority for the tax treatment of an item if the treatment is supported by controlling precedent of a United States Court of Appeals to which the taxpayer has a right of appeal with respect to the item.

(C) WHEN SUBSTANTIAL AUTHORITY DETERMINED. There is substantial authority for the tax treatment of an item if there is substantial authority at the time the return containing the item is filed or there was substantial authority on the last day of the taxable year to which the return relates.

(v) SUBSTANTIAL AUTHORITY FOR TAX RETURNS DUE BEFORE JANUARY 1, 1990. There is substantial authority for the tax treatment of an item on a return that is due (without regard to extensions) after December 31, 1982 and before January 1, 1990, if there is substantial authority for such treatment under either the provisions of paragraph (d)(3)(iii) of this section (which set forth an expanded list of authorities) or of section 1.6661-3(b)(2) (which set forth a narrower list of authorities). Under either list of authorities, authorities both for and against the position must be taken into account.

(e) DISCLOSURE OF CERTAIN INFORMATION -- (1) EFFECT OF ADEQUATE DISCLOSURE. Items for which there is adequate disclosure as provided in this paragraph (e) and in paragraph (f) of this section are treated as if such items were shown properly on the return for the taxable year in computing the amount of the tax shown on the return. Thus, for purposes of section 6662(d), the tax attributable to such items is not included in the understatement for that year.

(2) CIRCUMSTANCES WHERE DISCLOSURE WILL NOT HAVE AN EFFECT. The rules of paragraph (e)(1) of this section do not apply where the item or position on the return is --

(i) Frivolous (as defined in section 1.6662-3(b)(3));

(ii) Attributable to a tax shelter (as defined in section 6662(d)(2)(C)(ii) and paragraph (g)(2) of this section); or

(iii) Not properly substantiated, or the taxpayer failed to keep adequate books and records with respect to the item or position.

(f) METHOD OF MAKING ADEQUATE DISCLOSURE -- (1) DISCLOSURE STATEMENT. Disclosure is adequate with respect to an item (or group of similar items, such as amounts paid or incurred for supplies by a taxpayer engaged in business) or a position on a return if the disclosure is made on a properly completed form attached to the return or to a qualified amended return (as defined in section 1.6664-2(c)(3)) for the taxable year. In the case of an item or position other than one that is contrary to a regulation, disclosure must be made on Form 8275 (Disclosure Statement); in the case of a position contrary to a regulation, disclosure must be made on Form 8275-R (Regulation Disclosure Statement).

(2) DISCLOSURE ON RETURN. The Commissioner may by annual revenue procedure (or otherwise) prescribe the circumstances under which disclosure of information on a return (or qualified amended return) in accordance with applicable forms and instructions is adequate. If the revenue procedure does not include an item, disclosure is adequate with respect to that item only if made on a properly completed Form 8275 or 8275-R, as appropriate, attached to the return for the year or to a qualified amended return.

(3) RECURRING ITEM. Disclosure with respect to a recurring item, such as the basis of recovery property, must be made for each taxable year in which the item is taken into account.

(4) CARRYBACKS AND CARRYOVERS. Disclosure is adequate with respect to an item which is included in any loss, deduction or credit that is carried to another year only if made in connection with the return (or qualified amended return) for the taxable year in which the carryback or carryover arises (the "loss or credit year"). Disclosure is not also required in connection with the return for the taxable year in which the carryback or carryover is taken into account.

(5) PASS-THROUGH ENTITIES. Disclosure in the case of items attributable to a pass-through entity (pass-through items) is made with respect to the return of the entity, except as provided in this paragraph (f)(5). Thus, disclosure in the case of pass-through items must be made on a Form 8275 or 8275-R, as appropriate, attached to the return (or qualified amended return) of the entity, or on the entity's return in accordance with the revenue procedure described in paragraph (f)(2) of this section, if applicable. A taxpayer (i.e., partner, shareholder, beneficiary, or holder of a residual interest in a REMIC) also may make adequate disclosure with respect to a pass- through item, however, if the taxpayer files a properly completed Form 8275 or 8275-R, as appropriate, in duplicate, one copy attached to the taxpayer's return (or qualified amended return) and the other copy filed with the Internal Revenue Service Center with which the return of the entity is required to be filed. Each Form 8275 or 8275-R, as appropriate, filed by the taxpayer should relate to the pass- through items of only one entity. For purposes of this paragraph (f)(5), a pass-through entity is a partnership, S corporation (as defined in section 1361(a)(1)), estate, trust, regulated investment company (as defined in section 851(a)), real estate investment trust (as defined in section 856(a)), or real estate mortgage investment conduit ("REMIC") (as defined in section 860D(a)).

(g) ITEMS RELATING TO TAX SHELTERS -- (1) IN GENERAL. Tax shelter items (as defined in paragraph (g)(3) of this section) are treated as if such items were shown properly on the return for a taxable year in computing the amount of the tax shown on the return, and thus the tax attributable to such items is not included in the understatement for the year, if --

(i) There is substantial authority (as provided in paragraph (d) of this section) for the tax treatment of that item; and

(ii) The taxpayer reasonably believed at the time the return was filed that the tax treatment of that item was more likely than not the proper treatment (see paragraph (g)(4) of this section).

Disclosure made with respect to a tax shelter item does not affect the amount of an understatement.

(2) TAX SHELTER -- (i) IN GENERAL. For purposes of section 6662(d), the term "tax shelter" means --

(A) A partnership or other entity (such as a corporation or trust),

(B) An investment plan or arrangement, or

(C) Any other plan or arrangement,

if the principal purpose of the entity, plan or arrangement, based on objective evidence, is to avoid or evade Federal income tax. The principal purpose of an entity, plan or arrangement is to avoid or evade Federal income tax if that purpose exceeds any other purpose. Typical of tax shelters are transactions structured with little or no motive for the realization of economic gain, and transactions that utilize the mismatching of income and deductions, overvalued assets or assets with values subject to substantial uncertainty, certain nonrecourse financing, financing techniques that do not conform to standard commercial business practices, or the mischaracterization of the substance of the transaction. The existence of economic substance does not of itself establish that a transaction is not a tax shelter if the transaction includes other characteristics that indicate it is a tax shelter.

(ii) PRINCIPAL PURPOSE. The principal purpose of an entity, plan or arrangement is not to avoid or evade Federal income tax if the entity, plan or arrangement has as its purpose the claiming of exclusions from income, accelerated deductions or other tax benefits in a manner consistent with the statute and Congressional purpose. For example, an entity, plan or arrangement does not have as its principal purpose the avoidance or evasion of Federal income tax solely as a result of the following uses of tax benefits provided by the Internal Revenue Code: the purchasing or holding of an obligation bearing interest that is excluded from gross income under section 103; taking an accelerated depreciation allowance under section 168; taking the percentage depletion allowance under section 613 or section 613A; deducting intangible drilling and development costs as expenses under section 263(c); establishing a qualified retirement plan under sections 401-409; claiming the possession tax credit under section 936; or claiming tax benefits available by reason of an election under section 992 to be taxed as a domestic international sales corporation ("DISC"), under section 927(f)(1) to be taxed as a foreign sales corporation ("FSC"), or under section 1362 to be taxed as an S corporation.

(3) TAX SHELTER ITEM. An item of income, gain, loss, deduction or credit is a "tax shelter item" if the item is directly or indirectly attributable to the principal purpose of a tax shelter to avoid or evade Federal income tax. Thus, if a partnership is established for the principal purpose of avoiding or evading Federal income tax by acquiring and overstating the basis of property for purposes of claiming accelerated depreciation, the depreciation with respect to the property is a tax shelter item. However, a deduction claimed in connection with a separate transaction carried on by the same partnership is not a tax shelter item if the transaction does not constitute a plan or arrangement the principal purpose of which is to avoid or evade tax.

(4) REASONABLE BELIEF. For purposes of section 6662(d), a taxpayer is considered reasonably to believe that the tax treatment of an item is more likely than not the proper tax treatment if --

(i) The taxpayer analyzes the pertinent facts and authorities in the manner described in paragraph (d)(3)(ii) of this section and, in reliance upon that analysis, reasonably concludes that there is a greater than 50-percent likelihood that the tax treatment of the item will be upheld if challenged by the Internal Revenue Service; or

(ii) The taxpayer in good faith relies on the opinion of a professional tax advisor, if the opinion is based on the tax advisor's analysis of the pertinent facts and authorities in the manner described in paragraph (d)(3)(ii) of this section and unambiguously states that the tax advisor concludes that there is a greater than 50-percent likelihood that the tax treatment of the item will be upheld if challenged by the Internal Revenue Service.

(5) PASS-THROUGH ENTITIES. In the case of tax shelter items attributable to a pass-through entity, the actions described in paragraphs (g)(4)(i) and (g)(4)(ii) of this section, if taken by the entity, are deemed to have been taken by the taxpayer and are considered in determining whether the taxpayer reasonably believed that the tax treatment of an item was more likely than not the proper tax treatment.

SECTION 1.6662-5 SUBSTANTIAL AND GROSS VALUATION MISSTATEMENTS UNDER CHAPTER 1.

(a) IN GENERAL. If any portion of an underpayment, as defined in section 6664(a) and section 1.6664-2, of any income tax imposed under chapter 1 of subtitle A of the Code that is required to be shown on a return is attributable to a substantial valuation misstatement under chapter 1 ("substantial valuation misstatement"), there is added to the tax an amount equal to 20 percent of such portion. Section 6662(h) increases the penalty to 40 percent in the case of a gross valuation misstatement under chapter 1 ("gross valuation misstatement"). No penalty under section 6662(b)(3) is imposed, however, on a portion of an underpayment that is attributable to a substantial or gross valuation misstatement unless the aggregate of all portions of the underpayment attributable to substantial or gross valuation misstatements exceeds the applicable dollar limitation ($5,000 or $10,000), as provided in section 6662(e)(2) and paragraphs (b) and (f)(2) of this section. This penalty also does not apply to the extent that the reasonable cause and good faith exception to this penalty set forth in section 1.6664-4 applies. There is no disclosure exception to this penalty.

(b) DOLLAR LIMITATION. No penalty may be imposed under section 6662(b)(3) for a taxable year unless the portion of the underpayment for that year that is attributable to substantial or gross valuation misstatements exceeds $5,000 ($10,000 in the case of a corporation other than an S corporation (as defined in section 1361(a)(1)) or a personal holding company (as defined in section 542)). This limitation is applied separately to each taxable year for which there is a substantial or gross valuation misstatement.

(c) SPECIAL RULES IN THE CASE OF CARRYBACKS AND CARRYOVERS -- (1) IN GENERAL. The penalty for a substantial or gross valuation misstatement applies to any portion of an underpayment for a year to which a loss, deduction or credit is carried that is attributable to a substantial or gross valuation misstatement for the year in which the carryback or carryover of the loss, deduction or credit arises (the "loss or credit year"), provided that the applicable dollar limitation set forth in section 6662(e)(2) is satisfied in the carryback or carryover year.

(2) TRANSITION RULE FOR CARRYBACKS TO PRE-1990 YEARS. The penalty under section 6662(b)(3) is imposed on any portion of an underpayment for a carryback year, the return for which is due (without regard to extensions) before January 1, 1990, if --

(i) That portion is attributable to a substantial or gross valuation misstatement for a loss or credit year; and

(ii) The return for the loss or credit year is due (without regard to extensions) after December 31, 1989.

The preceding sentence applies only if the underpayment for the carryback year exceeds the applicable dollar limitation ($5,000, or $10,000 for most corporations). See Example 3 in paragraph (d) of this section.

(d) EXAMPLES. The following examples illustrate the provisions of paragraphs (b) and (c) of this section. These examples do not take into account the reasonable cause exception under section 1.6664-4.

EXAMPLE 1. Corporation Q is a C corporation. In 1990, the first year of its existence, Q had taxable income of $200,000 without considering depreciation of a particular asset. On its calendar year 1990 return, Q overstated its basis in this asset by an amount that caused a substantial valuation misstatement. The overstated basis resulted in depreciation claimed of $350,000, which was $250,000 more than the $100,000 allowable. Thus, on its 1990 return, Q showed a loss of $150,000. In 1991, Q had taxable income of $450,000 before application of the loss carryover, and Q claimed a carryover loss deduction under section 172 of $150,000, resulting in taxable income of $300,000 for 1991. Upon audit of the 1990 return, the basis of the asset was corrected, resulting in an adjustment of $250,000. For 1990, the underpayment resulting from the $100,000 taxable income (- $150,000 + $250,000) is attributable to the valuation misstatement. Assuming the underpayment resulting from the $100,000 taxable income exceeds the $10,000 limitation, the penalty will be imposed in 1990. For 1991, the elimination of the loss carryover results in additional taxable income of $150,000. The underpayment for 1991 resulting from that adjustment is also attributable to the substantial valuation misstatement on the 1990 return. Assuming the underpayment resulting from the $150,000 additional taxable income for 1991 exceeds the $10,000 limitation, the substantial valuation misstatement penalty also will be imposed for that year.

EXAMPLE 2. (i) Corporation T is a C corporation. In 1990, the first year of its existence, T had a loss of $3,000,000 without considering depreciation of its major asset. On its calendar year 1990 return, T overstated its basis in this asset in an amount that caused a substantial valuation misstatement. This overstatement resulted in depreciation claimed of $3,500,000, which was $2,500,000 more than the $1,000,000 allowable. Thus, on its 1990 return, T showed a loss of $6,500,000. In 1991, T had taxable income of $4,500,000 before application of the carryover loss, but claimed a carryover loss deduction under section 172 in the amount of $4,500,000, resulting in taxable income of zero for that year and leaving a $2,000,000 carryover available. Upon audit of the 1990 return, the basis of the asset was corrected, resulting in an adjustment of $2,500,000.

(ii) For 1990, the underpayment is still zero (-$6,500,000 + $2,500,000 = -$4,000,000). Thus, the penalty does not apply in 1990. The loss for 1990 is reduced to $4,000,000.

(iii) For 1991, there is additional taxable income of $500,000 as a result of the reduction of the carryover loss ($4,500,000 reported income before carryover loss minus corrected carryover loss of $4,000,000 = $500,000). The underpayment for 1991 resulting from reduction of the carryover loss is attributable to the valuation misstatement on the 1990 return. Assuming the underpayment resulting from the $500,000 additional taxable income exceeds the $10,000 limitation, the substantial valuation misstatement penalty will be imposed in 1991.

EXAMPLE 3. Corporation V is a C corporation. In 1990, V had a loss of $100,000 without considering depreciation of a particular asset which it had fully depreciated in earlier years. V had a depreciable basis in the asset of zero, but on its 1990 calendar year return erroneously claimed a basis in the asset of $1,250,000 and depreciation of $250,000. V reported a $350,000 loss for the year 1990, and carried back the loss to the 1987 and 1988 tax years. V had reported taxable income of $300,000 in 1987 and $200,000 in 1988, before application of the carryback. The $350,000 carryback eliminated all taxable income for 1987, and $50,000 of the taxable income for 1988. After disallowance of the $250,000 depreciation deduction for 1990, V still had a loss of $100,000. Because there is no underpayment for 1990, no valuation misstatement penalty is imposed for 1990. However, as a result of the 1990 depreciation adjustment, the carryback to 1987 is reduced from $350,000 to $100,000. After absorption of the $100,000 carryback, V has taxable income of $200,000 for 1987. This adjustment results in an underpayment for 1987 that is attributable to the valuation misstatement on the 1990 return. The valuation misstatement for 1990 is a gross valuation misstatement because the correct adjusted basis of the depreciated asset was zero. (See paragraph (e)(2) of this section.) Therefore, the 40 percent penalty rate applies to the 1987 underpayment attributable to the 1990 misstatement, provided that this underpayment exceeds $10,000. The adjustment also results in the elimination of any loss carryback to 1988 resulting in an increase in taxable income for 1988 of $50,000. Assuming the underpayment resulting from this additional $50,000 of income exceeds $10,000, the gross valuation misstatement penalty is imposed on the underpayment for 1988.

(e) DEFINITIONS -- (1) SUBSTANTIAL VALUATION MISSTATEMENT. There is a substantial valuation misstatement if the value or adjusted basis of any property claimed on a return of tax imposed under chapter 1 is 200 percent or more of the correct amount.

(2) GROSS VALUATION MISSTATEMENT. There is a gross valuation misstatement if the value or adjusted basis of any property claimed on a return of tax imposed under chapter 1 is 400 percent or more of the correct amount.

(3) PROPERTY. For purposes of this section, the term "property" refers to both tangible and intangible property. Tangible property includes property such as land, buildings, fixtures and inventory. Intangible property includes property such as goodwill, covenants not to compete, leaseholds, patents, contract rights, debts and choses in action.

(f) MULTIPLE VALUATION MISSTATEMENTS ON A RETURN -- (1) DETERMINATION OF WHETHER VALUATION MISSTATEMENTS ARE SUBSTANTIAL OR GROSS. The determination of whether there is a substantial or gross valuation misstatement on a return is made on a property-by-property basis. Assume, for example, that property A has a value of 60 but a taxpayer claims a value of 110, and that property B has a value of 40 but the taxpayer claims a value of 100. Because the claimed and correct values are compared on a property-by-property basis, there is a substantial valuation misstatement with respect to property B, but not with respect to property A, even though the claimed values (210) are 200 percent or more of the correct values (100) when compared on an aggregate basis.

(2) APPLICATION OF DOLLAR LIMITATION. For purposes of applying the dollar limitation set forth in section 6662(e)(2), the determination of the portion of an underpayment that is attributable to a substantial or gross valuation misstatement is made by aggregating all portions of the underpayment attributable to substantial or gross valuation misstatements. Assume, for example, that the value claimed for property C on a return is 250 percent of the correct value, and that the value claimed for property D on the return is 400 percent of the correct value. Because the portions of an underpayment that are attributable to a substantial or gross valuation misstatement on a return are aggregated in applying the dollar limitation, the dollar limitation is satisfied if the portion of the underpayment that is attributable to the misstatement of the value of property C, when aggregated with the portion of the underpayment that is attributable to the misstatement of the value of property D, exceeds $5,000 ($10,000 in the case of most corporations).

(g) PROPERTY WITH A VALUE OR ADJUSTED BASIS OF ZERO. The value or adjusted basis claimed on a return of any property with a correct value or adjusted basis of zero is considered to be 400 percent or more of the correct amount. There is a gross valuation misstatement with respect to such property, therefore, and the applicable penalty rate is 40 percent.

(h) PASS-THROUGH ENTITIES -- (1) IN GENERAL. The determination of whether there is a substantial or gross valuation misstatement in the case of a return of a pass-through entity (as defined in section 1.6662-4(f)(5)) is made at the entity level. However, the dollar limitation ($5,000 or $10,000, as the case may be) is applied at the taxpayer level (i.e., with respect to the return of the shareholder, partner, beneficiary, or holder of a residual interest in a REMIC).

(2) EXAMPLE. The rules of paragraph (h)(l) of this section may be illustrated by the following example.

EXAMPLE. Partnership P has two partners, individuals A and B. P claims a $40,000 basis in a depreciable asset which, in fact, has a basis of $15,000. The determination that there is a substantial valuation misstatement is made solely with reference to P by comparing the $40,000 basis claimed by P with P's correct basis of $15,000. However, the determination of whether the $5,000 threshold for application of the penalty has been reached is made separately for each partner. With respect to partner A, the penalty will apply if the portion of A's underpayment attributable to the passthrough of the depreciation deduction, when aggregated with any other portions of A's underpayment also attributable to substantial or gross valuation misstatements, exceeds $5,000 (assuming there is not reasonable cause for the misstatements (see section 1.6664-4(c)).

(i) [Reserved]

(j) TRANSACTIONS BETWEEN PERSONS DESCRIBED IN SECTION 482 AND NET SECTION 482 TRANSFER PRICE ADJUSTMENTS. [Reserved]

(k) RETURNS AFFECTED. Except in the case of rules relating to transactions between persons described in section 482 and net section 482 transfer price adjustments, the provisions of section 6662(b)(3) apply to returns due (without regard to extensions of time to file) after December 31, 1989, notwithstanding that the original substantial or gross valuation misstatement occurred on a return that was due (without regard to extensions) before January 1, 1990. Assume, for example, that a calendar year corporation claimed a deduction on its 1990 return for depreciation of an asset with a basis of X. Also assume that it had reported the same basis for computing depreciation on its returns for the preceding 5 years and that the basis shown on the return each year was 200 percent or more of the correct basis. The corporation may be subject to a penalty for substantial valuation misstatements on its 1989 and 1990 returns, even though the original misstatement occurred prior to the effective date of sections 6662(b)(3) and (e).

SECTION 1.6664-0 TABLE OF CONTENTS.

This section lists the captions in sections 1.6664-1 through 1.6664-4.

 SECTION 1.6664-1 ACCURACY-RELATED AND FRAUD PENALTIES;

(a) IN GENERAL. Section 6664(a) defines the term "underpayment" for purposes of the accuracy-related penalty under section 6662 and the fraud penalty under section 6663. The definition of "underpayment" of income taxes imposed under subtitle A is set forth in section 1.6664-2. Ordering rules for computing the total amount of accuracy-related and fraud penalties imposed with respect to a return are set forth in section 1.6664-3. Section 6664(c) provides a reasonable cause and good faith exception to the accuracy-related penalty. Rules relating to the reasonable cause and good faith exception are set forth in section 1.6664-4.

(b) EFFECTIVE DATE. Sections 1.6664-1 through 1.6664-4 apply to returns the due date of which (determined without regard to extensions of time to file) is after December 31, 1989.

SECTION 1.6664-2 UNDERPAYMENT.

(a) UNDERPAYMENT DEFINED. In the case of income taxes imposed under subtitle A, an underpayment for purposes of section 6662, relating to the accuracy-related penalty, and section 6663, relating to the fraud penalty, means the amount by which any income tax imposed under this subtitle (as defined in paragraph (b) of the section) exceeds the excess of --

(1) The sum of --

(i) The amount shown as the tax by the taxpayer on his return (as defined in paragraph (c) of this section), plus

(ii) Amounts not so shown previously assessed (or collected without assessment) (as defined in paragraph (d) of this section), over

(2) The amount of rebates made (as defined in paragraph (e) of this section).

The definition of underpayment also may be expressed as --

UNDERPAYMENT = W - (X + Y - Z),

where W = the amount of income tax imposed; X = the amount shown as the tax by the taxpayer on his return; Y = amounts not so shown previously assessed (or collected without assessment); and Z = the amount of rebates made.

(b) AMOUNT OF INCOME TAX IMPOSED. For purposes of paragraph (a) of this section, the "amount of income tax imposed" is the amount of tax imposed on the taxpayer under subtitle A for the taxable year, determined without regard to --

(1) The credits for tax withheld under sections 31 (relating to tax withheld on wages) and 33 (relating to tax withheld at source on nonresident aliens and foreign corporations);

(2) Payments of tax or estimated tax by the taxpayer;

(3) Any credit resulting from the collection of amounts assessed under section 6851 as the result of a termination assessment, or section 6861 as the result of a jeopardy assessment; and

(4) Any tax that the taxpayer is not required to assess on the return (such as the tax imposed by section 531 on the accumulated taxable income of a corporation).

(c) AMOUNT SHOWN AS THE TAX BY THE TAXPAYER ON HIS RETURN -- (1) DEFINED. For purposes of paragraph (a) of this section, the "amount shown as the tax by the taxpayer on his return" is the tax liability shown by the taxpayer on his return, determined without regard to the items listed in section 1.6664-2(b)(1), (2), and (3), except that it is reduced by the excess of --

(i) The amounts shown by the taxpayer on his return as credits for tax withheld under section 31 (relating to tax withheld on wages) and section 33 (relating to tax withheld at source on nonresident aliens and foreign corporations), as payments of estimated tax, or as any other payments made by the taxpayer with respect to a taxable year before filing the return for such taxable year, over

(ii) The amounts actually withheld, actually paid as estimated tax, or actually paid with respect to a taxable year before the return is filed for such taxable year.

(2) EFFECT OF QUALIFIED AMENDED RETURN. The "amount shown as the tax by the taxpayer on his return" includes an amount shown as additional tax on a qualified amended return (as defined in paragraph (c)(3) of this section), except that such amount is not included if it relates to a fraudulent position on the original return.

(3) QUALIFIED AMENDED RETURN DEFINED. A qualified amended return is an amended return, or a timely request for an administrative adjustment under section 6227, filed after the due date of the return for the taxable year (determined with regard to extensions of time to file) and before the earliest of --

(i) The time the taxpayer is first contacted by the Internal Revenue Service concerning an examination of the return;

(ii) The time any person described in section 6700(a) (relating to the penalty for promoting abusive tax shelters) is first contacted by the Internal Revenue Service concerning an examination of an activity described in section 6700(a) with respect to which the taxpayer claimed any tax benefit on the return directly or indirectly through the entity, plan or arrangement described in section 6700(a)(1)(A); or

(iii) In the case of a pass-through item (as defined in section 1.6662-4(f)(5)), the time the pass-through entity (as defined in section 1.6662-4(f)(5)) is first contacted by the Internal Revenue Service in connection with an examination of the return to which the pass-through item relates.

A qualified amended return includes an amended return that is filed solely to disclose information pursuant to section 1.6662-3(c) or section 1.6662-4(e) and (f) and that does not report any additional tax liability.

(4) SPECIAL RULE FOR QUALIFIED AMENDED RETURNS. The Commissioner may by revenue procedure prescribe the manner in which the rules of paragraph (c) of this section regarding qualified amended returns apply to particular classes of taxpayers.

(d) AMOUNTS NOT SO SHOWN PREVIOUSLY ASSESSED (OR COLLECTED WITHOUT ASSESSMENT). For purposes of paragraph (a) of this section, "amounts not so shown previously assessed" means only amounts assessed before the return is filed that were not shown on the return, such as termination assessments under section 6851 and jeopardy assessments under section 6861 made prior to the filing of the return for the taxable year. For purposes of paragraph (a) of this section, the amount "collected without assessment" is the amount by which the total of the credits allowable under section 31 (relating to tax withheld on wages) and section 33 (relating to tax withheld at source on nonresident aliens and foreign corporations), estimated tax payments, and other payments in satisfaction of tax liability made before the return is filed, exceed the tax shown on the return (provided such excess has not been refunded or allowed as a credit to the taxpayer).

(e) REBATES. The term "rebate" means so much of an abatement credit, refund or other repayment, as was made on the ground that the tax imposed was less than the excess of --

(1) The sum of --

(i) The amount shown as the tax by the taxpayer on his return, plus

(ii) Amounts not so shown previously assessed (or collected without assessment), over

(2) Rebates previously made.

(f) UNDERPAYMENTS FOR CERTAIN CARRYBACK YEARS NOT REDUCED BY AMOUNT OF CARRYBACKS. The amount of an underpayment for a taxable year that is attributable to conduct proscribed by sections 6662 or 6663 is not reduced on account of a carryback of a loss, deduction or credit to that year. Such conduct includes negligence or disregard of rules or regulations; a substantial understatement of income tax; and a substantial (or gross) valuation misstatement under chapter 1, provided that the applicable dollar limitation is satisfied for the carryback year.

(g) EXAMPLES. The following examples illustrate this section:

EXAMPLE 1. Taxpayer's 1990 return showed a tax liability of $18,000. Taxpayer had no amounts previously assessed (or collected without assessment) and received no rebates of tax. Taxpayer claimed a credit in the amount of $23,000 for income tax withheld under section 3402, which resulted in a refund received of $5,000. It is later determined that the taxpayer should have reported additional income and that the correct tax for the taxable year is $25,500. There is an underpayment of $7,500, determined as follows:

 Tax imposed under subtitle A                           $25,500

(a) IN GENERAL. This section provides rules for determining the order in which adjustments to a return are taken into account for the purpose of computing the total amount of penalties imposed under sections 6662 and 6663, where --

(1) There is at least one adjustment with respect to which no penalty has been imposed and at least one with respect to which a penalty has been imposed, or

(2) There are at least two adjustments with respect to which penalties have been imposed and they have been imposed at different rates.

This section also provides rules for allocating unclaimed prepayment credits to adjustments to a return.

(B) ORDER IN WHICH ADJUSTMENTS ARE TAKEN INTO ACCOUNT. In computing the portions of an underpayment subject to penalties imposed under sections 6662 and 6663, adjustments to a return are considered made in the following order:

(1) Those with respect to which no penalties have been imposed.

(2) Those with respect to which a penalty has been imposed at a 20 percent rate (i.e., a penalty for negligence or disregard of rules or regulations, substantial understatement of income tax, or substantial valuation misstatement, under sections 6662(b)(1) through 6662(b)(3), respectively).

(3) Those with respect to which a penalty has been imposed at a 40 percent rate (i.e., a penalty for a gross valuation misstatement under sections 6662(b)(3) and (h)).

(4) Those with respect to which a penalty has been imposed at a 75 percent rate (i.e., a penalty for fraud under section 6663).

(c) MANNER IN WHICH UNCLAIMED PREPAYMENT CREDITS ARE ALLOCATED. Any income tax withholding or other payment made before a return was filed, that was neither claimed on the return nor previously allowed as a credit against the tax liability for the taxable year (an "unclaimed prepayment credit"), is allocated as follows --

(1) If an unclaimed prepayment credit is allocable to a particular adjustment, such credit is applied in full in determining the amount of the underpayment resulting from such adjustment.

(2) If an unclaimed prepayment credit is not allocable to a particular adjustment, such credit is applied in accordance with the ordering rules set forth in paragraph (b) of this section.

(d) EXAMPLES. The following examples illustrate the rules of this section 1.6664-3. These examples do not take into account the reasonable cause exception to the accuracy-related penalty under section 1.6664-4.

EXAMPLE 1. A and B, husband and wife, filed a joint federal income tax return for calendar year 1989, reporting taxable income of $15,800 and a tax liability of $2,374. A and B had no amounts previously assessed (or collected without assessment) and no rebates had been made. Subsequently, the return was examined and the following adjustments and penalties were agreed to:

 Adjustment # 1 (No penalty imposed)                      $1,000

STEP 1 Determine the portion, if any, of the underpayment on which no accuracy-related or fraud penalty is imposed:

 Taxable income shown on return                         $15,800

EXAMPLE 3. The facts are the same as in Example 1 except that the taxpayers made a timely estimated tax payment of $1,500 for 1989 which they failed to claim (and which the Service had not previously allowed). This unclaimed prepayment credit is not allocable to any particular adjustment. Therefore, the credit is allocated first to the portion of the underpayment on which no penalty is imposed ($150). The remaining amount ($1,350) is allocated next to the 20 percent penalty portion of the underpayment ($9,356). Thus, the portion of the underpayment that is not penalized is zero ($150 - $150), the portion subject to a 20 percent penalty is $8,006 ($9,356 - $1,350) and the portion subject to a 75 percent penalty is unchanged at $13,948.

SECTION 1.6664-4 REASONABLE CAUSE AND GOOD FAITH EXCEPTION TO SECTION 6662 PENALTIES.

(a) IN GENERAL. No penalty may be imposed under section 6662 with respect to any portion of an underpayment upon a showing by the taxpayer that there was reasonable cause for, and the taxpayer acted in good faith with respect to, such portion. Rules for determining whether the reasonable cause and good faith exception applies are set forth in paragraphs (b), (c), (d) and (e) of this section.

(b) FACTS AND CIRCUMSTANCES TAKEN INTO ACCOUNT -- (1) IN GENERAL. The determination of whether a taxpayer acted with reasonable cause and in good faith is made on a case-by-case basis, taking into account all pertinent facts and circumstances. The most important factor is the extent of the taxpayer's effort to assess the taxpayer's proper tax liability. Circumstances that may indicate reasonable cause and good faith include an honest misunderstanding of fact or law that is reasonable in light of the experience, knowledge and education of the taxpayer. An isolated computational or transcriptional error generally is not inconsistent with reasonable cause and good faith. Reliance on an information return or on the advice of a professional (such as an appraiser, attorney or accountant) does not necessarily demonstrate reasonable cause and good faith. Similarly, reasonable cause and good faith is not necessarily indicated by reliance on facts that, unknown to the taxpayer, are incorrect. Reliance on an information return, professional advice or other facts, however, constitutes reasonable cause and good faith if, under all the circumstances, such reliance was reasonable and the taxpayer acted in good faith. For example, reliance on erroneous information (such as an error relating to the cost or adjusted basis of property, the date property was placed in service, or the amount of opening or closing inventory) inadvertently included in data compiled by the various divisions of a multidivisional corporation or in financial books and records prepared by those divisions generally indicates reasonable cause and good faith, provided the corporation employed internal controls and procedures, reasonable under the circumstances, that were designed to identify such factual errors. Reasonable cause and good faith ordinarily is not indicated by the mere fact that there is an appraisal of the value of property. Other factors to consider include the methodology and assumptions underlying the appraisal, the appraised value, the relationship between appraised value and purchase price, the circumstances under which the appraisal was obtained, and the appraiser's relationship to the taxpayer or to the activity in which the property is used. (See paragraph (e) of this section for special rules relating to appraisals for "charitable deduction property") A taxpayer's reliance on erroneous information reported on a Form W-2, Form 1099 or other information return indicates reasonable cause and good faith, provided the taxpayer did not know or have reason to know that the information was incorrect. Generally, a taxpayer knows or has reason to know that the information on an information return is incorrect if such information is inconsistent with other information reported or otherwise furnished to the taxpayer, or with the taxpayer's knowledge of the transaction. This knowledge includes, for example, the taxpayer's knowledge of the terms of his employment relationship or of the rate of return on a payor's obligation.

(2) EXAMPLES. The following examples illustrate the provisions of paragraph (b) of this section:

EXAMPLE 1. A, an individual calendar year taxpayer, engages B, a tax professional, to give him advice concerning the deductibility of certain state and local taxes. A provides B with full details concerning the taxes at issue. B advises A that the taxes are fully deductible. A, in preparing his own tax return, claims a deduction for the taxes. Under these facts, A is considered to have demonstrated good faith by seeking the advice of a tax professional, and to have shown reasonable cause for any underpayment attributable to the deduction claimed for the taxes. However, if A had sought advice from someone that he knew, or should have known, lacked knowledge in federal income taxation, A would not be considered to have shown reasonable cause or to have acted in good faith.

EXAMPLE 2. C, an individual, sought advice from D, a friend who was not a tax professional, as to how C might reduce his Federal tax obligations. D advised C that, for a nominal investment in Corporation X, D had received certain tax benefits which virtually eliminated D's Federal tax liability. D also named other investors who had received similar benefits. Without further inquiry, C invested in X and claimed the benefits that he had been assured by D were due him. In this case, C did not make any good faith attempt to ascertain the correctness of what D had advised him concerning his tax matters, and is not considered to have reasonable cause for the underpayment attributable to the benefits claimed.

EXAMPLE 3. E, an individual, worked for Company X doing odd jobs and filling in for other employees when necessary. E worked irregular hours and was paid by the hour. The amount of E's pay check differed from week to week. The Form W-2 furnished to E reflected wages for 1990 in the amount of $29,729. It did not, however, include compensation of $1,467 paid for some hours E worked. Relying on the Form W-2, E filed a return reporting wages of $29,729. E had no reason to know that the amount reported on the Form W-2 was incorrect. Under the circumstances, E is considered to have acted in good faith in relying on the Form W-2 and to have reasonable cause for the underpayment attributable to the unreported wages.

EXAMPLE 4. H, an individual, did not enjoy preparing his tax returns and procrastinated in doing so until April 15th. on April 15th, H hurriedly gathered together his tax records and materials, prepared a return, and mailed it before midnight. The return contained numerous errors, some of which were in H's favor and some of which were not. The net result of all the adjustments, however, was an underpayment of tax by H. Under these circumstances, H is not considered to have reasonable cause for the underpayment or to have acted in good faith in attempting to file an accurate return.

(c) PASS-THROUGH ITEMS. In the case of an underpayment that is related to an item on the return of a pass-through entity (as defined in section 1.6662-4(f)(5)), reasonable cause and good faith by the entity generally is imputed to the taxpayer that has the underpayment. Reasonable cause and good faith is not imputed from the entity to the taxpayer, however, if there are factors which indicate that the taxpayer did not act with reasonable cause and in good faith. Correspondingly, a lack of reasonable cause or bad faith also may be imputed from the entity to the taxpayer.

(d) TRANSACTIONS BETWEEN PERSONS DESCRIBED IN SECTION 482 AND NET SECTION 482 TRANSFER PRICE ADJUSTMENTS. [Reserved]

(e) VALUATION MISSTATEMENTS OF CHARITABLE DEDUCTION PROPERTY --

(1) IN GENERAL. There may be reasonable cause and good faith with respect to a portion of an underpayment that is attributable to a substantial (or gross) valuation misstatement of charitable deduction property (as defined in paragraph (e)(2)(i) of this section) only if --

(i) The claimed value of the property was based on a qualified appraisal (as defined in paragraph (e)(2)(ii) of this section) by a qualified appraiser (as defined in paragraph (e)(2)(iii) of this section), and

(ii) In addition to obtaining a qualified appraisal, the taxpayer made a good faith investigation of the value of the contributed property.

The rules of this paragraph (e) apply regardless of whether section 1.170A-13 permits a taxpayer to claim a charitable contribution deduction for the property without obtaining a qualified appraisal. The rules of this paragraph (e) apply in addition to the generally applicable rules concerning reasonable cause and good faith.

(2) DEFINITIONS -- (i) CHARITABLE DEDUCTION PROPERTY. For purposes of this paragraph (e), the term "charitable deduction property" means any property (other than money or publicly traded securities, as defined in section 1.170A-13(c)(7)(xi)) contributed by the taxpayer in a contribution for which a deduction was claimed under section 170.

(ii) QUALIFIED APPRAISAL. For purposes of this paragraph (e), the term "qualified appraisal" means a qualified appraisal as defined in section 1.170A-13(c)(3).

(iii) QUALIFIED APPRAISER. For purposes of this paragraph (e), the term "qualified appraiser" means a qualified appraiser as defined in section 1.170A-13(c)(5).

PART 602 -- OMB CONTROL NUMBERS UNDER THE PAPERWORK REDUCTION ACT

Par. 3. The authority for part 602 continues to read as follows:

Authority: (26 U.S.C. 7805)

Par. 4. Section 602.101 (c) is amended by adding the following in the table:

Section 1.6662-3(c) -- 1545-0889

Section 1.6662-4(e) and (f) -- 1545-0889