There are at least three questions when it comes to IRS tax disclosure: (1) Should a taxpayer disclose; (2) How should a taxpayer disclose; and (3) How much detail should be disclosed? Should a taxpayer simply attach a statement or footnote to the tax return, or should the taxpayer use a Form 8275, Form 8275-R, or Form 8886? This article addresses these questions and draws on experience with hundreds of tax returns. We also investigate open issues related to IRS disclosures.
To disclose or not to disclose, that is the question
The Internal Revenue Code (IRC) imposes penalties on taxable items that result in underpayment of taxes or undervaluation of liability and (1) not properly empowered and / or (2) not adequately disclosed. The accuracy penalties imposed by Section 6662 (taxpayer) and Section 6694 (preparer) are two examples.
Section 6662 imposes a 20% penalty for underpayment for: negligence or failure to comply with any rule or regulation; a significant understatement of income tax; a material incorrect assessment according to Chapter 1; and other violations.[1] In some cases, the underpayment penalty is increased to 40%.
In addition, Section 6694 imposes a penalty on a tax advisor if (1) he or she makes a statement or claim that reflects an understatement of liability based on an inappropriateness of position, and (2) the person knew or reasonably knew of the inappropriateness should have known position.[2]
However, tax disclosure offers a potential defense against IRS penalties. In fact, in many cases, insufficient disclosure can lead to sanctions against both a taxpayer and a tax return preparer.
Disclosure
The IRS offers three possible methods of formal disclosure: Form 8275, Form 8275-R, and Form 8886.
The Form 8275 Disclosure Statement enables a taxpayer to disclose certain items or positions that do not violate IRS regulations and that are otherwise not adequately disclosed on a tax return.[3] This form is available to individuals, businesses, pass-through companies, and tax return preparers.[4]
The Form 8275-R, Regulation Disclosure Statement, enables a taxpayer to disclose reporting positions that violate Treasury Regulations.[5] In other words, if an item is not in violation of the regulations, an individual must use Form 8275 – not Form 8275-R.[6] Like Form 8275, Form 8275-R can be submitted by individuals, corporations, pass-through companies, and tax return preparers.[7]
Finally, Form 8886, Reportable Transaction Disclosure Statement, is available to disclose information related to reportable transactions.[8] Reportable transactions include listed transactions, confidential transactions, transactions with contractual protection, loss transactions, and interest rate transactions.[9]
A taxpayer will generally need to use separate Form 8886 for each reportable transaction, unless the transactions are the same or substantially similar.[10] A transaction is essentially similar if (1) it is expected to have the same or similar types of tax consequences and (2) either factually similar or based on the same or a similar tax strategy.[11]According to the IRS, findings of material similarity should be construed in favor of disclosure.[12]
How Much Disclosed?
What information is required to comply with the detailed regulations of the IRS, case law, and administrative authorities is usually a matter of a qualified tax attorney. Failure to have a confidential disclosure reviewed or prepared by a tax attorney can expose a taxpayer or the tax return creator to severe penalties. In certain circumstances, non-compliant disclosure (or failure to disclose if necessary) may result in criminal prosecution.
Proper tax disclosure generally requires a knowledge of the tax laws at issue and an understanding of the nuances of the positions available. The amount of information and details required will depend on the facts and circumstances and the specific IRS regulations that are being challenged.
Believe it or not, the most common mistake is likely to be “excessive” disclosure or a failure to properly tailor disclosure. Remember, a taxpayer only needs to disclose enough details to tell the IRS what this is about. Therefore, disclosure should generally be concise and precise. Unnecessary disclosures can put a taxpayer at additional risk.
Open questions
Is it possible to reduce the amount of an underpayment?
Yes, it is possible to reduce the amount of an underpayment in terms of both taxpayers and creators.
Section 6662 (d) (2) (B) allows for the reduction of what part of an understatement is due to:
I. The tax treatment of an object by the taxpayer if there is or has been a material justification for such treatment; or
ii. Any article if-
I. the relevant facts that influence the tax treatment of the object are appropriately disclosed in the declaration or in a declaration accompanying the declaration, and
II. There is a reasonable basis for the taxpayer’s tax treatment of such an item.
Substantial authority exists when the authorities that allow a particular treatment are substantial compared to the sources that do not support that treatment.[13] Note, however, that IRS regulations only allow certain types of authorities to be included in the equation, and these tax authorities have well-established hierarchies in tax law. Whether or not there is substantial authority is a legal issue – in general, a tax attorney can prepare a tax opinion on the matter. Appropriate disclosure is when the disclosure is made on a proper form or an amended statement.[14] Likewise, “appropriate basis” is an artificial term in tax law, and whether there is a reasonable basis for a tax return position often requires an examination by a tax attorney.
Similarly, penalties for creators can be reduced. Section 6694 (b) (3) reduces the amount of understatement by the amount a creator paid under subsection (a).[15]
Is it possible to change a disclosure?
Yes. One person can file an amended statement[16] or request for administrative adjustment in accordance with section 6227.[17] If the return is a qualified altered return and is submitted in a timely manner, accuracy-related penalties will be reduced.
[1] 26 USC § 6662.
[2] 26 USC § 6694.
[3] https://www.irs.gov/instructions/i8275
[4] https://www.irs.gov/instructions/i8275
[5] https://www.irs.gov/instructions/i8275r
[6] https://www.irs.gov/instructions/i8275r
[7] https://www.irs.gov/instructions/i8275r
[8] https://www.irs.gov/instructions/i8886
[9] https://www.irs.gov/instructions/i8886
[10] https://www.irs.gov/instructions/i8886
[11] https://www.irs.gov/instructions/i8886#idm139691597207824
[12] https://www.irs.gov/instructions/i8886#idm139691597207824
[13] https://www.thetaxadviser.com/issues/2009/jun/establishingsubstantialauthorityforundisclosedtaxpositions.html
[14] https://www.thetaxadviser.com/issues/2009/jun/establishingsubstantialauthorityforundisclosedtaxpositions.html
[15] 26 USC § 6694.
[16] 26 CFR § 1.6664-2.
[17] 26 USC § 6227.
[View source.]