Can penalties be abated when a taxpayer fails to report income from pass-through entities, but later files an amended return?
Taxpayer Says: The penalties should be abated because amended returns showing the correct information were filed.
Internal Revenue Service Says: The amended returns were not qualified amended returns because they were filed after the date the taxpayer was first contacted in connection with the examination of the original returns. The penalties should not be abated.
From Internal Revenue Code Section 6662(a) and (b)(1) and (2): Imposes an accuracy-related penalty equal to 20% of the portion of an underpayment of tax attributable to, among other things, negligence or disregard of rules or regulations, or any substantial understatement of income tax.
From Internal Revenue Code Section 6662(d)(1)(A): Defines a “substantial understatement of income tax” as an understatement in an amount exceeding the greater of 10% of the tax required to be shown on the return or $5,000.
From Internal Revenue Code Section 6662(d)(2)(A): As pertinent, the term “understatement” is defined as the excess of the amount of tax required to be shown on the return over the amount shown.
From Internal Revenue Code Section 6662(d)(2)(B): Reduces the amount of an understatement by the portion of the understatement for which (1) there is substantial authority for the taxpayer’s tax treatment of the item or (2) there is adequate disclosure of the relevant facts affecting the item’s tax treatment and there is a reasonable basis for the taxpayer’s treatment of the item.
From Federal Tax Regulation 1.6662-2(c): Only one accuracy-related penalty may be applied with respect to any given portion of an underpayment, even if that portion is subject to the penalty on more than one of the grounds set forth in section 6662(b).
From Federal Tax Regulation 1.6664-2(c)(2) and (3): Provides that an amount shown on a qualified amended return can reduce or eliminate an underpayment. A qualified amended return is an amended return * * * filed after the due date of the return for the taxable year * * * and before the earliest of–(A) The date the taxpayer is first contacted by the * * * [IRS] concerning any examination * * * with respect to the return; * * * * * * * (C) In the case of a pass-through item * * * the date the passthrough entity * * * is first contacted by the IRS in connection with an examination of the return to which the pass-through item relates.
THE CAUSE OF THE DISPUTE
Generally, when you’re missing information that you need to complete your federal income tax return (and no additional extensions are available), you should file the return with the best information you have, disclose what information is missing, and file an amendment later.
In some cases, disclosure can relieve you of penalties that would normally be assessed for failing to file a complete and accurate return. IRS Forms 8082 and 8275 meet the requirements for disclosure and penalty relief. In addition, filing a qualified amended return can reduce or eliminate accuracy-related penalties.
In this case, the taxpayer, a doctor, owned two subchapter S corporations. For tax years 2007 and 2008, neither corporate return was complete when his individual return was due, and no Schedule K-1 was available to use in the preparation of his individual returns. His tax preparer completed the individual returns with no income amounts from either corporation. The preparer attached typed statements indicating the Schedule K-1 information was not included and that an amended return would be filed when the K-1s were completed.
In October 2010, the IRS notified the taxpayer that his 2008 individual return had been selected for examination. In January 2011, the taxpayer received notification that his 2009 return had also been selected for examination. The taxpayer filed Forms 1040X, Amended U.S. Individual Income Tax Return, for tax years 2008 and 2009 on January 3 and May 13, 2011, respectively. The amended returns included the information from the corporate returns, which were also filed in January and May of 2011.
The IRS accepted the amended returns and made adjustments, and the taxpayer agreed to the changes and paid the tax due.
The IRS also assessed accuracy-related penalties equal to 20% of the portion of the underpaid tax.
The taxpayer disagreed with the penalty assessment, saying there was substantial authority for the way he treated the unreported income, and that he filed amended returns reporting the income, which would reduce the penalties.
The IRS says the regulations provide a safe harbor for a taxpayer who files a “qualified amended return.” However, the taxpayer’s amended returns were not qualified amended returns because they were filed after the date the IRS first contacted him in connection with the examination of the original returns.
WHAT WOULD YOU DECIDE?
Make your selection, then see “The Court’s Decision” below for a full explanation
THE COURT’S DECISION
HL Carpenter, an experienced investor and a CPA, specializes in reader friendly articles on taxes and investing for individuals and small businesses, and publishes two newsletters: Taxing Lessons and Top Drawer Ink. Visit TaxingLessons.com and HLCarpenter.com.
This information should not be considered legal, investment or tax advice. Taxing Lessons and Top Drawer Ink Corp. do not provide legal, investment or tax advice. Always consult your legal, investment and/or tax advisor regarding your personal situation.