WHEN WILL DISCLOSURE OF “AMOUNTS” ON A RETURN CONSTITUTE REASONABLE DISCLOSURE FOR AVOIDING PENALTIES?

Taxpayers can avoid the Code §6662 penalty for substantial underpayment of income tax by adequately disclosing amounts on the income tax return. A recent Revenue Procedure provides details as to when the inclusion of “amounts” on a return constitutes adequate disclosure for this purpose. These rules will also apply for purposes of avoiding preparer penalties.

The following summarizes the requirement of disclosure for “amounts” to meet the adequate disclosure requirements:

A.  The money amounts entered on the forms must be verifiable. A number is verifiable if, on audit, the taxpayer can prove the origin of the amount (even if that number is not ultimately accepted by the Internal Revenue Service) and the taxpayer can show good faith in entering that number on the applicable form.

B. However, for certain items [which are listed in Rev.Proc. 2010-15, § 4.02, such as itemized deductions], a disclosure of an amount is not adequate when the understatement arises from a transaction between related parties. If an entry may present a legal issue or controversy because of a related-party transaction, then that transaction and the relationship must be disclosed on a Form 8275, Disclosure Statement, or Form 8275-R, Regulation Disclosure Statement.

C. When the amount of an item is shown on a line that does not have a preprinted description identifying that item (such as on an unnamed line under an "Other Expense" category) the taxpayer must clearly identify the item by including the description on that line. For example, to disclose a bad debt for a sole proprietorship, the words "bad debt" must be written or typed on the line of Schedule C that shows the amount of the bad debt.

D. In all cases, for such a disclosure to be adequate, the following general requirements must be met: (1) There must be a reasonable basis for the item as defined in Treas.Reg. §1.6662-3(b)(3); (2) The item is NOT attributable to a tax shelter item as defined in   section 6662(d)(2); and (3) The item is properly substantiated and the taxpayer kept adequate books and records with respect to the item or position.

Overall, these requirements are probably “fair” as to whether the IRS was given adequate notice of the particular items on the form. However, the requirement for a special disclosure for the related party items puts a burden (and a trap for the unwary) for taxpayers and their preparers, and may cross the line in having taxpayers and their preparers act as policemen for the IRS.

Rev.Proc. 2010-15