Uncertain Tax Position? File Form 8275 to Avoid PenaltiesTax Planning
Are you about to take an aggressive position on your tax return that could result in a substantial tax reduction?
If it passes IRS muster, you’re home free.
But if it doesn’t, you could end up having to pay a good-sized penalty.
The IRS can impose a 20 percent penalty for a substantial underpayment of tax. For example, if the IRS concludes you underpaid your taxes by $50,000, it can impose a $10,000 penalty that must be paid in addition to the tax due plus interest.
How big must a tax underpayment be to be “substantial”? Not very big.
Individual taxpayers who understate their tax by more than 10 percent or $5,000, whichever is greater, can end up with this penalty. The 10 percent is reduced to 5 percent if you claim the Section 199A qualified business income (QBI) deduction on your return.
Fortunately, there is a way to avoid the understatement penalty. All you need do is adequately disclose on your return (or amended return) the item that might result in the understatement. In this event, the item is treated as if it were shown properly when computing the amount of tax on the return. Thus, the tax attributable to the item is not included in the tax understatement for that year.
This way, if your aggressive position backfires, at least you won’t have to pay a big underpayment penalty.
How to Disclose
There are two IRS forms for such disclosures: Form 8275, Disclosure Statement, and Form 8275-R, Regulation Disclosure Statement.
Form 8275 is commonly filed to disclose all types of tax positions. But you can’t use it to avoid imposition of penalties for tax shelter items. A tax shelter is an investment whose main purpose is avoiding or evading federal income tax. Form 8275 should be filed with your original or amended return.
Form 8275-R is filed only to disclose tax positions that contradict IRS regulations. This form is almost never filed by taxpayers because it virtually guarantees an IRS audit.
A C corporation can file a Schedule UTP, Uncertain Tax Position Statement, instead of Form 8275.
Pass-through entities (i.e., S corporations, multi-member LLCs, partnerships) should file Form 8275 with the entity’s tax return. If the pass-through fails to file the form, individual owners may make a disclosure for pass-through items by filing Form 8275 with their original or amended returns, and by filing a duplicate copy with the IRS Service Center where the entity files its return.
What Is an Adequate Disclosure?
To make an adequate disclosure, your Form 8275 must show you had a “reasonable basis” for the tax position that resulted in the underpayment. In addition, you must have kept proper books and records and substantiated the items properly.
Even if the IRS doesn’t agree with your position, you still can have a reasonable basis for it. You have a reasonable basis if your claim is more than arguable or colorable. A 20 percent likelihood of success is enough. This is not a very high bar. Thus, you can take a fairly aggressive position on your return and avoid an underpayment penalty by disclosing it on Form 8275.
A return position has a reasonable basis if it is reasonably based on almost any type of tax authority. This includes the following:
- The tax code
- Proposed, temporary, and final IRS regulations
- IRS revenue rulings and revenue procedures
- Tax treaties and their regulations
- Court cases
- Congressional intent as reflected in committee reports and in joint explanatory statements included in conference committee reports
- The General Explanation of Tax Legislation, prepared by the Joint Committee on Taxation (otherwise known as the Bluebook)
- IRS private letter rulings and technical advice memoranda
- IRS actions on decisions
- IRS general counsel memoranda
- IRS information or press releases—for example, IRS website FAQs
- IRS notices and announcements
The most common mistake taxpayers make is disclosing too much on Form 8275 or including voluminous substantiation. This isn’t necessary. Many disclosures are quite brief.
You need only provide enough information to apprise the IRS of the identity of the item, its amount, and the nature of the controversy or potential controversy.
Keep in mind that the purpose of the disclosure is to put the IRS on notice of a potential controversy concerning the item or tax position. There is no need to provide unnecessary information or legal argument.
For example, if the IRS might question a deduction, a disclosure on Form 8275 is adequate if it identifies the item being deducted, the amount, the rule under which the item is being deducted, and the issue the IRS could raise as to whether the item is properly deducted.
Carryovers, Carrybacks, and Recurring Items
Carryover items must be disclosed for the tax year in which they originated. You do not have to file another Form 8275 for those items for the later tax years in which the carryover is taken into account.
But if you disclose recurring items (such as depreciation), you must file Form 8275 for each tax year in which the item occurs.
When Form 8275 Is Not Required
Some tax items already require a form that, if completed correctly, provides full disclosure for purposes of the understatement penalty. Form 8275 may not be filed for these items. The items are listed in a revenue procedure that the IRS updates annually.
These include the itemized deductions listed on Schedule A: medical and dental expenses, taxes, interest expenses, charitable contributions, and casualty and theft losses. Thus, for example, you should not file Form 8275
to adequately disclose a charitable contribution. Instead, complete the charitable contributions section of Schedule A and attach any other required forms.
You would not generally file Form 8275 to disclose the following business or rental property expenses:
- Casualty and theft losses
- Legal expenses
- Specific bad debt charge-offs
- Officers’ compensation
- Repair expenses
Filing Form 8275 Can Help Avoid Six-Year Statute of Limitations
In addition to avoiding the underpayment penalty, filing Form 8275 can have a big added benefit: avoiding a lengthy time permitted for the IRS to examine your return. Ordinarily, the statute of limitations for an audit is three years after a return is filed. But if you omit more than 25 percent of gross income from your return, the statute of limitations is extended to six years.
In determining whether you omitted income from your return, the IRS counts as income included in your return the amount you disclosed on Form 8275, even if you claimed it wasn’t taxable. This can help you stay under the 25 percent omitted income threshold—and keep the statute of limitations period at a much more comfortable three years.
Does Filing Form 8275 Invite an IRS Audit?
The IRS says that filing Form 8275 does not increase your chances for an audit. And most returns that contain Form 8275 are not audited.
But it is true that the form is typically filed for tax returns that invite extra scrutiny by the IRS. Form 8275 may not be a red flag for an audit, but it can provide the IRS with a blueprint for what to question on a return. For this reason, some tax professionals believe it’s better not to file the form.
What Happens If You Don’t File Form 8275?
Filing Form 8275 is purely optional. So, what happens if you don’t file the form, you’re audited, and the IRS finds you’ve substantially underpaid your taxes?
You can still avoid the 20 percent underpayment penalty, but it will be more difficult. Because you didn’t file Form 8275, you’ll avoid the penalty only if you show that you had “substantial authority” for your position.
Substantial authority is a higher bar than reasonable basis. The substantial-authority standard is less stringent than the more-likely-than-not standard (requiring a more than 50 percent likelihood of success), but more stringent than the reasonable-basis standard. It requires about a 40 percent likelihood of success—twice as much as the reasonable-basis standard.
What About Other Tax Penalties?
Technically, filing Form 8275 has no impact on whether the IRS imposes accuracy-related penalties other than the substantial underpayment penalty. These include the penalty for negligence or disregard of rules or regulations, the economic-substance penalty, and tax-shelter penalties.
But when the IRS decides whether to impose other types of penalties, having filed Form 8275 and made an adequate disclosure can only help you.
Here are five takeaways from this article:
- The IRS can impose a 20 percent penalty if you underpay your taxes by the greater of $10,000 or 10 percent (5 percent if you claim the QBI deduction).
- Taxpayers can avoid the underpayment penalty by disclosing uncertain tax positions on IRS Form 8275 and filing it with their return or amended return. Items disclosed on Form 8275 are not counted toward the 20 percent penalty.
- To properly disclose an item on Form 8275, taxpayers must show a reasonable basis for the item. This only requires that your claim has about a 20 percent likelihood of success. Citing almost any type of tax authority is sufficient.
- Items that already require a form should not be disclosed on Form 8275. This includes itemized personal deductions listed on Schedule A and certain business and rental expenses.
- Filing Form 8275 likely does not increase the chances of a return being audited. But it can provide the IRS with a guide for what to question in your tax return.