Accuracy-related Penalty

DEPARTMENT OF THE TREASURY

26 CFR Part 1

[IA-55-94]

RIN 1545-AT13

Accuracy-related Penalty

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Notice of proposed rulemaking and notice of public hearing.

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SUMMARY: This document contains proposed regulations which provide

guidance as to when a taxpayer may rely upon the advice of others as

evidence of reasonable cause and good faith within the meaning of

section 6664(c) of the Internal Revenue Code of 1986 for purposes of

avoiding the accuracy-related penalty of section 6662, and what

constitutes reasonable cause and good faith within the meaning of

section 6664(c) as it applies to the substantial understatement penalty

of section 6662(b)(2) with respect to tax shelter items of a

corporation. The proposed regulations implement changes to the

accuracy-related penalty under section 6662 that were made by Title VII

of the Uruguay Round Agreements Act (the Act) implementing the Uruguay

Round of the General Agreement on Tariffs and Trade. Finally, this

document provides notice of a public hearing on the proposed amendments

to the regulations.

DATES: Written comments must be received by April 7, 1995. The IRS

intends to hold a public hearing on these proposed regulations on April

28, 1995, beginning at 10 a.m. Persons wishing to speak at the hearing

must submit outlines of their comments by April 7, 1995.

ADDRESSES: Send submissions to: Internal Revenue Service, Attn:

CC:DOM:CORP:T:R (IA-55-94), room 5228, POB 7604, Ben Franklin Station,

Washington, DC 20044. The public hearing will be held in the IRS

Auditorium, Internal Revenue Building, 1111 Constitution Avenue, NW,

Washington, DC.

FOR FURTHER INFORMATION CONTACT: Concerning the regulations, David L.

Meyer, 202-622-6232; concerning submissions, Christina Vasquez, 202-

622-6803. (These are not toll-free numbers).

SUPPLEMENTARY INFORMATION:

Background

Section 6662 of the Internal Revenue Code (Code) imposes an

accuracy-related penalty on certain underpayments of tax. Section

6664(c) provides that no accuracy-related penalty is imposed with

respect to any portion of an underpayment if it is shown that there was

a reasonable cause for such portion and that the taxpayer acted in good

faith with respect to such portion.

Under current regulations interpreting sections 6662 and 6664, a

taxpayer's good faith reliance on the advice (including an opinion) of

a professional tax advisor may be taken into account for purposes of

determining whether the taxpayer will be subject to an accuracy-related

penalty. See, e.g., Secs. 1.6662-4(g)(4)(ii) and 1.6664-4(b).

Section 6662(b)(2) of the Code imposes a penalty for a substantial

understatement of income tax. An understatement is substantial if it

exceeds the greater of 10 percent of the tax required to be shown on

the taxpayer's return for the taxable year, or $5,000 ($10,000 in the

case of a corporation other than an S corporation or a personal holding

company). An understatement is defined as the excess of (1) the amount

of tax required to be shown on the taxpayer's return, over (2) the

amount of tax imposed which is shown on the return, reduced by any

rebate.

The Code provides that the amount of an understatement is reduced

to the extent that certain conditions are met. For example, section

6662(d)(2), prior to amendment by the Act (Pub. L. 103-465), provided

that an understatement is reduced by the portion of the understatement

attributable to a tax shelter item of the taxpayer (the section 6662

tax shelter rule) if: (1) there is substantial authority for the

taxpayer's treatment of the tax shelter item; and (2) the taxpayer

reasonably believed (at the time its return was filed) that its

treatment of such item was more likely than not the proper treatment.

The substantial understatement penalty was first adopted in section

323 of the Tax Equity and Fiscal Responsibility Act of 1982, Pub. L.

97-248. At that time, Congress believed that the new standards would

``assure that taxpayers who take highly aggressive filing positions are

penalized while those who endeavor in good faith to self-assess are not

penalized'' and that, with respect to tax shelters, ``if the principal

purpose of a transaction is the reduction of tax, it is not

unreasonable to hold participants to a higher standard than ordinary

taxpayers.'' H.R. Conf. Rep. No. 97th Cong., 2d Sess. 575-76 (1982),

1982-2 C.B.650. More recently, Congress has been concerned that the

substantial understatement penalty has not been effectively deterring

corporate tax shelter transactions and thus, in Section 744 of the Act,

eliminated the section 6662 tax shelter rule as it applies to

corporations. As a result of this change, ``the standards applicable to

corporate tax shetlers are tightened'' and ``in no instance [will] this

modification result in a penalty not being imposed where a penalty

would have been imposed under prior law.'' S. Rep. No. 412, 103d Cong.,

2d Sess. 165 (1994); H.R. Rep. No. 826, 103d Cong., 2d Sess. 198-99

(1994). The change is effective for transactions occurring after

December 8, 1994.

The proposed regulations set forth in this document address issues

related to the section 6662 tax shelter rule and the reasonable cause

exception of section 6664. This guidance includes, but is not limited

to, rules that reflect the amendment of section 6662 by the Act.

Explanation of Provisions

Reliance on Tax Advisor

The proposed regulations set forth general rules clarifying when a

taxpayer may be considered to have reasonably relied in good faith upon

advice (including an opinion provided by a professional tax advisor).

These rules apply to all taxpayers and to both tax shelter items and

non-tax shelter items. In particular, the rules apply in determining

whether reasonable cause and good faith exist for purposes of section

6664(c) and also apply in determining whether a taxpayer other than a

corporation is considered to have reasonably relied in good faith on an

opinion in order to satisfy the ``reasonable belief'' requirement of

the section 6662 tax shelter rule.

In general, the proposed regulations require advice to be based on

all material facts (including, for example, the taxpayer's purposes for

entering into a transaction) and to relate applicable law to such facts

in reaching its conclusion. The advice must not be based upon

unreasonable factual or legal assumptions (including assumptions as to

future events), nor [[Page 407]] unreasonably rely on the

representations, findings or agreements of the taxpayer or any other

person.

Reasonable Cause for Tax Shelter Items of a Corporation

The proposed regulations provide additional guidance with respect

to the application of the reasonable cause exception of section 6664(c)

to a substantial understatement penalty attributable to a tax shelter

item of a corporation. These changes apply only to corporations.

Accordingly, no inference is intended with respect to the application

of section 6664(c) to a substantial understatement penalty attributable

to a tax shelter item of a taxpayer other than a corporation. Treasury

and the IRS invite comments as to the need for clarification of the

application of this exception to such items.

The proposed regulations provide that a corporation's legal

justification may be taken into account, as appropriate, in

establishing that the corporation acted with reasonable cause and in

good faith in its treatment of a tax shelter item only if there is

substantial authority for the treatment of the item and the corporation

reasonably believes in good faith that such treatment is more likely

than not the proper treatment. For this purpose, legal justification

includes any justification relating to the treatment or

characterization under the Federal tax law of the tax shelter item or

of the entity, plan or arrangement that gave rise to the item. Thus, a

taxpayer's belief (whether independently formed or based on the advice

of others) as to the merits of the taxpayer's underlying position is a

legal justification. Satisfaction of the substantial authority and

reasonable belief criteria is an important factor to be considered in

determining whether the taxpayer acted with reasonable cause and in

good faith. However, it is not necessarily dispositive. A corporation

will qualify for the reasonable cause and good faith exception only if,

under all pertinent facts and circumstances, it acted with reasonable

cause and in good faith.

The proposed regulations also provide that facts and circumstances

other than a corporation's legal justification may be taken into

account, as appropriate, in determining whether it acted with

reasonable cause and in good faith, regardless of whether the

substantial authority and reasonable belief requirements are satisfied.

The provisions relating to the reasonable cause and good faith

exception with respect to corporate tax shelters apply only for

purposes of the substantial understatement penalty. No inference is

intended with respect to how the reasonable cause exception may apply

to the negligence penalty of section 6662(b)(1). The proposed

regulations do not alter the definitions of tax shelter or tax shelter

items contained in Sec. 1.6662-4(g)(2) and (3).

Conforming Changes

The proposed regulations would amend the existing regulations under

section 6662 to reflect the changes made by the Act and to clarify the

definition of reasonable belief under the section 6662 tax shelter

rule.

In addition, the proposed regulations clarify that the

determination of whether a corporate or non-corporate taxpayer acted

with reasonable cause and in good faith with respect to an underpayment

that is related to an item reflected on the return of a pass-through

entity is made on the basis of all pertinent facts and circumstances,

including the taxpayer's own actions, as well as the actions of the

pass-through entity.

Proposed Effective Date

The amendments contained in this notice are proposed to be

effective for returns the due date of which (determined without regard

to extensions) is after the date on which final regulations are

published in the Federal Register.

Special Analyses

It has been determined that this notice of proposed rulemaking is

not a significant regulatory action as defined in EO 12866. Therefore,

a regulatory assessment 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 Regulatory Flexibility

Analysis is not required. Pursuant to section 7805(f) of the Internal

Revenue Code, this notice of proposed rulemaking will be submitted to

the Chief Counsel for Advocacy of the Small Business Administration for

comment on its impact on small business.

Comments and Public Hearing

Before the adoption of these proposed regulations, consideration

will be given to any written comments that are submitted timely (a

signed original and eight (8) copies) to the IRS. All comments will be

available for public inspection and copying in their entirety.

A public hearing will be held on April 28, 1995, in the IRS

Auditorium, Internal Revenue Building, 1111 Constitution Avenue, NW,

Washington, DC. Because of access restrictions, visitors will not be

admitted beyond the building lobby more than 15 minutes before the

hearing starts.

The rules of 26 CFR 601.601(a)(3) apply to the hearing.

Persons who wish to present oral comments at the hearing must

submit written comments, an outline of the topics to be discussed, and

the time to be devoted to each topic by April 7, 1995.

A period of 10 minutes will be allotted to each person for making

comments.

An agenda showing the scheduling of the speakers will be prepared

after the deadline for receiving outlines has passed. Copies of the

agenda will be available free of charge at the hearing.

Drafting Information

The principal author of these proposed regulations is David L.

Meyer, Office of Assistant Chief Counsel, Income Tax and Accounting,

IRS. However, other personnel from the IRS and Treasury Department

participated in their development.

List of Subjects in 26 CFR Part 1

Income taxes, Reporting and recordkeeping requirements.

Proposed Amendments to the Regulations

Accordingly, 26 CFR part 1 is proposed to be amended as follows:

PART 1--INCOME TAXES

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

part as follows:

Authority: 26 U.S.C. 7805 * * *

Par. 2. Section 1.6662-0 is amended by revising the entries for

Secs. 1.6662-2(d) and 1.6662-4(g) to read as follows:

Sec. 1.6662-0 Table of contents.

* * * * *

Sec. 1.6662-2 Accuracy related penalty.

* * * * *

(d) Effective date.

(1) In general.

(2) Special rules for tax shelter items.

* * * * *

Sec. 1.6662-4 Substantial understatement of income tax.

* * * * *

(g) Items relating to tax shelters.

(1) In general.

(i) Non-corporate taxpayers.

(ii) Corporate taxpayers.

(A) In general.

(B) Special rule for transactions occurring prior to December 9,

1994.

(iii) Disclosure irrelevant.

(iv) Cross-reference. [[Page 408]]

(2) Tax shelter.

(i) In general.

(ii) Principal purpose.

(3) Tax shelter item.

(4) Reasonable belief.

(i) In general.

(ii) Facts and circumstances; reliance on tax advisor.

* * * * *

Par. 3. Section 1.6662-2 is amended by:

1. Redesignating the text of paragraph (d) following the heading as

paragraph (d)(1), adding a new heading for newly designated paragraph

(d)(1), and revising the second sentence of newly redesignated

paragraph (d)(1).

2. Adding a new paragraph (d)(2).

The additions and revisions read as follows:

Sec. 1.6662-2 Accuracy-related penalty.

* * * * *

(d) Effective date--(1) In general. * * * Except as provided in the

preceding sentence and in paragraph (d)(2) of this section,

Secs. 1.6662-1 through 1.6662-5 apply to returns the due date of which

(determined without regard to extensions of time for filing) is after

December 31, 1989. * * *

(2) Special rules for tax shelter items. Sections 1.6662-4(g)(1)

and 1.6662-4(g)(4) apply to returns the due date of which (determined

without regard to extensions of time for filing) is after the date on

which final regulations are published in the Federal Register. Sections

1.6662-4(g)(1) and (4) (as contained in 26 CFR Part 1 revised April 1,

1994) apply to returns the due date of which (determined without regard

to extensions of time for filing) is on or before the date on which

final regulations are published in the Federal Register and after

December 31, 1989, subject to changes resulting from Section 744 of

Title VII of the Uruguay Round Agreements Act, Pub. L. 103-465 (108

Stat, 4809).

Par. 4. Section 1.6662-4 is amended by revising paragraphs (g)(1),

(g)(4), and (g)(5) to read as follows:

Sec. 1.6662-4 Substantial understatement of income tax.

* * * * *

(g) Items relating to tax shelters--(1) In general--(i) Non-

corporate taxpayers. Tax shelter items (as defined in paragraph (g)(3)

of this section) of a taxpayer other than a corporation are treated for

purposes of this section as if such items were shown properly on the

return for a taxable year in computing the amount of tax shown on the

return, and thus the tax attributable to such items is not included in

the understatement for the year, if--

(A) There is substantial authority (as provided in paragraph (d) of

this section) for the tax treatment of that item; and

(B) 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.

(ii) Corporate taxpayers--(A) In general. Except as provided in

paragraph (g)(1)(ii)(B) of this section, all tax shelter items (as

defined in paragraph (g)(3) of this section) of a corporation are taken

into account in computing the amount of any understatement.

(B) Special rule for transactions occurring prior to December 9,

1994. The tax shelter items of a corporation arising in connection with

transactions occurring prior to December 9, 1994 are treated for

purposes of this section as if such items were shown properly on the

return if the requirements of paragraph (g)(1)(i) are satisfied with

respect to such items.

(iii) Disclosure irrelevant. Disclosure made with respect to a tax

shelter item of either a corporate or non-corporate taxpayer does not

affect the amount of an understatement.

(iv) Cross-reference. See Sec. 1.6664-4(e) for certain rules

regarding the availability of the reasonable cause and good faith

exception to the substantial understatement penalty with respect to tax

shelter items of corporations.

* * * * *

(4) Reasonable belief--(i) In general. For purposes of section

6662(d) and paragraph (g)(1)(i)(B) of this section (pertaining to tax

shelter items of non-corporate taxpayers), a taxpayer is considered

reasonably to believe that the tax treatment of an item is more likely

than not the proper tax treatment if (without taking into account the

possibility that a return will not be audited, that an issue will not

be raised on audit, or that an issue will be settled)--

(A) 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 in good faith 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

(B) The taxpayer reasonably relies in good faith 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.

(ii) Facts and circumstances; reliance on professional tax advisor.

All facts and circumstances must be taken into account in determining

whether a taxpayer satisfies the requirements of paragraph (g)(4)(i) of

this section. However, in no event will a taxpayer be considered to

have reasonably relied in good faith on the opinion of a professional

tax advisor for purposes of paragraph (g)(4)(i)(B) of this section

unless the requirements of Sec. 1.6664-4(c)(1) are met. The fact that

the requirements of Sec. 1.6664-4(c)(1) are satisfied will not

necessarily establish that the taxpayer reasonably relied on the

opinion in good faith. For example, reliance may not be reasonable or

in good faith if the taxpayer knew, or should have known, that the

advisor lacked knowledge in the relevant aspects of Federal tax law.

(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)(A) and (B) 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.

Par. 5. Section 1.6664-0 is amended by revising the entries for

Secs. 1.6664-1(b) and 1.6664-4 to read as follows:

Sec. 1.6664-0 Table of contents.

* * * * *

Sec. 1.6664-1 Accuracy-related and fraud penalties; definitions

and special rules.

* * * * *

(b) Effective date.

(1) In general.

(2) Reasonable cause and good faith exception to section 6662

penalties.

* * * * *

Sec. 1.6664-4 Reasonable cause and good faith exception to section

6662 penalties.

(a) In general.

(b) Facts and circumstances taken into account.

(1) In general.

(2) Examples.

(c) Reliance on opinion or advice.

(1) Fact and circumstances; minimum requirements.

(i) All facts and circumstances considered.

(ii) No unreasonable assumptions.

(iii) Law is related to actual facts.

(2) Definitions.

(i) Advice. [[Page 409]]

(ii) Material.

(d) Pass-through items.

(e) Special rules for substantial understatement penalty

attributable to tax shelter items of corporations.

(1) In general; facts and circumstances.

(2) Reasonable cause based on legal justification.

(i) Minimum requirements.

(A) Authority requirement.

(B) Belief requirement.

(ii) Legal justification defined.

(3) Minimum requirements not dispositive.

(4) Other factors.

(f) Transactions between persons described in section 482 and net

section 482 transfer price adjustments. [Reserved]

(g) Valuation misstatements of charitable deduction property.

(1) In general.

(2) Definitions.

(i) Charitable deduction property.

(ii) Qualified appraisal.

(iii) Qualified appraiser.

* * * * *

Par. 6. Section 1.6664-1 is amended by:

1. Redesignating the text of paragraph (b) following the heading as

paragraph (b)(1), adding a heading for newly designated paragraph

(b)(1), and revising the text of newly designated paragraph (b)(1).

2. Adding paragraph (b)(2).

The additions and revisions read as follows:

Sec. 1.6664-1 Accuracy-related and fraud penalties; definitions and

special rules.

* * * * *

(b) Effective date--(1) In general. Sections 1.6664-1 through

1.6664-3 apply to returns the due date of which (determined without

regard to extensions of time for filing) is after December 31, 1989.

(2) Reasonable cause and good faith exception to section 6662

penalties. Section 1.6664-4 applies to returns the due date of which

(determined without regard to extensions of time for filing) is after

the date on which the final regulations are published in the Federal

Register. Section 1.6664-4 (as contained in 26 CFR Part 1 revised April

1, 1994) applies to returns the due date of which (determined without

regard to extensions of time for filing) is on or before the date on

which the final regulations are published in the Federal Register and

after December 31, 1989, subject to changes resulting from Section 744

of Title VII of the Uruguay Round Agreements Act, Pub. L. 103-465 (108

Stat. 4809).

Par. 7. Section 1.6664-4 is amended by:

1. Revising the last sentence of paragraph (a).

2. Revising paragraph (b)(1).

3. Revising the introductory language of paragraph (b)(2) and

Example 1.

4. Redesignating paragraphs (c), (d) and (e) as paragraphs (d), (f)

and (g), respectively.

5. Revising newly designated paragraph (d).

6. Adding new paragraphs (c) and (e).

The revisions and additions read as follows:

Sec. 1.6664-4 Reasonable cause and good faith exception to section

6662 penalties.

(a) * * * Rules for determining whether the reasonable cause and

good faith exception applies are set forth in paragraphs (b) through

(g) 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. (See paragraph (e) of this section

for certain rules relating to a substantial understatement penalty

attributable to tax shelter items of corporations.) Generally, 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 all of the facts and

circumstances, including 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 tax advisor or

an appraiser 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. (See paragraph (c) of this section for

certain rules relating to reliance on the advice of others.) 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 (g) of this section for certain

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 this paragraph (b).

They do not involve tax shelter items. (See paragraph (e) of this

section for certain rules relating to the substantial understatement

penalty in connection with the tax shelter items of corporations.)

Example 1. A, an individual calendar year taxpayer, engages B, a

professional tax advisor, to give A 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. Absent other facts, and assuming

the facts and circumstances surrounding B's advice and A's reliance

on such advice satisfy the requirements of paragraph (c) of this

section, A is considered to have demonstrated good faith by seeking

the advice of a professional tax advisor, 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 A knew, or should have known, lacked knowledge in the relevant

aspects of Federal tax law, or if other facts demonstrate that A

failed to act reasonably or in good faith, A would not be considered

to have shown reasonable cause or to have acted in good faith.

* * * * * [[Page 410]]

(c) Reliance on opinion or advice--(1) Facts and circumstances;

minimum requirements. All facts and circumstances must be taken into

account in determining whether a taxpayer has reasonably relied in good

faith on advice (including the opinion of a professional tax advisor)

as to the treatment of the taxpayer (or any entity, plan or

arrangement) under Federal tax law. However, in no event will a

taxpayer be considered to have reasonably relied in good faith on

advice unless the requirements of this paragraph (c)(1) are satisfied.

The fact that these requirements are satisfied will not necessarily

establish that the taxpayer reasonably relied on the advice (including

the opinion of a professional tax advisor) in good faith. For example,

reliance may not be reasonable or in good faith if the taxpayer knew,

or should have known, that the advisor lacked knowledge in the relevant

aspects of Federal tax law.

(i) All facts and circumstances considered. The advice must be

based upon all material facts and circumstances, including, for

example, the taxpayer's purposes (and the relative weight of such

purposes) for entering into a transaction and for structuring a

transaction in a particular manner.

(ii) No unreasonable assumptions. The advice must not be based on

unreasonable factual or legal assumptions (including assumptions as to

future events) and must not unreasonably rely on the representations,

statements, findings or agreements of the taxpayer or any other person.

For example, the advice must not be based upon a representation or

assumption which the taxpayer knows or has reason to know is unlikely

to be true, such as an inaccurate representation or assumption as to

the taxpayer's purposes for entering into a transaction or for

structuring a transaction in a particular manner.

(iii) Law is related to actual facts. The advice must be based on

the law as it relates to the actual facts.

(2) Definitions--(i) Advice. Advice is any communication, including

the opinion of a professional tax advisor, setting forth the analysis

or conclusion of a person, other than the taxpayer, provided to (or for

the benefit of) the taxpayer and on which the taxpayer relies, directly

or indirectly, with respect to the imposition of the section 6662

accuracy-related penalty. Advice does not have to be in any particular

form.

(ii) Material. A fact is material if it reasonably could be

expected, based upon information available at the time the advice is

given, to be relevant to the proper tax treatment of the item or the

taxpayer's exposure to the accuracy-related penalty under section 6662.

(d) Pass-through items. The determination of whether a taxpayer

acted with reasonable cause and in good faith with respect to an

underpayment that is related to an item reflected on the return of a

pass-through entity shall be made on the basis of all pertinent facts

and circumstances, including the taxpayer's own actions, as well as the

actions of the pass-through entity.

(e) Special rules for substantial understatement penalty

attributable to tax shelter items of corporations--(1) In general;

facts and circumstances. The determination of whether a corporation

acted with reasonable cause and in good faith in its treatment of a tax

shelter item (as defined in Sec. 1.6662-4(g)(3)) is based on all

pertinent facts and circumstances. Paragraphs (e)(2), (3) and (4) of

this section set forth rules which apply, in the case of a penalty

attributable to a substantial understatement of income tax (within the

meaning of section 6662(d)), in determining whether a corporation acted

with reasonable cause and in good faith with respect to a tax shelter

item.

(2) Reasonable cause based on legal justification--(i) Minimum

requirements. A corporation's legal justification (as described in

paragraph (e)(2)(ii) of this section) may be taken into account, as

appropriate, in establishing that the corporation acted with reasonable

cause and in good faith in its treatment of a tax shelter item only if

the authority requirement of paragraph (e)(2)(i)(A) of this section and

the belief requirement of paragraph (e)(2)(i)(B) of this section are

satisfied (the minimum requirements). Thus, a failure to satisfy the

minimum requirements will preclude a finding of reasonable cause and

good faith based (in whole or in part) on the corporation's legal

justification.

(A) Authority requirement. The authority requirement is satisfied

only if there is substantial authority (within the meaning of

Sec. 1.6662-4(d)) for the tax treatment of the item.

(B) Belief requirement. The belief requirement is satisfied only

if, based on all facts and circumstances, the corporation reasonably

believed, at the time the return was filed, that the tax treatment of

the item was more likely than not the proper treatment. For purposes of

the preceding sentence, a corporation is considered reasonably to

believe that the tax treatment of an item is more likely than not the

proper tax treatment if (without taking into account the possibility

that a return will not be audited, that an issue will not be raised on

audit, or that an issue will be settled)--

(1) The corporation analyzes the pertinent facts and authorities in

the manner described in Sec. 1.6662-4(d)(3)(ii), and in reliance upon

that analysis, reasonably concludes in good faith 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

(2) The corporation reasonably relies in good faith 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 Sec. 1.6662-4(d)(3)(ii) 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. (See paragraph (c) of this

section for certain rules governing reliance upon the opinion of a

professional tax advisor.)

(ii) Legal justification defined. For purposes of this paragraph

(e), legal justification includes any justification relating to the

treatment or characterization under the Federal tax law of the tax

shelter item or of the entity, plan or arrangement that gave rise to

the item. Thus, a taxpayer's belief (whether independently formed or

based on the advice of others) as to the merits of the taxpayer's

underlying position is a legal justification.

(3) Minimum requirements not dispositive. Satisfaction of the

minimum requirements of paragraph (e)(2) of this section is an

important factor to be considered in determining whether a corporation

acted with reasonable cause and in good faith, but is not necessarily

dispositive.

(4) Other factors. Facts and circumstances other than a

corporation's legal justification may be taken into account, as

appropriate, in determining whether the corporation acted with

reasonable cause and in good faith with respect to a tax shelter item

regardless of whether the minimum requirements of paragraph (e)(2) of

this section are satisfied.

* * * * *

Margaret Milner Richardson,

Commissioner of Internal Revenue.

[FR Doc. 95-120 Filed 1-3-95; 8:45 am]

BILLING CODE 4830-01-U