Substantial Authority Update: Tax Penalty Avoidance By Good Faith Reference To Judicial, Administrative And Legislative Authorities

Internal Revenue Code (IRC) 6662(b) authorizes the Internal Revenue Service (IRS) to impose a penalty if an underpayment of income tax by a taxpayer exceeds a computational threshold called a substantial understatement. An understatement is reduced, however, by the portion attributable to an item for which the taxpayer had substantial authority. Substantial authority is defined in Treasury Regulation §1,66624(d)(2), but taxpayers are required to recognize and take into account the relative weight of various authorities such as regulations, revenue rulings, legislative histories, court cases and IRS pronouncements. Alternatively, taxpayers may make a reasonable cause argument for the waiver of underpayment penalties, claiming that they made a good faith effort to comply with the IRC requirements. We examine the manner and extent to which courts have been willing to waive penalties based on substantial authority cited by taxpayers. We also analyze cases in which taxpayers have claimed reasonable cause. We draw conclusions about judicial responses to these two penalty avoidance arguments