Harold and Betty, factory workers who until this year prepared their own individ

Question

Harold and Betty, factory workers who until this year prepared their own individual tax returns, purchased an investment from a broker last year. Although they reviewed the prospectus for the investment, the broker explained the more complicated features of the investment. Earlier this year, they struggled to prepare their individual return for last year but, because of the investment, found it too complicated to complete. Consequently, they hired a CPA to prepare the return.
The CPA deducted losses generated from the investment against income that Harold and Betty generated from other sources. The IRS audited the return for last year and contended that the loss is not deductible. After consulting their CPA, who further considered the tax consequences of the investment, Harold and Betty agreed the loss is not deductible and consented to paying the deficiency.
The IRS also contended that the couple owes the substantial understatement penalty because did not disclose the value of the investment on their return and did not have substantial authority for their position.
Assume you are representing the taxpayers before the IRS and intend to argue that they should be exempted from the substantial understatement penalty. Your tax manager reminds you to consult Sections 6662 and 6664 of the Internal Revenue Code, and the accompanying Treasury regulations, when conducting your research and preparing your analysis. She also recommends researching the Fifth Circuit's opinion in the Heasley case and the Tenth Circuit's opinion in the Mauerman case, which she says may be helpful in your analysis. Write a letter to the IRS auditor describing, in detail, based on the specific facts and applicable law, your position that Harold and Betty should not be subject to the penalty.

Explanation / Answer

*Taxpayer Penalties Under Section 6662: (a) Imposition of penalty If this section applies to any portion of an underpayment of tax required to be shown on a return, there shall be added to the tax an amount equal to 20 percent of the portion of the underpayment to which this section applies. (b)Portion of underpayment to which section applies This section shall apply to the portion of any underpayment which is attributable to 1 or more of the following: (1) Negligence or disregard of rules or regulations. (2) Any substantial understatement of income tax. (3) Any substantial valuation misstatement under chapter 1. (4) Any substantial overstatement of pension liabilities. (5) Any substantial estate or gift tax valuation understatement *Taxpayer Penalties Under Section 6662: a) Underpayment For purposes of this part, the term “underpayment” means the amount by which any tax imposed by this title exceeds the excess of— (1) the sum of— (A) the amount shown as the tax by the taxpayer on his return, plus (B) amounts not so shown previously assessed (or collected without assessment), over (2) the amount of rebates made. For purposes of paragraph (2), the term “rebate” means so much of an abatement, credit, refund, or other repayment, as was made on the ground that the tax imposed was less than the excess of the amount specified in paragraph (1) over the rebates previously made. (b) Penalties applicable only where return filed The penalties provided in this part shall apply only in cases where a return of tax is filed (other than a return prepared by the Secretary under the authority of section 6020 (b)). (c) Reasonable cause exception for underpayments (1) In general No penalty shall be imposed under section 6662 or 6663 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. In the case of any underpayment attributable to a substantial or gross valuation overstatement under chapter 1 with respect to charitable deduction property, paragraph (1) shall not apply. The preceding sentence shall not apply to a substantial valuation overstatement under chapter 1 if— (A) the claimed value of the property was based on a qualified appraisal made by a qualified appraiser, and (B) in addition to obtaining such appraisal, the taxpayer made a good faith investigation of the value of the contributed property. (4) Definitions For purposes of this subsection— (A) Charitable deduction property The term “charitable deduction property” means any property contributed by the taxpayer in a contribution for which a deduction was claimed under section 170. For purposes of paragraph (3), such term shall not include any securities for which (as of the date of the contribution) market quotations are readily available on an established securities market. (1) In general No penalty shall be imposed under section 6662A with respect to any portion of a reportable transaction understatement 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. (2) Exception Paragraph (1) shall not apply to any portion of a reportable transaction understatement which is attributable to one or more transactions described in section 6662 (b)(6). (3) Special rules Paragraph (1) shall not apply to any reportable transaction understatement unless— (A) the relevant facts affecting the tax treatment of the item are adequately disclosed in accordance with the regulations prescribed under section 6011, (B) there is or was substantial authority for such treatment, and (C) the taxpayer reasonably believed that such treatment was more likely than not the proper treatment. A taxpayer failing to adequately disclose in accordance with section 6011 shall be treated as meeting the requirements of subparagraph (A) if the penalty for such failure was rescinded under section 6707A (d). (4) Rules relating to reasonable belief For purposes of paragraph (3)(C)— (A) In general A taxpayer shall be treated as having a reasonable belief with respect to the tax treatment of an item only if such belief— (i) is based on the facts and law that exist at the time the return of tax which includes such tax treatment is filed, and (ii) relates solely to the taxpayer’s chances of success on the merits of such treatment and does not take into account the possibility that a return will not be audited, such treatment will not be raised on audit, or such treatment will be resolved through settlement if it is raised. (B) Certain opinions may not be relied upon (i) In general An opinion of a tax advisor may not be relied upon to establish the reasonable belief of a taxpayer if— (I) the tax advisor is described in clause (ii), or (II) the opinion is described in clause (iii). (ii) Disqualified tax advisors A tax advisor is described in this clause if the tax advisor

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