Avoid IRS Penalties With Form 8275
Form 8275 is filed to disclose all types of tax positions. When you’re considering taking an aggressive position on your tax return that could result in a substantial tax reduction, but you’re worried about having to pay a penalty, talk with Ken-Mar Tax for a free consultation. As an Enrolled Agent, Ken Weinberg is up-to-date on the IRS tax codes and as a tax strategist for the self-employed, Ken is always looking for tax reductions.
Beware of IRS Penalties
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 on Form 8275
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
What Happens If You Don’t File Form 8275?
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 the Form?
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 the form, 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.
To avoid unfavorable tax outcomes and follow tax reduction strategies for your small business, contact Ken Weinberg to set up a free consultation by filling out the form on this page.