Definition of Reasonable Basis

DEPARTMENT OF THE TREASURY
Internal Revenue Service 26 CFR Part 1 [TD 8790] RIN 1545-AU38

TITLE: Definition of Reasonable Basis

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulations.

SUMMARY: This document contains final regulations relating to the
accuracy-related penalty. These amendments are necessary to define
reasonable basis and to make conforming changes to existing
regulations. These regulations affect any taxpayer that files a tax
return.

DATES: Effective date. These regulations are effective December 2,
1998.

Applicability date. For dates of applicability, see ��1.6662-2(d)
and 1.6664-1(b)(2).

FOR FURTHER INFORMATION CONTACT: Beverly A. Baughman, 202-622- 4940
(not a toll-free number).

SUPPLEMENTARY INFORMATION:

Background

On September 1, 1995, the IRS issued final regulations [TD 8617 (60
FR 45661)], relating to the accuracy-related penalty under chapter 1
of the Internal Revenue Code. Those regulations provided guidance
concerning the reasonable basis standard for purposes of (1) the
negligence penalty under section 6662(b)(1), and (2) the disclosure
exception to the penalties for disregarding rules or regulations
under section 6662(b)(1) and the substantial understatement of
income tax under section 6662(b)(2). In the preamble to the final
regulations, the IRS and Treasury Department requested comments and
suggestions on providing further guidance on the reasonable basis
standard. On November 12, 1996, proposed regulations [IA-42-95
(1996-49 I.R.B. 21) (see �601.601(d)(2)(ii)(b) of this chapter)]
defining reasonable basis and making conforming changes to the final
regulations relating to the accuracy-related penalty were published
in the Federal Register (61 FR 58020).

Written comments responding to the notice of proposed rulemaking
were received. A public hearing was held on February 25, 1997. After
consideration of all the comments, the proposed regulations under
section 6662 relating to the definition of reasonable basis for
purposes of the accuracy-related penalty are adopted as revised by
this Treasury decision.

In addition, on August 5, 1997, the Taxpayer Relief Act (TRA) of
1997, Pub. L. 105-34 (111 Stat. 788), was enacted. The Act added a
restriction regarding whether or not a corporation has a reasonable
basis for its tax treatment of an item for purposes of reducing the
amount of the substantial understatement penalty. This restriction
has been incorporated into the final regulations.

Explanation of Provisions and Summary of Comments

These final regulations provide that a return position will have a
reasonable basis for purposes of the accuracy-related penalties if
it is reasonably based on one or more certain authorities. Also, if
the return position does not satisfy the reasonable basis standard,
a reasonable cause and good faith exception may still apply.

One commentator suggested that the substantial authority standard in
�1.6662-4(d)(3)(ii) of existing regulations and the reasonable basis
standard in �1.6662-3(b)(3) of the proposed regulations be expanded
to include as authority a well-reasoned construction of the
applicable regulatory provisions in addition to the statutory
provisions. The substantial authority standard in �1.6662-4(d)(3)
(ii) has not been expanded to reflect this comment. However, the
definition of reasonable basis in �1.6662- 3(b)(3) has been
clarified to include an explicit cross-reference to the nature of
the analysis discussion in �1.6662-4(d)(3)(ii) of the substantial
authority regulations.

Several commentators suggested that the final regulations explain
where the reasonable basis standard ranks in the hierarchy of return
position standards. This suggestion was not adopted. The final
regulations do not rank the standards formally because such a
comparison would change the focus of the reasonable basis
regulations from the taxpayer's obligation to determine his or her
tax liability in accordance with the internal revenue laws to the
probability of the return position prevailing in litigation.

Several commentators supported the exclusion of a numerical
qualification of the reasonable basis standard in the proposed
regulations because they believed that such a qualification would
encourage arbitrary and mechanical application of the standards and
create bad precedent outside the scope of the reasonable basis
standard. The final regulations do not include a numerical
qualification.

One commentator requested that the final regulations refer
specifically to Rev. Rul. 59-60 (1959-1 C.B. 237) (see �601.601(d)
(2)(ii)(b) of this chapter), which provides guidance regarding the
valuation of stock of closely held corporations for estate and gift
tax purposes. The final regulations do not adopt this suggestion. It
is not necessary to include a reference to a specific revenue ruling
because �1.6662-4(d)(3)(iii) of the existing regulations already
lists revenue rulings as an acceptable type of authority.

One commentator requested that the final regulations clarify the
effect of the Omnibus Budget Reconciliation Act of 1993, Pub.

L. 103-66 (107 Stat. 312), and the reasonable cause and good faith
exception under section 6664 on a taxpayer's access to prepayment
litigation in Tax Court. The final regulations do not adopt this
suggestion. It is not necessary to clarify that a taxpayer has
access to prepayment litigation in Tax Court because under section
6665 the Tax Court has jurisdiction to redetermine additions to tax
in the same manner as the underlying tax.

Pursuant to the Taxpayer Relief Act of 1997, Pub. L. 105-34 (111
Stat. 788), �1.6662-4(e)(3) has been added to the final regulations.
That section provides that for purposes of reducing the amount of
the substantial understatement penalty by making an adequate
disclosure, a corporation will not be treated as having a reasonable
basis for its tax treatment of an item attributable to a multi-party
financing transaction entered into after August 5, 1997, if the
treatment does not clearly reflect the income of the corporation.

The Chief Counsel for Advocacy of the Small Business Administration
requested that the preamble to the regulations explain why the IRS
has concluded that this regulation is not subject to the Regulatory
Flexibility Act (5 U.S.C. chapter 6).

The Chief Counsel for Advocacy submits that the regulations tighten
the definition of reasonable basis and, thus, impose a de facto
recordkeeping requirement because they may require small businesses
to keep and maintain records (such as the documents referred to in
�1.6662-4(d)(3)(iii)) to support tax reporting decisions.

After carefully considering these comments, the IRS and Treasury
have concluded that this regulation is not subject to the Regulatory
Flexibility Act, 5 U.S.C. � 603 (1994). That section requires a
regulatory flexibility analysis for an interpretative rule involving
the internal revenue laws only to the extent the interpretative rule
imposes a collection of information requirement on small entities. A
collection of information requirement is defined in 5 U.S.C. �
601(7) (1994) to mean the obtaining, causing to be obtained,
soliciting, or requiring the disclosure to third parties or the
public, of facts or opinions by or for an agency, regardless of form
or format, calling for either (i) answers to identical questions
posed to, or identical reporting or recordkeeping requirements
imposed on, ten or more persons, other than agencies,
instrumentalities, or employees of the United States, or (ii)
answers to questions posed to agencies, instrumentalities, or
employees of the United States that are to be used for general
statistical purposes.

Furthermore, the phrase, recordkeeping requirement, is defined in 5
U.S.C. � 601(8) (1994) as a requirement imposed by an agency on
persons to maintain specified records. Ever since this term was
first used in the Paperwork Reduction Act of 1980 (44 U.S.C. chapter
35), the IRS and Treasury have consistently interpreted the phrase
as applying only when Treasury regulations directly require persons
to maintain specified records. We believe this interpretation is
consistent with the explicit statutory language as well as
Congressional intent to apply the law only to situations in which
government agencies require per-sons to maintain particular records.

Thus, we believe the final regulations do not impose a recordkeeping
requirement or other collection of information requirement, as
defined in 5 U.S.C. �� 601(7), (8) (1994). The regulations do not
impose on taxpayers additional requirements to either report
information to the IRS or to keep specified records. Because the
regulations do not contain a reporting requirement or other
collection of information requirement, the provisions of the
Regulatory Flexibility Act do not apply.

Special Analyses

It has been determined that this Treasury decision is not a
significant regulatory action as defined in EO 12866. Therefore, a
regulatory assessment is not required. It also has been determined
that section 553(b) of the Administrative Procedure Act (5 U.S.C.
chapter 5) does not apply to these regulations.

Pursuant to section 7805(f) of the Internal Revenue Code, the notice
of proposed rulemaking preceding these regulations was submitted to
the Chief Counsel for Advocacy of the Small Business Administration
for comment on the impact of the proposed regulations on small
business. The Chief Counsel for Advocacy submitted comments on these
regulations, which are discussed above.

Drafting Information

The principal author of these regulations is Beverly A.

Baughman, Office of the Assistant Chief Counsel (Income Tax &
Accounting). 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.

Adoption of Amendments to the Regulations Accordingly, 26 CFR part 1
is 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:

1. Adding the entry for �1.6662-2(d)(4).

2. Removing the entries for �1.6662-3(b)(3)(i) and (ii).

3. Adding the entry for �1.6662-4(e)(3).

4. Revising the entry for �1.6662-7(d).

5. Removing the entries for �1.6662-7(d)(1) and (2).

The revision and additions read as follows:

�1.6662-0 Table of contents.

* * * * *

�1.6662-2 Accuracy-related penalty.

* * * * *

(d) * * *

(4) Special rule for reasonable basis.

* * * * *

�1.6662-4 Substantial understatement of income tax.

* * * * *

(e) * * *

(3) Restriction for corporations.

* * * * *

�1.6662-7 Omnibus Budget Reconciliation Act of 1993 changes to the
accuracy-related penalty.

* * * * *

(d) Reasonable basis.

Par 3. Section 1.6662-2 is amended by:

1. Revising the second sentence in paragraph (d)(1).

2. Revising the first sentence in paragraph (d)(2).

3. Adding paragraph (d)(4).

The addition and revisions read as follows:

�1.6662-2 Accuracy-related penalty.

* * * * *

(d) * * * (1) * * * Except as provided in the preceding sentence and
in paragraphs (d)(2), (3), and (4) of this section, ��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, but before January 1, 1994.

* * *

(2) Returns due after December 31, 1993. Except as provided in
paragraphs (d)(3) and (4) of this section and the last sentence of
this paragraph (d)(2), the provisions of ��1.6662-1 through 1.6662-4
and �1.6662-7 (as revised to reflect the changes made to the
accuracy-related penalty by the Omnibus Budget Reconciliation Act of
1993) and of �1.6662-5 apply to returns the due date of which
(determined without regard to extensions of time for filing) is
after December 31, 1993. * * *

* * * * *

(4) Special rules for reasonable basis. Section 1.6662- 3(b)(3)
applies to returns filed on or after December 2, 1998.

Par. 4. Section �1.6662-3 is amended by:

1. Revising the third sentence in paragraph (b)(1) introductory
text.

2. Revising paragraph (b)(3).

The revisions read as follows:

�1.6662-3 Negligence or disregard of rules or regulations.

* * * * *

(b)* * * (1) * * * A return position that has a reasonable basis as
defined in paragraph (b)(3) of this section is not attributable to
negligence. * * *

* * * * *

(3) Reasonable basis. Reasonable basis is a relatively high standard
of tax reporting, that is, significantly higher than not frivolous
or not patently improper. The reasonable basis standard is not
satisfied by a return position that is merely arguable or that is
merely a colorable claim. If a return position is reasonably based
on one or more of the authorities set forth in �1.6662-4(d)(3)(iii)
(taking into account the relevance and persuasiveness of the
authorities, and subsequent developments), the return position will
generally satisfy the reasonable basis standard even though it may
not satisfy the substantial authority standard as defined in
�1.6662-4(d)(2).

(See �1.6662-4(d)(3)(ii) for rules with respect to relevance,
persuasiveness, subsequent developments, and use of a well-reasoned
construction of an applicable statutory provision for purposes of
the substantial understatement penalty.) In addition, the reasonable
cause and good faith exception in �1.6664-4 may provide relief from
the penalty for negligence or disregard of rules or regulations,
even if a return position does not satisfy the reasonable basis
standard.

* * * * *

Par. 5. Section 1.6662-4 is amended by:

1. Revising the second sentence in paragraph (d)(2).

2. Adding paragraph (e)(3).

The addition and revision reads as follows:

�1.6662-4 Substantial understatement of income tax.

* * * * *

(d) * * * (1) * * *

(2) * * * The substantial authority standard is less stringent than
the more likely than not standard (the standard that is met when
there is a greater than 50-percent likelihood of the position being
upheld), but more stringent than the reasonable basis standard as
defined in �1.6662-3(b)(3). * * *

* * * * *

(e) * * * (1) * * *

(3) Restriction for corporations. For purposes of paragraph (e)(2)
(i) of this section, a corporation will not be treated as having a
reasonable basis for its tax treatment of an item attributable to a
multi-party financing transaction entered into after August 5, 1997,
if the treatment does not clearly reflect the income of the
corporation.

* * * * *

Par. 6. In �1.6662-7, paragraph (d) is revised to read as follows:

�1.6662-7 Omnibus Budget Reconciliation Act of 1993 changes to the
accuracy-related penalty.

* * * * * (d) Reasonable basis. For purposes of ��1.6662-3(c) and
1.6662-4(e) and (f) (relating to methods of making adequate
disclosure), the provisions of �1.6662-3(b)(3) apply in determining
whether a return position has a reasonable basis.

Par. 7. Section 1.6664-0 is amended by:

1. Revising the entry for �1.6664-4(c)(2).

2. Removing the entries for ��1.6664-4(c)(1)(iii), (c)(2)(i), and
(c)(2)(ii).

3. Adding the entry for �1.6664-4(g)(3).

The revision and addition reads as follows:

�1.6664-0 Table of contents.

* * * * *

�1.6664-4 Reasonable cause and good faith exception to section 6662
penalties.

* * * * *

(c) * * *

(2) Advice defined.

* * * * *

(g) * * *

(3) Special rules.

* * * * *

Par. 8. In �1.6664-4, paragraph (g) is revised to read as follows:

�1.6664-4 Reasonable cause and good faith exception to section 6662
penalties.

* * * * *

(g) Valuation misstatements of charitable deduction property--(1) In
general. There may be reasonable cause and good faith with respect
to a portion of an underpayment that is attributable to a
substantial (or gross) valuation misstatement of charitable
deduction property (as defined in paragraph (g)(2) of this section)
only if--

(i) The claimed value of the property was based on a qualified
appraisal (as defined in paragraph (g)(2) of this section) by a
qualified appraiser (as defined in paragraph (g)(2) of this
section); and

(ii) In addition to obtaining a qualified appraisal, the taxpayer
made a good faith investigation of the value of the contributed
property.

(2) Definitions. For purposes of this paragraph (g):

Charitable deduction property means any property (other than money
or publicly traded securities, as defined in �1.170A-13( c)(7)(xi))
contributed by the taxpayer in a contribution for which a deduction
was claimed under section 170.

Qualified appraisal means a qualified appraisal as defined in
�1.170A-13(c)(3).

Qualified appraiser means a qualified appraiser as defined in
�1.170A-13(c)(5)..(3) Special rules. The rules of this paragraph (g)
apply regardless of whether �1.170A-13 permits a taxpayer to claim a
charitable contribution deduction for the property without obtaining
a qualified appraisal. The rules of this paragraph (g) apply in
addition to the generally applicable rules concerning reasonable
cause and good faith.

Michael P. Dolan
Deputy Commissioner of Internal Revenue
Approved: November 17, 1998
Donald C. Lubick
Acting Assistant Secretary of the Treasury

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