[Title 26 CFR 1.6694-2]
[Code of Federal Regulations (annual edition) - April 1, 2002 Edition]
[Title 26 - INTERNAL REVENUE]
[Chapter I - INTERNAL REVENUE SERVICE, DEPARTMENT OF THE TREASURY]
[Subchapter A - INCOME TAX (CONTINUED)]
[Part 1 - INCOME TAXES]
[Sec. 1.6694-2 - Penalty for understatement due to an unrealistic position.]
[From the U.S. Government Printing Office]


26INTERNAL REVENUE122002-04-012002-04-01false1.6694-2Sec. 1.6694-2INTERNAL REVENUEINTERNAL REVENUE SERVICE, DEPARTMENT OF THE TREASURYINCOME TAX (CONTINUED)INCOME TAXES
Sec. 1.6694-2  Penalty for understatement due to an unrealistic position.

    (a) In general--(1) Proscribed conduct. Except as otherwise provided 
in this section, if any part of an understatement of liability relating 
to a return of tax under subtitle A of the Internal Revenue Code or 
claim for refund of tax under subtitle A of the Internal Revenue Code is 
due to a position for which there was not a realistic possibility of 
being sustained on its merits, any person who is a preparer with respect 
to such return or claim for refund who knew or reasonably should have 
known of such position is subject to a penalty of $250 with respect to 
such return or claim for refund.
    (2) Special rule for employers and partnerships. An employer or 
partnership of a preparer subject to penalty under section 6694(a) is 
also subject to penalty only if--
    (i) One or more members of the principal management (or principal 
officers) of the firm or a branch office participated in or knew of the 
conduct proscribed by section 6694(a);
    (ii) The employer or partnership failed to provide reasonable and 
appropriate procedures for review of the position for which the penalty 
is imposed; or
    (iii) Such review procedures were disregarded in the formulation of 
the advice, or the preparation of the return or claim for refund, that 
included the position for which the penalty is imposed.
    (b) Realistic possibility of being sustained on its merits--(1) In 
general. A position is considered to have a realistic possibility of 
being sustained on its merits if a reasonable and well-informed analysis 
by a person knowledgeable in the tax law would lead such a person to 
conclude that the position has approximately a one in three, or greater, 
likelihood of being sustained on its merits (realistic possibility 
standard). In making this determination, the possibility that the 
position will not be challenged by the Internal

[[Page 1071]]

Revenue Service (e.g., because the taxpayer's return may not be audited 
or because the issue may not be raised on audit) is not to be taken into 
account. The analysis prescribed by Sec. 1.6662-4(d)(3)(ii) for purposes 
of determining whether substantial authority is present applies for 
purposes of determining whether the realistic possibility standard is 
satisfied.
    (2) Authorities. The authorities considered in determining whether a 
position satisfies the realistic possibility standard are those 
authorities provided in Sec. 1.6662-4(d)(3)(iii).
    (3) Examples. The provisions of paragraphs (b)(1) and (b)(2) of this 
section are illustrated by the following examples:

    Example 1. A new statute is unclear as to whether a certain 
transaction that a taxpayer has engaged in will result in favorable tax 
treatment. Prior law, however, supported the taxpayer's position. There 
are no regulations under the new statute and no authority other than the 
statutory language and committee reports. The committee reports state 
that the intent was not to adversely affect transactions similar to the 
taxpayer's transaction. The taxpayer's position satisfies the realistic 
possibility standard.
    Example 2. A taxpayer has engaged in a transaction that is adversely 
affected by a new statutory provision. Prior law supported a position 
favorable to the taxpayer. The preparer believes that the new statute is 
inequitable as applied to the taxpayer's situation. The statutory 
language is unambiguous as it applies to the transaction (e.g., it 
applies to all manufacturers and the taxpayer is a manufacturer of 
widgets). The committee reports do not specifically address the 
taxpayer's situation. A position contrary to the statute does not 
satisfy the realistic possibility standard.
    Example 3. The facts are the same as in Example 2, except the 
committee reports indicate that Congress did not intend to apply the new 
statutory provision to the taxpayer's transaction (e.g., to a 
manufacturer of widgets). Thus, there is a conflict between the general 
language of the statute, which adversely affects the taxpayer's 
transaction, and a specific statement in the committee reports that 
transactions such as the taxpayer's are not adversely affected. A 
position consistent with either the statute or the committee reports 
satisfies the realistic possibility standard. However, a position 
consistent with the committee reports constitutes a disregard of a rule 
or regulation and, therefore, must be adequately disclosed in order to 
avoid the section 6694(b) penalty.
    Example 4. The instructions to an item on a tax form published by 
the Internal Revenue Service are incorrect and are clearly contrary to 
the regulations. Before the return is prepared, the Internal Revenue 
Service publishes an announcement acknowledging the error and providing 
the correct instruction. Under these facts, a position taken on a return 
which is consistent with the regulations satisfies the realistic 
possibility standard. On the other hand, a position taken on a return 
which is consistent with the incorrect instructions does not satisfy the 
realistic possibility standard. However, if the preparer relied on the 
incorrect instructions and was not aware of the announcement or the 
regulations, the reasonable cause and good faith exception may apply 
depending on all facts and circumstances. See Sec. 1.6694-2(d).
    Example 5. A statute is silent as to whether a taxpayer may take a 
certain position on the taxpayer's 1991 Federal income tax return. Three 
private letter rulings issued to other taxpayers in 1987 and 1988 
support the taxpayer's position. However, proposed regulations issued in 
1990 are clearly contrary to the taxpayer's position. After the issuance 
of the proposed regulations, the earlier private letter rulings cease to 
be authorities and are not taken into account in determining whether the 
taxpayer's position satisfies the realistic possibility standard. See 
Sec. 1.6694-2(b)(2) and Sec. 1.6662-4(d)(3)(iii). The taxpayer's 
position may or may not satisfy the realistic possibility standard, 
depending on an analysis of all the relevant authorities.
    Example 6. In the course of researching whether a particular 
position has a realistic possibility of being sustained on its merits, a 
preparer discovers that a taxpayer took the same position on a return 
several years ago and that the return was audited by the Service. The 
taxpayer tells the preparer that the revenue agent who conducted the 
audit was aware of the position and decided that the treatment on the 
return was correct. The revenue agent's report, however, made no mention 
of the position. The determination by the revenue agent is not authority 
for purposes of the realistic possibility standard. However, the 
preparer's reliance on the revenue agent's determination in the audit 
may qualify for the reasonable cause and good faith exception depending 
on all facts and circumstances. See Sec. 1.6694-2(d). Also see 
Sec. 1.6694-2(b)(4) and Sec. 1.6662-4(d)(3)(iv)(A) regarding affirmative 
statements in a revenue agent's report.
    Example 7. In the course of researching whether an interpretation of 
a phrase incorporated in the Internal Revenue Code has a realistic 
possibility of being sustained on its merits, a preparer discovers that 
identical language in the taxing statute of another jurisdiction (e.g., 
a state or foreign country) has been authoritatively construed by a

[[Page 1072]]

court of that jurisdiction in a manner which would be favorable to the 
taxpayer, if the same interpretation were applied to the phrase 
applicable to the taxpayer's situation. The construction of the statute 
of the other jurisdiction is not authority for purposes of determining 
whether the position satisfies the realistic possibility standard. See 
Sec. 1.6694-2(b)(2) and Sec. 1.6662-4(d)(3)(iii). However, as in the 
case of conclusions reached in treatises and legal periodicals, the 
authorities underlying the court's opinion, if relevant to the 
taxpayer's situation, may give a position favorable to the taxpayer a 
realistic possibility of being sustained on its merits. See Sec. 1.6694-
2(b)(2) and Sec. 1.6662-4(d)(3)(iii).
    Example 8. In the course of researching whether an interpretation of 
a statutory phrase has a realistic possibility of being sustained on its 
merits, a preparer discovers that identical language appearing in 
another place in the Internal Revenue Code has consistently been 
interpreted by the courts and by the Service in a manner which would be 
favorable to the taxpayer, if the same interpretation were applied to 
the phrase applicable to the taxpayer's situation. No authority has 
interpreted the phrase applicable to the taxpayer's situation. The 
interpretations of the identical language are relevant in arriving at a 
well reasoned construction of the language at issue, but the context in 
which the language arises also must be taken into account in determining 
whether the realistic possibility standard is satisfied.
    Example 9. A new statutory provision is silent on the tax treatment 
of an item under the provision. However, the committee reports 
explaining the provision direct the Treasury to issue regulations 
interpreting the provision in a specified way. No regulations have been 
issued at the time the preparer must recommend a position on the tax 
treatment of the item, and no other authorities exist. The position 
supported by the committee reports satisfies the realistic possibility 
standard.

    (4) Written determinations. To the extent a position has substantial 
authority with respect to the taxpayer by virtue of a ``written 
determination'' as provided in Sec. 1.6662-4(d)(3)(iv)(A), such position 
will be considered to satisfy the realistic possibility standard with 
respect to the taxpayer's preparer for purposes of section 6694(a).
    (5) When ``realistic possibility'' determined. For purposes of this 
section, the requirement that a position satisfy the realistic 
possibility standard must be satisfied on the date prescribed by 
paragraph (b)(5)(i) or (b)(5)(ii) of this section, whichever is 
applicable.
    (i) Signing preparers--(A) In the case of a signing preparer, the 
relevant date is the date the preparer signs and dates the return or 
claim for refund.
    (B) If the preparer did not date the return or claim for refund, the 
relevant date is the date the taxpayer signed and dated the return or 
claim for refund. If the taxpayer also did not date the return or claim 
for refund, the relevant date is the date the return or claim for refund 
was filed.
    (ii) Nonsigning preparers. In the case of a nonsigning preparer, the 
relevant date is the date the preparer provides the advice. That date 
will be determined based on all the facts and circumstances.
    (c) Exception for adequate disclosure of nonfrivolous positions--(1) 
In general. The section 6694(a) penalty will not be imposed on a 
preparer if the position taken is not frivolous and is adequately 
disclosed. For an exception to the section 6694(a) penalty for 
reasonable cause and good faith, see paragraph (d) of this section.
    (2) Frivolous. For purposes of this section, a ``frivolous'' 
position with respect to an item is one that is patently improper.
    (3) Adequate disclosure--(i) Signing preparers. In the case of a 
signing preparer, disclosure of a position that does not satisfy the 
realistic possibility standard is adequate only if the disclosure is 
made in accordance with Sec. 1.6662-4(f) (which permits disclosure on a 
properly completed and filed Form 8275 or 8275-R, as appropriate, or on 
the return in accordance with an annual revenue procedure).
    (ii) Nonsigning preparers. In the case of a nonsigning preparer, 
disclosure of a position that does not satisfy the realistic possibility 
standard is adequate if the position is disclosed in accordance with 
Sec. 1.6662-4(f) (which permits disclosure on a properly completed and 
filed Form 8275 or 8275-R, as appropriate, or on the return in 
accordance with an annual revenue procedure). In addition, disclosure of 
a position is adequate in the case of a nonsigning preparer if, with 
respect to that position, the preparer complies with the provisions of 
paragraph (c)(3)(ii)(A) or (B) of this section, whichever is applicable.

[[Page 1073]]

    (A) Advice to taxpayers. If a nonsigning preparer provides advice to 
the taxpayer with respect to a position that does not satisfy the 
realistic possibility standard, disclosure of that position is adequate 
if the advice includes a statement that the position lacks substantial 
authority and, therefore, may be subject to penalty under section 
6662(d) unless adequately disclosed in the manner provided in 
Sec. 1.6662-4(f) (or in the case of a tax shelter item, that the 
position lacks substantial authority and, therefore, may be subject to 
penalty under section 6662(d) regardless of disclosure). If the advice 
with respect to the position is in writing, the statement concerning 
disclosure (or the statement regarding possible penalty under section 
6662(d)) also must be in writing. If the advice with respect to the 
position is oral, advice to the taxpayer concerning the need to disclose 
(or the advice regarding possible penalty under section 6662(d)) also 
may be oral. The determination as to whether oral advice as to 
disclosure (or the oral advice regarding possible penalty under section 
6662(d)) was in fact given is based on all facts and circumstances. 
Contemporaneously prepared documentation of the oral advice regarding 
disclosure (or the oral advice regarding possible penalty under section 
6662(d)) generally is sufficient to establish that the advice was given 
to the taxpayer.
    (B) Advice to another preparer. If a nonsigning preparer provides 
advice to another preparer with respect to a position that does not 
satisfy the realistic possibility standard, disclosure of that position 
is adequate if the advice includes a statement that disclosure under 
section 6694(a) is required. If the advice with respect to the position 
is in writing, the statement concerning disclosure also must be in 
writing. If the advice with respect to the position is oral, advice to 
the preparer concerning the need to disclose also may be oral. The 
determination as to whether oral advice as to disclosure was in fact 
given is based on all facts and circumstances. Contemporaneously 
prepared documentation of the oral advice regarding disclosure generally 
is sufficient to establish that the advice regarding disclosure was 
given to the other preparer.
    (d) Exception for reasonable cause and good faith. The penalty under 
section 6694(a) will not be imposed if considering all the facts and 
circumstances, it is determined that the understatement was due to 
reasonable cause and that the preparer acted in good faith. Factors to 
consider include:
    (1) Nature of the error causing the understatement. Whether the 
error resulted from a provision that was so complex, uncommon, or highly 
technical that a competent preparer of returns or claims of the type at 
issue reasonably could have made the error. The reasonable cause and 
good faith exception does not apply to an error that would have been 
apparent from a general review of the return or claim for refund by the 
preparer.
    (2) Frequency of errors. Whether the understatement was the result 
of an isolated error (such as an inadvertent mathematical or clerical 
error) rather than a number of errors. Although the reasonable cause and 
good faith exception generally applies to an isolated error, it does not 
apply if the isolated error is so obvious, flagrant or material that it 
should have been discovered during a review of the return or claim. 
Furthermore, the reasonable cause and good faith exception does not 
apply if there is a pattern of errors on a return or claim for refund 
even though any one error, in isolation, would have qualified for the 
reasonable cause and good faith exception.
    (3) Materiality of errors. Whether the understatement was material 
in relation to the correct tax liability. The reasonable cause and good 
faith exception generally applies if the understatement is of a 
relatively immaterial amount. Nevertheless, even an immaterial 
understatement may not qualify for the reasonable cause and good faith 
exception if the error or errors creating the understatement are 
sufficiently obvious or numerous.
    (4) Preparer's normal office practice. Whether the preparer's normal 
office practice, when considered together with other facts and 
circumstances such as the knowledge of the preparer, indicates that the 
error in question

[[Page 1074]]

would rarely occur and the normal office practice was followed in 
preparing the return or claim in question. Such a normal office practice 
must be a system for promoting accuracy and consistency in the 
preparation of returns or claims and generally would include, in the 
case of a signing preparer, checklists, methods for obtaining necessary 
information from the taxpayer, a review of the prior year's return, and 
review procedures. Notwithstanding the above, the reasonable cause and 
good faith exception does not apply if there is a flagrant error on a 
return or claim for refund, a pattern of errors on a return or claim for 
refund, or a repetition of the same or similar errors on numerous 
returns or claims.
    (5) Reliance on advice of another preparer. Whether the preparer 
relied on the advice of or schedules prepared by (``advice'') another 
preparer as defined in Sec. 1.6694-1(b). The reasonable cause and good 
faith exception applies if the preparer relied in good faith on the 
advice of another preparer (or a person who would be considered a 
preparer under Sec. 1.6694-1(b) had the advice constituted preparation 
of a substantial portion of the return or claim for refund) who the 
preparer had reason to believe was competent to render such advice. A 
preparer is not considered to have relied in good faith if--
    (i) The advice is unreasonable on its face;
    (ii) The preparer knew or should have known that the other preparer 
was not aware of all relevant facts; or
    (iii) The preparer knew or should have known (given the nature of 
the preparer's practice), at the time the return or claim for refund was 
prepared, that the advice was no longer reliable due to developments in 
the law since the time the advice was given.

The advice may be written or oral, but in either case the burden of 
establishing that the advice was received is on the preparer.
    (e) Burden of proof. In any proceeding with respect to the penalty 
imposed by section 6694(a), the issues on which the preparer bears the 
burden of proof include whether--
    (1) The preparer knew or reasonably should have known that the 
questioned position was taken on the return;
    (2) There is reasonable cause and good faith with respect to such 
position; and
    (3) The position was disclosed adequately in accordance with 
paragraph (c) of this section.

[T.D. 8382, 56 FR 67516, Dec. 31, 1991; T.D. 8382, 57 FR 6061, Feb. 19, 
1992]