When a taxpayer enters into a transaction in which the tax consequences are not 100% certain, there is a concern about the imposition of a tax penalty.  The most common penalty is due to Internal Revenue Code Section 6662, the so-called accuracy-related penalty.  It is 20% of the understatement.  So if the taxpayer reports $100,000 of tax, but the IRS later determines that the tax should have been $150,000, the understatement is $50,000 and the penalty is $10,000.  That does not sound like much.  But if the taxpayer is in a 50% bracket the taxpayer must earn $20,000 to pay $10,000, which makes the penalty more like a 40% penalty.

          The tax laws effectively recognize 5 levels of authority which, starting at the bottom are: frivolous; colorable; reasonable basis; substantial authority; and more likely than not.  If the taxpayer's position is frivolous or merely colorable, the penalty will be imposed.  "Reasonable basis" is viewed by some as a position that has a 20% to 1/3rd chance of prevailing on the merits.  If the taxpayer's position has a "reasonable basis," then the penalty should not be imposed if the taxpayer includes with the tax return an IRS Form 8275, which is a "Disclosure Statement."  Many people are afraid that including such a disclosure with a tax return is an invitation to an audit.  However, there is no evidence that such a relationship exists.

          If the taxpayer's position has a 40% or greater chance of prevailing on the merits, that is viewed as "substantial authority".  That means that the taxpayer should not be subject to a penalty even without disclosure.  Of course "Nirvana" is if the taxpayer's position is "more likely than not" to prevail on the merits.

          If the taxpayer and the CPA are uncertain, they can request a written opinion from a tax lawyer.  Usually when asked we need to spend several hours to determine if we can even give the opinion.  However, if a "reasonable basis" or "substantial authority" level of comfort is available, we are happy to issue those opinions.