You are preparing the tax return for Agre Corporation, which has sales of $50 million. Agre made a $2 million expenditure for which the appropriate tax treatment, deductible or capitalizable, is a gray area. The corporation's Chief Financial Officer wants you to deduct the expenditure. What tax compliance issues should you consider in deciding whether to deduct the expenditure?
What will be an ideal response?
• Will you as the tax return preparer have sufficient support, according to IRC Sec. 6694 and the AICPA's SRTP, to deduct the expenditure?
• Will the client have substantial authority for a deduction?
• If not, will the client have a reasonable basis for deducting the expenditure?
• Should you present a disclosure as part of the tax return about the expenditure if you deduct it?
Background comments: the information presented is not complete enough for the students to conclude definitively whether the reasonable basis and substantial authority standards are met. The problem was designed, however, as an issue recognition problem, not a question for which there is a definitive answer.
According to Sec. 6694 and the AICPA's Statements on Standards in Tax Services, you (the preparer) should believe that sufficient authority exists to meet the realistic possibility of being sustained test. Treasury Regulations quantify this test as being approximately a one-in-three likelihood of being sustained. If you do not believe that sufficient authority exists for meeting this test, you may adopt a pro-taxpayer position, so long as you make a disclosure, and the position is not frivolous.
The substantial authority standard is less stringent than the more-likely-than-not (>50%) test. It means, according to Treasury Regulations, that the authorities supporting a position are substantial in relation to authorities going the other way. It is possible for substantial authority to be present for more than one position. Treasury Regulations explain that reasonable basis refers to a position that is arguable but unlikely to be upheld in court. Provided a disclosure is made and sufficient support exists to meet the reasonable basis standard, the client will not owe the substantial understatement penalty (of Sec. 6662) in the event the IRS audits its return and it agrees to delete the $1 million deduction. Without such a disclosure, the IRS might levy the 20% substantial underpayment penalty. Furthermore, the IRS might levy a $250 preparer penalty against you if you do not include a disclosure with the return.
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