| Date: | 12/19/2012 |
|---|---|
| Organization: | Massachusetts Department of Revenue |
| Referenced Sources: | Massachusetts General Laws |
Tax Administration
I. Introduction
The underpayment penalty authorized by G.L. c. 62C, § 35A adds to the tax due a penalty of twenty percent of any underpayment of tax required to be shown on a return. The term “underpayment” is defined as the amount by which the tax due exceeds the amount shown as the tax by the taxpayer on the return. G.L. c. 62C, § 35A(a).[1] This penalty applies only where a return has been filed. In order for the penalty to apply, the underpayment must be attributable to either:
(1) “negligence or disregard” of the Commonwealth’s tax laws or public written statements issued by the Department of Revenue (the Department), or
(2) a “substantial understatement” of liability (i.e., one that is greater than (a) 10% of the tax required to be shown on the return and (b) $1,000).[2] For purposes of determining whether there is a “substantial understatement,” the amount of an understatement will be reduced by that portion which is attributable to:
-
- the tax treatment of an item for which there is substantial authority, or
- an item (other than one involving a listed abusive transaction or strategy) as to which the relevant facts affecting the tax treatment are adequately disclosed in the taxpayer’s return or a statement included therewith and there is a “reasonable basis” for such tax treatment.
The § 35A penalty will not be imposed with respect to any portion of an underpayment if the taxpayer can demonstrate that it had reasonable cause and acted in good faith with respect to such portion. G.L. c. 62C, § 35B. The reasonable cause and good faith exception does not apply with respect to any portion of an underpayment attributable to a listed abusive transaction or strategy. Id. (See also 830 CMR 62C.33.1(5)(k), providing for application of the § 35A penalty to abusive plans or arrangements including, but not limited to, listed transactions as described by the IRS in Treasury Regulation § 1.6011-4(b)(2)).
A taxpayer may request relief from imposition of a § 35A penalty at any time within the applicable statute of limitations.[3] The Department will consider such requests consistent with the standards set out in this Directive.
As noted previously in TIR 06-5 and Directive 11-3, the § 35A penalty is in substantial part derived from Internal Revenue Code (Code) § 6662, imposing a like penalty with respect to federal returns. The Department applies and interprets the § 35A penalty in a manner generally consistent with such provision of the Code and the Treasury Regulations promulgated thereunder, to the extent that such federal law provides a pertinent analogy. [4]
II. Negligence or Disregard of the Tax Laws of the Commonwealth
The § 35A penalty may be imposed on any portion of an underpayment attributable to negligence or disregard of the Commonwealth’s tax laws or public written statements issued by the Department and applicable to the taxpayer irrespective of whether there is a “substantial understatement” of liability. Negligence or disregard of the tax laws is an independent basis for imposing a § 35A penalty.[5]
The term “negligence” is defined to include any failure to make a reasonable attempt to comply with the laws of the Commonwealth or public written statements issued by the Department. G.L. c. 62C, § 35A(c). Negligence would include, but is not limited to, the failure to exercise ordinary business care in the preparation of a tax return and failure to keep adequate books and records to substantiate items claimed on tax returns. See Treas. Reg. § 1.6662-3(a). The term “disregard” includes any careless, reckless, or intentional disregard of the Department’s rules, regulations or other public written statements. G.L. c. 62C, § 35A(c). Disregard may be evidenced by, among other things, knowingly taking a position that is incorrect or taking a position on a return with little to no effort to determine if the return position is correct. See Treas. Reg. § 1.6662-3(b)(2). When a § 35A penalty is being imposed for negligence or disregard of the Commonwealth’s tax laws or public written statements issued by the Department, the penalty will only be imposed on the additional tax that is attributable to such negligence or disregard.[6] The determination of when negligence or disregard of the Commonwealth’s tax laws exists will generally be made on a case by case basis. In making this determination:
- A taxpayer is responsible for the positions taken on its returns and may not delegate that responsibility to a third party such as an outside tax professional. The Department may attribute negligence or disregard of the tax laws on the part of a tax preparer or other tax professional to the taxpayer who has procured the services of such professional. The taxpayer’s education, sophistication, and business experience will be relevant in determining whether it will be held responsible for the negligence or disregard of the tax laws by a paid tax preparer.[7] Business taxpayers that substantially “outsource” their tax compliance functions or whose staff are otherwise unable to review adequately the positions taken on the taxpayers’ returns will generally be held responsible for any negligence or disregard of the tax laws reflected in the positions taken on the returns; assertions of reliance on a professional or of inability of staff to perform tax compliance functions do not relieve such taxpayers of responsibility for their return positions.
- In any case where a taxpayer files a return and fails to report to the Commissioner any portion of required trustee or transactional taxes that it has collected, such failure will be deemed to constitute a disregard of the tax laws of the Commonwealth.
Example 1 illustrates a circumstance where the taxpayer’s underreporting is so egregious that it establishes that the taxpayer filed its return negligently or in disregard of the tax laws such that the § 35A penalty on a resulting underpayment may be imposed.
Example 1. A taxpayer operates a convenience store. The taxpayer sells grocery items, some of which are taxable. The taxpayer also has taxable sales of cigarettes and phone cards. The taxpayer reports approximately $100 per month in sales tax. From a review of the taxpayer’s purchase information it is determined that the taxpayer purchased at wholesale substantially more items to be sold in taxable transactions than the taxpayer reported as being sold at retail or retained in inventory. The taxpayer’s purchases and remaining inventory reveal that it should have collected and remitted to the Department between $500 and $750 per month in sales tax. This pattern of underreporting establishes at a minimum that the taxpayer was negligent. Whether or not the taxpayer’s actions constituted fraud, the facts indicate that the taxpayer should have known that it had additional taxable sales. It neglected to report all of its sales. The Department will impose the § 35A penalty in this situation.
Example 2 illustrates a circumstance where a paid tax preparation firm’s disregard of the Commonwealth’s tax laws will be attributed to the corporate taxpayer that has retained the tax preparation firm and give rise to the § 35A penalty irrespective of whether there is a substantial understatement of tax liability on the taxpayer’s return.
Example 2. A large manufacturing corporation decides to outsource its tax preparation and compliance functions. The accounting firm retained by the taxpayer erroneously fails to calculate the taxpayer’s apportionment of income to Massachusetts based upon the single sales factor for manufacturing corporations mandated by G.L. c. 63, § 38(l) and 830 CMR 63.38.1(1)(c). In the circumstances of this case, the accounting firm’s error results in an underpayment of tax required to be shown on the return. The taxpayer asserts that, due to time constraints, it did not have an opportunity to review the return prepared by the outside accounting firm and should not be liable for the § 35A penalty imposed with respect to the underpayment. However, the penalty will not be waived or abated. The Department will attribute the negligence or disregard of the tax laws on the part of the accounting firm to the taxpayer.
III. Substantial Understatement of Liability
As stated above, the § 35A penalty can be applied to any substantial understatement of tax required to be shown on a return. The term “understatement” is defined as the excess of the amount of tax required to be shown on the return over the amount of tax which is shown on the return. G.L. c. 62C, § 35A(d). An understatement is substantial for any tax period if it exceeds the greater of 10% of the tax required to be shown and $1,000. However, a § 35A penalty will not be imposed on any portion of an understatement attributable to an item for which there is:
(1) substantial authority for the tax treatment by the taxpayer; or
(2) adequate disclosure in the taxpayer’s Massachusetts tax return (or in a statement submitted with the return) of the relevant facts affecting the taxpayer’s tax treatment of the item and a reasonable basis for such tax treatment. However, disclosure of relevant facts does not preclude application of the § 35A penalty with respect to any Massachusetts or federal listed transaction or tax strategy as defined under G.L. c. 62C, § 35B.[8] See G.L. c. 62C, § 35A(d)(ii).
For returns filed under G.L. c. 62 or c. 63, disclosure should be made on Form TDS.[9] For all other tax types, disclosure may be made by submission of an email to the following address: disclosurestatements@dor.state.ma.us.
In considering whether there is “substantial authority” for a non-disclosed position or a “reasonable basis” for a disclosed (and non-“listed transaction”) position, the Department will generally interpret these terms consistent with the standards set out in Code § 6662(d) and the regulations promulgated thereunder, adjusted as necessary to reflect the Massachusetts tax context.
A. Substantial Authority
The "substantial authority" standard is an objective standard involving an analysis of the law and application of the law to the relevant facts. The “substantial authority” standard is less stringent than the “more likely than not” standard that requires that there be a greater than 50-percent likelihood of the taxpayer’s reporting position being upheld, but it is more stringent than the “reasonable basis” standard. The possibility that a return will not be audited or, if audited, that an item will not be raised on audit, is not relevant in determining whether the substantial authority standard (or, for that matter, the reasonable basis standard) is satisfied. There is substantial authority for the tax treatment of an item only if the weight of the authorities supporting the treatment is substantial in relation to the weight of authorities supporting contrary treatment. In connection with the substantial authority standard, see Treas. Reg. § 1-6662-4(d)(2),(3).
The Department will consider the following items as authority for purposes of determining whether there is substantial authority for the tax treatment of an item:
- The tax laws of the Commonwealth and other applicable statutory and regulatory provisions, including provisions of the Code where expressly incorporated into Massachusetts law by reference;
- Regulations duly promulgated by the Department in administering the tax laws;
- Public written statements and other official statements of policy issued by the Department, including Technical Information Releases, DOR Directives and Letter Rulings;[10]and;
- Pertinent decisions from Massachusetts courts and the Massachusetts Appellate Tax Board.
Where applicable and pertinent to the Massachusetts tax laws at issue, other federal administrative pronouncements and case law may also be considered in determining whether a taxpayer has substantial authority for a return position. An authority that is overruled, rescinded, or modified, implicitly or explicitly, by a body with authority to take such action may no longer be relied upon to the extent such authority has been overruled, rescinded, or modified.
Conclusions reached in treatises, legal periodicals, legal opinions, or opinions rendered by tax professionals are not considered authority. However, the authorities underlying such expressions of opinion, where applicable to the facts of a particular case, may give rise to substantial authority for the tax treatment of an item.
B. Adequate Disclosure and Reasonable Basis
Adequate disclosure pertains to the relevant facts affecting the tax treatment of an item and requires that such facts be adequately disclosed in the return or in a statement submitted with the return. For returns filed under c. 62 or c. 63, disclosure can be made on Form TDS or otherwise as may be specified by the Department. See footnote 9, supra. For all other tax types, disclosure may be made by submission of an email to the following address: disclosurestatements@dor.state.ma.us.
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 items of substantial authority as delineated above (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 be directly supported by authority that would satisfy the substantial authority standard. Cf. Treas. Reg. § 1.6662-3(b)(3).
C. Calculation of Substantial Understatement for § 35A
To determine if a substantial understatement exists, there is first excluded from an understatement any amounts attributable to (i) items that the taxpayer reported in its tax return in a manner that was supported by substantial authority, or (ii) items the tax treatment of which was adequately disclosed by the taxpayer in or with its return and for which there was a reasonable basis. However, no amount may be excluded more than once. If the adjusted underpayment after any such exclusions exceeds both 10% of the tax required to be shown on the return and $1,000, the adjusted underpayment constitutes a substantial understatement and the § 35A penalty will be calculated on the adjusted amount.
Examples 3 and 4 illustrate this calculation:
Example 3. A taxpayer files its original 2007 personal income tax return showing $10,000 in tax due. Upon completion of an audit, the Department determines that the tax required to be shown on the return was $15,000. Therefore, the tax was understated by $5,000. However, the taxpayer establishes that there was substantial authority for the exclusion of an item of income from its return with associated tax in the amount of $3,900. The resulting adjusted understatement for purposes of § 35A(c) is $1,100. While this understatement exceeds $1,000, it is not considered a substantial understatement unless it also exceeds 10% of the tax required to be shown on the return, in this case $1,500 (i.e., 10% of $15,000). Since the understatement does not exceed $1,500, there is no substantial understatement and the § 35A penalty will not be imposed.
Example 4. A taxpayer files its original 2007 personal income tax return showing $20,000 in tax due. Upon completion of an audit, the Department determines that the tax required to be shown on the return was $30,000. Therefore, the tax was understated by $10,000. The taxpayer establishes that there was substantial authority for a claimed deduction that was denied under audit. The tax associated with the claimed deduction for which there was substantial authority was $4,000. For purposes of determining if there was a substantial understatement under § 35A(c) this $4,000 may be excluded from calculation of the understatement. The resulting adjusted understatement for purposes of § 35A(c) is $6,000. For the understatement to be considered substantial it must exceed both $1,000 and 10% of the tax required to be shown on the return, in this case $3,000 (i.e., 10% of $30,000). In this case the $6,000 adjusted understatement exceeds both $1,000 and 10% of the tax required to be shown on the return and, therefore, a penalty of 20% of the $6,000 adjusted understatement, or $1,200 will be imposed.
IV. Section 35B Exception for Reasonable Cause and Good Faith
A. In General
Section 35B provides that the § 35A penalty will not be imposed with respect to any portion of an underpayment if it is shown that there was reasonable cause and that the taxpayer acted in good faith with respect to such portion. As noted in the Introduction to this Directive, the reasonable cause and good faith exception does not apply with respect to any portion of an underpayment attributable to a listed abusive transaction or strategy.
Example 5 illustrates a circumstance where, although a substantial understatement under § 35A exists, the penalty will not be imposed based upon the taxpayer’s reasonable cause and good faith as provided in § 35B.
Example 5. A taxpayer is a national wholesaler/retailer that has only a small physical presence in Massachusetts. While the taxpayer makes approximately $20 million of sales per month in Massachusetts, almost all of its sales are sales for resale that are not taxable for sales and use tax purposes. As a result, the taxpayer’s taxable sales are quite small, and its average monthly sales/use tax liability is roughly $2,000. The Department undertakes an audit of the taxpayer in which the Audit Division conducts a sampling of the taxpayer’s sales and purchases. All the selected sales for the sample period are reviewed, including all of the taxpayer’s resale certificates. The taxpayer’s records are found to be in good order and it has proper internal controls for requesting and maintaining certificates. Although the records are in good order, a handful of resale certificates are found to be missing. The missing certificates result in an error factor for sales of less than 1%. However, when that error factor is applied to the $20 million of total monthly sales, the proposed deficiency for the taxpayer exceeds both $1,000 and 10% of the tax required to be shown on the return. Therefore, a substantial understatement exists.
The taxpayer’s good records and internal controls are evidenced by its overall 99% compliance rate. It is only because of the high volume of sales and the fact that most of the sales are non-taxable sales for resale that the deficiency resulted in a substantial understatement. Given the taxpayer’s high compliance rate, record retention, and internal controls, the taxpayer has demonstrated reasonable cause and a good faith effort to comply with the Commonwealth’s tax laws. For this reason, the § 35A penalty will not be imposed.
B. Factors That Affect Reasonable Cause and Good Faith Determinations
The determination of whether a taxpayer acted with reasonable cause and in good faith is made on a case-by-case basis, taking into account all pertinent facts and circumstances. Commonly, the most important factor is the extent of the taxpayer’s efforts to determine and report its proper tax liability.
The Department may request all relevant documents in order to determine whether a taxpayer has acted with reasonable cause and in good faith. If a taxpayer refuses to provide such documents after request, the Department may make any and all reasonable inferences from such refusal.
Some particular factors that affect determinations as to reasonable cause and good faith are as follows:
1. Whether the taxpayer relied on erroneous information reported on a Form W-2, Form 1099, or other information return and did not know or have reason to know that the information was incorrect.
A taxpayer's reliance on erroneous information reported on a Form W-2, Form 1099, or other information return indicates reasonable cause and good faith, provided the taxpayer did not know or have reason to know that the information was incorrect. Generally, a taxpayer knows, or has reason to know, that the information on an information return is incorrect if such information is inconsistent with other information reported or otherwise furnished to the taxpayer or with the taxpayer's knowledge of the underlying transactions or other activities resulting in tax. This knowledge includes, for example, the taxpayer's general or specific knowledge of the terms of his employment relationship or of the rate of return or gain on an investment held or disposed of by the taxpayer.
2. Whether the taxpayer reasonably relied on professional tax advice.
A taxpayer is responsible for the positions taken on its returns and may not delegate that responsibility to a third party such as an outside tax professional. Thus, reliance on the advice of a tax professional will not, in and of itself, constitute reasonable cause. However, a taxpayer’s reliance on professional tax advice may constitute reasonable cause if, under all the circumstances, the Department determines that such reliance was reasonable and the taxpayer acted in good faith. Utilization of a professional tax preparer does not absolve a taxpayer of the responsibility to review the taxpayer’s return for accuracy and correct any reasonably discernible errors. Reliance on the advice of a tax professional will not constitute reasonable cause if the taxpayer fails to disclose to the professional a fact that it knows, or reasonably should know, to be relevant to the proper tax treatment of an item.
The Department generally will not reject a taxpayer’s claim of reliance where the taxpayer obtained the tax advice of a competent tax professional, the associated understatement of tax liability in any one year was $2,500 or less, and there are no other facts or circumstances suggesting an absence of reasonable cause and good faith on the part of the taxpayer.[11]
In order for a taxpayer to claim reasonable reliance on the tax advice of a tax professional, the professional must be experienced in Massachusetts tax matters and the taxpayer must provide the professional with all the relevant facts and information. As noted, all facts and circumstances will be taken into consideration. For example, the taxpayer’s education, sophistication and business experience, if any, will be relevant in determining whether the taxpayer reasonably relied on such advice.
As a general matter, a large business taxpayer or a high income and/or net worth individual taxpayer will be presumed to have a greater level of sophistication than other taxpayers, and will therefore be held to a higher level of responsibility in understanding the authority for and the ramifications of the tax filing positions taken on its returns.
Taxpayer reliance upon professional tax advice will generally not be a basis for asserting the § 35B reasonable cause and good faith exception to § 35A penalties where the facts show that the advisor was either promoting or assisting the taxpayer with tax minimization planning. Situations where the advisor was promoting or assisting the taxpayer with tax minimization planning include but are not limited to those in which the tax professional’s compensation was related in any way to anticipated or potential tax savings.
Reliance on professional tax advice is not reasonable where that advice is based on unreasonable factual or legal assumptions (including assumptions as to future events). Professional advice must not unreasonably rely on the representations, statements, findings, or agreements of the taxpayer or any other person. Cf. Treas. Reg. § 1.6664-4(c).
Example 6. A taxpayer, headquartered in Massachusetts, manufactures and sells widgets. The taxpayer makes sales both at retail and for resale. In an effort to cut costs, the taxpayer outsources its tax compliance functions. The accounting firm that prepares the taxpayer’s returns reviews the taxpayer’s sales information and files monthly returns reporting the sales tax collected. The accounting firm does not report any purchases as being subject to use tax on the taxpayer’s monthly sales/use tax returns. The taxpayer is subsequently selected for audit. Although the taxpayer’s sales are found to be reported correctly, the audit reveals that the taxpayer made numerous purchases of tangible personal property on which no sales or use tax was paid. For some of these purchases the taxpayer properly claimed an exemption and issued proper certificates to its vendors. However, there are substantial purchases for which no exemption exists. The use tax due on these purchases exceeds both $1,000 and 10% of the tax required to be shown on the return for each period under audit. The taxpayer does not have substantial authority for not reporting any use tax on any of these purchases. The taxpayer states that it was unaware that it was not remitting the proper use tax because it relied on the accounting firm’s advice in the preparation of its sales/use tax returns. Therefore the taxpayer requests a waiver of the penalty, asserting that it acted with reasonable cause and in good faith. In this case the waiver is denied. Neither the taxpayer nor its outside accounting firm attempted to implement a system to record and report use tax with respect to the taxpayer’s purchases. Furthermore, the taxpayer’s various claims of exemption show that either the taxpayer or the accounting firm, or both, were aware of the requirement to pay taxes on purchases except where a specific exemption applies. A taxpayer cannot be relieved of its responsibility to file correct returns based solely on the hiring of an outside professional. In this case the taxpayer did not exercise ordinary business care and prudence. Consequently, the § 35A penalty is applicable to the understatement in each period attributable to the taxpayer’s negligence or disregard of Massachusetts tax laws.
3. Inadvertent errors.
An isolated computational or transcriptional error generally is not inconsistent with reasonable cause and good faith. Multiple errors or any error repeated on returns in two or more tax years reflect a pattern and will not be considered isolated or inadvertent.
V. Procedure to Apply for Relief from Imposition of Penalty
A taxpayer may request relief from the § 35A penalty by claiming, in a detailed statement explaining and substantiating the reasons for such claim:
1. With respect to a substantial understatement, that the taxpayer had substantial authority for the tax treatment of an item, or adequately disclosed the relevant facts and had a reasonable basis for its tax treatment of the item;
2. With respect to an underpayment where the Department is asserting negligence or disregard of the Commonwealth’s tax laws, that the taxpayer was not negligent or did not disregard such laws, or
3. That there was reasonable cause for the underpayment or some portion thereof and the taxpayer acted in good faith with respect to such portion.[12]
If a § 35A penalty is proposed, it will generally result from an audit undertaken by the Department. However, in many of these instances the applicability of the § 35A penalty cannot be determined until the audit is near completion. Therefore, a taxpayer might not know until it receives a final set of workpapers or a Notice of Intention to Assess (NIA) that a § 35A penalty has been imposed. Regardless of when it discovers that the § 35A penalty is applicable, a taxpayer may request relief from imposition of the penalty at any time prior to the expiration of the applicable statute of limitations. Therefore relief from the penalty may be requested both pre-assessment and post-assessment.
Pre-Assessment Requests for Relief – If a § 35A penalty is proposed, the taxpayer may request pre-assessment relief from the Audit Division, the Office of Appeals (Appeals), or both.
1. When it becomes known that the Audit Division will be proposing the § 35A penalty the taxpayer may submit a request for relief from the § 35A penalties to the Audit Division. The Audit Division will generally review the request and make a determination as to whether any relief is appropriate. At times the Audit Division may defer making a determination if the taxpayer has already indicated that it will be requesting a hearing or settlement consideration before Appeals with respect to the underlying tax assessment, penalties, or both.
2. A taxpayer may also request pre-assessment relief from the § 35A penalty from Appeals. If an NIA including a § 35A penalty is issued, the taxpayer may request a pre-assessment conference or settlement consideration before Appeals with respect to the § 35A penalty even if the Audit Division previously denied such request.
Post-Assessment Appeals - If a § 35A penalty is assessed, the taxpayer may file an Application for Abatement (Form CA-6) to contest the imposition of the penalty as long as the statute of limitations for filing an abatement has not expired. Requests for post-assessment relief can be made to the Customer Service Bureau (CSB) on Form CA-6. If CSB intends to deny all or part of the requested relief from the § 35A penalty and the taxpayer has requested hearing or settlement consideration, the matter will be referred to Appeals.
The standards for waiver or abatement of a § 35A penalty are the same for all bureaus and divisions within the Department.
Requests for relief from the imposition of a § 35A penalty must include a detailed statement of facts signed by the taxpayer under the penalties of perjury supporting the taxpayer's contention(s). Such requests may contend, as the case may be, that: (i) with respect to a substantial understatement, the taxpayer had substantial authority for the tax treatment of an item, or adequately disclosed the relevant facts and had a reasonable basis for its tax treatment of the item, (ii) with respect to an underpayment where the Department is asserting negligence or disregard of the Commonwealth’s tax laws, such underpayment was not attributable to negligence or disregard of the tax laws of the Commonwealth, or (iii) there was reasonable cause for the underpayment or some portion thereof and the taxpayer acted in good faith with respect to such portion. A taxpayer must provide a detailed, substantiated explanation of the basis for its request for relief from imposition of the penalty. Therefore, for example, the mere assertion that a taxpayer satisfies one or more of the aforementioned standards is not sufficient.
/s/Amy Pitter
Amy Pitter
Commissioner of Revenue
AP:MTF:ds
December 19, 2012
DD 12-7