In the complex world of U.S. tax law, understanding the difference between reasonable basis and substantial authority is crucial for taxpayers and tax professionals alike. These two standards play an important role in determining whether a tax position is adequately supported and whether penalties can be avoided if the Internal Revenue Service (IRS) challenges a return. Although the terms might sound similar, they represent different levels of confidence and documentation that justify a tax position under the law. Knowing the distinction between reasonable basis vs substantial authority helps individuals and businesses make informed, compliant tax decisions.
Understanding the Concept of Tax Authority Levels
The IRS uses several levels of authority to define how strong a tax position must be to avoid penalties. When preparing a tax return, a position must be backed by existing tax law, regulations, or precedents. The level of support required depends on the nature of the position and the type of disclosure made. Reasonable basis and substantial authority are two key standards in this hierarchy, each reflecting a different degree of confidence in the position’s legal validity.
To put it simply, substantial authority represents a higher level of confidence compared to reasonable basis. If a position meets the substantial authority standard, it means the legal support for that position is strong enough to defend it without disclosure. A reasonable basis, on the other hand, is a lower threshold but may still provide penalty protection if the taxpayer adequately discloses the position on their return.
What Is a Reasonable Basis?
A reasonable basis is a relatively low standard of tax support. It generally means that there is a reasonable chance that a tax position could be upheld by the IRS if challenged, though not necessarily a strong likelihood. The IRS describes reasonable basis as a position that is more than merely arguable it must have at least some merit based on law and facts.
Characteristics of a Reasonable Basis
- It is based on one or more authorities, such as statutes, regulations, court cases, or IRS rulings.
- The position has a roughly 20% or greater chance of being upheld if examined.
- It is sufficient to avoid negligence penalties if the taxpayer properly discloses the position.
Having a reasonable basis does not mean the taxpayer will win the argument with the IRS, but it does show that the position is not frivolous. For example, if a taxpayer takes a deduction based on an interpretation of the tax code that has some legal foundation but is not fully supported by precedent, it could qualify as having a reasonable basis.
Importance of Disclosure
If a tax position is only supported by a reasonable basis, it typically must be disclosed on the return to avoid penalties under Internal Revenue Code (IRC) Section 6662. Disclosure can be made using Form 8275, Disclosure Statement. By providing this information, the taxpayer signals transparency and good faith, which can mitigate potential penalties if the IRS disagrees with the position.
What Is Substantial Authority?
Substantial authority represents a higher standard than reasonable basis and indicates stronger support for a tax position. This level of authority exists when the weight of authorities supporting the taxpayer’s position is substantial compared to those opposing it. Unlike reasonable basis, substantial authority does not require disclosure to avoid penalties, as the strength of the position itself is deemed sufficient.
Characteristics of Substantial Authority
- The position is supported by substantial legal authority, including the Internal Revenue Code, Treasury Regulations, IRS revenue rulings, and court decisions.
- There is approximately a 40% or greater likelihood of the position being upheld if challenged.
- No disclosure is needed if substantial authority exists.
In practice, determining substantial authority involves weighing the quality and relevance of the supporting authorities. For example, a position that relies on a well-established Tax Court decision or Treasury Regulation is much stronger than one based on informal IRS guidance or untested interpretations. When a tax professional concludes that the supporting legal precedents outweigh the opposing ones, the position likely meets the substantial authority standard.
Comparing Reasonable Basis vs Substantial Authority
The difference between reasonable basis and substantial authority lies mainly in the strength of the legal support and the need for disclosure. Understanding this distinction helps taxpayers and advisors assess the level of risk involved in taking a particular position on a tax return.
Key Differences
- Level of ConfidenceReasonable basis implies a lower likelihood of success, while substantial authority requires a stronger case supported by credible sources.
- Disclosure RequirementPositions with only reasonable basis generally require disclosure, while those with substantial authority do not.
- Penalty ProtectionBoth can provide penalty relief, but the conditions differ based on disclosure and the strength of the argument.
- Percentage LikelihoodReasonable basis roughly equates to a 20% chance of success, while substantial authority is around 40% or higher.
In simpler terms, substantial authority is like having a solid foundation that can stand on its own, while reasonable basis is a weaker but still valid argument that needs additional transparency to be protected from penalties.
Examples to Illustrate the Difference
Consider a scenario where a taxpayer claims a deduction for certain business expenses that the IRS has not explicitly addressed in regulations. If the taxpayer bases the deduction on general tax principles and previous similar cases but there is no clear precedent, the position might have a reasonable basis. However, if multiple court decisions or IRS rulings support the same interpretation, then the taxpayer may have substantial authority for that deduction.
Another example involves claiming tax credits. Suppose a company interprets an ambiguous provision of the Internal Revenue Code to qualify for a specific credit. If legal commentary and previous rulings partially support the interpretation, that may qualify as a reasonable basis. But if the company can cite a strong court precedent or a Treasury Regulation that aligns with its view, that would rise to the level of substantial authority.
Why These Standards Matter
Understanding reasonable basis vs substantial authority is essential for avoiding penalties and ensuring compliance with IRS regulations. Taxpayers and preparers must evaluate the strength of each tax position carefully. The IRS imposes accuracy-related penalties for underpayments due to negligence or substantial understatement of income tax, but these penalties can often be avoided if the taxpayer demonstrates one of the recognized standards of authority.
In professional practice, tax preparers are also subject to standards of conduct under Circular 230, which governs the behavior of those authorized to practice before the IRS. Circular 230 requires tax practitioners to ensure that any position taken on a return has at least a reasonable basis and is not frivolous. When providing advice or signing a return, practitioners must exercise due diligence to determine whether substantial authority exists for the position.
Best Practices for Tax Professionals
For accountants, tax attorneys, and enrolled agents, applying these standards consistently is part of maintaining professional integrity and client trust. Here are some best practices when evaluating tax positions
- Conduct thorough research on applicable statutes, court cases, and IRS guidance.
- Document the rationale for each position taken, citing relevant authorities.
- Determine whether the position meets reasonable basis or substantial authority standards.
- Use disclosure forms when necessary to protect clients from potential penalties.
- Stay updated on changes in tax law that might affect authority levels.
The distinction between reasonable basis and substantial authority may seem technical, but it plays a vital role in tax compliance and risk management. Reasonable basis offers minimal yet legitimate support for a tax position, provided it is properly disclosed, while substantial authority provides a stronger foundation that can stand independently. Both standards serve as safeguards for taxpayers and professionals, ensuring that tax positions are grounded in law and taken in good faith. By understanding these concepts and applying them correctly, taxpayers can confidently navigate complex tax matters while minimizing exposure to IRS penalties.