REG · Tax Procedures and Accounting Issues · 10 practice questions
Adequate Disclosure: Reasonable Basis vs. Substantial Authority
For ordinary non-tax-shelter, nonreportable positions, adequate disclosure plus reasonable basis can satisfy both taxpayer and signing-preparer penalty standards. Below, change the support level or tax-shelter status and compare the results.
Try one first
Hint
Keep the taxpayer's penalty standard separate from the paid preparer's signing standard, and ask how adequate disclosure changes each one.
Answer C. For a non-tax-shelter item, adequate disclosure plus a reasonable basis generally prevents the taxpayer's substantial understatement penalty even if substantial authority is lacking. Likewise, a paid preparer may sign a return taking a disclosed position if the position has a reasonable basis. The stem states reasonable basis and adequate disclosure, so both standards are met.
Why not A: This option mixes the correct preparer rule with an incorrect statement about the taxpayer's penalty. For non-tax-shelter items, adequate disclosure combined with a reasonable basis generally suffices to avoid the substantial understatement penalty even without substantial authority.
Why not B: This distractor plays on the common misremembered rule that preparers always need substantial authority. For non-tax-shelter positions, adequate disclosure lowers the preparer's standard to reasonable basis; since the stem gives reasonable basis and disclosure, the preparer may sign.
Why not D: This overstates the authority threshold. Substantial authority is required for undisclosed positions, but for disclosed non-tax-shelter positions disclosure plus reasonable basis lowers the applicable standard for both the substantial understatement analysis and the preparer's unreasonable-position analysis.
Same scenario, one fact changes
Base case
Nina owns Pine Design, a sole proprietorship. Her paid signing CPA finds substantial authority for a deduction. It is not a tax shelter or reportable transaction. Nina adequately discloses it on her timely return. Disallowance would otherwise cause a substantial understatement. Assume the CPA meets due diligence requirements and no other defenses or penalties apply.
Answer: Nina may exclude the item from the substantial-understatement calculation, and the CPA satisfies the §6694(a) position standard.
Substantial authority satisfies both ordinary standards. Adequate disclosure is present, but this level of support would suffice even without disclosure.
Before you open each one, predict the answer.
Change 1The position has reasonable basis but lacks substantial authority.
Answer: Nina may still exclude the item, and the CPA still satisfies the §6694(a) position standard.
This is the key switch: disclosure permits reasonable basis instead of substantial authority for both ordinary standards.
Change 2The position is nonfrivolous but lacks reasonable basis.
Answer: Nina does not qualify for the disclosure exception, and the CPA fails the §6694(a) position standard.
Nonfrivolous is not enough. Both ordinary disclosure rules require at least reasonable basis.
Change 3The deduction is attributable to a tax shelter.
Answer: Nina cannot use the ordinary understatement reduction, and the CPA must satisfy the higher tax-shelter standard.
Tax-shelter status removes the ordinary reduction. Substantial authority and disclosure do not establish taxpayer protection or satisfy the preparer's higher standard.
Key points
- Remember: Disclosure lowers the ordinary support threshold to reasonable basis, not merely a nonfrivolous position.
- §6662(d) addresses the taxpayer's substantial understatement; §6694(a) addresses the paid preparer's position standard.
- Substantial authority weighs supporting and opposing authorities. It is stronger than reasonable basis.
- Penalty relief does not erase additional tax or interest if the IRS disallows the deduction.
How the exam traps you
- Reasonable basis protects an undisclosed position. Without disclosure, an ordinary position generally needs substantial authority under both standards.
- Any nonfrivolous disclosed position qualifies. Adequate disclosure must be paired with at least reasonable basis.
- Disclosure cures a tax-shelter position. The ordinary disclosure exception does not apply to tax shelters. Analyze each party's special rules.
Now the same facts as questions
Each question changes one fact from the one before. Watch which change flips the answer.
Question 1
Answer B. Substantial authority satisfies both ordinary standards; adequate disclosure is also present.
Why not A: An ordinary position supported by substantial authority meets the preparer standard without more-likely-than-not support.
Why not C: Nina can exclude this ordinary item from the substantial-understatement calculation.
Why not D: Penalty protection does not depend on the IRS ultimately allowing the deduction.
Question 2
Answer C. Adequate disclosure lowers the required support to reasonable basis for both ordinary standards.
Why not A: Disclosure plus reasonable basis also satisfies the ordinary preparer position standard.
Why not B: Disclosure plus reasonable basis also permits Nina to exclude the item from the understatement calculation.
Why not D: Substantial authority is not required when an ordinary position has adequate disclosure and reasonable basis.
Question 3
Answer D. Both disclosure routes require at least reasonable basis, which is stronger than merely nonfrivolous.
Why not A: Disclosure alone cannot satisfy either standard when reasonable basis is missing.
Why not B: Nina's disclosure exception also requires reasonable basis.
Why not C: The CPA's disclosed position also requires reasonable basis.
Question 4
Answer A. Tax-shelter status blocks ordinary taxpayer relief and invokes the preparer's special standard.
Why not B: Disclosure and substantial authority alone do not establish protection under the tax-shelter rules.
Why not C: The preparer must meet the tax-shelter standard, not merely substantial authority.
Why not D: Tax-shelter status also prevents Nina from using the ordinary disclosure reduction.
Question 2
Hint
Separate the paid-preparer signing standard from higher standards used in some other tax contexts, and focus on what adequate disclosure changes.
Answer A. For a non-tax-shelter, non-reportable-transaction position, the preparer-signing standard is met if the position has substantial authority or if it has a reasonable basis and is adequately disclosed on the return. Here Lake has only a reasonable basis and Orion will disclose, so Lake may sign. If Orion refuses to disclose, the substantial-authority alternative is not satisfied and Lake should not sign.
Why not B: This imports the more-likely-than-not standard from other contexts (e.g., tax shelters or certain litigation standards). For ordinary non-shelter, non-reportable items, disclosure plus a reasonable basis is an accepted alternative to substantial authority, so this choice is incorrect.
Why not C: Reasonable basis is a valid threshold only when combined with adequate disclosure if substantial authority is lacking. Without disclosure, reasonable basis alone does not meet the preparer-signing standard when substantial authority is absent.
Why not D: This reflects a common overgeneralization. For non-tax-shelter, non-reportable positions, disclosure can make a reasonable-basis position acceptable for the preparer to sign; D ignores the disclosure alternative and is therefore incorrect.
Question 3
Hint
Distinguish the preparer (Sec. 6694(a)) standard from taxpayer accuracy-related penalties, ask whether disclosure changes the level of authority the preparer must have.
Answer A. Under Sec. 6694(a), an adequately disclosed non-tax-shelter position that is supported by at least a reasonable basis can meet the preparer standard; substantial authority is not required for such disclosed positions. The stem states the position will be adequately disclosed, is not a tax shelter, has reasonable basis, and that Lark met due diligence, so Lark generally would avoid the 6694(a) preparer understatement penalty if the deduction is disallowed.
Why not B: This is tempting because substantial authority is the familiar standard for avoiding penalties on undisclosed positions; however it is incorrect here because the position is stated to be adequately disclosed and not a tax shelter, and disclosure allows a preparer to rely on reasonable basis under Sec. 6694(a).
Why not C: This distractor confuses taxpayer accuracy-related penalties with the preparer penalty framework. While disclosure is relevant to taxpayer penalty defenses, disclosure also affects the preparer standard under Sec. 6694(a): an adequately disclosed non-tax-shelter position supported by reasonable basis can protect the preparer.
Why not D: This is tempting because it correctly states that reasonable basis suffices for disclosed non-tax-shelter positions, but it is overbroad: disclosure matters. For undisclosed positions a preparer typically must meet the higher substantial authority standard to avoid the 6694(a) penalty.
Question 4
Hint
Recall whether any statutory/regulatory category of item is excluded from the usual 'adequate disclosure + reasonable basis' reduction for understatement; focus on item attribution rather than the strength of particular authorities or form of disclosure.
Answer D. Items attributable to tax shelters are a statutory/regulatory carve‑out to the ordinary reduction available for adequately disclosed positions with reasonable basis. When an item qualifies as a tax‑shelter item under the Code or Treasury regulations, the adequate‑disclosure plus reasonable‑basis treatment generally does not reduce the understatement; instead, stricter standards or special rules apply. Thus attributability to a tax shelter most clearly prevents the general disclosure/reasonable‑basis reduction.
Why not A: Good‑faith reliance on competent advice can be relevant to penalty defenses and to assessing reasonableness, but reliance on an advisor whose opinion reaches only 'reasonable basis' does not raise the standard to avoid the tax‑shelter exception. Reliance and an advisor's conclusion do not change whether an item is attributable to a tax shelter for the understatement rules.
Why not B: This is tempting because a position contrary to a regulation looks weak, but disclosure of a non‑tax‑shelter position can still preserve the reduced understatement treatment when the position has reasonable basis. The tax‑shelter exclusion depends on the item's status as a tax‑shelter item, not merely on a conflict with a regulation or the fact of disclosure.
Why not C: This distractor plays on the weakness of legislative history and out‑of‑circuit decisions, but weaker authority alone does not trigger the tax‑shelter carve‑out. Unless the item is attributable to a tax shelter, an adequately disclosed position with reasonable basis can still qualify for the reduced understatement treatment even if the authorities fall short of substantial authority.
Question 5
Hint
Focus on how adequate disclosure changes the required level of authority for disclosed non‑tax‑shelter positions and which standard applies to the taxpayer versus the preparer.
Answer D. For disclosed, non‑tax‑shelter/nonreportable positions, adequate disclosure lowers the applicable threshold so that a position with reasonable basis generally suffices for both the taxpayer (to avoid substantial‑understatement issues) and the preparer (unreasonable‑position rules). The stem gives reasonable basis plus disclosure, so substantial authority is not required.
Why not A: Tempting because candidates may conflate stricter standards for tax shelters or reportable transactions. It is incorrect here: the more‑likely‑than‑not (or higher) standards apply to tax shelters/reportable transactions, not to the disclosed non‑tax‑shelter situation in the stem.
Why not B: Tempting because candidates may overgeneralize that preparers always need substantial authority. It is wrong here: for disclosed, non‑tax‑shelter positions the preparer's applicable threshold falls to reasonable basis when adequate disclosure is made.
Why not C: Tempting because it swaps the taxpayer/preparer thresholds. It fails because, in the disclosed non‑tax‑shelter context, a taxpayer with reasonable basis and adequate disclosure is generally protected from the substantial‑understatement penalty without needing substantial authority.
Question 6
Hint
Confirm whether the stem says the position was actually disclosed on the return and whether the facts exclude tax-shelter or other higher-standard rules.
Answer C. Section 6662(d) provides, for non-tax-shelter items, an alternative to the substantial-authority standard: adequate disclosure on the return plus at least a reasonable basis can prevent an item from contributing to a substantial understatement. The stem states the position was adequately disclosed and has reasonable basis and expressly rules out tax-shelter/higher-standard contexts, so the disclosure-plus-reasonable-basis path applies.
Why not A: 'More likely than not' (>50%) is a higher standard used in other contexts; the facts here exclude those stricter regimes, and the disclosure-plus-reasonable-basis standard (a lower threshold) governs instead.
Why not B: This is tempting because substantial authority is a familiar safe harbor, but for non-tax-shelter positions the statute recognizes an alternative: adequate disclosure together with at least a reasonable basis can avoid inclusion in the understatement calculation.
Why not D: Disclosure alone is insufficient under the §6662(d) non-tax-shelter exception; the position must also meet at least the reasonable-basis standard to avoid contributing to a substantial understatement.
Common questions
Does adequate disclosure avoid the substantial understatement penalty?
For an ordinary non-tax-shelter, nonreportable item, adequate disclosure plus reasonable basis generally prevents the item from contributing to a substantial understatement. Disclosure alone is not enough.
Can a CPA sign a return with reasonable basis but no substantial authority?
For an ordinary non-tax-shelter, nonreportable position, yes, if the position is adequately disclosed. Without disclosure, the signing preparer generally needs substantial authority.
How do I adequately disclose a tax return position?
Use Form 8275, or Form 8275-R for a position contrary to a Treasury regulation, when appropriate. The disclosure must identify the issue and relevant facts; preparer workpapers are not return disclosure.
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