[Code of Federal Regulations]
[Title 26, Volume 13]
[Revised as of April 1, 2004]
From the U.S. Government Printing Office via GPO Access
[CITE: 26CFR]

[Page 472-475]
 
                       TITLE 26--INTERNAL REVENUE
 
    CHAPTER I--INTERNAL REVENUE SERVICE, DEPARTMENT OF THE TREASURY 
                               (CONTINUED)
 
Procedure and Administration--Table of Contents
 
Sec.  1.6661-2  Computation of penalty; meaning of terms.

    (a) Amount of penalty. If there is a substantial understatement of 
income tax for a taxable year (as defined in paragraph (b) of this 
section), section 6661 imposes a penalty equal to 10 percent of the 
understatement of tax liability.
    (b) Substantial understatement. The term substantial understatement 
means an understatement (as defined in paragraph (c) of this section) 
that exceeds the greater of--
    (1) 10 percent of the tax required to be shown on the return for the 
taxable year (as defined in paragraph (d)(4) of this section); or
    (2) $5,000 ($10,000 in the case of a corporation other than an S 
corporation (as defined in section 1361(a)(1)) or a personal holding 
company (as defined in section 542)).
    (c) Understatement. The term understatement means the excess of--
    (1) The amount of tax required to be shown on the return for the 
taxable year (as defined in paragraph (d)(4) of this section), over
    (2) The amount of tax shown on the return for the taxable year (as 
defined in paragraph (d)(2) of this section), reduced by any rebate (as 
defined in paragraph (d)(3) of this section).
    (d) Determination of amounts--(1) Amount of tax. For purposes of 
section 6661, the amount of tax is the amount of tax imposed by Subtitle 
A of the Code.
    (2) Tax shown on return. For purposes of section 6661, the amount of 
tax shown on the return for the taxable year is determined with the 
adjustments prescribed in this paragraph (d)(2), without regard to the 
items described in paragraph (d)(5) of this section, without regard to 
any net operating loss carryback, tax credit carryback, capital loss 
carryback, or commodity futures loss carryback (``carryback''), and 
without regard to any amount of additional tax shown on a return 
(including an amended return, so-called) filed after the taxpayer is 
first contacted by the Internal Revenue

[[Page 473]]

Service concerning the tax liability of the taxpayer for the taxable 
year. See Sec.  1.6661-6(c) for rules relating to waiver of the penalty 
if the taxpayer files a ``qualified amended return.'' If no return was 
filed for the taxable year or if the return (other than a return filed 
under section 6014) shows no tax due, the amount of tax shown on the 
return is considered to be zero. The amount of tax shown on the return 
for the taxable year is determined by computing the tax as if the 
following items (in addition to the items that were properly reported on 
the return) had received the proper tax treatment:
    (i) Items (other than tax shelter items as defined in Sec.  1.6661-
5(c)) for which there is or was substantial authority for the treatment 
claimed (as provided in Sec.  1.6661-3).
    (ii) Items (other than tax shelter items as defined in Sec.  1.6661-
5(c)) with respect to which there is adequate disclosure (as provided in 
Sec.  1.6661-4).
    (iii) Tax shelter items (as defined in Sec.  1.6661-5(c)) for which 
there is or was substantial authority for the treatment claimed (as 
provided in Sec.  1.6661-3), and with respect to which the taxpayer 
reasonably believes that the tax treatment of the item was more likely 
than not the proper tax treatment (as provided in Sec.  1.6661-5(d)).
    (iv) Items taken into account in computing the amount of any net 
operating loss, unused tax credit, or net capital loss for a taxable 
year the return for which was due (determined without regard to 
extensions of time for filing) before January 1, 1983 (regardless of 
whether there is substantial authority or adequate disclosure with 
respect to such items).
    (3) Rebate. For purposes of section 6661, the amount of a rebate is 
the rebate (within the meaning of section 6211(b)(2) and Sec.  301.6211-
1(f)), determined as if any items to which the rebate is attributable 
that are described in paragraphs (d)(2) (i) through (iv) of this section 
(in addition to the items that were properly reported on the return) had 
received the proper tax treatment.
    (4) Tax required to be shown. For purposes of section 6661, the 
amount of tax required to be shown on the return for the taxable year is 
the amount of tax imposed on the taxpayer for the taxable year 
determined without regard to items described in paragraph (d)(5) of this 
section and without regard to any allowable carryback that was not taken 
into account in computing the amount of a rebate for the taxable year.
    (5) Items disregarded. The amount of tax shown on the return for the 
taxable year and the amount of tax required to be shown on the return 
for the taxable year are both determined without regard to--
    (i) The credit under section 31 for tax withheld;
    (ii) The credit under section 33 for tax withheld at source on 
nonresident aliens and foreign corporations;
    (iii) Any credit resulting from the collection of amounts assessed 
under section 6851 as the result of a termination assessment;
    (iv) Payments of tax or estimated tax by the taxpayer; and
    (v) Any tax that the taxpayer is not required to assess on the 
return (such as the tax imposed by section 535 on the accumulated 
taxable income of a corporation).
    (6) Treatment of carryovers--(i) In general. A net operating loss 
carryover, tax credit carryover, or capital loss carryover shall be 
treated for purposes of section 6661 as a credit or deduction in the 
year in which the carryover is taken into account. See paragraph 
(d)(2)(iv) of this section for rules applicable to carryovers from a 
taxable year the return for which was due (without regard to extensions 
of time for filing) before January 1, 1983.
    (ii) Carryovers treated as carrybacks. For purposes of section 6661, 
a carryover to a taxable year shall be treated as a carryback rather 
than a carryover with respect to such year to the extent such carryover 
exceeds the amount of the carryover determined without taking into 
account carrybacks from taxable years subsequent to such years.
    (e) Examples. The following examples illustrate the computation of 
an understatement:

    Example (1). In 1983, An individual calendar year taxpayer, files a 
return for 1982, which shows taxable income of $18,200 and tax liability 
of $3,194. Subsequent adjustments on audit for 1982 increase taxable 
income to $51,500 and tax liability to $17,068. There was

[[Page 474]]

substantial authority for an item resulting in an adjustment that 
increases taxable income by $5,300. The item is not a tax shelter item. 
In computing the amount of the understatement, the amount of tax shown 
on A's return is determined as if the item for which there was 
substantial authority had been given the proper tax treatment. Thus, the 
amount of tax that is treated as shown on A's return is $4,837 (the tax 
on $23,500) ($18,200 taxable income actually shown on A's return plus 
$5,300, the amount of the adjustment for which there was substantial 
authority). The amount of the understatement is $12,231 ($17,068 (the 
amount of tax required to be shown) less $4,837 (the amount of tax 
treated as shown on A's return after adjustment for the item for which 
there was substantial authority)). Because the understatement exceeds 
the greater of 10 percent of the tax required to be shown on the return 
for the year ($1,707 ($17,068x.10)) or $5,000, A has a substantial 
understatement of income tax for the year. The amount of section 6661 
penalty is $1,223.10 (.10x$12,231).
    Example (2). Corporation X was formed on January 1, 1982. In 1983, X 
adopts a calendar taxable year and files a return for 1982 showing a tax 
liability of $10,000. In 1984, X determines that it has an unused 
investment tax credit for taxable year 1983 in the amount of $20,000. X 
files an amended return, so-called, for taxable year 1982 claiming an 
investment tax credit carryback of $20,000 and receives a rebate of 
$10,000 (the tax liability shown on X's original return for taxable year 
1982). On audit for taxable years 1982 and 1983, adjustments increase 
tax liability for 1982 to $24,000, and decrease the unused investment 
tax credit for 1983 to $8,000. There was not substantial authority and X 
did not make adequate disclosure with respect to the items comprising 
the 1982 adjustments, but there was substantial authority for $1,000 of 
the $12,000 investment tax credit disallowed for 1983. The amount of the 
section 6661 penalty for 1982 is computed as follows:
    (i) The amount of tax required to be shown on the return for 1982 is 
$16,000 (i.e., the tax liability as adjusted on audit ($24,000) reduced 
by the allowable tax credit carryback taken into account in computing 
the amount of the rebate ($8,000)).
    (ii) The amount of tax shown on the return is $10,000 (i.e., the tax 
shown on the return without adjustment for carryback of the investment 
tax credit).
    (iii) The amount of the rebate is $9,000 (i.e., the amount of the 
rebate determined as if the items described in paragraph (d)(2)(i) of 
this section ($1,000 item for which there was substantial authority) had 
received the proper tax treatment ($10,000-$1,000=$9,000)).
    (iv) The understatement is $15,000 (i.e., the excess of the tax 
required to be shown ($16,000) over the tax shown reduced by the rebate 
($10,000-$9,000=$1,000)).
    (v) Since the understatement exceeds the greater of 10 percent of 
the tax required to be shown or $10,000, X has a substantial 
understatement of income tax for the year. The amount of the section 
6661 penalty is $1,500 (.10 x $15,000).
    Example (3). Corporation Y was formed on January 1, 1982. In 1983, Y 
adopts a calendar taxable year and files a return for 1982 showing tax 
liability of $50,000. Y subsequently determines that it has unused 
investment tax credits in the amount of $20,000 for taxable year 1983, 
$20,000 for taxable year 1984, and $37,000 for taxable year 1985. Y 
files an amended return, so-called, for taxable year 1982 claiming 
investment tax credit carrybacks of $77,000 and receives a rebate of 
$50,000 (the tax liability shown on Y's original return for 1982). On 
audit for taxable years 1982, 1983, 1984, and 1985, the only adjustments 
decrease the unused investment tax credit for taxable year 1983 to 
$5,000, and the unused investment tax credit for 1984 to $8,000. There 
was not substantial authority and X did not make adequate disclosure 
with respect to the items comprising the 1983 and 1984 adjustments. The 
amount of the section 6661 penalty for 1982 is computed as follows:
    (i) The amount of the tax required to be shown on the return for 
1982 is $27,000 (i.e., the original tax liability ($50,000) reduced by 
the allowable carrybacks taken into account in computing the amount of 
the rebate ($5,000+$8,000+$10,000=$23,000)).
    (ii) The amount of the tax shown on the return is $50,000 (i.e., the 
tax shown on the return without adjustment for carryback of the 
investment tax credit).
    (iii) The amount of the rebate is $50,000 (i.e., the amount of the 
rebate determined as if any items described in paragraph (d)(2)(i)-(iv) 
of this section ($0) had received the proper tax treatment ($50,000-
0=$50,000)).
    (iv) The understatement is $27,000 (i.e., the excess of the tax 
required to be shown ($27,000) over the tax shown reduced by the rebate 
($50,000-$50,000=0)).
    (v) Since the understatement exceeds the greater of 10 percent of 
the tax required to be shown or $10,000, Y has a substantial 
understatement of income tax for the year. The amount of the section 
6661 penalty is $2,700 (.10 x $27,000).

    (f) Coordination with penalty for valuation overstatments--(1) In 
general. The amount of the penalty imposed under section 6661 shall be 
determined without taking into account the portion of the substantial 
understatement on which the penalty under section 6659 (relating to 
valuation overstatements) has been imposed. The portion of the 
understatement on which the penalty under section 6659 has been imposed 
is

[[Page 475]]

taken into account, however, in determining whether there is a 
substantial understatement of tax. For purposes of section 6661, a 
penalty under section 6659 is not considered to have been imposed to the 
extent that the penalty is waived under the authority of section 
6659(e). If a penalty is imposed under section 6659, the amount to which 
the section 6661 penalty applies is the amount by which the 
understatement exceeds the amount of the underpayment attributable to a 
valuation overstatement as determined under section 6659.
    (2) Example. The following example illustrates the coordination of 
the penalties under sections 6659 and 6661:

    Example. In 1983, A, an individual calendar year taxpayer, files a 
return for 1982 which shows taxable income of $40,000 and tax liability 
of $11,408. Subsequent adjustments on audit for 1982 increases taxable 
income to $70,000 and tax liability to $26,318. The increase in taxable 
income is attributable to a $20,000 adjustment for a valuation 
overstatement and a $10,000 adjustment not related to a valuation 
overstatement. There are no adjustments under paragraph (d)(2) of this 
section. Since the amount of the understatement, $14,910 ($26,318-
$11,408), exceeds the greater of $2,631.80 (10 percent of the tax 
required to be shown) or $5,000, there is a substantial understatement. 
Assume that under section 6659 the $20,000 adjustment for the valuation 
overstatement results in a $10,000 underpayment attributable to a 
valuation overstatement on which the section 6659 penalty is imposed. 
The amount of the understatement on which the section 6661 penalty is 
imposed is $4,910. (The amount by which the $14,910 understatement 
exceeds the $10,000 underpayment to which the section 6659 penalty 
applies.) The amount of the section 6661 penalty is $491 ($4,910x.10).

[T.D. 8017, 50 FR 12014, Mar. 27, 1985]