Tax advisers often use the term ‘disclosure’ when discussing tax positions with their clients. However, many individuals may be hesitant to disclose certain information as it may seem like extra work or expose them to additional audit risk. Despite these concerns, disclosure can actually help reduce risk in some cases. Disclosure is not simply listing income or expenses, but providing additional explanation about certain tax positions. The level of detail required for disclosure can vary based on legal requirements and individual circumstances.
The IRS typically requires disclosure when a taxpayer does not have at least ‘substantial authority’ for a particular tax position. For example, claiming a deduction for the cost of obtaining a law degree may require disclosure since case law generally does not support this deduction. By disclosing this position, the taxpayer is acknowledging that it may be subject to IRS scrutiny. While technically not required, disclosure can help prevent penalties and extend the statute of limitations for assessing income tax if certain requirements are met.
In order to avoid penalties for substantial understatement of income tax, taxpayers can provide disclosure along with a reasonable basis for their tax position. This can be done by filing Form 8275, a common form used for disclosure. However, it is important to strike a balance when providing detail on this form. While disclosing enough information to inform the IRS of your tax position is necessary, providing excessive detail or attachments may not be appropriate and could potentially raise red flags.
Even though filing Form 8275 does not automatically trigger an audit, it is essential to ensure that the information provided is concise and relevant. Overly detailed explanations or excessive attachments, such as legal agreements or excerpts, may not be necessary for a disclosure and could potentially complicate matters. While it is important to disclose enough to explain your tax position, it is equally important to keep the disclosure clear and to the point.
In summary, while the term ‘disclosure’ may have negative connotations, it is a necessary tool for taxpayers to provide additional explanation for certain tax positions. By disclosing these positions, taxpayers can potentially reduce their risk of audit and penalties, as well as extend the statute of limitations for assessing income tax. While disclosure is not always required, it can be a valuable strategy for taxpayers to protect themselves and ensure compliance with tax laws.
