United States

Congress changes penalty for erroneous refund claims


In 2007, Congress added section 6676 that imposed a penalty for erroneous refund claims made after May 25, 2007. Under section 6676, a 20 percent penalty could be imposed against the ‘excessive amount’ of a refund claim. An excessive amount of a refund claim is defined as the amount that exceeds the allowable amount of the claim. In context, if a taxpayer filed a claim for refund and, after IRS examination, half of the claim was allowed by the IRS, the disallowed portion of the claim could be treated as an excessive amount subject to the section 6676 penalty. In extreme situations, a taxpayer could file a claim for refund, have the entire claim disallowed, and end up with a penalty calculated at 20 percent of the original claim.   

To avoid the penalty on an erroneous refund claim, the taxpayer need only demonstrate that a ‘reasonable basis’ exists for claiming the refund. Reasonable basis is described as a return position reasonably based on one or more tax authorities, even though the position does not rise to the level of substantial authority. Reasonable basis is the level of authority needed to avoid the negligence penalty, although the higher standard of substantial authority is needed to avoid the accuracy-related penalty for a substantial understatement of tax. 

As part of the Protecting Americans from Tax Hikes (PATH) Act passed in December 2015, Congress changed the erroneous refund penalty for claims filed after Dec. 18, 2015. Under the recent legislation, a taxpayer must demonstrate reasonable cause to avoid the penalty, with reasonable cause supplanting the reasonable basis standard in the statute. Reasonable cause generally refers to the actions of the taxpayer. Specifically, reasonable cause exists if the taxpayer acted reasonably and in good faith in filing the refund claim. Reasonable cause is different than reasonable basis in that reasonable basis refers to whether the taxpayer’s position is supported by one or more legal authorities. In contrast, reasonable cause looks at the facts and circumstances surrounding the filing of the claim including the taxpayer’s knowledge and experience with the subject matter of the claim or with the tax law.

Congress changed the law to avoid penalizing unwary and unsophisticated taxpayers filing claims for refundable tax credits. However, business taxpayers with tax knowledge and expertise who consciously file a claim for refund may be subject to the penalty despite the fact that there was a reasonable basis for taking the tax position on the refund claim. 

With the removal of the objective reasonable basis standard in favor of a subjective reasonable cause standard, it is uncertain whether the IRS will now require a higher standard or a lower standard to support the claim. Specifically, the IRS could interpret the reasonable cause standard to require the taxpayer to show that it reasonably believed it would prevail on the claim. In such a case, the IRS would be creating a higher standard than that which existed under reasonable basis—a standard similar to the reasonable cause standard with respect to section 6662 and ‘corporate tax shelters.’ In contrast, the IRS could consider that reasonable cause exists if the claim is merely not frivolous and the taxpayer believes that the claim is reasonable and filed in good faith. Such a lax standard would effectively invalidate the penalty in most circumstances.   

It is unclear whether Congress fully understood the significance of this change to section 6676. How the IRS will interpret the change is equally unclear. In light of the uncertainty, business taxpayers should exercise a level of caution in preparing and filing refund claims that could be challenged by the IRS. The position supporting the claim should be documented and preserved as should the taxpayer’s efforts to evaluate the support for the claim.