Most penalty defenses are excuses for an error. These two are different. They say the position was defensible enough, or transparent enough, that it should not count as an understatement at all.

IRC 6662(d)(2)(B) reduces the understatement used to compute the substantial understatement penalty by the portion attributable to an item with substantial authority, or an item whose relevant facts were adequately disclosed and that had a reasonable basis. Reduce the understatement enough, and it may fall below the statutory threshold, taking the penalty with it.

How the reduction works

Treas. Reg. 1.6662-4(d)(1) says that if there is substantial authority for an item, the item is treated as if it were shown properly on the return. The tax attributable to it is not included in the understatement. Treas. Reg. 1.6662-4(e)(1) says the same for items adequately disclosed.

This matters because the substantial understatement penalty has a threshold. For individuals, IRC 6662(d)(1)(A) requires an understatement greater than 10 percent of the correct tax or $5,000, whichever is greater, with 5 percent substituted for taxpayers claiming the section 199A deduction. Take a large contested item out of the understatement, and what is left may not be substantial.

Note the limits. These reductions apply to the substantial understatement component. The negligence component has its own disclosure rule, discussed below. And under section 6662(d)(2)(C), neither reduction applies to items attributable to a tax shelter, defined to include arrangements with a significant purpose of avoiding or evading federal income tax.

What substantial authority means

Treas. Reg. 1.6662-4(d)(2) calls substantial authority an objective standard involving an analysis of the law and its application to the relevant facts. It is less stringent than more likely than not, which the regulation defines as a greater than 50 percent likelihood of being upheld, but more stringent than the reasonable basis standard.

The regulation also says what does not matter. The chance that a return will not be audited, or that an issue will not be raised, is irrelevant. So is your own belief. Because the standard is objective, your belief that you had substantial authority does not establish that you did.

The test is a weighing. Under Treas. Reg. 1.6662-4(d)(3)(i), there is substantial authority only if the weight of authorities supporting your treatment is substantial in relation to the weight supporting the contrary treatment. All relevant authorities count, including the ones against you. There may be substantial authority for more than one position on the same item.

What counts as authority

Treas. Reg. 1.6662-4(d)(3)(iii) lists the sources that count, including:

  • The Internal Revenue Code and other statutes.
  • Proposed, temporary and final regulations.
  • Revenue rulings and revenue procedures.
  • Tax treaties and official explanations of them.
  • Court cases.
  • Congressional committee reports and certain other legislative history, and the Joint Committee on Taxation's General Explanations.
  • Private letter rulings and technical advice memoranda issued after October 31, 1976, and actions on decisions and general counsel memoranda issued after March 12, 1981.
  • IRS information and press releases, and notices, announcements and other pronouncements published in the Internal Revenue Bulletin.

Just as important is what is excluded. Conclusions in treatises, legal periodicals, legal opinions or opinions of tax professionals are not authority, although the authorities they rely on may be. An article saying a position is fine does not count. The cases and rulings the article cites might.

Weight matters too. The regulation says an authority's weight depends on its relevance, persuasiveness and type. A revenue ruling outweighs a private letter ruling on the same issue. Older private rulings carry less weight, and those more than 10 years old generally carry very little. A well-reasoned construction of the statute alone can be substantial authority.

IRM 20.1.5.9.1.1 adds that substantial authority can exist either when the return is filed or on the last day of the tax year, and that a ruling or determination letter issued to you, a technical advice memorandum naming you, or an affirmative statement in a revenue agent's report for a prior year can also supply it, subject to limits.

Adequate disclosure

The second route does not require strong authority. It requires transparency plus a reasonable basis.

Under Treas. Reg. 1.6662-4(f)(1), disclosure is adequate if made on a properly completed form attached to the return or to a qualified amended return: Form 8275 for most items, and Form 8275-R for a position contrary to a regulation. Under (f)(2), the IRS publishes an annual revenue procedure identifying when information shown on the return itself, following the forms and instructions, counts as adequate disclosure. IRM 20.1.5.9.1.2 lists them; for 2025 returns it is Rev. Proc. 2026-12. If an item is not covered by the revenue procedure, Form 8275 or 8275-R is required.

The regulation adds practical rules. Disclosure of a recurring item must be made every year it is taken into account. For pass-through items, disclosure generally belongs on the entity's return, though a partner or shareholder can also file Form 8275 in duplicate as the regulation describes.

When disclosure does not help

Treas. Reg. 1.6662-4(e)(2) lists three situations where disclosure has no effect:

  • The position does not have a reasonable basis.
  • The item is attributable to a tax shelter.
  • The item is not properly substantiated, or you failed to keep adequate books and records for it.

That last one surprises people. Disclosure is not a substitute for records. If you claim a deduction you cannot substantiate, attaching a Form 8275 does not protect it.

Disclosure and the negligence penalty

The negligence and disregard component has a narrower disclosure rule. Under Treas. Reg. 1.6662-3(c), adequate disclosure on Form 8275 or 8275-R can avoid the penalty for disregarding rules or regulations, but only for a position with a reasonable basis that is properly substantiated, and for a position contrary to a regulation, only if it represents a good faith challenge to the regulation's validity. The annual revenue procedure route does not apply for this purpose. Disclosure does not cure negligence itself. See the negligence penalty defense.

A hypothetical trade-off

Picture a hypothetical business owner deciding how to treat a large payment that could reasonably be called either a deductible repair or a capital improvement. The regulations and cases point both ways, and she is not confident the deduction would win.

If she deducts it and later loses, the question is whether there was substantial authority. If the weight of authority on her side is substantial compared with the authority against her, the item comes out of the understatement. If it is not, she is exposed to the 20 percent penalty unless she can show reasonable cause and good faith.

If she deducts it and attaches a Form 8275 describing the facts, she only needs a reasonable basis, a lower bar, to take the item out of the substantial understatement computation, provided the expense is substantiated. The cost is that she has pointed the IRS at the issue. That is the real decision disclosure presents: a lower penalty standard in exchange for visibility.

Using these defenses

After the fact, substantial authority is an argument you can make for any item, disclosed or not. Assemble the authorities on both sides and show the weight on yours is substantial. Remember the IRS will weigh the contrary authorities too.

Disclosure is a decision made when the return is filed. If a position is uncertain, filing Form 8275 can protect against the substantial understatement penalty, at the cost of flagging the issue. That trade-off is worth discussing with whoever prepares your return before you file, not after the audit letter arrives.

And if neither applies, you still have reasonable cause and good faith, which looks at your conduct rather than the strength of your position.