An IRS Internal Legal Memorandum explains the new penalty for filing erroneous refund claims after May 25, 2007, which was enacted as part of the 2007 Small Business Act.

New penalty. Under the 2007 Small Business Act, if a claim for refund or credit of income tax (other than a claim for refund or credit relating to the earned income credit) is made for an “excessive amount,” the person making the claim is liable for a penalty equal to 20% of the excessive amount. (Code Sec. 6676(a))

OBSERVATION: Under pre-2007 Small Business Act law, there was no separate penalty imposed on the filing of refund claims that had no basis in fact or law. If a taxpayer wrongfully claimed a refund, there might be no penalty if there was no additional tax liability attributable to the wrongful claim. Thus, IRS reported that aggressive claims were made that were not deterred by the accuracy-related penalty framework, which was geared toward deterrence of reported tax deficiencies.

An “excessive amount” is the amount by which the amount of a person's claim for refund or credit for any tax year exceeds the amount of the claim allowable under the Code for that tax year. (Code Sec. 6676(b))

The penalty doesn't apply if it is shown that the claim for the excessive amount has a reasonable basis. (Code Sec. 6676(a))

The penalty doesn't apply to any portion of the excessive amount or credit which is subject to an accuracy-related penalty imposed under Code Sec. 6662 or Code Sec. 6662A or under the Code Sec. 6663 fraud penalty. (Code Sec. 6676(c))

ILM confirms the workings of the penalty. The ILM confirms that the manner by which the penalty is calculated is 20% of the excessive amount. The excessive amount is defined in the statute as the amount by which the claim for refund or credit exceeds the allowable amount of the claim. Any claim for refund or credit relating to the Code Sec. 32 earned income credit is excluded from the computation of the penalty. The ILM provides the following simple formula for understanding the computation of the penalty:

• X = amount of claim for refund or credit requested.
• Y = amount of claim for refund or credit allowed.
• Z = excessive amount.
• 20% of (X−Y) = amount of the Code Sec. 6676 penalty.

Illustration: On Mar. 8, 2008, taxpayer mails Form 1040 along with a check for $400 to cover the amount due to the applicable Service Center. On June 10, 2008, he files an amended return claiming a $2,000 refund based on a change in the amount of his itemized deductions. IRS determines that he is only allowed a refund of $1,000. The disparity is not due to any argument having a reasonable basis. The excessive amount is $1,000 ($2,000−$1,000). Taxpayer will be assessed a $200 penalty (20% of ($2,000−$1,000)). (Internal Legal Memorandum 200747020)

The ILM further notes that, if the claim for refund or credit originates with a credit offset for tax such as those listed on page 2 of the Form 1040, then that credit offset is included in the computation of the penalty, subject to the earned income credit exception.

Source:  Federal Taxes Weekly Alert (preview) 12/06/2007, Volume 53, No. 49