Accuracy-Related Penalty

An audit that ends with a tax adjustment often ends with something else attached: a 20 percent accuracy-related penalty under Internal Revenue Code section 6662. The penalty applies to the portion of the underpayment the IRS attributes to specific conduct, and on a six-figure adjustment it can add tens of thousands of dollars to what you owe. Interest runs on the penalty as well.

The penalty is asserted routinely, but it is not automatic. Congress built several defenses into the statute, and the IRS has to satisfy procedural requirements before the penalty can be assessed.

Whiteford's tax controversy attorneys defend individuals, businesses, and tax-exempt organizations against accuracy-related penalties at examination, in IRS Appeals, and in the United States Tax Court. If a revenue agent has proposed a section 6662 penalty in your case, contact our team to review the report before you respond.

What the accuracy-related penalty covers

Section 6662 is not a single penalty so much as a group of them sharing one rate. The 20 percent penalty attaches to the portion of an underpayment attributable to any of the following:

• Negligence or disregard of rules or regulations
• A substantial understatement of income tax
• A substantial valuation misstatement
• A substantial overstatement of pension liabilities
• A substantial estate or gift tax valuation understatement

Congress has since added further categories, including transactions found to lack economic substance, understatements involving undisclosed foreign financial assets, inconsistent estate basis reporting, and overstated conservation contribution deductions. The IRS cannot stack accuracy-related penalties: only one section 6662 penalty applies to any given portion of an underpayment, even when the agent identifies more than one ground for it.

Substantial understatement of income tax

This is the most commonly asserted ground, and it is purely mathematical. No finding of carelessness is required. For an individual, an understatement is substantial when it exceeds the greater of 10 percent of the tax required to be shown on the return or $5,000. Taxpayers claiming the qualified business income deduction under section 199A face a tighter test, with 5 percent substituted for 10 percent.

Corporations are measured differently. For a C corporation that is not an S corporation or a personal holding company, the understatement must exceed the lesser of two figures: 10 percent of the tax required to be shown on the return, or $10,000 if that is greater, or $10,000,000. Because the test turns on the tax required to be shown rather than the tax reported, recalculating the correct liability sometimes drops an understatement below the threshold and eliminates the penalty entirely.

Negligence and disregard of rules or regulations

Negligence means a failure to make a reasonable attempt to comply with the tax laws or to exercise ordinary and reasonable care in preparing a return. It also covers a failure to keep adequate books and records or to substantiate items properly, which is why substantiation disputes so often carry a penalty alongside the adjustment.

Disregard of rules or regulations covers careless, reckless, and intentional conduct, ranging from a failure to check whether a contrary position is correct to knowingly departing from a known rule. A return position that has a reasonable basis, a comparatively low bar, is not negligent.

When the penalty doubles to 40 percent

Three situations raise the rate from 20 percent to 40 percent. A valuation misstatement is substantial, and triggers the 20 percent penalty, when the value or basis claimed is 150 percent or more of the correct amount. It becomes gross, doubling the rate, when the claimed figure exceeds 200 percent of the correct amount. The reasonable cause defense is unavailable for gross valuation misstatements involving charitable contribution property, which makes getting the appraisal right before filing the only reliable protection.

The rate is also 40 percent where claimed tax benefits are disallowed because a transaction lacked economic substance and the relevant facts were not adequately disclosed, and reasonable cause is not a defense to that penalty at all. Understatements attributable to undisclosed foreign financial assets, including those reportable on Forms 5471, 8865, 8938, and 3520, carry the same 40 percent rate.

Defenses to an accuracy-related penalty

The defenses differ depending on which ground the IRS has asserted, and choosing the wrong one wastes the opportunity. No section 6662 penalty applies to a portion of an underpayment for which the taxpayer had reasonable cause and acted in good faith, judged on all the facts, with the taxpayer's effort to assess the correct liability weighed most heavily.

Relying on an accountant or attorney can establish reasonable cause, but not automatically. The advice has to rest on all the pertinent facts and the applicable law, and the taxpayer cannot have withheld facts he knew or should have known were relevant. Substantial authority, a defense to substantial understatements, asks whether the weight of authority supporting the return position is substantial relative to the weight against it, an objective test sitting between reasonable basis and more likely than not.

A taxpayer who discloses a position adequately on Form 8275, or Form 8275-R for a position contrary to a regulation, can remove the item from the understatement calculation, provided the position has a reasonable basis, is not a tax shelter item, and is properly substantiated.

The procedural requirement the IRS sometimes misses

Section 6751(b) provides that a penalty cannot be assessed unless the initial determination was personally approved in writing by the immediate supervisor of the person who made it. Where the approval is missing, late, or signed by the wrong person, the penalty falls even if the underlying adjustment is correct. The requirement does not reach penalties calculated automatically through electronic means, and it does not apply to late-filing, late-payment, or estimated tax additions to tax.

The IRS bears the burden of production on penalties asserted against individuals in court, including showing compliance with the supervisory approval requirement. Once the IRS meets it, the taxpayer carries the burden of proving reasonable cause or the other defenses.

How accuracy-related penalties relate to fraud

Section 6662 and the civil fraud penalty do not coexist on the same dollars. Where the IRS establishes fraud, section 6663 imposes a penalty of 75 percent of the fraudulent portion of the underpayment, and it displaces the accuracy-related penalty for that portion. Once the IRS establishes that any part of an underpayment is attributable to fraud, the entire underpayment is treated as fraudulent unless the taxpayer proves by a preponderance of the evidence which part is not.

Why Whiteford

Whiteford's tax controversy practice handles IRS examinations, administrative appeals, and litigation in the United States Tax Court and the federal district courts, including conservation and facade easement disputes, where the 40 percent gross valuation misstatement penalty is most often at stake, and sensitive examinations where the risk of a fraud referral is present.

Penalty defense rewards early involvement. Reasonable cause depends on the record of what a taxpayer did to get the return right, and the supervisory approval issue is easiest to develop while the examination file is still being assembled.