If a taxpayer makes a mistake resulting in paying less federal tax to the IRS than actually owed, that taxpayer could be subject to the accuracy-related penalty under Code Sec. 6662. According to the IRS, the two most common accuracy-related penalties are the “substantial understatement” penalty and the “negligence or disregard of the rules or regulations” penalty. These penalties are calculated as 20-percent of the net understatement of tax.
The Tax Code defines the words “substantial understatement” differently for individuals and corporations. For individuals, a substantial understatement of tax is an amount that exceeds the greater of (1) 10 percent of the tax required to be shown on the return for the tax year; or (2) $5,000. For corporate taxpayers (other than S corporations and personal holding companies), an understatement is substantial if it exceeds the lesser of: (1) the greater of 10 percent of the taxpayer’s proper tax liability or $10,000; or (2) $10 million.
Negligence generally includes any failure to make a reasonable attempt to comply with the Tax Code. For example, negligence occurs when a taxpayer fails to include on a return an amount of income shown on an information return or fails to make a reasonable attempt to ascertain the correctness of a deduction, credit or exclusion on a return that would appear to be too good to be true to a reasonable and prudent person under the circumstances. Negligence may be excused if the taxpayer had a reasonable basis.
The penalty is increased to 40-percent in certain circumstances. For example, the penalty could be increased to 40 percent to the extent that a portion of the underpayment is attributable to a gross valuation misstatement. A gross valuation misstatement exists if the actuarial determination is 400 percent or more of the correct amount.
Furthermore, the 40-percent penalty would apply to the amount of an underpayment attributable to a nondisclosed transaction lacking economic substance. Finally, the 40-percent penalty applies in the case of any underpayment attributable to an undisclosed foreign financial asset understatement.
Throughout this article, we have referred to the Code Sec. 6662 provision as a “penalty.” It is more accurate to call it an addition to tax. This means that the amounts tacked on to a taxpayer’s total tax owed under Code Sec. 6662 are also considered tax, and interest accrues on those amounts just as it accrues on the unpaid tax liability. This can result in a hefty tax bill!
There are limitations on the penalty, however. First, the IRS cannot impose more than one accuracy-related penalty on the same portion of an underpayment. For example, if the taxpayer negligently made a substantial valuation misstatement that caused a $6,000 underpayment of tax, the IRS cannot impose a 20-percent penalty once for the negligence and a second time for the substantial valuation misstatement.
Second, the IRS cannot impose both the Code Sec. 6662 penalty and the Code Sec. 6663 penalty for civil fraud on the same portion of an underpayment. Penalty stacking is prohibited.
Finally, a taxpayer may be able to have the penalty removed from any portion of an underpayment if it can prove that it had a reasonable cause for that portion of an underpayment and acted in good faith with respect to it. Successful advocacy of this defense is complicated, and taxpayers should seek professional advice.
For more information on what taxpayers can do to avoid or reduce a penalty, please contact our offices at (908) 725-4414.