When an audit or a matching notice increases your tax, the IRS often adds a penalty on top: 20 percent of the increase. That is the accuracy-related penalty under IRC 6662, and it is one of the most common penalties assessed after an examination.
It is also one of the most defensible, because the Code and regulations build several defenses directly into it. But they are not the defenses most people know. First-time abatement does not apply. The phone call that removes a late-filing penalty will not remove this one. You need to know which door to knock on.
What the penalty is
IRC 6662(a) adds 20 percent of the portion of an underpayment to which the section applies. Section 6662(b) lists the grounds. The ones individuals and small businesses see most are the first two:
- Negligence or disregard of rules or regulations, under 6662(b)(1).
- A substantial understatement of income tax, under 6662(b)(2).
The others include substantial valuation misstatements, overstated pension liabilities, estate and gift valuation understatements, transactions lacking economic substance, undisclosed foreign financial asset understatements, inconsistent estate basis, and certain charitable deduction issues. Some of those carry a 40 percent rate, under section 6662(h), (i) and (j).
One important limit: there is no stacking. IRM 20.1.5.3.3.1, applying Treas. Reg. 1.6662-2(c), says the maximum penalty on any portion of an underpayment is 20 percent, or 40 percent in the specified cases, even if that portion is attributable to more than one type of misconduct. Negligence and substantial understatement on the same dollars is still one 20 percent penalty.
Defense one: there is no underpayment
The penalty is a percentage of an underpayment. If the adjustment is wrong, the penalty falls with it. Before you argue about the penalty, challenge the tax. A CP2000 that double counts a Form 1099, an audit adjustment that ignores basis, a disallowed deduction you can actually substantiate: fixing those shrinks or eliminates the penalty automatically.
IRC 6664(b) adds a related rule. The accuracy-related penalties apply only where a return was filed, and not to a return the IRS prepared under section 6020(b). They are a penalty on returns that are wrong, not on returns that were never filed.
Defense two: the understatement is not substantial
The substantial understatement penalty has a threshold. Under IRC 6662(d)(1)(A), an individual's understatement is substantial only if it exceeds the greater of 10 percent of the tax required to be shown on the return or $5,000. For taxpayers who claim the section 199A qualified business income deduction, section 6662(d)(1)(C) substitutes 5 percent for 10 percent. Corporations other than S corporations and personal holding companies have a different test under section 6662(d)(1)(B).
And the understatement is computed after reductions for items with substantial authority or adequate disclosure with a reasonable basis, under section 6662(d)(2)(B). Remove those items and the remaining understatement may fall below the threshold, which takes the penalty with it. That analysis is in substantial authority and adequate disclosure.
A quick illustration of the threshold
Take a hypothetical individual whose correct tax for the year is $40,000 and whose return showed $35,500. The understatement is $4,500. Ten percent of the correct tax is $4,000. The threshold under IRC 6662(d)(1)(A) is the greater of that figure or $5,000, so $5,000. A $4,500 understatement is not substantial, and the substantial understatement penalty does not apply, though the IRS could still try to assert negligence on the facts.
Now suppose the same taxpayer's understatement was $9,000, but $5,000 of it came from an item with substantial authority. After the reduction under section 6662(d)(2)(B), the understatement for penalty purposes is $4,000, below the $5,000 threshold. The arithmetic of the defense is often that simple once the right items are removed.
Defense three: the position had a reasonable basis
Negligence is the other common ground, and it has its own escape. Treas. Reg. 1.6662-3(b)(1) says a return position that has a reasonable basis is not attributable to negligence. The regulation describes reasonable basis as a relatively high standard, significantly higher than not frivolous, and not satisfied by a position that is merely arguable. A position reasonably based on recognized authorities generally meets it.
The IRM also says the negligence penalty will not be asserted solely for filing a return late, and generally not solely for failing to appear for an audit, unless the taxpayer failed to report income shown on an information return. The negligence penalty defense covers this in detail.
Defense four: reasonable cause and good faith
IRC 6664(c)(1) says no penalty shall be imposed under section 6662 or 6663 on any portion of an underpayment if there was reasonable cause for that portion and the taxpayer acted in good faith. This is the broadest defense, and it applies to most components of the penalty. Section 6664(c)(2) and (c)(3) exclude certain items, including transactions lacking economic substance and certain charitable deduction property issues.
Treas. Reg. 1.6664-4(b)(1) says the most important factor is generally the extent of the taxpayer's effort to assess the proper tax liability. Honest, reasonable misunderstandings, isolated computational errors, reliance on an incorrect information return you had no reason to doubt, and reasonable reliance on professional advice can all qualify. The full analysis is in reasonable cause and good faith under section 6664.
Defense five: procedure
Most accuracy-related penalties require written supervisory approval under IRC 6751(b) before assessment. Penalties automatically calculated by computer are exempt, but IRM 20.1.1.2.3.2 says that if you respond to an Automated Underreporter or campus exam letter challenging the penalty or the tax, and an examiner considers your response, written supervisory approval is required. See supervisory approval under section 6751(b).
In court, IRC 7491(c) puts the burden of production on the IRS for any penalty against an individual. The IRS has to come forward with evidence that the penalty applies, including the procedural prerequisites, before you have to prove your defenses.
Defense six: you fixed it first
If you discover the error yourself, there is a way to avoid the penalty entirely. Under Treas. Reg. 1.6664-2(c)(2) and (c)(3), additional tax shown on a qualified amended return is treated as shown on the original return. A qualified amended return is one filed after the original due date and before the earliest of several events, the most common being the date the IRS first contacts you about an examination of the return.
Translated: amend before the IRS calls, and the corrected tax is not an underpayment for penalty purposes. Amend after, and it is too late for this rule.
Timing matters for how you contest it
When the penalty is proposed in an examination of an income tax return, you can contest it with the examiner, in Appeals, or in the Tax Court after a notice of deficiency, before assessment. That is the best time.
After assessment, the options narrow. IRM 20.1.5.5 says that if you first request abatement of an accuracy-related penalty after notice and demand, the request will be considered on the evidence provided, but post-assessment accuracy-related penalty abatement requests are not forwarded to Appeals. If denied, the remaining recourse described there is to pay and file a refund claim on Form 843.
Raise every defense while the penalty is still proposed. A defense you never raised is a defense nobody weighs. For how the firm approaches penalty defense generally, see penalty abatement at getirshelp.com.