Reasonable Cause and Good Faith Under Section 6664: Beating the Accuracy Penalty

The accuracy-related penalty under IRC 6662 has a general escape hatch. IRC 6664(c)(1) says no penalty shall be imposed under section 6662 or 6663 on any portion of an underpayment if the taxpayer shows reasonable cause for that portion and that the taxpayer acted in good faith.

This is not the same reasonable cause test used for late filing and late payment. That test, from Treas. Reg. 301.6651-1(c), asks about ordinary business care in meeting a deadline. This one asks whether you made a real effort to report the right tax. The facts that matter are different, and so is the evidence.

The governing factor

Treas. Reg. 1.6664-4(b)(1) says the determination is made case by case, considering all pertinent facts and circumstances. It then names the single most important factor: generally, the extent of the taxpayer's effort to assess the proper tax liability.

IRM 20.1.5.7.1 repeats it, and adds that other factors include the taxpayer's experience, knowledge and education, and reliance on a tax advisor. IRM 20.1.5.7.3 says the taxpayer's mental and physical condition, and sophistication with respect to the tax laws when the return was filed, are relevant too. It also says, in a sentence worth quoting to an examiner, that if a taxpayer is misguided and unsophisticated in tax law but acts in good faith, a penalty is not warranted.

Situations the regulations recognize

Treas. Reg. 1.6664-4(b)(1) gives examples of circumstances that may indicate reasonable cause and good faith:

• An honest misunderstanding of fact or law that is reasonable in light of all the circumstances, including your experience, knowledge and education.
• An isolated computational or transcriptional error, which the regulation says generally is not inconsistent with reasonable cause and good faith.
• Reliance on erroneous information on a Form W-2, Form 1099 or other information return, if you did not know or have reason to know it was wrong.
• Reliance on professional advice or an appraisal, when the reliance was reasonable and in good faith under all the circumstances.

On information returns, the regulation adds a warning. You generally know or have reason to know information is wrong if it is inconsistent with other information you received or with your own knowledge of the transaction, such as the terms of your employment or the rate of return on an investment. If your 1099 shows half of what you know you were paid, relying on it is not good faith.

Reliance on advice

This is where most accuracy-related penalty defenses live, and the regulation sets minimum requirements. Under Treas. Reg. 1.6664-4(c)(1), advice cannot support the defense unless:

• It was based on all pertinent facts and circumstances and the law as it relates to them, including your purposes for a transaction.
• You did not fail to disclose a fact you knew, or reasonably should have known, was relevant.
• It was not based on unreasonable factual or legal assumptions, and did not unreasonably rely on representations you knew, or had reason to know, were unlikely to be true.

Meeting those minimums does not by itself establish the defense; the regulation says so. Your education, sophistication and business experience bear on whether your reliance was reasonable, and reliance may not be reasonable if you knew or should have known the advisor lacked knowledge in the relevant area of tax law.

Advice does not need a particular form. Treas. Reg. 1.6664-4(c)(2) defines it as any communication setting forth the analysis or conclusion of someone other than the taxpayer, on which the taxpayer relies. An email can be advice. A formal opinion letter is not required.

Two practical points from IRM 20.1.5.7.4. The IRS will want to see the advice; if a taxpayer refuses to provide an opinion it claims to have relied on, the manual directs examiners to treat the position as not verifiable. And when an examiner decides not to assert the penalty because of reliance on advice, the manual requires contacting the advisor to confirm the advice was given. Expect your adviser to get a call.

The broader distinction between relying on substantive advice and delegating deadlines is covered in relying on a tax professional.

What does not work

The regulation is explicit that some things do not automatically establish the defense. Reliance on an information return, professional advice or an appraisal does not necessarily demonstrate reasonable cause; it depends on whether the reliance was reasonable. An appraisal alone is not enough; the regulation lists the methodology, assumptions, appraised value, relationship to purchase price, how the appraisal was obtained and the appraiser's relationship to the taxpayer as factors.

And under Treas. Reg. 1.6664-4(c)(1)(iii), you cannot rely on advice that a regulation is invalid unless you adequately disclosed the position that it is invalid.

IRM 20.1.5.7.6 adds that where a tax benefit depends on non-tax facts, such as the economics of an investment, the taxpayer has a duty to investigate those facts rather than relying on a promoter, and relying on a tax advisor who does not know the non-tax matters does not suffice.

Where the defense is barred

IRC 6664(c)(2) says the defense does not apply to any portion of an underpayment attributable to transactions lacking economic substance under section 6662(b)(6), or to disallowed deductions described in section 6662(b)(10). Section 6664(c)(3) bars it for substantial or gross valuation overstatements of charitable deduction property, except that a substantial overstatement can still qualify if the value was based on a qualified appraisal by a qualified appraiser and the taxpayer also made a good faith investigation of value.

For reportable transaction understatements under section 6662A, section 6664(d) imposes stricter requirements: adequate disclosure, substantial authority, and a reasonable belief that the treatment was more likely than not correct.

Portion by portion

Consider a hypothetical audit with two adjustments. One disallows a home office deduction because the space was also used as a guest room. The other adds a $12,000 Form 1099-NEC the taxpayer never reported.

On the home office, the taxpayer may have a good faith argument: she read the instructions, believed occasional guest use did not matter, and kept records of the space. That is an honest misunderstanding of law, evaluated in light of her education and experience under Treas. Reg. 1.6664-4(b)(1).

On the 1099, the answer depends on why it was missed. If the payer sent it to an address she had left two years earlier and she had no other record of the payment, she has something to argue. If she deposited the check and simply forgot, she does not.

The statute lets each portion stand or fall on its own facts. Present them that way.

Building the case

Because the governing factor is your effort, your evidence should show effort:

• Records you kept and gave your preparer.
• Questions you asked, and of whom.
• Research you did, or the instructions and publications you followed.
• Why the error was the kind a reasonable person in your position could make: the complexity of the issue, a recent change, a misleading information return.
• What you did when you learned of the error.

Present it portion by portion. The statute speaks of any portion of an underpayment, so you can win the defense on one adjustment and lose it on another. Do not let a weak item drag down a strong one. And raise it early, before assessment, because the accuracy-related penalty defenses guide explains how options narrow after the penalty is assessed.