Return Related Penalties

A computerized Form 1040

Penalty Policy as a Bargaining Point During Audits

IRS examiners and their managers should not use penalties as a bargaining chip during an audit. The purpose of tax penalties is to encourage voluntary compliance with the tax laws and to conserve IRS resources while ensuring consistent and fair treatment of all taxpayers.

IRC section §6662 Accuracy Related Penalty

The accuracy related penalty is imposed on any act, or failure to act, that results in any of the following:

Negligence or disregard of the rules or regulations
Substantial understatement of income tax
Substantial valuation misstatement
Substantial overstatement of pension liability
Substantial estate or gift tax valuation understatement
Gross valuation misstatement

Miscellaneous Return Related Penalties

IRC §6663 allows for the imposition of a penalty on any portion of an underpayment that is attributable to fraud. IRC §6662A imposes an accuracy-related penalty on an understatement attributable to a reportable transaction. IRC §6707A imposes a penalty for failing to include a reportable transaction statement with a return. IRC §6676 imposes a penalty for claiming an erroneous refund or credit with respect to income tax.

Large and Mid-Sized Businesses and Listed Transactions

IRS Agents are required to consider, and if appropriate, develop the accuracy related penalty in all cases in which there is an underpayment of tax attributable to a listed transaction. The examiner must prepare a written report supporting the recommendation to impose or not to impose the tax penalty.

Managerial Approval of IRS Penalties

Managerial approval is required for all IRS penalties that are not automatically computed through electronic means. IRC §6751(b) requires written supervisory approval of the initial determination of the tax penalty. The immediate manager or a higher level manager must approve the employee’s initial penalty assertion.

The IRS employee who makes the initial penalty determination should provide the name of the tax penalty, the penalty code section, and the amount of the penalty being proposed. The employee should document this information in the taxpayer’s case file. Taxpayer’s can file a Freedom of Information Request to obtain the record.

Sometimes the accuracy-related penalties for negligence and substantial understatement are assessed under the Automated Underreporter program. When there is an automatic assessment for the negligence and substantial understatement penalty there is no requirement for managerial approval. However, if a taxpayer responds to either the initial letter proposing the penalty, or to the notice of deficiency, an IRS employee will have to consider the taxpayer’s response. Therefore, at the time an IRS employee makes a determination to assert an accuracy-related penalty, the determination will require managerial approval.

Common Features of the Accuracy-Related and Civil Fraud Penalties

Both the accuracy-related and civil fraud penalties only apply if a return is filed. Penalty review, abatement, and reconsideration follow the same guidelines established for the examination of the return. Tax penalty issues are developed separately from the tax law issues underlying the understatement. This allows taxpayers to demonstrate that they met the reasonable cause standard allowing the penalty to be abated even though the underlying tax is still imposed.

An examiner is not allowed to apply the accuracy-related penalties to a delinquent return after an assessment is made under a substitute-for-return (“SFR”).

Claims for a refund on assessed or other accuracy-related and civil fraud penalties are treated like other claims.

Coordination of the Accuracy-Related and Civil Fraud Penalties

The accuracy-related penalty and the civil fraud penalties cannot be asserted on the same portion of an underpayment; except as an alternative incase one penalty is deemed not assessable. This rule also applies to the accuracy related penalty attributable to a reportable transaction and the civil fraud penalty.

Interest on the Civil Fraud and Accuracy Related Penalties

The civil fraud and accuracy-related penalties accrue interest from the due date of the return, including extensions, until paid. However, once a notice and demand is issued interest is suspended if the amount is paid within 21 calendar days (10 days if the amount is over $100,000).

No Stacking

Treas. Reg. §1.6662-2(c) provides that the IRS may not to stack penalties. This means that the maximum accuracy-related penalties that may be imposed on any portion of an underpayment is 20 percent (40 percent if the portion of underpayment is attributable to a gross valuation misstatement). The IRS penalty is applied at a rate of 75% for civil fraud.

Carrybacks and Carryovers

The amount of an underpayment will not be reduced by any carryback of a net operating loss (NOL), deduction, or credit to that year. If a taxpayer uses a loss from a previous year to credit a future year, and that loss is subsequently disallowed, the credit from the future year will be adjusted and the taxpayer may be subject to underpayment penalties.

Listed Transaction

A listed transaction is a transaction that the Secretary of the Treasury has specifically stated needs to be reported. Please see IRC §6011 for details regarding listed transactions.

Reportable Transaction

A reportable transaction is where information is required to be provided with a return or statement as required under IRC §6011. These transactions are of the type that the Secretary determined has a potential for tax avoidance or evasion.

Notice of Inconsistent Treatment

A partner, S-Corporate shareholder, beneficiary of an estate or trust, owner of a foreign trust, or residual interest holder in a real estate mortgage investment conduit (REMIC) are typically required to report items in the same way as reported on Schedule K-1, Schedule Q, or a foreign trust statement.

If a taxpayer is going to report an item differently than as reported then the taxpayer must file a Form 8082, Notice of Inconsistent Treatment or Administrative Adjustment Request (AAR).

If a Taxpayer did not receive, but should have received, one of the above mentioned schedules or statements then the taxpayer can also file Form 8082 to notify the IRS that they did not receive such schedule or statement.

Failure to properly file Form 8082 could result in the IRS asserting the accuracy-related penalty or the fraud penalty.

Examination Penalty Assertion

The accuracy-related and fraud penalties should be address in all examinations. Examiners are required to document the procedures used, information obtained, and conclusions reached in deciding what penalties to assert or not assert.

Automated Underreported Program

The automated underreporter program automatically generates notices. If the automated program determines that the accuracy related-penalty should apply, the notices sent to taxpayers will include a paragraph or more to such an affect. If the taxpayer and IRS do not agree on the penalty, the Service will provide a complete explanation of the penalty. Furthermore, once an employee makes an independent determination that the penalty should apply, managerial approval is required.

Penalty Rates

The penalty rates are as follows:

A) 20% of the amount of an underpayment due to misconduct by the taxpayer.

B) 40% in some situations if the amount is a gross valuation misstatement.

C) 75% of any underpayment due to fraud.

D) 20% of a reportable transaction understatement. 30% where the reportable transaction was not properly disclosed.

E) 20% for an excessive amount claimed as a refund or credit

Post-Assessment Abatement Consideration of the Accuracy-Related Penalties

If the IRS contacts the taxpayer with respect to an examination and the taxpayer does not respond, then the IRS will issue a statutory notice of deficiency (90 day letter). If the taxpayer does not respond to the notice or petition the tax court and later acknowledges the underlying tax is due, but disputes the penalty, the IRS should consider the taxpayer’s request.

Statute of Limitations

Under normal circumstances the statute of limitations for assessment is three years from the due date of the tax return, or when the taxpayer filed the return, whichever is later. A substantial understatement or gross misevaluation can extend the statute to six years. If the taxpayer filed a false or fraudulent return the statute of limitations is extended indefinitely. In the case of an assessment related to an undisclosed listed transaction the statute of limitations may also be extended.

Penalty Relief Through Reasonable Cause

The IRS should abate an accuracy-related penalty if the taxpayer can demonstrate that he/she had reasonable cause and good faith for their return position. The reasonable cause standard is also applied in the case of understating a reportable transaction. See our page on the introduction to IRS penalties for a more thorough discussion of factors the IRS (and courts) looks to in determining reasonable cause.

For reportable transactions taxpayers must file Form 8886, Reportable Transaction Disclosure Statement. The IRS considers a taxpayer’s failure to file Form 8886 to be a strong indication that the taxpayer did not act in good faith.

What is Reasonable Cause

One of the most important factors that the IRS looks to in order to determine if the reasonable cause standard is met is the taxpayer’s effort to report the proper amount of tax.

If in preparing their tax return the taxpayer relied on an information return or books and records prepared by a multidivisional corporation the IRS will generally consider the reasonable cause standard to have been met. The taxpayer is generally not required to duplicate the work prepared by bookkeepers and accountants. Therefore if the taxpayer reasonably relied on these professionals they are typically considered to have acted with ordinary business care and prudence.

Experience, Knowledge, Sophisticate and Education of the Taxpayer

The taxpayer’s level of knowledge, experience, sophistication, and education are factors that the IRS must consider when determining if the taxpayer acted with reasonable cause and good faith. Furthermore, the taxpayer’s physical and mental condition in conjunction with their knowledge of tax laws must enter the decision making process.

Reliance on Professional Tax Advice

Professional tax advice is defined as any communication by a tax professional to a taxpayer that provides an analysis or conclusion on a tax matter.

If a taxpayer relies on the advice of a tax advisor the IRS will typically consider the taxpayer to have met the reasonable cause standard. However, the advice must be objectively reasonable. The Taxpayer must provide the tax advisor with all the necessary records and information so that the tax advisor was able to provide an opinion based on all the facts and circumstances.

Reportable Transactions

If a taxpayer is required to disclose a transaction under IRC §6011 and fails to do so the IRS will generally consider this taxpayer to have not met the reasonable cause standard. If a taxpayer does not disclose a transaction because he/she relied on the advice of a tax advisor who stated that the transaction was not reportable the taxpayer may have met the reasonable cause standard. However, the taxpayer’s reliance on that advice must be reasonable and made in good faith.

Advisor’s independence

If a tax advisor lacks independence and the taxpayer knew or should have known about the lack of independence then this will be strong evidence tending to showing that the taxpayer did not act in good faith. This rule tends to be applied when a taxpayer relies on the advice of a promoter.

The mere fact that a taxpayer consulted an independent tax advisor is not by itself conclusive evidence that the taxpayer exercised business prudence and acted in good faith. For example, if the taxpayer knew that the information was “too good to be true.”

Special Rules for Tax Shelter Items of a Corporation

If a corporate taxpayer is assessed additional tax due to a tax shelter item the accuracy-related penalty can be imposed by the IRS unless the reasonable cause and good faith exception applies.

The reasonable cause standard is met if:

1) The corporation analyzed the pertinent facts and relevant authorities and reasonably came to the conclusion that their position would more likely than not be upheld if challenged by the IRS; or

2) The corporation reasonably relied on an independent tax advisor who armed with all the pertinent facts and relevant authorities provided unambiguous advice that states there is a greater than 50% chance the taxpayer’s position would be upheld if challenged by the IRS.

Negligence or Disregard of Rules or Regulations

The negligence penalty is not limited to income tax as it also applies to other taxes, including excise taxes. The rate for the negligence and disregard penalties is 20% of the underpayment attributable to the negligence or disregard of the rules and/or regulations.

Definition of Negligence

Negligence is the failure to keep adequate books and records, failure to make a reasonable attempt to comply with the tax law, or failure to exercise ordinary business care and prudence with respect to tax preparation.

If a taxpayer fails to make a reasonable attempt to ascertain the correctness of a reported item that would tend to demonstrate negligence. Consulting with a tax advisor alone is not necessarily itself enough to avoid the negligence penalty.

The negligence penalty will not be asserted against a taxpayer solely on the basis that he/she filed their return late. Furthermore, the mere fact that a taxpayer did not respond to an audit also does not justify the negligence penalty.

Reasonable Basis

The negligence penalty will not apply if the taxpayer had a reasonable basis for taking the return position he/she took.

Disregard of Rules and/or Regulations

The disregard of rules or regulations penalty applies when a taxpayer fails to follow the relevant law in completing their return. This penalty requires a disregard of the code, regulations, revenue rulings, or notices.

Disregard of rules or regulations requires the following characteristics:

1) Carelessness: Where the taxpayer does not take reasonable care in determining the correctness of a tax return.

2) Recklessness: Where the taxpayer makes little or no effort in determining the rules or regulations regarding a return item and substantially deviates from a reasonable standard of care.

3) Intentional: If the taxpayer knows of a rule or regulation and ignores it.

Adequate Disclosure

If a taxpayer provides adequate disclosure the negligence or disregard of rules or regulations penalty will not apply. The taxpayer needs to file Form 8275, Disclosure Statement, or Form 8275-R, Regulation Disclosure Statement to adequately disclosure a return item.

If a taxpayer has engaged in a reportable transaction, they must disclose this transaction on Form 8886.

Even if the taxpayer fails to provide disclosure on the proper form, there are times when the IRS will accept alternative forms of disclosure. In the case of an alternative form there must be a statement from the taxpayer and it should provide:

A) A caption identifying the statement as a disclosure under IRC §6662.

B) Identification of the item to which disclosure relates.

C) The facts and circumstances surrounding the item, or potential item, to provide the IRS with adequate knowledge of the circumstances.

Substantial Understatement Penalty

The substantial understatement penalty may be imposed by the IRS if there is an understatement of income tax liability that is the larger of ten percent of the correct tax liability, or $5,000 ($10,000 if it is a C-corporation or holding company).

Definition of an Understatement

An understatement is the excess of the amount of:

A. The amount of income tax required to be shown on the return, over

B. The amount of income tax that was actually shown on the return.

Adequate Disclosure and the Understatement Penalty

An understatement penalty will not be imposed if it is due to an item that was adequately disclosed.

Substantial Authority Exception

Substantial authority is where the weight of the authorities supporting the taxpayer’s method of treating the questionable item is substantial compared to the weight of authorities contradicting the taxpayer’s treatment.

If the taxpayer can demonstrate that there was substantial authority then the understatement penalty should not apply.

No Understatement Reduction for Tax Shelter Items

Typically no taxpayer can reduce an understatement of income tax penalty due to a tax shelter item. For understatement penalty purposes a tax shelter is generally an arrangement or set of transactions of which the significant purpose was the avoidance or evasion of tax. See Treas. Reg. §1.6662-4(g)(3) for a more complete definition.

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Disclaimer: Teogathalaw Law does not guarantee the accuracy of the material contained on this website, or webpage. None of the material presented on this website concerning tax matters may be used by any taxpayer for the purpose of avoiding penalties that may be imposed on the taxpayer by the taxing authorities.

Page last revised : November 14, 2011