When an audit increases the tax on a return, the IRS may also propose an accuracy-related penalty under Internal Revenue Code section 6662. The penalty does not apply in every case, and the law provides specific defenses. This article explains when the penalty applies, the procedural safeguards, and the main ways to contest it.
When the Accuracy-Related Penalty Applies
Section 6662 imposes a penalty equal to 20% of the portion of an underpayment attributable to specified causes. The most common are:
- Negligence or disregard of rules or regulations. Negligence includes any failure to make a reasonable attempt to comply with the tax law. Disregard includes any careless, reckless or intentional disregard of rules or regulations.
- Substantial understatement of income tax. For individuals, an understatement is substantial if it exceeds the greater of 10% of the tax required to be shown on the return or $5,000. For a taxpayer who claims the section 199A qualified business income deduction, 5% replaces 10%. Different thresholds apply to most corporations.
- Other categories, including substantial valuation misstatements, transactions lacking economic substance and undisclosed foreign financial assets.
The rate increases to 40% for gross valuation misstatements and certain other categories. Under Treasury Regulation section 1.6662-2(c), the penalties do not stack: the maximum on any portion of an underpayment is 20% (or 40% where the higher rate applies), even if more than one ground applies. If part of an underpayment is due to fraud, the separate 75% civil fraud penalty under section 6663 applies to that portion instead.
Procedural Safeguards
Written supervisory approval
Under section 6751(b), no penalty may be assessed unless the initial determination is personally approved in writing by the immediate supervisor of the individual making it, or by a higher-level official the IRS designates. The statute contains exceptions, including penalties automatically calculated through electronic means.
Burden of production
Under section 7491(c), in any court proceeding involving an individual’s liability for a penalty, the IRS has the burden of production. The taxpayer generally remains responsible for proving defenses such as reasonable cause.
Defense 1: Reasonable Cause and Good Faith
Under section 6664(c)(1), no accuracy-related penalty is imposed on any portion of an underpayment if the taxpayer shows reasonable cause for that portion and acted in good faith. Treasury Regulation section 1.6664-4 provides that the determination is made case by case, taking into account all pertinent facts and circumstances. Generally, the most important factor is the extent of the taxpayer’s effort to assess the proper tax liability. The taxpayer’s experience, knowledge and education are also relevant, and an honest misunderstanding of fact or law that is reasonable in light of all the facts can indicate reasonable cause.
Reliance on a tax professional can support reasonable cause, but it does not establish it automatically. Under the regulation, the advice must be based on all pertinent facts and the law as it relates to them, the taxpayer must not have withheld facts it knew or reasonably should have known were relevant, and the advice must not rest on unreasonable factual or legal assumptions.
Useful evidence often includes engagement letters, the information given to the advisor, the advice received, records showing the effort made to report correctly, and an explanation of any circumstances that affected the return.
Defense 2: Substantial Authority or Adequate Disclosure
For the substantial understatement penalty, the understatement is reduced by the portion attributable to an item for which there was substantial authority, or to an item that was adequately disclosed and had a reasonable basis. Under Treasury Regulation section 1.6662-4, substantial authority is an objective standard that is less stringent than “more likely than not” but more stringent than “reasonable basis.” Disclosure is made on Form 8275, or on Form 8275-R for a position contrary to a regulation. Special rules limit these reductions for tax shelter items.
First-time penalty abatement is an administrative waiver for failure-to-file, failure-to-pay and failure-to-deposit penalties. The IRS does not list the accuracy-related penalty among the penalties it covers, so the defenses above are the usual path.
Correcting Errors Before an Audit
Under Treasury Regulation section 1.6664-2, additional tax shown on a qualified amended return is treated as tax shown on the original return for purposes of the accuracy-related penalty. In general, a qualified amended return must be filed before the IRS first contacts the taxpayer concerning an examination of the return, among other cutoff events.
How to Contest the Penalty
A proposed penalty can be addressed at several stages:
- During the examination. Provide a written explanation and supporting documents for reasonable cause, substantial authority or disclosure before the examiner closes the case.
- In Appeals. If the examiner does not agree, the penalty can be raised in a protest to the IRS Independent Office of Appeals after the 30-day letter.
- In the Tax Court. Accuracy-related penalties determined in an audit are generally included in the notice of deficiency, so they can be contested in a Tax Court petition without paying first.
A request should identify the penalty, state the legal basis for relief, and tie each fact to the standard in the statute or regulation.
The Bottom Line
The accuracy-related penalty is a significant addition to an audit adjustment, but it is subject to procedural requirements and statutory defenses. A careful record of the effort made to report correctly, the advice relied on, and any disclosure on the return is the foundation for contesting it.
Facing penalties after an audit?
Tax attorney Cassra Minai, Esq. can review the proposed penalties and available defenses in a confidential consultation.