A taxpayer who underpays their tax liability may be subject to an accuracy-related penalty under Section 6662 of the Internal Revenue Code. That statute provides for a penalty equal to 20% of the underpayment of tax. So this is something that can definitely add up.
There are three types of accuracy-related penalties under Section 6662:
(2) Disregard of Rules and Regulations; or
(3) Substantial Understatement.
In the tax context, the term negligence essentially means a failure to make a reasonable attempt to comply with the provisions of the Internal Revenue Code or a failure to exercise ordinary and reasonable care in the preparation of a tax return. I.R.C. § 6662(c); Treas. Reg. § 1.6662-3(b)(1). Thus, the relevant question is essentially whether a reasonable taxpayer would have made similar compliance efforts under similar circumstances. If the answer is yes, than the taxpayer's underpayment cannot be said to be the result of negligence. But if a reasonable taxpayer would have made more of an effort to comply with the tax law, then the taxpayer might be subject to a negligence penalty.
Disregard of Rules and Regulations
When the Internal Revenue Code refers to a disregard of tax rules and regulations, it contemplates taxpayer conduct that is in disregard of the Internal Revenue Code, Treasury regulations, or IRS authority. I.R.C. § 6662(c); Treas. Reg. § 1.6662-3(b)(2). But in order for a taxpayer to be considered to have "disregarded" the rules or regulations, the taxpayer's non-compliance must be careless, reckless, or intentional. In this respect, a taxpayer's disregard of tax rules is "careless" if the taxpayer fails to exercise reasonable diligence to determine the correctness of a tax return position. Treas. Reg. § 1.6662-3(b)(2). A taxpayer's disregard of tax rules is "reckless" if the taxpayer makes little or no effort to determine whether a rule or regulation exists under circumstances which demonstrate a substantial deviation from the standard of conduct that a reasonable person would observe. Id. Finally, a taxpayer's disregard of tax rules is "intentional" if the taxpayer knows that a rule exists, but nevertheless disregards it. Id. Thus, whether a taxpayer has disregarded rules and regulations within the contemplated meaning of this statute is a subjective analysis which will necessarily turn on the facts and circumstances of the particular case.
In determining whether there has been a "substantial understatement" within the meaning of the statute, the question is whether the taxpayer understated the gross tax on the return by the greater of $5,000 or 10% of the gross tax required to be shown. Thus, unlike the previous two grounds for assessing an accuracy-related penalty, this ground is clear and objective.
It is important to note that only one 20% accuracy penalty can apply under I.R.C. § 6662. See Treas. Reg. § 1.6662-2(c) (providing that there can be no stacking of accuracy-related penalties). That is, the IRS cannot assess multiple accuracy penalties, even if the taxpayer's understatement satisfies more than one of the three grounds discussed above. Note, however, that the IRS may permissibly assess both an accuracy penalty and a delinquency penalty. For a summary of IRS delinquency penalties, see IRS Delinquency Penalties in a Nutshell.
As a final matter, keep in mind that there are defenses that can be asserted to avoid IRS penalties. For an overview of IRS penalty defense, see IRS Penalty Defense 101.
Is the IRS asserting that you owe an accuracy-related penalty? Contact me today. I may be able to obtain a waiver of the penalties, and consultation is always free.