When Is the Accuracy-Related Penalty Imposed?

The IRS imposes the accuracy-related penalty when the taxpayer’s underpayment of federal taxes is due to a substantial understatement of income tax, negligence, or other errors in the tax return. The civil tax penalty is 20% of the underpayment. The main reason for implementing an accuracy-related penalty is to encourage the accurate payment and filing of annual tax returns.  

Underpayment of Taxes 

For the IRS to impose the 20% accuracy-related penalty against the taxpayer, there must be an underpayment in taxes related to one of the following instances identified in 26 USC Section 6662(b)

  • Disregard of rules, regulations, or negligence; 
  • Any substantial understatement of income taxes; 
  • Any substantial valuation misstatement; 
  • Any substantial overstatement of pension liabilities; 
  • Any substantial estate tax or gift tax valuation understatement; 
  • Any disallowance of claimed tax benefits because of a transaction lacking economic substance; 
  • Any undisclosed foreign financial asset understatement; or 
  • Any inconsistent estate basis. 

The accuracy-related penalty is not applicable if the taxpayer can show that the underpayment is due to a reasonable cause and that the taxpayer acted in good faith. Reasonable cause is considered on a case-by-case basis with a determinant factor being the extent to which the taxpayer exerted effort to determine the proper tax liability. Other factors include the following: 

  • Experience, knowledge, and education of the taxpayer; 
  • The complexity of the law; 
  • The novelty of issue or the first impression to the courts; 
  • Whether there was no receipt of the third party’s information return/reliance; 
  • Adequate records; 
  • The credibility of the taxpayer; and 
  • Reliance on tax adviser advice. 

Procedural Defense 

Aside from the reasonable cause defense, the taxpayer can raise a procedural defense.  

As for the procedural argument, the IRS must show that the accuracy-related penalty is approved in writing by its examiner’s immediate supervisor. The IRS must do this not later than the issuance date of the notice of deficiency asserting the subject penalty. Failure of the IRS in proving the procedural burden will make the taxpayer avoid accuracy-related penalties. 

For the imposition of the accuracy-related penalty, the Internal Revenue Code imposes the burden of proof on the IRS to establish that the accuracy related penalty is warranted under IRC Section 6662(b). Suppose the taxpayer can show credible evidence of good faith to comply with U.S. tax laws, correctly substantiate items, maintain records, and cooperate with reasonable IRS requests, then the IRS may have difficulty carrying the burden of proof. 

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