An Overview of the Accuracy-Related Penalty, 26 U.S.C. 6662

The Accuracy-Related Penalties & Reasonable Cause (6662 & 6664)

Section 6662(b) Accuracy-Related Penalty

There are many different types of tax penalties that the Internal Revenue Service may assess against a taxpayer when they fail to file their tax return or file their tax returns untimely or inaccurately. One type of penalty that taxpayers should be aware of is the substantial understatement penalty relating to the accuracy of the tax return. Typically, the way that an understatement penalty is issued is because either the taxpayer underreported their income or overreported their deductions. Noting, that these types of penalties occur when the taxpayer makes a mistake resulting in understatement. If instead, the taxpayer intentionally or willfully underreported their income or over-embellished their deduction slash expenses, then this could be considered a type of tax fraud and the penalties could be significantly worse and more far-reaching. Let’s walk through the basics of the substantial understatement of income tax penalty; how it works, and provide an example and explanation to give taxpayers some insight into how an individual may get assessed an accuracy-related penalty for substantial understatement of income.

An Overview of the Accuracy-Related Penalty

The first place to begin when analyzing the substantial understatement penalty is the statute, which is 26 U.S.C. 6662.

26 USC 6662 (Accuracy-Related Penalty on Underpayments)

(a)Imposition of penalty

• • • If this section applies to any portion of an underpayment of tax required to be shown on a return, there shall be added to the tax an amount equal to 20 percent of the portion of the underpayment to which this section applies.

(b) Portion of underpayment to which section applies

• • • This section shall apply to the portion of any underpayment which is attributable to 1 or more of the following:

      • • (1) Negligence or disregard of rules or regulations.

        • (2) Any substantial understatement of income tax.

        • (3) Any substantial valuation misstatement under chapter 1.

        • (4) Any substantial overstatement of pension liabilities.

        • (5) Any substantial estate or gift tax valuation understatement.

        • (6) Any disallowance of claimed tax benefits by reason of a transaction lacking economic substance (within the meaning of section 7701(o)) or failing to meet the requirements of any similar rule of law.

        • (7) Any undisclosed foreign financial asset understatement.

        • (8) Any inconsistent estate basis.

        • (9) Any overstatement of the deduction provided in section 170(p).

        • (10) Any disallowance of a deduction by reason of section 170(h)(7). This section shall not apply to any portion of an underpayment on which a penalty is imposed under section 6663. Except as provided in paragraph (1) or (2)(B) of section 6662A(e), this section shall not apply to the portion of any underpayment which is attributable to a reportable transaction understatement on which a penalty is imposed under section 6662A.

IRC 6662 (b)(2) Any substantial understatement of income tax.

When referring to substantial understatement, the term is defined under 6662(d) as follows:

• • • In general

      • For purposes of this section, there is a substantial understatement of income tax for any taxable year if the amount of the understatement for the taxable year exceeds the greater of—

        • • (i) 10 percent of the tax required to be shown on the return for the taxable year, or

          • (ii) $5,000.

Regulation 1.6662-4 Substantial understatement of income tax 

• • • (a) In general.

      • If any portion of an underpayment, as defined in section 6664(a) and § 1.6664-2, of any income tax imposed under subtitle A of the Code that is required to be shown on a return is attributable to a substantial understatement of such income tax, there is added to the tax an amount equal to 20 percent of such portion.

      • Except in the case of any item attributable to a tax shelter (as defined in paragraph (g)(2) of this section), an understatement is reduced by the portion of the understatement that is attributable to the tax treatment of an item for which there is substantial authority, or with respect to which there is adequate disclosure. General rules for determining the amount of an understatement are set forth in paragraph (b) of this section and more specific rules in the case of carrybacks and carryovers are set forth in paragraph (c) of this section.

      • The rules for determining when substantial authority exists are set forth in § 1.6662-4(d). The rules for determining when there is adequate disclosure are set forth in § 1.6662-4 (e) and (f).

      • This penalty does not apply to the extent that the reasonable cause and good faith exception to this penalty set forth in § 1.6664-4 applies.

IRC 6662, Example (1)

• • • “Example 1. In 1990, Individual A, a calendar year taxpayer, files a return for 1989, which shows taxable income of $18,200 and tax liability of $2,734. Subsequent adjustments on audit for 1989 increase taxable income to $51,500 and tax liability to $12,339. There was substantial authority for an item resulting in an adjustment that increases taxable income by $5,300. The item is not a tax shelter item. In computing the amount of the understatement, the amount of tax shown on A’s return is determined as if the item for which there was substantial authority had been given the proper tax treatment.

    • Thus, the amount of tax that is treated as shown on A’s return is $4,176, i.e., the tax on $23,500 ($18,200 taxable income actually shown on A’s return plus $5,300, the amount of the adjustment for which there was substantial authority). The amount of the understatement is $8,163, i.e., $12,339 (the amount of tax required to be shown) less $4,176 (the amount of tax treated as shown on A’s return after adjustment for the item for which there was substantial authority). Because the $8,163 understatement exceeds the greater of 10 percent of the tax required to be shown on the return for the year, i.e., $1,234 ($12,339 × .10) or $5,000, A has a substantial understatement of income tax for the year.”

Understanding Example (1)

This example above is taken directly from the regulation. Essentially what happened is:

• • • The taxpayer reported $18,200.00 of income with a tax liability of $2,734.

    • Subsequently, the IRS determined that there should have been a $51,500 income with a $12,339 tax liability.

    • But, from the increased income, $5,300 should be removed along with the amount of tax relative to that $5,300 due to substantial authority.

In this case, it does not matter, because the additional amount of unreported income and applicable tax liability still puts it over the amount that results in a substantial understatement penalty.

IRC 6662, Example (2)

• • • Example 2. Individual B, a calendar year taxpayer, files a return for 1990 that fails to include income reported on an information return, Form 1099, that was furnished to B. The Service detects this omission through its document matching program and assesses $3,000 in unreported tax liability. B’s return is later examined and as a result of the examination the Service makes an adjustment to B’s return of $4,000 in additional tax liability. Assuming there was neither substantial authority nor adequate disclosure with respect to the items adjusted, there is an understatement of $7,000 with respect to B’s return.

    • There is also an underpayment of $7,000. (See § 1.6664-2.) The amount of the understatement is not reduced by imposition of a negligence penalty on the $3,000 portion of the underpayment that is attributable to the unreported income. However, if the Services does impose the negligence penalty on this $3,000 portion, the Service may only impose the substantial understatement penalty on the remaining $4,000 portion of the underpayment. (See § 1.6662-2(c), which prohibits stacking of accuracy-related penalty components.)

Understanding Example 2

Example two refers to the fact that there is no stacking of penalties so depending on whether or not the taxpayer was imposed a negligence penalty on any portion of the understatement, the IRS is limited to issuing the substantial understatement penalty for the remaining portion that was not subject to the negligence penalty to avoid any penalty stacking.

IRS Summary of Substantial Understatement of Income

As provided by the IRS:

Substantial understatement of income tax penalty

• • • For individuals, a substantial understatement of tax applies if you understate your tax liability by 10% of the tax required to be shown on your tax return or $5,000, whichever is greater.

    • If you claim a Section 199A Qualified Business Income Deduction on your tax return, the penalty applies if you understate your tax liability by 5% of the tax required to be shown on your return or $5,000, whichever is greater.

Penalty for substantial understatement

• • • You understate your tax if the tax shown on your return is less than the correct tax. The understatement is substantial if it is more than the larger of 10 percent of the correct tax or $5,000 for individuals. For corporations, the understatement is considered substantial if the tax shown on your return exceeds the lesser of 10 percent (or if greater, $10,000) or $10,000,000.

    • You may avoid the substantial understatement penalty if you have substantial authority for your tax treatment of the item or through adequate disclosure. To avoid the substantial understatement penalty by adequate disclosure, you must properly disclose the position on the tax return and there must at least be a reasonable basis for the position.

    • To properly disclose the position, complete and attach IRS Form 8275 to your tax return and disclose all relevant facts. A reasonable basis is one that has approximately 10 percent or greater chance of success if challenged. This means that the position must be more than just arguable. There must be some authority supporting the position.

Late Filing Penalties May be Reduced or Avoided

For Taxpayers who did not timely file their FBAR and other international information-related reporting forms, the IRS has developed many different offshore amnesty programs to assist taxpayers with safely getting into compliance. These programs may reduce or even eliminate international reporting penalties.

Current Year vs Prior Year Non-Compliance

Once a taxpayer missed the tax and reporting (such as FBAR and FATCA) requirements for prior years, they will want to be careful before submitting their information to the IRS in the current year. That is because they may risk making a quiet disclosure if they just begin filing forward in the current year and/or mass filing previous year forms without doing so under one of the approved IRS offshore submission procedures. Before filing prior untimely foreign reporting forms, taxpayers should consider speaking with a Board-Certified Tax Law Specialist who specializes exclusively in these types of offshore disclosure matters.

Avoid False Offshore Disclosure Submissions (Willful vs Non-Willful)

In recent years, the IRS has increased the level of scrutiny for certain streamlined procedure submissions. When a person is non-willful, they have an excellent chance of making a successful submission to Streamlined Procedures. If they are willful, they would submit to the IRS Voluntary Disclosure Program instead. But, if a willful Taxpayer submits an intentionally false narrative under the Streamlined Procedures (and gets caught), they may become subject to significant fines and penalties. 

Need Help Finding an Experienced Offshore Tax Attorney?

When it comes to hiring an experienced international tax attorney to represent you for unreported foreign and offshore account reporting, it can become overwhelming for taxpayers trying to trek through all the false information and nonsense they will find in their online research. There are only a handful of attorneys worldwide who are Board-Certified Tax Specialists and who specialize exclusively in offshore disclosure and international tax amnesty reporting. 

This resource may help taxpayers seeking to hire offshore tax counsel: How to Hire an Offshore Disclosure Lawyer.

Golding & Golding: About Our International Tax Law Firm

Golding & Golding specializes exclusively in international tax, specifically IRS offshore disclosure. 

Contact our firm today for assistance.