Examples of the Accuracy-Related Penalty

The accuracy-related penalty is a civil penalty the Internal Revenue Service (IRS) can impose when a taxpayer fails to report their tax liability correctly. Outlined in Internal Revenue Code Section 6662, this penalty encourages compliance with tax laws. An underpayment of tax can occur if you do not report all your income or if you claim deductions and credits for which you are not eligible. The IRS notifies a taxpayer of an owed penalty through a formal notice, such as a CP2000, which proposes changes to a tax return.

Conduct Subject to the Penalty

The accuracy-related penalty applies to conduct that results in an underpayment of tax. One of the most common triggers is negligence or disregard of the rules. Negligence involves a failure to make a reasonable attempt to comply with tax laws, while disregard implies a careless or intentional ignoring of those rules.

Another trigger is a substantial understatement of income tax. For individuals, an understatement is substantial if it exceeds the greater of $5,000 or 10% of the tax that should have been shown on the return. The penalty also applies to a substantial valuation misstatement and substantial understatements of estate or gift tax valuations.

Negligence and Disregard Scenarios

Negligence can be demonstrated by a failure to exercise reasonable care. For example, a freelance graphic designer who fails to maintain any records of their business income and expenses could be found negligent. If this lack of record-keeping leads to a significant underreporting of net profit on their Schedule C, the IRS may determine the taxpayer did not make a reasonable attempt to ascertain their correct tax liability.

Another scenario involves claiming a filing status without meeting the legal requirements. For instance, a taxpayer might claim Head of Household status to benefit from a larger standard deduction, despite not having a qualifying child or relative living with them for the required time. This represents a disregard of the rules. A similar situation occurs when a taxpayer receives a Form 1099-NEC for freelance work but omits this income from their tax return.

Substantial Understatement Scenarios

The substantial understatement penalty is triggered when the understated tax passes a mathematical test. Consider a taxpayer whose correct tax liability is $30,000. If this individual files a return showing a tax of only $24,000, the understatement is $6,000. This amount is greater than the $5,000 minimum threshold, so the 20% accuracy-related penalty would apply.

To further clarify, imagine a taxpayer whose correct tax liability is $12,000, but they file a return showing a tax of $10,500, an understatement of $1,500. This amount is compared to $5,000 and 10% of the correct tax ($1,200). The penalty would not be triggered because the $1,500 understatement is less than the $5,000 threshold, and the rule requires the understatement to exceed the greater of the two benchmarks.

Valuation Misstatement Scenarios

Valuation misstatements often occur with non-cash charitable contributions or on estate and gift tax returns. A substantial valuation misstatement occurs if the value of property is claimed at 150% or more of its correct amount. For example, if a taxpayer donates a painting valued at $40,000, but an appraisal finds it was only worth $15,000, the penalty would apply. For estate and gift tax returns, a substantial understatement occurs if the value of property is 65% or less of the correct amount, but only if the resulting tax underpayment exceeds $5,000. A gross valuation misstatement is where the reported value is 200% or more of the correct value, which causes the penalty rate to double from 20% to 40%.

Calculating the Penalty Amount

The standard penalty is 20% of the portion of the tax underpayment caused by the specific conduct, such as negligence or a substantial understatement. For instance, if an audit determines that a taxpayer’s negligence in failing to report $10,000 of income resulted in a $2,200 underpayment of tax, the penalty would be $440 (20% of $2,200). The penalty is applied only to the part of the underpayment linked to the inaccurate behavior. If a return has multiple errors, but only one is due to negligence, the penalty is calculated solely on the tax underpayment from that specific act.