What Is the Accuracy-Related Penalty Under 26 USC 6662?
Learn how the IRS applies the accuracy-related penalty for tax underpayments and the standards taxpayers must meet to show their position had reasonable cause.
The accuracy-related penalty, established under 26 U.S.C. § 6662, is a civil penalty the Internal Revenue Service (IRS) imposes on taxpayers who underpay their tax liability due to specific errors. The penalty’s purpose is to encourage careful and precise tax filing, acting as a financial disincentive against inaccuracies.
Unlike criminal tax evasion, this penalty does not require proof of willful intent and instead targets a lower threshold of error. It is calculated as a percentage of the tax underpayment resulting from the specific inaccuracy. Understanding this penalty is a primary step for taxpayers to ensure compliance and avoid financial consequences.
Triggers for the Accuracy-Related Penalty
The accuracy-related penalty is not applied arbitrarily but is tied to specific failures in tax reporting. The IRS must attribute the underpayment of tax to one or more of these behaviors before asserting the penalty. Each trigger has a distinct definition and threshold.
Negligence or Disregard of Rules or Regulations
One of the most common triggers is negligence or the disregard of tax rules and regulations. Negligence is any failure to make a reasonable attempt to comply with tax law, such as failing to keep adequate records or exercise ordinary care. It does not require an intent to deceive; simple carelessness can be enough.
Disregard involves a higher level of culpability. It can be careless, which is failing to exercise reasonable diligence; reckless, which is making little effort to determine if a rule exists; or intentional, which is knowingly ignoring the law. Claiming deductions for personal expenses without a plausible argument is an example of disregarding the rules.
Substantial Understatement of Income Tax
A substantial understatement of income tax is another primary trigger. This trigger is purely mathematical and does not depend on the taxpayer’s intent. 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 example, if a taxpayer’s correct tax liability was $40,000 but they only reported $32,000, the understatement is $8,000. This amount is greater than both 10% of the correct tax ($4,000) and the $5,000 threshold. Therefore, it qualifies as a substantial understatement.
Substantial Valuation Misstatement
The penalty also applies to a substantial valuation misstatement. This occurs when the value or adjusted basis of any property claimed on a tax return is 150% or more of the correct amount. The penalty is only imposed if the resulting underpayment of tax exceeds $5,000.
This trigger is common in situations involving charitable contributions of property where a taxpayer might inflate an asset’s value for a larger deduction. For instance, if a taxpayer claims a deduction for art valued at $50,000, but its correct value is $30,000, the claimed value is about 167% of the correct value, triggering the penalty.
Other Triggers
The law also includes more specialized triggers, such as substantial overstatements of pension liabilities and substantial understatements of estate or gift tax valuations. These follow the same principle of penalizing significant inaccuracies that lead to tax deficiencies.
Calculating the Penalty Amount
Once an underpayment is attributed to a specific trigger, the penalty calculation is straightforward. It is a flat percentage applied only to the portion of the tax underpayment that resulted from the inaccurate reporting.
The general penalty rate is 20% of the underpayment of tax attributable to the specified misconduct. For instance, if a taxpayer underpaid by $10,000, but only $7,000 was due to a substantial understatement, the 20% penalty would apply only to the $7,000. The penalty would be $1,400.
Increased Penalty for Gross Valuation Misstatements
The penalty rate can double to 40% for more severe errors called “gross valuation misstatements.” This higher rate applies if the value or adjusted basis of property claimed on a return is 200% or more of the correct amount.
Returning to the art donation example, if the art was valued at $70,000 instead of its correct value of $30,000, the claimed value is over 233% of the correct amount. Since this is above the 200% threshold, the penalty would be calculated at the 40% rate on the resulting underpayment.
The Reasonable Cause Exception
Under 26 U.S.C. § 6664, no penalty will be imposed if a taxpayer demonstrates they had reasonable cause for an underpayment and acted in good faith. This exception recognizes that some errors result from genuine uncertainty or honest mistakes. The taxpayer has the burden of proving that both conditions are met.
Whether a taxpayer acted with reasonable cause and in good faith is determined on a case-by-case basis, considering all facts and circumstances. The IRS evaluates the taxpayer’s effort to assess their proper tax liability, considering their experience, knowledge, and education. An honest misunderstanding of fact or law may be considered reasonable cause depending on the taxpayer’s background and the issue’s complexity.
Reliance on advice from a qualified professional, like a tax advisor or appraiser, is a common basis for this exception. To use this defense, a taxpayer must show they gave the advisor all necessary and accurate information and reasonably relied on their judgment. For example, using a certified appraisal for a donated property can support a reasonable cause claim, provided the taxpayer did not withhold information or rely on a questionable valuation.
Disclosing Tax Positions
Taxpayers can proactively mitigate the risk of certain penalties by formally disclosing a questionable tax position on their return. Adequate disclosure can protect against the penalty for a substantial understatement of income tax and for the disregard of rules, as long as the position has a reasonable basis. This alerts the IRS to a potentially controversial item, allowing for review.
However, disclosure does not protect against all triggers for the accuracy-related penalty. Specifically, it cannot be used to avoid the penalty for negligence or for any substantial or gross valuation misstatement.
To make a disclosure, taxpayers use IRS Form 8275, Disclosure Statement, which is attached to the tax return. On this form, the taxpayer must provide detailed information about the tax position, including the amount, relevant facts, and the legal basis for their treatment of the item. This includes identifying any statutes, regulations, or court cases that support the position.
The explanation on Form 8275 must be transparent and clear enough for the IRS to understand the potential controversy. Filing the form does not guarantee the IRS will agree with the position. However, it demonstrates transparency and can be a powerful tool for preventing certain penalties if the tax position is ultimately disallowed.