What is the Substantial Understatement Penalty

What is the Substantial Understatement Penalty 

While there are many different types of penalties that the Internal Revenue Service may issue to U.S. Taxpayers across the globe, one of the more common types of penalties refers to the substantial understatement penalty period. If a taxpayer files a tax return but unfortunately understates their tax liability by more than 10% of what is shown on their tax return (or $5000, whichever is greater), the IRS can deem this a substantial understatement of income tax penalty and issue penalties upwards of 20% of the portion of the underpayment of tax that was understated and should have been included on the tax return. In addition to the understatement penalty, interest also accrues on the portion of the tax that should have been reported at the time the return was filed. Let’s walk through some of the basics of the substantial understatement penalty.

26 U.S.C. 6662 

 (d) Substantial understatement of income tax

• • • Substantial understatement

      • (A) 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

Substantial Underpayment Example (Sec. 1.6662-4)

Here is an example provided in the Regulation:

• 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.

Can You Reduce the Substantial Underpayment Penalty?

You may be able to reduce the penalty or possibly dispute the penalty depending on the facts and circumstances of the substantial underpayment penalty.

As provided by the IRS:

Reasonable Cause

• • • “Reasonable cause is determined on a case-by-case basis considering all the facts and circumstances of your situation. Reasons that qualify for relief due to reasonable cause depend on the type of penalty you owe and the laws in the Internal Revenue Code (IRC) for each penalty. Reasonable cause doesn’t apply to certain penalties such as the estimated tax penalty. For businesses, the reasons apply to the person with authority to submit the return, deposit, or tax.”

Appeals

• • • “If the IRS rejected your request to remove a penalty, you may be able to request an Appeals conference or hearing. You generally have 30 days from the date of the rejection letter to file your request for an appeal. Refer to your rejection letter for the specific deadline.

    • You can file an appeal if all the following have occurred:

    • • • You received a letter that the IRS assessed a failure to file and/or failure to pay penalty to your individual or business tax account

        • You sent a written request to the IRS asking them to remove the penalty

        • The IRS denied your request to remove the penalty (penalty abatement)

        • You received a letter denying your request, which gives you your appeal rights”

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