IRS accuracy-related penalty: how we think about the 20%

The audit report arrives, and the tax adjustment isn't the only number on it. A few lines down sits a second figure, 20 percent of the additional tax, labeled as a penalty under section 6662. That's the IRS accuracy-related penalty, and for owners of closely held companies it tends to land on the personal return, attached to adjustments that started on the company's books.

This is a federal article. Oklahoma has its own penalty rules for state returns, and nothing here describes them.

We don't treat the 20 percent as one question. We treat it as six, asked in a fixed order, because the answer to an early one often decides whether a later one is worth the effort.

Why the IRS accuracy-related penalty follows the owner home

Closely held Oklahoma companies are commonly organized as pass-through entities, meaning S corporations and partnerships (including LLCs taxed as either) whose income is taxed on the owners' returns instead of the company's. An error on the entity's books doesn't stay there. It flows to the owner's return, raises the owner's tax, and the penalty is computed on that increase.

In our experience the usual sources are unglamorous. They include income reported to the IRS on a Form 1099 that never reached the ledger, deductions the company can't substantiate, losses claimed beyond an owner's basis, and assets carried at a basis the records don't support.

Section 6662's operative sentence is short: the penalty equals 20 percent of the portion of the underpayment to which the section applies. Two words in that sentence do most of the work in a defense, "portion" and "applies."

There's a fair reason the penalty exists. The income tax runs on self-assessment, and a return that's prepared carelessly shifts cost onto everyone who prepared theirs with care. An honest reading of the rules starts there.

1. The ground the IRS is asserting

Section 6662 isn't one penalty. It's a single rate applied on a list of separate grounds, and each ground has its own elements and its own defenses.

Two grounds account for most of what owners see, in our experience: negligence or disregard of rules or regulations, and a substantial understatement of income tax. The list also includes a substantial valuation misstatement, an estate or gift tax valuation understatement, a transaction lacking economic substance, and an undisclosed foreign financial asset understatement.

Negligence is about conduct. The statute says it includes any failure to make a reasonable attempt to comply with the tax law, and the regulations add a failure to use ordinary and reasonable care in preparing the return and a failure to keep adequate books and records or to substantiate items properly.

The regulations go further and say negligence is "strongly indicated" in certain situations, and the IRS's plain-language page repeats two of them. One is leaving off income that appears on an information return. Another is failing to make a reasonable attempt to check a deduction or credit that would seem to a reasonable and prudent person "too good to be true."

We'll say it plainly: when a Form 1099 was issued and the income isn't on the return, the negligence ground is hard to resist. The argument that remains is usually reasonable cause, which is question four.

The wrinkle: the penalty is built adjustment by adjustment

Because the penalty attaches to a portion of the underpayment, a single report can carry different grounds for different adjustments. In our experience, reports also commonly assert negligence and substantial understatement together on the same adjustment, as alternatives.

The regulations don't let those grounds stack. Their own example is a portion of an underpayment attributable both to negligence and to a substantial understatement, where the maximum is 20 percent of that portion. The statute does set higher rates for a few categories, a gross valuation misstatement among them, but a second ground piled on the first isn't one of them. So defeating one ground doesn't reduce the penalty if the other still stands, and a defense that removes the penalty from one adjustment may not touch the next one.

That's why we read the penalty explanation line by line before anything else. A separate statute requires each penalty notice to identify the penalty by name and Code section and to include a computation, so the information is supposed to be there.

2. Whether the arithmetic reaches the threshold

Substantial understatement is a math test, and its definition says nothing about carelessness. For an individual, an understatement is substantial if it exceeds the greater of 10 percent of the tax required to be shown on the return or $5,000.

Here is the part pass-through owners rarely know. For a taxpayer who claims the section 199A deduction, the qualified business income deduction many pass-through owners take, the statute substitutes 5 percent for 10 percent.

Run the numbers on a hypothetical. If the tax required to be shown is $200,000, the ordinary threshold is $20,000, and for an owner claiming the deduction it's $10,000.

At $80,000 of required tax, the ordinary threshold is $8,000, and the reduced one is $5,000, because 5 percent of $80,000 falls below the $5,000 floor. By our own arithmetic, not a figure printed in the statute, the substitution changes the threshold only once the required tax passes $50,000. Below that, both tests land on the $5,000 floor.

C corporations get a different formula. For a corporation other than an S corporation or a personal holding company, the understatement is substantial if it exceeds the lesser of 10 percent of the required tax (or $10,000, if that's greater) or $10,000,000.

Owners tend to skip a step here. The statute reduces the understatement, before it's compared to the threshold, by any item for which there was substantial authority and by any item that was adequately disclosed and had a reasonable basis. If enough of the adjustment comes out, the remaining understatement may fall under the line and this ground fails on its own terms.

Two cautions. That reduction isn't available for tax shelter items. And clearing the threshold test does nothing about a negligence assertion on the same adjustment.

3. Substantial authority, or disclosure plus a reasonable basis

Substantial authority

Substantial authority is an objective standard: the weight of the legal authorities supporting the return position, measured against the weight of those cutting the other way. The regulations place it below "more likely than not," which they describe as a greater than 50 percent likelihood of being upheld, and above reasonable basis.

What counts as authority is a defined list. It includes the Code, regulations, revenue rulings and revenue procedures, court cases, and congressional committee reports, among other official materials. The regulations test it as of the time the return was filed or the last day of the tax year.

Left off that list are things people expect to find on it. Conclusions reached in treatises and legal periodicals are not authority, and neither are opinions rendered by tax professionals. An advisor's opinion may point to authorities that do count, and it may matter a great deal for reasonable cause, but the opinion itself isn't weighed on this question.

Disclosure and reasonable basis

The second route is disclosure. The regulations provide for it on Form 8275, or Form 8275-R for a position contrary to a regulation, and they allow the IRS to prescribe by annual revenue procedure when information on the return itself is enough.

For pass-through items, disclosure is generally made with the entity's return. The regulations also describe a way for an owner to file a separate disclosure, but the practical point holds: an owner's protection can depend on what the company's return said, a decision made at a different desk.

Disclosure only helps a position that has a reasonable basis, and that standard is demanding by design. The regulations call it "significantly higher than not frivolous or not patently improper" and say a position that is "merely arguable" doesn't meet it.

Nor does disclosure cure negligence. The disclosure exception in the negligence regulation covers a position contrary to a rule or regulation, and it is unavailable where the taxpayer failed to keep adequate books and records or to substantiate items properly.

Disclosure has a real cost, too. It tells the IRS exactly where to look. That trade is weighed when the return is filed, and by the time of an audit the only question left is whether it was done.

A word on valuation

Where an adjustment turns on value or basis, a separate ground can apply. A substantial valuation misstatement exists when the value or adjusted basis claimed on the return is 150 percent or more of the correct amount, and the rate rises to 40 percent for a gross valuation misstatement, which the statute sets at 200 percent or more. An appraisal that looked aggressive when it was obtained deserves a second look for this reason.

4. Reasonable cause and good faith

This is the defense most owners reach for first, and we reach for it fourth. The statute says no accuracy-related penalty is imposed on any portion of an underpayment if there was reasonable cause for that portion and the taxpayer acted in good faith. It carves out, among others, underpayments attributable to transactions lacking economic substance, so the defense isn't universal.

The regulations make it a case-by-case judgment on all the facts and circumstances. They also say what matters most: "Generally, the most important factor is the extent of the taxpayer's effort to assess the taxpayer's proper tax liability."

Some of the regulation favors taxpayers. An isolated computational or transcriptional error generally isn't inconsistent with reasonable cause and good faith. An honest misunderstanding of fact or law can qualify if it's reasonable in light of what the taxpayer knows from experience and education, which cuts the other way for a sophisticated owner.

What reliance on a preparer really requires

"My CPA prepared it" is where the reliance analysis starts. The regulation is blunt that reliance on a professional tax advisor or an appraiser "does not necessarily demonstrate reasonable cause and good faith." Reliance counts when, under all the circumstances, it was reasonable and the taxpayer acted in good faith.

The minimum requirements sit on the taxpayer's side of the table as much as the advisor's. Advice has to be based on all pertinent facts and circumstances and the law as it relates to them, and it can't rest on unreasonable factual or legal assumptions. The requirements also aren't met if the taxpayer failed to disclose a fact it knew, or reasonably should have known, was relevant to the item.

So the questions we ask are concrete ones. We want to know what the preparer was actually given, and whether the documents behind the return existed when it was signed. A 1099 left in a drawer is a fact the preparer never had.

Records created after the audit letter arrives rarely carry the weight of records kept at the time. That's our general experience, not a rule you'll find in the regulation, but it follows from a test that looks at the taxpayer's effort when the return was prepared.

Owners of pass-throughs face one more turn. For an item reflected on a pass-through entity's return, the regulation considers the taxpayer's own actions as well as the actions of the entity. An owner who also runs the company's books will find it hard to separate the two.

One thing this defense is not: first-time abatement. The IRS page describing that waiver lists the failure-to-file, failure-to-pay and failure-to-deposit penalties as the ones eligible, and the accuracy-related penalty doesn't appear on that page. We've covered first-time abatement and reasonable cause for late filing separately, and the standards there shouldn't be imported here.

5. Whether the IRS followed its own procedure

Section 6751(b) says no penalty may be assessed unless the initial determination was personally approved in writing by the immediate supervisor of the person who made it, or by a designated higher-level official.

Exceptions exist. The requirement doesn't reach certain additions to tax, such as those for failing to file or pay and for underpaid estimated tax, or any penalty automatically calculated through electronic means. Within section 6662 itself, additions under two of the listed grounds, paragraphs (9) and (10) of subsection (b), are excepted as well.

When the approval has to happen is set by regulation for penalties assessed on or after December 23, 2024. For a penalty included in a pre-assessment notice that gives the Tax Court jurisdiction, approval is timely if given on or before the date the notice is mailed. For a penalty that isn't subject to pre-assessment Tax Court review, approval must come before assessment.

The same regulation is forgiving to the government on form. It treats any writing, including an electronic one, as sufficient if it was intended as approval, and it requires no signature or particular words. For penalties outside the regulation's reach, timing has been litigated, and we wouldn't generalize about it here.

We treat this as a document check, not a strategy. The approval record either exists and is timely or it doesn't, and it's better to know which early.

6. Where the argument gets made

There are three rooms: the examination, the IRS Independent Office of Appeals, and court. Penalty arguments are fact-heavy, and in our experience they're stronger when the facts are developed with the examiner than when they first appear later.

If the examiner and the group manager aren't persuaded, the next step is usually a written protest to Appeals. After that comes the decision about whether the case belongs in Tax Court. Partnership audits follow their own procedure, which changes who raises these arguments and when.

Time has a price while all of this plays out. The IRS charges interest on penalties, and its page on this penalty says the date interest starts varies by the type of penalty.

If an audit report or notice in front of you carries a section 6662 penalty, the point where the grounds are being sorted and the reliance facts gathered is the point where we'd want a lawyer looking at it. You can reach us through the contact page or at our Oklahoma City office. A conversation before the response goes in tends to cost less than repairing a record after it has been made.

This article is general information about Oklahoma, Texas, and federal law, not legal advice, and it does not create an attorney-client relationship. Facts matter; talk to a lawyer about yours.