It’s Not Your Fault . . . Or Is It?

Taxpayers have a duty to file an accurate tax return. But errors occur nonetheless. There can be mathematical errors or omissions of income and overstatements of deductions. When the errors are the result of a substantial understatement of income, negligence, or certain other cases, the IRS can impose an accuracy-related penalty. However, the penalty can be avoided in some situations. Here are the situations in which a penalty can be imposed and the acceptable excuses that can be used to avoid the penalty.

When Penalties May Apply

There is a 20% accuracy-related penalty on any portion of a tax underpayment that results from:

• Negligence. Negligence means failing to make a reasonable attempt to comply with the tax law, to exercise reasonable care, to keep adequate records, or to substantiate items properly. For example, claiming a deduction that to a reasonable person would seem “too good to be true” could indicate negligence unless the taxpayer can show that he or she attempted to verify the correctness of the deduction.
• Disregard (careless, reckless, or intentional) of IRS rules or regulations. The tax rules are complicated, but this is no excuse to disregard them. Form 8275 can be used to disclose items or a position that is contrary to IRS rules; this will avoid an accuracy-related penalty but will most likely invite an IRS audit.
• Substantial understatement of tax liability. An understatement is substantial if it is more than 10% of the tax shown on the return or $5,000, whichever is greater.
• Overvaluation of property. An overvaluation exists if it is 150% or more of the correct value. If the overvaluation is 200% or more of the correct value, the 20% penalty is doubled. Overvaluation commonly appears in the context of charitable contributions of property.
• Undervaluation of property on a gift tax or estate tax return. This is the flip side to overvaluation; undervaluations are made to minimize gift or estate taxes.

There is also a penalty of up to $10,000 for failure to adequately disclose a “reportable transaction.”

Finally, there is a 75% penalty on an underpayment due to fraud.

Interest on penalties. Interest on any penalty starts to run from the date it is assessed by the IRS unless the penalty is paid within 10 days of assessment.

Shifting Blame

When a taxpayer owes tax resulting from an understatement, the taxes can’t be avoided, but the accuracy-related penalty (and interest on the penalty) may be waived in some situations. The accuracy-related penalty can be avoided by demonstrating reasonable cause for the underpayment and that the actions were in good faith. Whether there is reasonable cause (so that no penalty applies) is determined on a case-by-case basis.

• Ignorance of the law. Usually, this is no defense to the accuracy-related penalty; taxpayers are under an obligation to find out the correct thing to do. However, when an understatement of tax results from something very complex, a court may be somewhat sympathetic.
• Tax professionals. Relying on the advice of a tax professional can establish reasonable cause and good faith for purposes of avoiding the accuracy-related penalty. But this reliance is not an absolute defense; a taxpayer must show the facts and circumstances of the situation to establish reasonable cause.
• Tax preparation software. The fact that a return is prepared using software is not, in and of itself, sufficient to avoid the penalty. As the Tax Court has noted: “Tax preparation software is only as good as the information one inputs into it.”

The Tax Court has rejected the so-called “Geithner defense”; one taxpayer charged with an accuracy-related penalty tried to avoid it by arguing that her mistakes, like Secretary of the Treasury Timothy Geithner, were the result of using tax software.

Note: The penalty related to valuation misstatements cannot be avoided by showing reasonable cause for negligence. Once the IRS established the misstatement, the penalty applies. The taxpayer’s only option is to contest the IRS’s valuation and demonstrate that the taxpayer’s valuation was not an over- (or under-) valuation.