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Accuracy Related Penalties

Accuracy related penalties are a collection of different penalties, the two most common being the "substantial understatement" penalty and the "negligence and disregard of the rules and regulations" penalty.

These penalties are calculated as a flat 20% of the net understatement of tax.

The accuracy related penalties may usually be avoided by providing adequate disclosures on the tax return, ensuring that the positions taken on your return are defensible, or by showing that you acted with reasonable cause and good faith.

"Substantial Understatement" penalty

An "understatement" is loosely defined as the excess of the tax imposed over the amount shown on the return.

To be subject to the substantial understatement penalty, the net understatement of tax must exceed the greater of (1) 10% of the tax required to be shown on the return or (2) $5,000.

Avoiding the penalty

There are various ways to avoid the substantial understatement penalty, including (1) establishing that the positions taken on the return were based on "substantial authority", (2) "adequate disclosure" on the tax return of a position with a reasonable basis of success, or (3) establishing that you acted with reasonable cause and in good faith.

Meeting these requirements is difficult and may require the assistance of an experienced tax professional.

"Substantial Authority"

A position is based on "substantial authority" if it has about a 35% or greater chance of success if challenged *and is adequately supported by various authorities recognized by the IRS. These authorities include the Internal Revenue Code, tax court cases, revenue rulings, technical advice memos, and the like.

"Adequate Disclosure"

To avoid the substantial understatement penalty by adequate disclosure, you must properly disclose the position on the tax return and there must at least be a reasonable basis for the position.

To properly disclose the position, complete and attach IRS Form 8275 to your tax return and disclose all relevant facts. A reasonable basis is one that has approximately 10% or greater chance of success if challenged. This means that the position must be more than just arguable. There must be some authority supporting the position.

"Reasonable Cause & Good Faith"

Finally, you can avoid the substantial understatement by showing that you acted with "reasonable cause and good faith."

The determination of whether you acted with reasonable cause and in good faith is based on all pertinent facts and circumstances. One important factor is the extent of your effort to assess the proper tax liability. An honest misunderstanding of fact or law may be "reasonable cause and in good faith" if the misunderstanding is reasonable in view of your experience, knowledge, and education.

Simply claiming that you relied on the advice of your tax return preparer or some other party may not be enough. At a minimum, you will have to show that you disclosed all pertinent facts to the adviser and that the adviser was qualified to render such advice.

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