An “accuracy-related” penalty applies to any portion of an underpayment of tax required to be shown on a return which is attributable to one or more of the following:

negligence or disregard of rules or regulations

any substantial understatement of income tax

any substantial valuation misstatement under Chapter 1 of subtitle A of the Internal Revenue Code

any substantial overstatement of pension liabilities, or

any substantial estate or gift tax valuation understatement,  Code Sec. 6662(b) .

disallowance of claimed benefits by reason of a transaction lacking economic substance (within the meaning of Code Sec. 7701(o) or failing to meet the requirements of any similar rule of law

any undisclosed foreign financial asset understatement.

The accuracy-related penalty generally equals 20% of the tax underpayment due to the above reasons. However, the penalty rate for undisclosed foreign financial asset understatements is 40% rather than 20% . A tax underpayment equals the excess of the tax imposed over:

the amount shown as tax on the taxpayer's return, plus

the amounts not shown but previously assessed or collected; over

any rebates. Code Sec. 6664(a) .

Example 1. John's tax return was audited and his tax liability for the year in question was fixed at $7,500. On his return, he reported a tax of $3,800. He failed to take a credit for $1,200. The credit is treated as an amount previously assessed or collected. John didn't receive any rebates. The underpayment equals $2,500-the $7,500 tax imposed less: the $3,800 tax shown on the return and the $1,200 tax credit treated as a tax assessed or collected.

If there was a reasonable cause for the underpayment, the penalty won't be imposed. Only one accuracy-related penalty can be imposed on an underpayment even if more than one of the above acts occurs. So there is no stacking of penalties. Reg §1.6662-2(c) . Additionally, the accuracy-related penalties work in conjunction with other civil tax penalties to avoid overlap. For example, an accuracy-related penalty doesn't apply to any portion of an underpayment on which the fraud penalty is imposed. Code Sec. 6662(b) .

The accuracy-related penalty only applies to filed tax returns. Code Sec. 6664(b) . Late filing, in and of itself, isn't considered in determining whether the accuracy-related penalty is imposed. But if the return is filed late and it has an accuracy-related penalty, both penalties can be imposed. The accuracy-related penalty, however, is not imposed on any part of a tax underpayment on which a fraud penalty is imposed. Reg §1.6662-2(a) .

Prior law.

For underpayments attributable to transactions entered into before Mar. 31, 2010, the penalty for underpayments attributable to transactions lacking economic substance didn't apply. Sec. 1409(e)(2), PL 111-152, 03/30/2010 ; Code Sec. 6662 before amend by Sec. 1409(b), PL 111-152, 03/30/2010 .

For tax years beginning before Mar. 19, 2010, the penalty for undisclosed foreign financial understatements didn't apply. Sec. 512(b), PL 111-147, 03/18/2010 ; Code Sec. 6662 before amend by Sec. 512(a), PL 111-147, 03/18/2010 .

Tax returns due before 1990 were subject to similar penalties but they were separately imposed. The Revenue Reconciliation Act of 1989, PL 101-239, 12/19/89 , consolidated these penalties. Code Sec. 6662 . The Code sections before the change were:

negligence-former Code Sec. 6653(a) ,

substantial understatement of tax-former Code Sec. 6661 ,

substantial valuation understatement-former Code Sec. 6659 ,

overstatement of pension liability-former Code Sec. 6659A , and

estate and gift tax valuation understatement-former Code Sec. 6660 .

 OBSERVATION: In addition to the accuracy-related penalties under Code Sec. 6662 listed above, there is also a Code Sec. 6662A penalty for “reportable transaction understatements,”  and which is designated by the Code as an accuracy-related penalty. This penalty has its own reasonable cause exception  and it is not subject to the reasonable cause rules that apply to other accuracy-related penalties. Moreover, calculation of this penalty is not based on an “underpayment” as it is for other accuracy-related penalties. On the other hand the Code Sec. 6664(b) rule that makes filing a return a prerequisite for a penalty seems to apply to this penalty as it does to other accuracy-related penalties.  References to the “accuracy-related penalty” below and elsewhere in the USTR Explanations relate to the Code Sec. 6662 penalty, unless otherwise indicated.

Disclosure on one of the forms  may avoid the penalty for disregard of rules and regulations or, in non-tax shelter cases where the taxpayer's position has a reasonable basis, the penalty for substantial understatement.

Negligence or disregard of rules or regulations.

The 20% penalty is imposed on any portion of the underpayment attributable to negligence or disregard of rules or regulations without intent to defraud. Reg §1.6662-3(a) . “ Negligence” includes any failure to make a reasonable attempt to comply with the internal revenue laws, or to exercise ordinary and reasonable care in tax return preparation. It also includes the failure to keep adequate books and records. A position on an item is negligent if it lacks a reasonable basis. Reg §1.6662-3(b)(1) . The taxpayer bears the burden of proving the IRS's negligence determination is wrong. .

Avoiding the penalty.

The negligence or disregard penalties and other accuracy-related penalties can be avoided by demonstrating a reasonable cause for the underpayment and that the taxpayer acted in good faith. The penalty for disregard of rules or regulations, but not the negligence penalty, can be avoided by meeting a disclosure test .

Substantial understatement of income tax.

The accuracy-related penalty is imposed on the portion of an underpayment that is due to a substantial understatement of income tax on a tax return. Code Sec. 6662(b)(2) . An understatement is substantial if it exceeds the greater of:

10% of the tax required to be shown on the return, or

$5,000. Code Sec. 6662(d)(1)(A) .

A special definition of substantial understatement applies for corporate taxpayers (other than S corporations and personal holding companies). Under this definition, an understatement is substantial if the amount of the understatement exceeds the lesser of (a) 10% of the tax required to be shown on the return for that tax year (or $10,000 if that is greater), or (b) $10 million. Code Sec. 6662(d)(1)(B)

Prior law.

For tax years starting before Oct. 23, 2004, the above definition of substantial understatement for corporations (other than S corporations and personal holding companies), which requires imposition of a penalty for any $10 million understatement, did not apply and a tax understatement by a corporation (other than an S corporation or personal holding company) for a tax year was substantial if it exceeded the greater of 10% of the tax required to be shown on the return for that year, or $10,000. Sec. 819(c), PL 105-357, 10/22/2004 ; Code Sec. 6662(d)(1)(B) before amend by Sec. 819(a), PL 108-357, 10/22/2004 .

Avoiding the penalty.

This penalty and other Code Sec. 6662 accuracy-related penalties can be avoided by demonstrating a reasonable cause for the underpayment and the taxpayer's good faith actions. Code Sec. 6664(c) .

Except in the case of tax-shelter items, this penalty can be avoided for any portion of the understated tax that is due to a tax treatment that is:

supported by substantial authority, or

adequately disclosed (if there was a reasonable basis for the treatment). Reg §1.6662-4(a) .

Substantial income tax valuation misstatement.

A substantial valuation misstatement made on a return is subject to an accuracy-related penalty equalling 20% of the underpayment due to such misstatement. The penalty rises to 40% of the underpayment if the misstatement is “gross.” Code Sec. 6662(a)(b)(3)(h) . A substantial valuation misstatement occurs when the value or adjusted basis of property claimed on a return is 150% or more of its correct amount. A gross misstatement occurs when the amount is 200% or more of its correct amount. No penalty applies unless the underpayment resulting from the misstatement exceeds $5,000 ($10,000 for a corporation other than an S corporation or a personal holding company). Code Sec. 6662(e)(2) .  

Avoiding the penalty.

Disclosure will not prevent the imposition of a substantial or gross valuation misstatement penalty. If there is a reasonable cause for the underpayment and the taxpayer acted in good faith, this penalty won't apply. Code Sec. 6664(c) .  

Prior law.

For returns filed before Aug. 18, 2006, a substantial valuation misstatement existed if: the value or adjusted basis of any property claimed on a return was 200% or more of the correct value or adjusted basis. Sec. 1219(e)(1), PL 109-270, 8/17/2006 ; Code Sec. 6662(e)(1)(A) before amend by Sec. 1219(a)(1)(A), PL 109-280, 8/17/2006 . A gross valuation misstatement was a substantial valuation misstatement with respect to which the value or adjusted basis claimed was 400% or more of the correct value or adjusted basis. Sec. 1219(e)(1), PL 109-270, 8/17/2006 ; Code Sec. 6662(h)(2)(A)(i) before amend by Sec. 1219(a)(2)(A), PL 109-280, 8/17/2006 . However, in the case of a contribution of a qualified real property interest that is a restriction regarding the exterior of a building described in Code Sec. 170(h)(4)(C)(ii) and any property appraisal for that contribution, the 150% test and the 200% test for gross valuation misstatements applied to returns filed after July 25, 2006. Sec. 1219(e)(3), PL 109-270, 8/17/2006 .

 OBSERVATION: Code Sec. 170(h)(4)(C)(ii) describes a building which is located in a registered historic district (as defined in Code Sec. 47(c)(3)(B) ) and certified by the Secretary of the Interior to the IRS as being of historic significance to the district.

 OBSERVATION: The above changes made it easier for the IRS to impose the substantial and gross valuation misstatement penalties because of the lower 150% (rather than 200%) and 200% (rather than 400%) tests.

Substantial valuation misstatement penalty on transfer prices.

Transfer prices for property or services exchanged between related parties are subject to the accuracy-related penalty for substantial valuation misstatement. Valuation misstatements from Code Sec. 482 reallocations of intercompany transfers can trigger a 20% or 40% accuracy-related penalty.

The substantial valuation misstatement penalty on transfer prices can be avoided or minimized by the use of specific methods detailed in Reg §1.6662-6 for determining prices. See ¶66,624.07 for details.

Substantial overstatement of pension liabilities.

A substantial overstatement of pension liabilities is subject to an accuracy-related penalty equalling 20% of the underpayment caused by the overstatement. Pension liabilities are substantially overstated if the actuarial determination of liabilities for the Code Sec. 404(a)(1) or Code Sec. 404(a)(2) deduction is 200% or more of the correct amount. If the actuarially determined amount exceeds 400% of the correct amount, the overstatement is “gross”, and it's subject to a penalty equal to 40% of the understatement attributable to the overstatement of pension liabilities. Code Sec. 6662(f) and Code Sec. 6662(h) . But no penalty is imposed unless the portion of the underpayment attributable to the overstatement of pension liabilities exceeds $1,000. Code Sec. 6662(f)(2) .  

Avoiding the penalty.

The accuracy-related penalty for substantial overstatement of pension liabilities can't be avoided by disclosure. The penalty can be avoided by showing a reasonable cause for the underpayment and the taxpayer's good faith actions. Code Sec. 6664(c) .  

Substantial estate or gift tax valuation understatement.

An estate or gift tax return that has a substantial valuation understatement is subject to an accuracy-related penalty equalling 20% of the underpayment attributable to the understatement. The penalty increases to 40% if the valuation misstatement is “gross.” A valuation understatement is substantial if the value of any property claimed on an estate or gift tax return is 65% or less of the corrected amount. Code Sec. 6662(g)(1) . If the value is 40% or less of the correct amount, the understatement is gross. Code Sec. 6662(h)(2)(C) . No penalty is imposed unless the understatement attributable to the valuation understatement exceeds $5,000. Code Sec. 6662(g)(2) . See ¶66,624.10 for details.

Avoiding the penalty.

The penalty for substantial estate or gift tax valuation understatement can be avoided for any portion of the underpayment for which the taxpayer can show reasonable cause and good faith. Code Sec. 6664(c)  

Prior law.

For returns filed before Aug. 18, 2006, the valuation percentage triggering the gross valuation misstatement penalty was 25% or less of the correct amount (rather than 40% or less). Sec. 1219(e)(1), PL 109-270, 8/17/2006 ; Code Sec. 6662(h)(2)(C) before amend by Sec. 1219(a)(2)(B), PL 109-280, 8/17/2006 . The percentage triggering the substantial valuation misstatement penalty was 50% or less (rather than 65% or less). Sec. 1219(e)(1), PL 109-270, 8/17/2006 ; Code Sec. 6662(g)(1) before amend by Sec. 1219(a)(1)(B), PL 109-280, 8/17/2006 . However, in the case of a contribution of a qualified real property interest that is a restriction regarding the exterior of a building described in Code Sec. 170(h)(4)(C)(ii) and any property appraisal for that contribution, the 40% and 65% tests applied to returns filed after July 25, 2006. Sec. 1219(e)(3), PL 109-270, 8/17/2006 .

 OBSERVATION: Code Sec. 170(h)(4)(C)(ii) describes a building which is located in a registered historic district (as defined in Code Sec. 47(c)(3)(B) ) and certified by the Secretary of the Interior to the IRS as being of historic significance to the district.

 OBSERVATION: The above changes made it harder for taxpayers to avoid the estate and gift tax substantial and gross valuation misstatement penalties because they need to exceed 65% and 40% standards rather than just the 50% and 25% standards of accuracy that applied under pre-2006 Pension Protection Act law.

Carryovers and carrybacks.

Special rules apply to carryovers and carrybacks of losses, deductions, or credits if an accuracy-related penalty is imposed for:

negligence or disregard of rules or regulations, Reg §1.6662-3(d) , or

a substantial understatement of income tax, Reg §1.6662-4(c) .

Negligence or disregard.

A 20% penalty is imposed on any portion of an underpayment caused by a carryback or carryover that is created as a result of negligence or disregard of rules or regulations in a loss year. The penalty even applies if a loss is carried back to a return that was due before 1990 and that was subject to the former Code Sec. 6653 negligence penalty. Reg §1.6662-3(d) . See, ¶66,624.01 for details.

The penalty can be avoided by using the defenses that are generally available for negligence or disregard of rules or regulation penalties. See, ¶66,624.02 for details.

Substantial understatement of income tax.

The penalty for a substantial understatement of income tax applies to any portion of an underpayment for a year to which a loss, deduction, or credit is carried that is attributable to a “tainted item” in the loss year. A “tainted item” is any item, except for tax shelters, for which there is neither substantial authority nor adequate disclosure in the loss year. Reg §1.6662-4(c) . The determination of a substantial understatement of income tax is identical to the above explanation of substantial understatement of income tax. This penalty applies even if the loss is carried back to a return that was due before 1990. Reg §1.6662-4(c) . See, ¶66,624.03 for details.

To avoid this penalty, rely on the defenses of disclosure and substantial authority. .

Liability for penalties on joint returns.

The liability for penalties due on a joint return is joint and several. Code Sec. 6013(d)(3) . Penalties are collectible from either spouse. A spouse can resist liability by proof that the return was in fact a separate return of the other spouse only, or that he or she signed the return under duress.

Under Code Sec. 6015(b) , an innocent spouse is relieved of liability on a joint return if:

there is an understatement of tax attributable to erroneous items of the other spouse,

the innocent spouse shows that in signing the return he or she didn't know and had no reason to know there was an understatement,

under all the facts and circumstances, it would be inequitable to hold the innocent spouse liable, and

the spouse makes an innocent spouse election no more than two years after the first collection action taken by the IRS against that spouse .

Relief from joint and several liability is also available under the separate liability election rules for a divorced or separated spouse, which are discussed at ¶60,154.02 , and under the IRS's power to grant equitable relief .

Coordination rules.

The accuracy-related penalty does not apply to any portion of an underpayment on which a civil fraud penalty is imposed. Code Sec. 6662(b) . For coordination of the Code Sec. 6662 accuracy-related penalty with the Code Sec. 6662A reportable transaction understatement penalty .

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