The Accuracy-Related Penalties & Reasonable Cause (6662 & 6664)
Contents
Section 6662(b) Accuracy-Related Penalty
While there are many different types of civil tax violations under the Internal Revenue Code, one of the most common types of penalties involves the penalty for filing inaccurate tax returns. Not every inaccurate tax return results in accuracy-related penalties; generally, it depends on the amount of underpayment relative to the total amount of payments that are due. In addition, when there are ‘Gross Value Misstatements,’ or issues with ‘Foreign Financial Asset Understatements’, it can result in a significantly higher penalty. These types of cases are litigated often. When the matter turns from an IRS administrative scenario to a litigated case, the US Government has the initial burden whereas the Taxpayer then must take the initiative to show there was reasonable cause sufficient to avoid a penalty. Let’s look at the basics of the 26 USC 6662 accuracy-related penalty and the 26 USC 6664 Reasonable Cause exception, by walking through portions of the code:
26 USC 6662: Imposition of Penalty
(a) Imposition of penalty
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- If this section applies to any portion of an underpayment of tax required to be shown on a return, there shall be added to the tax an amount equal to 20 percent of the portion of the underpayment to which this section applies.
What does this Mean?
This means that when a Taxpayer’s return results in certain underpayments, the result may be that the filer is then penalized based on the underpayment amount.
(b) Portion of underpayment to which section applies
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This section shall apply to the portion of any underpayment which is attributable to 1 or more of the following:
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(1) Negligence or disregard of rules or regulations.
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(2) Any substantial understatement of income tax.
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(3) Any substantial valuation misstatement under chapter 1.
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(4) Any substantial overstatement of pension liabilities.
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(5) Any substantial estate or gift tax valuation understatement.
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(6) Any disallowance of claimed tax benefits by reason of a transaction lacking economic substance (within the meaning of section 7701(o)) or failing to meet the requirements of any similar rule of law.
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(7) Any undisclosed foreign financial asset understatement.
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(8) Any inconsistent estate basis.
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(9) Any overstatement of the deduction provided in section 170(p).
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- This section shall not apply to any portion of an underpayment on which a penalty is imposed under section 6663. Except as provided in paragraph (1) or (2)(B) of section 6662A(e), this section shall not apply to the portion of any underpayment which is attributable to a reportable transaction understatement on which a penalty is imposed under section 6662A.
What does this Mean?
This section refers to the specific types of tax violations that may result in the accuracy-related penalty.
(d) Substantial understatement of income tax
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(1) Substantial understatement
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(A) In general
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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.
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What does this Mean?
This subsection refers to what is considered a “substantial understatement of income.”
(j) Undisclosed foreign financial asset understatement
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(1)In general
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For purposes of this section, the term “undisclosed foreign financial asset understatement” means, for any taxable year, the portion of the understatement for such taxable year which is attributable to any transaction involving an undisclosed foreign financial asset.
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(2) Undisclosed foreign financial asset
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For purposes of this subsection, the term “undisclosed foreign financial asset” means, with respect to any taxable year, any asset with respect to which information was required to be provided under section 6038, 6038B, 6038D, 6046A, or 6048 for such taxable year but was not provided by the taxpayer as required under the provisions of those sections.
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(3) Increase in penalty for undisclosed foreign financial asset understatements
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In the case of any portion of an underpayment which is attributable to any undisclosed foreign financial asset understatement, subsection (a) shall be applied with respect to such portion by substituting “40 percent” for “20 percent”.
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What does this Mean?
This subsection is very important since it deals with noncompliance with foreign financial assets, which as of late has been a key enforcement priority. With undisclosed foreign financial assets understatement, the penalty can be increased to 40%.
Reasonable Cause Exception (26 USC 6664)
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(c) Reasonable cause exception for underpayments
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(1) In general
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No penalty shall be imposed under section 6662 or 6663 with respect to any portion of an underpayment if it is shown that there was a reasonable cause for such portion and that the taxpayer acted in good faith with respect to such portion.
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(2) Exception
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Paragraph (1) shall not apply to any portion of an underpayment which is attributable to one or more transactions described in section 6662(b)(6)
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CFR 1.6664-4 (Regulation For 6662 Reasonable Cause)
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(b) Facts and circumstances taken into account –
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(1) In general.
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The determination of whether a taxpayer acted with reasonable cause and in good faith is made on a case-by-case basis, taking into account all pertinent facts and circumstances. (See paragraph (e) of this section for certain rules relating to a substantial understatement penalty attributable to tax shelter items of corporations.)
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Generally, the most important factor is the extent of the taxpayer’s effort to assess the taxpayer’s proper tax liability. Circumstances that may indicate reasonable cause and good faith include an honest misunderstanding of fact or law that is reasonable in light of all of the facts and circumstances, including the experience, knowledge, and education of the taxpayer. An isolated computational or transcriptional error generally is not inconsistent with reasonable cause and good faith.
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Reliance on an information return or on the advice of a professional tax advisor or an appraiser does not necessarily demonstrate reasonable cause and good faith. Similarly, reasonable cause and good faith is not necessarily indicated by reliance on facts that, unknown to the taxpayer, are incorrect. Reliance on an information return, professional advice, or other facts, however, constitutes reasonable cause and good faith if, under all the circumstances, such reliance was reasonable and the taxpayer acted in good faith. (See paragraph (c) of this section for certain rules relating to reliance on the advice of others.)
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For example, reliance on erroneous information (such as an error relating to the cost or adjusted basis of property, the date property was placed in service, or the amount of opening or closing inventory) inadvertently included in data compiled by the various divisions of a multidivisional corporation or in financial books and records prepared by those divisions generally indicates reasonable cause and good faith, provided the corporation employed internal controls and procedures, reasonable under the circumstances, that were designed to identify such factual errors.
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Reasonable cause and good faith ordinarily is not indicated by the mere fact that there is an appraisal of the value of property. Other factors to consider include the methodology and assumptions underlying the appraisal, the appraised value, the relationship between appraised value and purchase price, the circumstances under which the appraisal was obtained, and the appraiser’s relationship to the taxpayer or to the activity in which the property is used. (See paragraph (g) of this section for certain rules relating to appraisals for charitable deduction property.)
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A taxpayer’s reliance on erroneous information reported on a Form W-2, Form 1099, or other information return indicates reasonable cause and good faith, provided the taxpayer did not know or have reason to know that the information was incorrect. Generally, a taxpayer knows, or has reason to know, that the information on an information return is incorrect if such information is inconsistent with other information reported or otherwise furnished to the taxpayer, or with the taxpayer’s knowledge of the transaction. This knowledge includes, for example, the taxpayer’s knowledge of the terms of his employment relationship or of the rate of return on a payor’s obligation.
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What does this Mean?
When a Taxpayer can show reasonable cause, they may be able to avoid penalties. 26 USC 6664 and the corresponding regulation summarize the basics of what the Taxpayer would need to show to meet the burden of proving reasonable cause.
Current Year vs Prior Year Non-Compliance
Once a taxpayer missed the pension tax and reporting (such as FBAR and FATCA) requirements for prior years, they will want to be careful before submitting their information to the IRS in the current year. That is because they may risk making a quiet disclosure if they just begin filing forward in the current year and/or mass filing previous year forms without doing so under one of the approved IRS offshore submission procedures. Before filing prior untimely foreign reporting forms, taxpayers should consider speaking with a Board-Certified Tax Law Specialist that specializes exclusively in these types of offshore disclosure matters.
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