IRS penalties generally fall into two categories: delinquency penalties and accuracy-related ones.

Delinquency penalties

Filing or paying late can trigger delinquency penalties. These are what the IRS calls “assessable penalties,” meaning the IRS will assess the penalty and send you a bill. But being late can have serious consequences beyond having to pay a fine. If a return (or an extension) is filed late, any elections that would have normally been acceptable are now invalid. For corporations, an extension filed without the amount of taxes due fully paid, the extension may be declared invalid, causing the return to be filed late and triggering a penalty.

Accuracy-related penalties

Penalties such as the “negligence penalty” are accuracy-related sanctions that come up during an IRS exam. If the examination results in a proposed tax deficiency and the IRS attaches a penalty, the penalty then becomes part of the overall deficiency. This means it will not be assessed until you agree to the adjustments or any litigation becomes final.

Penalty avoidance

Delinquency penalties are calculated on the amount of tax owed after the due date (without extensions) of the tax return. If you are unable to file your return on time, paying off any tax liability will avoid a penalty. A late filing penalty can be avoided by filing on time, even if you can’t make full payment of the amount due.

Often, accuracy-related penalties can be avoided by filing a disclosure statement with your tax return. Some return positions lack a clear basis, as there are conflicting tax authorities making their own interpretations, regulations are vague or the taxpayer has utilized an unusual set of facts. To the extent a position lacks “substantial authority,” taxpayers can file a disclosure statement on Form 8275 and demonstrate a reasonable basis for taking the position. A position that has been disclosed to the IRS may be subject to an adjustment, but will generally not be subject to a penalty.

Accuracy-related penalties

 An IRS examiner may impose a penalty on any proposed adjustment. Accuracy-related penalties are computed at 20 percent of the tax deficiency. In fact, the accuracy-related penalty consists of several penalties grouped together, only one of which can actually be applied to the tax deficiency. The potential penalties are:

Negligence

Negligence is defined as a failure to make a reasonable attempt to comply with the tax law, or not to exercise ordinary and reasonable care in preparing a tax return. Negligence can include failure to substantiate items on the return, as well as failure to keep adequate records.

Disregard

The accuracy-related penalty applies only if an underpayment results from the reckless or intentional disregard of a rule or regulation. “Rule” includes the Internal Revenue Code, revenue rulings and notices. “Regulation” includes final or temporary Treasury regulations.

Substantial understatement

This penalty applies if there is an understatement of income tax, and the understatement is “substantial.” That generally means 10 percent of the tax required to be shown.

Valuation misstatements

Valuation misstatements come in several varieties, including substantial valuation misstatements of income tax deductions, substantial overstatements of pension liabilities, and substantial estate or gift tax valuation understatements. In the case of gross misstatements, the penalty may be as high as 40 percent of the tax deficiency.

Interest

On any tax deficiency, interest will accrue from the due date of the return until final payment is made. Interest is imposed by statute, and the IRS is not afforded discretion to waive it. The interest rate on an underpayment is the Federal short-term rate plus 3 percentage points. For large corporations, the interest rate can increase from 3 to 5 percentage points after receipt of a 30-day letter from the IRS.

Penalty relief

At the end of the audit, the IRS examiner will decide whether or not to include a penalty with any proposed adjustment. For a taxpayer to prevail in litigation for the underlying tax adjustment, they need to show that the position taken on the tax return was  “more likely than not” to be correct.  Expressed in numerical terms, that’s a +50 percent chance of being correct—a relatively high standard.  However, avoiding the accuracy-related penalty requires clearing a somewhat lower bar—either substantial authority for the position or reasonable basis.

• • • “Substantial authority” is defined as the weight of authorities supporting a position must be substantial in relation to the weight of authorities supporting the contrary position. This is often seen as having a 35 to 40 percent chance of prevailing in litigation. Generally, if you can demonstrate substantial authority for a position, the accuracy-related penalty will not apply.
      
      
    • “Reasonable basis” is an even lower threshold—one need only to demonstrate that the return position is reasonably based on one or more authorities. In numerical terms, reasonable basis represents about a 20 percent chance of prevailing in litigation. To avoid the negligence penalty, you need only to show that there was a reasonable basis for the position. For penalties such as the disregard and substantial understatement penalty, a taxpayer can file a disclosure statement with their return, then later demonstrate a reasonable basis for the position.
      
      
    • A taxpayer can be relieved from the accuracy-related penalty by demonstrating either substantial authority or a reasonable basis for the return position. For any return position that might be challenged, you should research and prepare a list of relevant authorities to support the position. In some cases, filing a disclosure statement on Form 8275 will result in you having to show nothing more than a reasonable basis for the position. Thus, it is entirely possible that a taxpayer may not prevail on the underlying tax issue but be able to avoid a penalty by demonstrating substantial authority or a reasonable basis for the position.