Section 6662 adds 20 percent to the portion of an underpayment that falls into one of its listed categories. The two that appear most often in exam reports are negligence and substantial understatement of income tax. Section 6664(c) is the main defense: no penalty applies to a portion of an underpayment if the taxpayer shows reasonable cause and good faith. Every adjustment on an examination report should be tested against both sections before the client agrees to it.
What does section 6662 cover?
Section 6662(a) imposes an addition to tax equal to 20 percent of the portion of the underpayment attributable to the conduct in subsection (b). The statute lists ten categories:
- Negligence or disregard of rules or regulations.
- A substantial understatement of income tax.
- A substantial valuation misstatement under chapter 1.
- A substantial overstatement of pension liabilities.
- A substantial estate or gift tax valuation understatement.
- Disallowed tax benefits from a transaction lacking economic substance.
- An understatement tied to an undisclosed foreign financial asset.
- An inconsistent estate basis.
- An overstatement of the deduction under section 170(p).
- A disallowed deduction under section 170(h)(7).
The penalty applies to the portion of the underpayment, not the whole balance, so a report with several adjustments can carry the penalty on some and not others.
What is a substantial understatement?
Section 6662(d)(1) sets the thresholds by taxpayer type.
- Individuals: the understatement must exceed the greater of 10 percent of the tax required to be shown on the return, or $5,000.
- Corporations other than S corporations and personal holding companies: the understatement must exceed the lesser of (i) 10 percent of the required tax (or $10,000 if that is greater), or (ii) $10,000,000.
- Section 199A claimants: where the taxpayer claims a section 199A deduction, 5 percent is substituted for 10 percent.
Worked example, individual. A client's correct tax is $60,000 and the return showed $52,000. The understatement is $8,000. The threshold is the greater of 10% x $60,000 = $6,000 and $5,000, which is $6,000. The understatement of $8,000 exceeds $6,000, so it is substantial. The penalty is 20% x $8,000 = $1,600. A second client has correct tax of $30,000 and an understatement of $4,000. The greater of $3,000 and $5,000 is $5,000, and $4,000 does not exceed it, so this prong does not apply.
Worked example, corporation. A C corporation has correct tax of $400,000. Ten percent is $40,000, which is greater than $10,000, and it is below the $10,000,000 cap. The threshold is $40,000. An understatement of $35,000 is not substantial, and one of $45,000 is.
How can the understatement be reduced?
Under section 6662(d)(2)(B), the understatement is reduced by the portion attributable to either:
- A treatment for which there is or was substantial authority.
- An item whose relevant facts are adequately disclosed on the return (or in a statement attached to it) and which has a reasonable basis.
These reductions do not apply to items tied to a tax shelter, meaning an entity or arrangement where a significant purpose is avoiding or evading federal income tax (6662(d)(2)(C)).
The reduction happens before the threshold test, so a position with substantial authority can keep a return under the line. That makes the research file part of the return, not only part of the defense. Document the authority at the time of filing. For uncertain positions in the financial statements, the same analysis feeds the audit; see ASC 740-10 uncertain tax positions: worked example.
What are the valuation penalties?
Section 6662(e) covers substantial valuation misstatements under chapter 1. The trigger is a claimed value or adjusted basis of property that is 150 percent or more of the correct amount. For related-party pricing under section 482, the price is 200 percent or more (or 50 percent or less) of the correct amount, or the net adjustment exceeds the lesser of $5,000,000 or 10 percent of gross receipts. The underpayment attributable to these misstatements must exceed $5,000, or $10,000 for corporations other than S corporations and personal holding companies.
Section 6662(h) raises the rate to 40 percent for gross valuation misstatements. The property trigger moves to 200 percent, the section 482 price triggers to 400 percent or 25 percent, and the net section 482 adjustment trigger to the lesser of $20,000,000 or 20 percent of gross receipts. These matter for basis claims on sales, contributed property and entity transfers, where an inflated basis is the usual cause.
What is the reasonable cause defense under 6664(c)?
Section 6664(c)(1) provides that no penalty is imposed under section 6662 or 6663 on any portion of an underpayment if the taxpayer shows reasonable cause for the portion and acted in good faith with respect to it. The burden of showing both is on the taxpayer.
Two exceptions limit the defense. Under 6664(c)(2), it does not apply to underpayments attributable to transactions lacking economic substance under 6662(b)(6), or to a disallowed deduction under 6662(b)(10). Under 6664(c)(3), it does not apply to substantial or gross valuation overstatements for charitable deduction property unless the claimed value was based on a qualified appraisal by a qualified appraiser and the taxpayer also made a good faith investigation of the value.
Treasury Regulation 1.6664-4 explains how the IRS decides:
- It is a facts and circumstances test. The most important factor is the extent of the taxpayer's effort to assess the proper tax liability.
- An honest misunderstanding of fact or law can qualify if reasonable given the taxpayer's experience, knowledge and education.
- Reliance on an information return, professional advice or other facts can qualify if reasonable and in good faith. Reliance on a W-2 or 1099 generally qualifies unless the taxpayer knew or had reason to know it was wrong.
- Reliance on advice must be based on all pertinent facts and applicable law, and cannot rest on unreasonable factual or legal assumptions. A taxpayer cannot withhold a fact known to be relevant.
- Reliance may fail if the taxpayer knew or should have known the advisor lacked the relevant expertise.
- An appraisal alone does not ordinarily establish reasonable cause.
What documentation supports the defense?
Build the file during the engagement, not after the notice arrives:
- Client information requests and responses, showing the client supplied the facts and the preparer asked follow-up questions.
- Research memo or authority list for each position that carries risk, with a conclusion on the level of authority.
- Disclosure decisions, including whether a statement was attached and why.
- Source documents for basis, receipts and valuations, with the date obtained.
- Engagement and representation letters showing what advice was requested and given.
- Preparer credentials and scope, relevant to whether reliance on the advisor was reasonable.
Preparers have their own standards of competence and diligence; see Circular 230 section 10.35. For one common exam target, see S corporation reasonable compensation. When a penalty is proposed on an exam, practitioner priority service can speed account questions while the written response is prepared.
CORAA prepares ready-to-review audit files for US CPA firms; see /us.
Sources
- Cornell Law School Legal Information Institute, 26 U.S.C. 6662, Imposition of accuracy-related penalty on underpayments: https://www.law.cornell.edu/uscode/text/26/6662
- Cornell Law School Legal Information Institute, 26 U.S.C. 6664, Definitions and special rules: https://www.law.cornell.edu/uscode/text/26/6664
- Cornell Law School Legal Information Institute, 26 CFR 1.6664-4, Reasonable cause and good faith exception to section 6662 penalties: https://www.law.cornell.edu/cfr/text/26/1.6664-4
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