In a typical non-criminal IRS tax audit case, the IRS may assess accuracy related penalties or civil fraud penalties for tax adjustments not in your favor. The penalties can be significant causing you more pain with the whole audit process. What are these two penalties?
Accuracy Related Penalties
Section 6662(a), 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% of the portion of the underpayment.
The two main accuracy related penalties the IRS may assess due to a tax audit are 1) Negligence or disregard of rules or regulations or 2) Any substantial understatement of income tax. The IRS auditors will generally assess the 20% accuracy related penalty if there are tax adjustments that meet one of these two criteria. For example, the IRS reduced your business office and mileage expenses by a total of $100,000. As a result of the $100,000 expense reduction, you are assessed $25,000 of additional taxes and the 20% accuracy penalty of $5,000. (25,000 * 20% = 5,000) The amount of additional taxes owed due to audit will be $30,000 plus interest.
Accuracy Related Penalty – Negligence or Disregard of Rules or Regulations
The IRS defines negligence as a failure to make a reasonable attempt to comply with your tax obligations, exercising ordinary and reasonable care when preparing your tax return, or failure to keep adequate books and records.
The IRS defines disregard of rules or regulations as careless, reckless or intentional disregard. Basically, you take a position on a tax return with little or no effort to determine if the position is correct or knowingly take a position that is incorrect.
Accuracy Related Penalty – Any Substantial Understatement of Tax
You may be assessed the accuracy related penalty if the understatement of tax is greater than 10% of the tax required to be shown or $5,000.
For example, the tax reported on the original return with no adjustments was $25,000. The IRS audited your return and concluded that you owe an additional $4,500 in taxes. 10% of $25,000 is $2,500. The $4,500 tax adjustment is greater than 10% which is $2,500. Therefore, the IRS can assess the 20% accuracy related penalty. The penalty would by $900 in this case. (4,500 * 20% = 900)
Civil Fraud Penalty
Section 6663(a), If any part of any understatement of tax required to be shown on a return due to fraud, there shall be added to the tax an amount equal to 75% of the portion of the underpayment which is attributable to fraud.
The 75% civil fraud penalty is a heavy consequence. In my first example, the IRS reduced the business expenses by $100,000 which resulted in $25,000 of additional taxes. If the IRS determines that the return was fraudulent and assess the 75% civil fraud penalty, the penalty would be $18,750. (25,000 * 75% = 18,750) The amount of additional taxes owed due to audit will be $43,750 plus interest.
IRS Circular 230 Disclosure: To the extent this writing contains advice on a federal tax issue, the advice is not intended to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code, or (ii) promoting, marketing, or recommending to another party any transaction or matter addressed in this communication.