While an ounce of inaccuracy can save a ton of explanation, in the world of US taxation the weight of the accuracy-related penalty may make the tradeoff less appealing.
Internal revenue code section 6662(a) applies a 20% penalty when you underpay your federal tax. The penalty can be assessed in situations such as when you’re negligent or disregard tax rules or regulations. For example, you can be penalized for not keeping accurate books and records or for not keeping adequate records to substantiate expenses underlying claimed deductions.
However, you may be able to get the penalty abated if you can show substantial authority for the position you took that caused the understatement or if you have a reasonable basis for your stance and adequately disclose the facts regarding the way you treated the item on your return.
In T.C. Summary Opinion 2015-61 (Wideman), the IRS determined that the taxpayer had underpaid his 2009 federal income tax by $3,731. The IRS imposed a $746 section 6662(a) accuracy-related penalty (20% of $3,731).
The taxpayer and the IRS agreed on the proper way to handle some of the disputed items, including $13,056 in income reported on the Schedule C, Profit or Loss From Business, $1,984 of interest, $3,468 of omitted wage income and a related withholding credit of $19, and a $1,700 deduction for office expenses in excess of the amount allowed in the notice. Those items were conceded before the case came before the court.
The issues remaining were whether the taxpayer was entitled to a deduction in excess of the amount the IRS allowed for telephone and miscellaneous expenses, as well as a casualty loss deduction. In addition, the court had to decide if the taxpayer was liable for a section 6662(a) accuracy-related penalty, and if that penalty should be the amount the IRS had assessed.
The taxpayer, an attorney who was a partner in a horse boarding and sales business, shared a home office with his wife who ran a real estate business. The taxpayer claimed deductions on the Schedule C for his law practice for five phone lines related to all the businesses. He did not provide specific information showing how much of the telephone charges should be allocated to each business. The IRS allowed half of the expense. The court agreed with the IRS, finding that the taxpayer failed to show he was entitled to a higher deduction.
The taxpayer also claimed a $25 deduction for miscellaneous expense, which the IRS disallowed. Because the taxpayer did not explain the expense, the court agreed with the IRS.
Finally, the taxpayer claimed a $69,100 casualty loss. The loss arose from expenses paid by the horse boarding business to correct defects in the original construction of the riding arena that allowed sinkholes to form, making the arena unsafe for use. The IRS said the sinkholes were not a casualty and disallowed the deduction. The court agreed with the IRS because the sinkholes were caused by defective construction, not an independent, sudden, or unexpected event.
After finding for the IRS on the disputed items, the court turned to the accuracy-related penalty.
The IRS said the taxpayer owed the penalty due to negligence. The IRS argued that the taxpayer failed to present sufficient information or documentation to substantiate reasonable cause—in other words, the taxpayer failed to comply with substantiation requirements and maintenance of records under the internal revenue code. Therefore, the taxpayer owed the penalty on the entire amount of the underpayment of $3,731, which included the items conceded before trial as well as those items the IRS won in court.
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According to the IRS, the taxpayer is liable for a section 6662(a) penalty on the entire underpayment (which, in this case, equals the deficiency) upon the ground of negligence. In a pretrial memorandum, the IRS argues that the taxpayer “failed to present sufficient information or documentation to substantiate reasonable cause or show that the understatement of tax for the 2009 tax year was not the result of negligence or disregard of rules of regulations.”
The pretrial memorandum goes on to acknowledge the IRS’s burden of production under section 7491(c) and argues the burden has been satisfied because the taxpayer “has not complied with all substantiation requirements or maintained all records under the code.”
We are mindful that the failure to keep adequate records to substantiate expenses underlying claimed deductions can support the imposition of the section 6662(a) accuracy-related penalty on the ground of negligence (see sec. 1.6662- 3(b)(1), Income Tax Regulations), but, for the most part, we agree with the IRS only with respect to the adjustments the taxpayer conceded.
With the exception of the deduction for miscellaneous expenses, the disallowances of the deductions addressed in this opinion are based upon technical reasons rather than lack of substantiation.
We can envision a case where the mere disallowance of a deduction on a technical ground, in and of itself, could give rise to the taxpayer’s liability for a negligence penalty, but this is not that case.
The taxpayer is liable for a section 6662(a) penalty, but only with respect to the underpayment of tax attributable to: (1) the adjustments otherwise conceded and (2) the disallowance of the deduction for miscellaneous expenses.