Case — Definition of Underpayment

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TL Case Summ

THE QUESTION

What’s the definition of an underpayment for purposes of figuring a 20% accuracy related penalty?

THE DISPUTE

Taxpayer Says: The IRS used the wrong number to calculate the 20% accuracy related penalty.

Internal Revenue Service Says: The penalty was calculated on the amount of the underpayment and is correct.

THE LAW

From Internal Revenue Code Section 6662(a) and (b)(1) and (2): Imposes an accuracy-related penalty equal to 20% of the portion of an underpayment of tax attributable to, among other things, negligence or disregard of rules or regulations, or any substantial understatement of income tax.

From Internal Revenue Code Section 6662(d)(1)(A): Defines a “substantial understatement of income tax” as an understatement in an amount exceeding the greater of 10% of the tax required to be shown on the return or $5,000.

From Internal Revenue Code Section 6662(d)(2)(A): As pertinent, the term “understatement” is defined as the excess of the amount of tax required to be shown on the return over the amount shown.

From Internal Revenue Code Section 6664(a): Underpayment.–For purposes of this part, the term “underpayment” means the amount by which any tax imposed by this title exceeds the excess of– (1) the sum of– (A) the amount shown as the tax by the taxpayer on his return, plus (B) amounts not so shown previously assessed (or collected without assessment), over (2) the amount of rebates made. For purposes of paragraph (2), the term “rebate” means so much of an abatement, credit, refund, or other repayment, as was made on the ground that tax imposed was less than the excess of the amount specified in paragraph (1) over the rebates previously made.

From Federal Tax Regulation 1.6664-2(a): The definition of underpayment also may be expressed as–Underpayment = W – (X + Y – Z), where W = the amount of income tax imposed; X = the amount shown as the tax by the taxpayer on his return; Y = amounts not so shown previously assessed (or collected without assessment); and Z = the amount of rebates made.

THE CAUSE OF THE DISPUTE

When you underpay the tax you owe, and the underpayment is due to (among other listed items) negligence and a substantial understatement of tax, the IRS can assess a 20% accuracy related penalty on the underpayment.

You’re considered to have substantially understated your tax on your personal federal income tax return when the understatement is more than 10% of the tax you should have shown on your return, or $5,000, whichever is more.

For purposes of the penalty, you calculate the understatement by adding the amount of tax due as reported on your return to amounts that were withheld by employers or others and that you paid, and subtracting rebates made to you. Then you subtract that total from your tax liability. Stated another way, you start at the bottom of your tax return (the balance due), add back your withholding and other payments, and subtract rebates. Your correct tax liability less the sum of those amounts is the amount you underpaid.

In this case, the tax court ruled against the taxpayer in a previous go-round (T.C. Memo. 2013-114). After the court’s decision, the IRS calculated the taxpayer’s correct liability to be $12,968. To calculate the penalty, the IRS added an “overstatement of prepayment credit” of $5,567 to the $12,968, and arrived at a total underpayment of $18,535 and a 20% penalty of $3,707.

The $5,567 “overstatement of prepayment credit” is the difference between the amount of the taxpayer’s actual federal income tax withholding as reported by employers ($11,118), and the amount of withholding reported on Form 1040 by the taxpayer ($16,685).

The taxpayer admits he incorrectly included social security and Medicare tax in the $16,685 of withholding reported on his income tax return, and that he received a federal tax refund of $16,685, which included the incorrectly reported amount. He also agrees the correct tax liability is $12,968 instead of zero as shown on his return.

However, he says the $5,567 should not be included when calculating the underpayment penalty. He believes the penalty should be assessed on $12,968, which would have been his correct liability.

The IRS says the penalty calculation is based on the actual amount the government was deprived of, which is the $12,968 actual liability plus the $5,567 of over-reported withholding that was refunded to the taxpayer. The IRS argues the penalty of $3,707 is correct.

WHAT WOULD YOU DECIDE?

Make your selection, then see “The Court’s Decision” below for a full explanation

For the or for the

THE COURT’S DECISION

Download (PDF, 71KB)

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HL Carpenter, an experienced investor and a CPA, specializes in reader friendly articles on taxes and investing for individuals and small businesses, and publishes two newsletters: Taxing Lessons and Top Drawer Ink. Visit TaxingLessons.com and HLCarpenter.com.

This information should not be considered legal, investment or tax advice. Taxing Lessons and Top Drawer Ink Corp. do not provide legal, investment or tax advice. Always consult your legal, investment and/or tax advisor regarding your personal situation.

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Sorry, wrong answer :(
Right answer!
For the IRS. Section 1.6664-2(a), Income Tax Regs., provides that the amount of the underpayment is equal to the amount of income tax imposed ($12,968) minus the amount shown as tax by taxpayer on his return (negative $5,567) minus amounts of tax not shown on the return that were previously assessed or collected ($0) plus the amounts of rebates made ($0). As a result, the taxpayer’s underpayment for purposes of section 6664(a) was $18,535 ($12,968 plus $5,567 minus $0 plus $0). Accordingly, under section 6662(a) the taxpayer is liable for an accuracy-related penalty of $3,707 (20% of $18,535).
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