Accuracy Related Penalties Do Not Apply to Full Understatement of Tax
In Hatcher v. Commissioner, T.C. Memo. 2016-188, the court considered a very common error IRS agents make in computing the Section 6662 accuracy related penalty. The IRS applied the penalty to the entire understatement of tax, rather than the portion of the understatement that was not subject to the reasonable cause defense. This is one of the adjustments taxpayers always have to check when their audit is closed if accuracy related penalties are at issue.
The Accuracy Related Penalty
The Section 6662 accuracy related penalty is a 20 percent penalty on the portion of any underpayment of income tax that is attributable to, among other things, “negligence” or any “substantial understatement of income tax.” Negligence” is defined as “any failure to make a reasonable attempt to comply” with the provisions of the Code. For individuals, an understatement of income tax is “substantial” if it exceeds the greater of $5,000 or 10% of the tax required to be shown on the return. The penalty applies unless the taxpayer had reasonable cause and acted in good faith with respect to the item.
The Facts in the Hatcher Case
In Hatcher, the taxpayer reported a $600,000 bad debt loss in 2010 for a loan Mrs. Hatcher made to Mr. Hatcher prior to their marriage. This resulted in the net operating loss (“NOL”) that Mrs. Hatcher carried back to her 2008 tax return (which was prior to the time she was married).
Mrs. Hatcher submitted a Form 1045, Application for Tentative Refund, seeking a refund for 2008 for the NOL carryback. The IRS processed the Form 1045 and issued Mrs. Hatcher the refund she requested.
The IRS and the court concluded that the loan was not deductible in 2010. Accordingly, they both disallowed the NOL carried back from 2010 to 2008. This resulted in various computational adjustments in 2010, including the disallowance of Schedule E rental losses in excess of $25,000 in 2010 and an increase in self-employment income taxes.
The IRS assessed accuracy related penalties for the tax adjustments in 2008 and 2010 based on the total understatements of tax it determined for each year.
The U.S. Tax Court’s Conclusions
The court had little difficulty in concluding that the taxpayers did not have reasonable cause or act in good faith with respect to the 2008 NOL. So it sustained the accuracy related penalty for 2008.
The court did not sustain the full penalty for 2010, as the court concluded that the taxpayer’s acted with reasonable cause and in good faith with respect to the computational adjustments that were only made as a result of the NOL adjustment. More specifically, the court concluded that the taxpayers acted with reasonable cause and in good faith for the $25,000 Schedule E rental losses and the increase in self-employment tax owing due to the NOL.
The IRS’s Error
It is not set out in detail in the court opinion, but what the IRS did in computing the Section 6662 accuracy related penalty was to simply take the 2008 and 2010 understatements and compute the penalty based on the total underpayments in each year. The IRS agent then plugged these penalty amounts into his or her Form 4549-A when the audit was closed.
What the IRS Agent Should Have Done
What the IRS agent should have done for the 2010 tax year, is to compute the penalty only on the portion of the understatement that was subject to the penalty. There is a three step process for doing this.
Step one is to compute the underpayment based on adjustments that are not subject to the accuracy related penalty. This would include the computational adjustments, such as the Schedule E rental loss and self employment tax adjustments in this case. This calculation would give the IRS agent the corrected taxable income to use to compute the underpayment due to the adjusted item. So in this case, it would give the IRS agent the corrected taxable income to use to compute the underpayment based on the NOL in 2010.
Step two is to determine the understatement to which the 20 percent penalty applies. This would use the tax determined in the first step, which would be subtracted from the tax determined using the corrected taxable income from the first step.
Step three is to multiply the 20 percent by the result from step two.
What the Taxpayer Should Have Done
The IRS does not typically volunteer to provide taxpayers with the various reports that it runs in preparing its Form 4549-A. The agents will normally just provide the Form 4549-A and, in most cases, they attach the final calculation. In other cases they do not attach any calculations.
One way to check whether the IRS agent did this is to review the Form 4549-A and see if the penalty amount is equal to 20 percent of the total understatement each year. If it is and there were purely computational adjustments involved, the taxpayer has to point out the error.
Even if the proposed penalty does not equal 20 percent of the total understatement each year, the taxpayer should evaluate the calculation to make sure that the IRS agent did not miss any computational adjustment or other adjustment for which the taxpayer acted with reasonable cause.
To do this, the taxpayer should request the IRS agent’s BNA or RGS reports to check the numbers at the conclusion of the audit. Most IRS agents will not object to this type of request. This is the easiest way to check that calculation was actually done and done correctly. If it turns out that the IRS agent applied the penalty to items that should not have been included in the calculation, it is up to the taxpayer to raise the reasonable cause defense on audit.
Most large corporate taxpayers make this a routine part of the audit closing process. It has been our experience that most smaller businesses and individuals do not know to check the computation or do not notice the issue.
This can result in the taxpayer paying significantly more than they should in penalties. This is particularly true in audits where the IRS agent proposes large adjustments, such as transfer pricing adjustments.