4.1 Taxpayer Penalties
Key Takeaways
- IRC §6662 adds 20 percent of the underpayment portion attributable to negligence, a substantial understatement of income tax, a substantial valuation misstatement, or other listed items; the rate is 40 percent for a gross valuation misstatement or a nondisclosed noneconomic-substance transaction.
- IRC §6663 adds 75 percent of the underpayment portion attributable to fraud; the IRS must establish fraud, and §6662 does not apply to the same underpayment portion on which §6663 is imposed.
- IRC §6651 adds 5 percent per month (maximum 25 percent) for failure to file and 0.5 percent per month (maximum 25 percent) for failure to pay; for any month both apply, §6651(c)(1) reduces the failure-to-file addition by the failure-to-pay addition so that month totals 5 percent, not 5.5 percent.
- The estimated-tax underpayment penalty is IRC §6654 for individuals (and §6655 for corporations), not a §6651 addition; §6651(e) expressly carves estimated tax out of failure-to-pay.
- IRC §6664(c) relieves §6662 and §6663 on any portion for which the taxpayer shows reasonable cause and good faith, with statutory exceptions for noneconomic-substance transactions.
4.1 Taxpayer Penalties
REG Blueprint I.C.3 asks you to recall situations that produce taxpayer penalties relating to tax returns and to identify the penalty on a fact pattern. These additions assess against the taxpayer. Chapter 2 already covered preparer penalties under IRC §§6694 and 6695, which assess against the person who prepared the return for compensation. One return can produce both stacks. One does not offset the other. Do not recycle a §6694 greater-of-fee computation when the stem asks for the taxpayer's §6662 amount. Contrast the preparer regime in /study-guides/cpa-reg/circular-230/preparer-penalties and leave it there.
Accuracy-related penalty — IRC §6662
If §6662 applies to any portion of an underpayment of tax required to be shown on a return, there is added to the tax an amount equal to 20 percent of that portion. The accuracy-related and fraud penalties apply only if a return is filed (other than a Secretary-prepared return under §6020(b)). IRC §6664(a) defines underpayment; for REG, treat it as tax imposed minus tax shown, adjusted for prior assessments and rebates.
The 20 percent rate applies to the portion attributable to one or more of the following:
- Negligence or disregard of rules or regulations. Negligence includes any failure to make a reasonable attempt to comply with the Code. Disregard includes careless, reckless, or intentional disregard. Ignoring an information return, keeping no books, or taking a position contrary to a regulation without a disclosed reasonable basis is the usual pattern.
- Substantial understatement of income tax. For an individual, an understatement is substantial if it exceeds the greater of 10 percent of the tax required to be shown, or $5,000. If the taxpayer claims the §199A deduction, substitute 5 percent for 10 percent. For a C corporation other than an S corporation or personal holding company, the threshold is the lesser of (i) 10 percent of the tax required to be shown (but not less than $10,000) or (ii) $10,000,000. An understatement is reduced by items for which there is substantial authority, or items that are adequately disclosed (typically Form 8275 or 8275-R) and have a reasonable basis. Those reductions do not apply to tax-shelter items as defined in §6662(d)(2)(C)(ii).
- Substantial valuation misstatement under chapter 1: claimed value or adjusted basis is 150 percent or more of the correct amount (with a $5,000 underpayment floor; $10,000 for most C corporations).
Forty percent substitutes for 20 percent on a gross valuation misstatement (claimed chapter 1 value or basis 200 percent or more of correct) and on a nondisclosed noneconomic-substance transaction. Undisclosed foreign financial asset understatements also take 40 percent. The components of §6662 do not stack on the same underpayment portion.
Worked number. Individual. Tax required to be shown $50,000. Tax shown $32,000. Understatement $18,000. Ten percent of $50,000 is $5,000; the dollar floor is $5,000; the greater amount is $5,000. $18,000 exceeds $5,000, so the understatement is substantial. With no substantial authority and no adequate disclosure, the §6662 addition is 20 percent × $18,000 = $3,600 if the underpayment equals the understatement. If $8,000 of that understatement has substantial authority, $10,000 remains, $10,000 still exceeds $5,000, and the penalty is 20 percent × $10,000 = $2,000.
Civil fraud — IRC §6663
If any part of any underpayment of tax required to be shown on a return is due to fraud, there is added 75 percent of the portion attributable to fraud. Once the Secretary establishes that any portion is attributable to fraud, the entire underpayment is treated as attributable to fraud, except any portion the taxpayer establishes (by a preponderance of the evidence) is not. On a joint return, the penalty does not apply to a spouse unless some part of the underpayment is due to that spouse's fraud.
The IRS bears the burden of proving fraud by clear and convincing evidence, the same allocation mapped in /study-guides/cpa-reg/tax-procedure/audits-appeals-judicial. Concealment, a second set of books, omitted cash, and false statements are badges of fraud. An honest mistake after a reasonable attempt to comply is not.
No stacking with §6662 on the same portion. Section 6662(b) provides that §6662 shall not apply to any portion of an underpayment on which a penalty is imposed under §6663. Split the underpayment when the taxpayer proves a nonfraudulent slice.
Worked number. Underpayment $20,000. IRS proves $12,000 is fraudulent. Taxpayer proves the other $8,000 is a negligent but nonfraudulent deduction error. §6663 = 75 percent × $12,000 = $9,000. §6662 = 20 percent × $8,000 = $1,600. Do not add 95 percent to the $12,000.
Failure to file and failure to pay — IRC §6651
Failure to file (§6651(a)(1)). Unless the failure is due to reasonable cause and not willful neglect, add 5 percent of the net tax required to be shown if the failure is not more than one month, plus 5 percent for each additional month or fraction thereof, not exceeding 25 percent in the aggregate. The base is reduced by tax paid on or before the original payment due date and by credits claimable on the return. A chapter 1 return more than 60 days late also faces a statutory minimum equal to the lesser of an inflation-adjusted dollar amount or 100 percent of the tax required to be shown; REG does not test the current dollar. If the failure to file is fraudulent, substitute 15 percent per month and 75 percent for the 25 percent cap.
Failure to pay (§6651(a)(2), (a)(3)). Unless reasonable cause and not willful neglect, add 0.5 percent per month or fraction, not exceeding 25 percent, of the unpaid amount. After notice of intent to levy, the monthly rate becomes 1 percent. An individual who filed on time and is in a §6159 installment agreement pays 0.25 percent per month while the agreement is in effect. An extension of time to file is not an extension of time to pay.
§6651(c)(1) interaction. For any month (or fraction) to which both (a)(1) and (a)(2) apply, the failure-to-file addition is reduced by the failure-to-pay addition for that month. Combined, that overlapping month is 5 percent (4.5 percent net failure-to-file + 0.5 percent failure-to-pay), not 5.5 percent. After the return is filed, only failure-to-pay continues, up to its own 25 percent cap.
Worked number. Tax required and unpaid $8,000. No payments. Return filed at the end of month 3. Each of the three overlapping months: 5 percent reduced by 0.5 percent = 5 percent combined. Total addition 15 percent × $8,000 = $1,200 ($1,080 failure-to-file + $120 failure-to-pay). The same taxpayer who filed on time and paid 10 months late would owe only 0.5 percent × 10 = 5 percent = $400.
| Penalty | Rate | Typical trigger |
|---|---|---|
| §6662 accuracy-related | 20% of the underpayment portion | Negligence; substantial understatement; substantial valuation misstatement |
| Gross valuation / undisclosed NES | 40% of that portion | Claimed value ≥ 200% of correct; undisclosed noneconomic-substance transaction |
| §6663 civil fraud | 75% of the fraud portion | Underpayment due to fraud; IRS burden |
| §6651(a)(1) failure to file | 5%/month, max 25% | Return late; reduced by failure-to-pay in overlapping months |
| §6651(a)(2) failure to pay | 0.5%/month, max 25% | Tax unpaid by the payment due date |
| Estimated-tax underpayment | IRC §6654 (individuals) | Failure to pay required estimated tax — not a §6651 penalty |
Estimated tax is a different section
§6651(e) states that §6651 does not apply to any failure to pay estimated tax required by §6654 or §6655. The individual estimated-tax underpayment penalty, including safe harbors, is taught in /study-guides/cpa-reg/tax-and-credits/estimated-tax. On REG, name the section. Do not compute a §6651 addition on missed estimates.
Reasonable cause and good faith — IRC §6664
§6664(c)(1): no penalty under §6662 or §6663 with respect to any portion of an underpayment if it is shown that there was reasonable cause for that portion and the taxpayer acted in good faith with respect to it. The test is facts-and-circumstances. The leading factor is the extent of the taxpayer's effort to assess the proper tax liability. Honest error after books were kept, or reasonable reliance on a competent adviser who was given all relevant facts, can support the defense. §6664(c)(2) turns the defense off for noneconomic-substance transactions described in §6662(b)(6). Failure-to-file and failure-to-pay use their own reasonable cause and not willful neglect standard in §6651(a), not the §6664(c) text. The client's reasonable-cause defense does not automatically cancel a preparer's §6694 penalty.
Sidebar: assessment limitations (IRC §6501)
Assessment limitations are not Blueprint I.C.3, but REG tests them constantly next to penalties. General rule: the IRS must assess within 3 years after the return is filed (an early return is treated as filed on the due date). Six years if the taxpayer omits from gross income an amount in excess of 25 percent of the gross income stated in the return. Unlimited if no return is filed, or if the return is false or fraudulent with intent to evade tax. A written consent (Form 872) can extend the period before it expires. These are assessment clocks, not collection clocks.
A calendar-year individual files a required income tax return three months after the original due date and pays the $8,000 balance due with that late return. No estimated-tax issue is presented. For each of those three months, both the failure-to-file addition and the failure-to-pay addition would otherwise apply. What combined §6651 addition applies for each overlapping month?
The IRS proves by clear and convincing evidence that $12,000 of a $20,000 underpayment is due to fraud. The taxpayer proves by a preponderance of the evidence that the remaining $8,000 is a negligent but nonfraudulent deduction error. Which taxpayer penalties apply to those portions?
An individual who does not claim a §199A deduction reports $32,000 of tax on a filed return. The correct tax required to be shown is $50,000. There is no substantial authority and no adequate disclosure for the items that produced the difference, and fraud is not involved. What accuracy-related penalty results if the underpayment equals the understatement?