NOVEMBER 05, 2023

IRS Substantial Understatement Penalty Explained by a CPA

The IRS substantial understatement penalty is the penalty described in Internal Revenue Code Section § 6662(b)(2) that is equal to 20% of a substantial understatement of tax made by a taxpayer on their tax return.

What Is an Understatement of Tax?

An understatement of tax liability is the difference between the amount of tax liability reported on a taxpayer’s tax return and the amount of tax liability that should have been reported on their tax return.

So if you filed a tax return that showed a tax liability of $1,000 but your liability should have been $1,500, your understatement of tax would be equal to $500.

What Is a Substantial Understatement of Tax?

A substantial understatement is an understatement of a taxpayer’s tax liability on their tax return that exceeds the greater of:

  • $5,000, or
  • 10% of their correct tax amount for the year (5% for those who claimed the qualified busine ss income deduction on their return)

Example of a Non-Substantial Underpayment of Tax

So let’s go back to the previous example where you showed a tax liability of $1,000 on your tax return but it should have been $1,500, resulting in an understatement of $500.

And let’s assume that you did not claim the qualified business income deduction on your return.

Your understatement of $500 would not be substantial since while it is greater than 10% of your correct tax liability for the year — that is, 10% of $1,500, which is $150 — it is not greater than $5,000.

Example of a Substantial Underpayment of Tax

But what if you showed a tax liability of $1,000 on your tax return but it should have been $10,000?

In this case, your understatement of $9,000 would be substantial since it exceeds $5,000, which is greater than 10% of your correct tax liability for the year — that is, 10% of $10,000, which is $1,000.

So in this case, the IRS would assess a substantial understatement penalty of $1,800 against you, which is equal to 20% of your substantial understatement of $9,000.

How the IRS Notifies You of the Substantial Understatement Penalty

The most common way that the IRS notifies a taxpayer that they intend to assess the substantial understatement penalty against them is by sending them a CP2000 Notice.

How to Fight the Substantial Understatement Penalty

To fight the substantial understatement penalty, you must convince the IRS of one of the things below:

  • You did not understate your tax liability on your return.
  • You did understate your tax liability on your return but not substantially so.
  • You did substantially understate your tax liability, but you had reasonable cause for the substantial understatement.

3 Ways to Avoid the IRS Substantial Understatement Penalty

Here are three ways to avoid the IRS substantial underpayment penalty.

1. Make sure you’ve gathered all your tax documents before filing your return.

Every year, at the beginning of the year — January for W-2s and sometimes into February and March for information from your stock brokerage — you start getting tax documents both electronically and in the mail.

(Yes, I know that sometimes there are corrected documents and even original documents like some K-1s that you don’t get into far later in the year, but the Average Joe or Jane Taxpayer is getting most of their tax docs in the first quarter of the year.)

Bottom line — keep an eye out for your tax documents.

I would recommend as soon as you get an email saying, “A tax document is ready for you” that you download it immediately so you don’t forget about it later, that you print out a hard copy of it and put it in a tax folder in your house that you can simply pull out when you do your tax return, and I would also recommend saving an electronic copy as well.

2. Consider pulling your wage and income transcripts before filing your return.

If you suspect that you haven’t received all your tax documents or you’ve possibly misplaced some, I would recommend filing an extension — ideally making sure you’re adequately paid in by April 15 to avoid a failure-to-pay penalty — and pulling your IRS wage and income transcript for the year when it becomes available, typically in mid-summer.

This wage and income transcript will show all the tax documents that the IRS has received for you.

Of course, if a tax form is filed later than when you pull your transcript, it won’t show on there, so some people to be really cautious wait to pull their final wage and income transcript for the year right before the extension deadline to make sure they’re including all their tax documents.

3. Disclose your position using Form 8275.

By following the two tips above, you should be able to completely avoid the substantial understatement penalty due to omitting a tax document on your tax return.

However, what if you reported all your tax documents on your return but you take an aggressive position on your return that, if successfully challenged by the IRS, would result in an assessment of the substantial understatement penalty?

In this case, you should:

  1. Make sure that you have a reasonable basis for the position you are taking on your tax return — having a reasonable basis for a position means that you have at least a 10% chance of successfully defending the position if it were challenged by the IRS.
  2. Disclose your position using IRS Form 8275.