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The Complexities of Calculating The Accuracy-Related Penalty – Part II



calculator1This blog offers insight into some of the complexities of calculating the accuracy-related penalty.  It will be shared as Parts I, II and III.

Calculating the Understatement

The steps for calculating a substantial-understatement penalty are:

Step 1: Compute the tax required to be shown on the return (minus any rebates).

Step 2: Determine the amount of tax actually reported on the return. Include adjustments for which there is substantial authority or adequate disclosure.

Step 3: Calculate the understatement (Step 1 − Step 2).

Step 4: Determine whether the understatement in Step 3 is substantial: for corporations, if it exceeds the lesser of (1) 10% of the tax required to be shown on the return or, if greater, $10,000; or (2) $10 million. For other taxpayers, if it exceeds the greater of (1) 10% of the tax required to be shown on the return, or (2) $5,000.

Step 5: If the understatement is substantial, calculate the penalty. Multiply the tax underpayment caused by the substantial understatement by 20%.

Example 1. Calculating the understatement: In 2012, ABC Corp. files its 2011 federal income tax return showing a taxable income of $20 million and a tax liability of $7 million (reflecting a tax rate of 35%). The IRS examines ABC’s return, resulting in a $40 million increase to taxable income and a $14 million increase to tax liability. Part of the adjustment increases taxable income by $5 million for an item for which there was substantial authority.

Step 1: The amount of tax required to be shown on ABC’s return is $21 million, i.e., the tax on $60 million ($20 million on the original return plus the $40 million increase to taxable income as a result of the IRS examination).

Step 2: The amount of tax shown on ABC’s return is determined as if the item for which there was substantial authority had been given the proper tax treatment. The amount of tax shown on the return is $7 million (the tax on the $20 million taxable income actually shown on ABC’s return), plus $1.75 million (the tax on the $5 million adjustment for which there was substantial authority), for a total of $8.75 million.

Step 3: The amount of understatement is $12.25 million, i.e., $21 million (the amount of tax required to be shown), less $8.75 million (the amount treated as shown on ABC’s return after adjustment for the item for which there was substantial authority).

Step 4: The $12.25 million understatement exceeds the lesser of (1) 10% of the tax required to be shown on the return for the tax year, i.e., $2.1 million ($21 million × 10%) (or, if greater, $10,000) or (2) $10 million. Therefore, ABC Corp. has a substantial understatement of income tax for the year.

Step 5: Because the understatement is deemed substantial, the penalty is computed at 20%. Therefore, the penalty is $2.45 million ($12.25 million × 20%).

Coordinating the Penalties

As noted above, a taxpayer with multiple adjustments to its tax return could be in a situation where each adjustment is subject to a different penalty. For example, a taxpayer could find itself with certain adjustments subject to a 20% negligence penalty and other adjustments subject to a 40% gross valuation misstatement penalty. Regs. Sec. 1.6664-3 provides rules for determining the order in which adjustments to a tax return are taken into account for the purpose of computing the total amount of penalties imposed in the following instances:

•  There are at least two adjustments, but only one adjustment is subject to a penalty; or
•  There are at least two adjustments subject to penalties, and the penalties are imposed at different rates.

According to Regs. Sec. 1.6664-3(b), adjustments are made in the following order: 

1.  Those with respect to which no penalties have been imposed.
2.  Those with respect to which a 20% penalty has been imposed.
3.  Those with respect to which a 40% penalty has been imposed.
4.  Those with respect to which a 75% penalty has been imposed.

Example 2. Coordination among penalties: ABC Corp. reported $5 million of taxable income on its federal income tax return and is in a 35% tax bracket. After examining ABC Corp.’s tax return, the IRS proposed three adjustments. The first adjustment has no penalty associated with it. The second adjustment is subject to the 20% substantial-understatement penalty. The third adjustment is subject to a 75% fraud penalty. The amount of each adjustment and the computation of the taxpayer’s understatement of its tax liability are shown in Exhibit 1.

The steps to calculate the total amount of penalties according to Regs. Sec. 1.6664-3 are:

Step 1: Adjustments not subject to a penalty: Determine the portion, if any, of the underpayment on which no penalty is imposed (see Exhibit 2).

Step 2: Adjustments subject to 20% penalty: Determine the portion, if any, of the understatement on which the 20% penalty is imposed (see Exhibit 3).

Step 3: Adjustments subject to 75% penalty: Determine the portion, if any, of the understatement on which the 75% penalty is imposed (see Exhibit 4).

Step 4: Determination of whether understatement is substantial: The $1.05 million understatement exceeds the lesser of (1) 10% of the tax required to be shown on the return for the taxable year, i.e., $490,000 ($4.9 million × 10%) (or, if greater, $10,000); or (2) $10 million. Therefore, the taxpayer has a substantial understatement of income tax for the year.

Step 5: Calculation of penalty: Multiply the penalty rate by each portion of the underpayment of tax subject to that penalty (see Exhibit 5).

by John Keenan, J.D., Washington, D.C., and Whitney Lessman, J.D., Chicago. Rona Hummel, CPA, an adjunct professor with the College of Business at Bloomsburg University in Bloomsburg, Pa., contributed to this item.  “Tax Clinic” The Tax Adviser, March 01, 2013

Edited and posted by Harold Goedde CPA, CMA, Ph.D. (taxation and accounting)

Dr. Goedde is a former college professor who taught income tax, auditing, personal finance, and financial accounting and has 25 years of experience preparing income tax returns and consulting. He published many accounting and tax articles in professional journals. He is presently retired and does tax return preparation and consulting. He also writes articles on various aspects of taxation. During tax season he works as a volunteer income tax return preparer for seniors and low income persons in the IRS’s VITA program.

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2 comments

  1. […] of the complexities of calculating the accuracy-related penalty.  It will be shared as Parts I, II and […]

  2. […] of the complexities of calculating the accuracy-related penalty.  It will be shared as Parts I, II and […]

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