Accuracy-related penalty under IRC 6662: negligence, substantial understatement and the defenses

The grounds and rates

IRC 6662(b) lists ten grounds. The penalty is 20 percent of the portion of the underpayment attributable to the ground, and “increases to 40 percent in certain circumstances involving gross valuation misstatements (including disallowances of a deduction under IRC 6662(b)(10)), nondisclosed noneconomic substance transactions, and undisclosed foreign financial asset understatements” (IRM 20.1.5.4.3).

The penalty applies only if a return was filed, generally not to a substitute for return under IRC 6020(b), and not to any portion of an underpayment penalized as fraud under IRC 6663 (IRM 20.1.5.3.2; IRC 6662(b)). Reportable transaction understatements have their own penalty under IRC 6662A. The penalty is subject to deficiency procedures, and interest on it runs from the return due date including extensions.

No stacking and alternative positions

“There is no stacking of accuracy-related penalty components”: the maximum on any portion of an underpayment is 20 percent, or 40 percent where a 40 percent ground applies, even if the portion is attributable to more than one ground (IRM 20.1.5.3.3.1). Examiners are told to assert the strongest ground as the primary position and write up the others as alternatives, so that if the adjustment shrinks below the substantial understatement threshold the negligence position can still sustain the penalty (IRM 20.1.5.2). The alternatives appear in the 30-day letter and the notice of deficiency, and “Written supervisory approval is required for both primary and alternative penalties” (IRM 20.1.5.4). When reviewing a revenue agent's report, look for which ground is primary and whether each alternative was separately approved.

Negligence and disregard of rules

IRC 6662(c) defines negligence to include “any failure to make a reasonable attempt to comply with the provisions of this title”. The IRM's indicators include unreported income, significantly overstated deductions, unexplainable items, inadequate records, and incorrect or incomplete information given to the preparer. Negligence is strongly suggested where a taxpayer fails to check an item that would seem “too good to be true” (IRM 20.1.5.8.1; Treas. Reg. 1.6662-3(b)(1)(ii)), and the regulations say it is strongly indicated where income shown on an information return is left off the tax return.

Defenses and limits in IRM 20.1.5.8.1:

• “The penalty for negligence does not apply if the taxpayer's position has a reasonable basis.”
• “The negligence penalty will not be asserted solely for filing a return late.”
• It is not asserted solely for failing to appear or respond, unless income shown on an information return was omitted or other facts in the file support it.

Disregard of rules or regulations can be careless, reckless or intentional. A position contrary to a revenue ruling or notice is not penalized if it has a realistic possibility of being sustained. Adequate disclosure on Form 8275 or Form 8275-R is an exception to the disregard penalty, but not to negligence, and does not help a position without a reasonable basis or without adequate books and records (IRM 20.1.5.8.2.1).

Substantial understatement

Source: IRC 6662(d)(1); IRM 20.1.5.9. The understatement is reduced by items with substantial authority, and by items adequately disclosed that have a reasonable basis (IRC 6662(d)(2)(B)). Substantial authority is objective: it exists “if the weight of the authorities supporting the treatment of the item is substantial in relation to the weight of the authorities supporting the contrary treatment”, measured when the return is filed or on the last day of the tax year, and treatises and professional opinions are not authority themselves (IRM 20.1.5.9.1.1). A ruling or determination letter to the taxpayer, a technical advice memorandum naming the taxpayer, or an affirmative statement in a prior-year revenue agent's report also count. Annual revenue procedures say when information reported on the return itself is adequate disclosure; for 2025 returns the IRM points to Rev. Proc. 2026-12. Tax shelter items cannot be reduced by either exception.

The IRM computation runs in order: compute the understatement, confirm it is substantial, remove items covered by an exception, retest whether it is still substantial, adjust for prepayments and refundable credits, then apply 20 percent (IRM 20.1.5.9.3). The retest matters: removing one supported item can drop the remainder below the threshold.

Valuation misstatements

A substantial valuation misstatement exists when the value or adjusted basis claimed is 150 percent or more of the correct amount; a gross valuation misstatement at 200 percent or more draws the 40 percent rate. Transfer pricing has its own transactional and net adjustment tests. The penalty applies only if the underpayment attributable to the misstatement exceeds $5,000 ($10,000 for a corporation other than an S corporation or personal holding company) (IRM 20.1.5.11 to 20.1.5.11.3).

Reasonable cause and good faith

IRC 6664(c)(1): “No penalty shall be imposed under section 6662 or 6663 with respect to any portion of an underpayment if it is shown that there was a reasonable cause for such portion and that the taxpayer acted in good faith with respect to such portion.” The exception does not apply to economic substance transactions under 6662(b)(6), disallowances under 6662(b)(10), or gross valuation overstatements on charitable deduction property (IRM 20.1.5.7.1).

Treas. Reg. 1.6664-4(b)(1) says “Generally, the most important factor is the extent of the taxpayer's effort to assess the taxpayer's proper tax liability.” Circumstances that can support the defense:

• An honest misunderstanding of fact or law reasonable in light of the taxpayer's experience, knowledge and education.
• An isolated computational or transcriptional error.
• Reliance on an erroneous Form W-2, Form 1099 or other information return, if the taxpayer did not know or have reason to know it was wrong.
• Reliance on professional advice that meets Treas. Reg. 1.6664-4(c).

Reliance on advice. The regulation requires that the advice be based on all pertinent facts and the law, not rest on unreasonable assumptions, and that the taxpayer not withhold relevant facts. Reliance may fail if the taxpayer knew or should have known the advisor lacked relevant expertise or had a conflict (IRM 20.1.5.7.4). The courts apply the same requirements through the three-part test of Neonatology Associates, P.A. v. Commissioner, 115 T.C. 43 (2000), aff'd 299 F.3d 221 (3d Cir. 2002): a competent professional with sufficient expertise, necessary and accurate information given to that professional, and actual good-faith reliance; see reasonable cause for how to document each prong. Two IRM instructions matter in practice. If the taxpayer refuses to produce an opinion it claims to have relied on, examiners are told to disallow the position as not verifiable. And when the penalty is dropped because of reliance on advice, contacting the advisor to confirm is “mandatory before the case is closed from the group”, with return preparer penalties under IRC 6694 and 6695 considered if the preparer's conduct is at issue. Advice need not be in any particular form.

In court, the IRS bears the burden of production on penalties against individuals (IRC 7491(c)); administratively, “The burden of proving entitlement to relief is generally upon the taxpayer” (IRM 20.1.1.3.5).

Procedure: approval, AUR and Appeals

Supervisory approval. IRC 6751(b)(1) requires the initial determination to be personally approved in writing by the examiner's immediate supervisor or a designated higher level official, on or before the date the notice of deficiency is mailed for penalties subject to Tax Court review (Treas. Reg. 301.6751(b)-1(c)). The IRS also requires supervisory approval when a substantial understatement exists and the penalty is not asserted. For penalties assessed before December 23, 2024, the deadline comes from case law and differs by circuit: the Tax Court's rule in Clay v. Commissioner, 152 T.C. 223 (2019), is approval before the first formal communication of the penalty (the 30-day letter and revenue agent's report), while the Ninth and Eleventh Circuits require approval only before assessment. In a deficiency case involving an individual, producing the approval is part of the IRS's burden under IRC 7491(c) (Chai v. Commissioner, 851 F.3d 190 (2d Cir. 2017); Frost v. Commissioner, 154 T.C. 23 (2020)). See supervisory approval under IRC 6751(b) for the decisions, the regulation's examples and what to request from the file.

AUR and correspondence exams. A substantial understatement penalty generated by the Automated Underreporter or campus exam systems with no taxpayer response is “automatically calculated through electronic means” and needs no approval. If the taxpayer responds challenging the penalty or the underlying tax and an employee considers the response before assessment, approval is required (IRM 20.1.5.2.1). See CP2000.

In the exam. Examiners must document consideration of penalties in every exam and any exceptions the taxpayer raises, “whether or not they are accepted”, and “The level of taxpayer cooperation is not grounds for asserting or not asserting a penalty” (IRM 20.1.5.4). Raise defenses in writing during the exam so they are in the file.

After assessment. A first post-assessment abatement request is considered on the evidence by the function that assessed the penalty. If denied, the Letter 854C points to paying and filing a Form 843 refund claim, and post-assessment 6662 and 6662A requests “are not forwarded to Appeals” (IRM 20.1.5.5). The better time to contest the penalty is before assessment: in response to the 30-day letter with a protest to Appeals, or in a Tax Court petition after the notice of deficiency.

A defense checklist

1. Identify the ground asserted and each alternative in the report (IRC 6751(a) requires name, section and computation).
2. Request the administrative file and check for timely written supervisory approval covering every year and every penalty, including alternatives. See reading the exam file.
3. Recompute the understatement after removing items with substantial authority or adequate disclosure and a reasonable basis; retest the threshold.
4. Build the reasonable cause and good faith record: the client's effort to get it right, sophistication, information returns relied on, advice received and the facts given to the advisor.
5. Check whether the adjustment itself can be reduced in Appeals; the penalty base moves with it.
6. If the penalty was assessed by default, consider audit reconsideration or a refund claim.

Questions practitioners ask