Near the end of an IRS personal income tax audit, after you have submitted documentation and discussed the case with the IRS Revenue Agent, you will receive a Form 4549 “Report of Income Tax Examination Changes.”  This form will go over the adjustments the Revenue Agent proposes to make to your return, the total tax due, and the penalty for understating your tax liability.

The most common penalties assessed by the IRS during a personal income tax audit are the 20% substantial understatement penalty, 20% negligence penalty, and the 75% civil fraud penalty.  

These penalties are all mutually exclusive, meaning the penalties do not stack—only one can be assessed against you per year.  The IRS’s first choice for penalty is typically the 20% substantial understatement penalty.  However, the IRS will often also assert 20% negligence penalty backup position just in case the substantial understatement penalty does not stick.  If the IRS thinks it can prove you intentionally understated your taxes, it will assert the 75% civil fraud penalty.

20% Substantial Understatement Penalty

The statutory authority for the 20% substantial understatement penalty is IRC § 6662(d).  This tax is assessed if the amount of understatement reaches a certain level—and that level is almost comically low.  For an individual, all the IRS only needs to show that the tax on your return was understated by the greater of 10% of the tax that needed to be shown, or $5,000.   In the vast majority of the audits I see, the adjustments the IRS initially proposes are typically far above this standard.  In fact, if the IRS did an initial review of your return and truly thought the adjustments would amount to less than $5,000 and not meet the substantial understatement standard, they likely would not have selected your return for audit it in the first place.

However, there are circumstances where the taxpayer fights back and reverses enough of the Revenue Agent’s adjustments to fall below the substantial understatement criteria.  That is why the IRS often packages the 20% negligence penalty as a backup position just in case.  

20% Negligence Penalty

The statutory authority for the 20% negligence penalty is IRC § 6662(b).  Negligence is defined in Treasury Reg. § 1.6662-3(b)(1) as “any failure to make a reasonable attempt to comply with the provisions of the internal revenue laws or to exercise ordinary and reasonable care in the preparation of a tax return. “Negligence” also includes any failure by the taxpayer to keep adequate books and records or to substantiate items properly.”

The negligence standard is a subjective one, which is why it’s usually asserted as the IRS’s secondary position rather than their primary position.  But asserting this penalty as a secondary position is important for them, because it means they can penalize you even if the final adjustments fall below the criteria for the 20% substantial understatement penalty.  

75% Civil Fraud Penalty

The highest civil penalty the IRS can assert during an audit is the 75% civil fraud penalty under § 6663.  To prove fraud, the Government must show the taxpayer intended to evade taxes the taxpayer knew to be due and owing by conduct intended to conceal or mislead.  Spies v United States, 317 U.S. 492 (1943).  

Unlike the substantial understatement and negligence penalty, the burden is on the government to demonstrate by “clear and convincing evidence” that there was an underpayment of tax and it was attributable to fraud.  See Clayton v Commissioner, 102 T.C. 632, 653 (1994).  

Fighting IRS Audit Penalties

The process to fight the 20% substantial understatement penalty and 20% negligence penalty is the same: by demonstrating “reasonable cause.”  

Both the 20% substantial understatement penalty and 20% negligence penalty are codified in IRC § 6662.  And IRC § 6664 provides that “[n]o penalty shall be imposed under section 6662… with respect to any portion of an underpayment if it is shown that there was reasonable cause for such portion and that the taxpayer acted in good faith with respect to such portion.”

Treasury Regs. Sec. 301.6651-1(c)(1) define “reasonable cause” as the “exercise of ordinary business care and prudence.”

If the IRS asserts either of these penalties, the burden is on the Taxpayer to show reasonable cause why their taxes were understated.  To dispute these penalties on reasonable cause grounds, you must submit a written statement to the IRS describing how your conduct meets reasonable cause criteria.  The timing of submitting this statement is critical.  Namely, you must submit your reasonable cause statement and request for removal of the penalty BEFORE the penalty is assessed.  Or, put simply, before the audit closes and your appeal rights expire.  Once the audit closes and your appeal rights expire, removal of these penalties becomes far more challenging and is not guaranteed even if your conduct fully meets reasonable cause criteria.

For the 75% civil fraud penalty, there is no reasonable cause defense.  However, as mentioned above, unlike the 20% substantial understatement penalty and 20% negligence penalty, the burden is on the government to show that you INTENDED to fraudulently underpay your taxes.  Fighting this penalty involves attacking IRS arguments that you   knew you were committing fraud during the act, or demonstrating that your conduct was a mistake or that you were unaware your actions constituted fraud.  

Because the 75% civil fraud penalty only applies to the portion of the understatement attributable to fraud, you can also argue that only a small portion of your understated tax was due to fraud.  

If the IRS asserts the 75% civil fraud penalty, it is similarly crucial that you timely submit your written protest and fight the penalty.  Because the IRS bears the burden on proving this penalty, there is a decent enough chance that fighting it will cause the IRS to (at least) agree to reduce it to the 20% negligence penalty.  If you do not fight the civil fraud penalty and it is assessed to your tax account, it can have a far-reaching impact beyond the mere need to repay.  A fraud penalty determination can impact applications from federal loans, can disqualify you from government jobs, and can trigger disclosure requirements or lead to discipline from state licensing boards if you are an attorney, CPA, doctor, financial advisor, real estate agent, etc.   Taxpayers should ALWAYS challenge the IRS if it asserts the fraud penalty.

Conclusion

When the IRS completes an audit of your tax return and finds understated tax, it is very likely to assert either the 20% substantial understatement penalty or 20% negligence penalty.  The 20% substantial understatement penalty is applied based on a mathematical formula, while the 20% negligence penalty is subjective and based on facts & circumstances.  To cover its bases, the IRS often asserts both penalties with one as the primary position and one as the secondary position (because they cannot stack the penalties together).  Once asserted, the burden is on the taxpayer to show that they have “reasonable cause” to explain why the taxes were understated. 

If the IRS thinks it can prove you intentionally understated your income taxes, it will assert the 75% civil fraud penalty.  Unlike the other penalties, the burden is on the IRS to prove that you knowingly and intentionally understated your income tax.   Taxpayers’ primary route to fighting fraud penalty assessments is by arguing that the conduct that lead to the understatement was unintentional or due to a mistake.  

For all penalties, timing is vitally important.  Specifically, you must formally protest the penalty in writing before the audit closes and appeal rights expire.   After your appeal rights expire, even with great facts, removal of the penalty becomes vastly more difficult.