Penalty assault: negligence, substantial understatement of tax penalties on IRS radar.

• Author: Caplan, Robert A.
• Position: Taxcompliance

as the IRS steps up efforts to ensure accuracy-related penalties are considered during correspondence audits, negligence and substantial understatement of income tax and in-person audits, it's important for CPAs to have a full understanding of the subtleties of these penalty provisions.

Along with these efforts, the IRS also is becoming increasingly stringent in allowing reasonable-cause exceptions to the penalties, especially related to substantial underpayments. However, as clients usually don't understand the complex subtleties of these penalty provisions, the CPA is often being asked to pay the penalty or lace the possibility of losing the client.

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To protect themselves, CPAs should consider adding language to the engagement letter detailing' the frequent imposition of these penalties and the client's responsibility for payment.

Review of the Statute

Internal Revenue Manual Sec. 6662(b) imposes accuracy-related penalties under certain conditions. This article focuses upon two of these conditions, which seem to be the most problematic.

* Negligence or disregard of rules or regulations 6662(b)(1): and

* Substantial understatement of income tax 6662(b)(2).

If these conditions are met, the taxpayer is subject to a penalty of 20 percent of the underpayment to which this section applies.

Negligence

According to IRC Sec. 6662(c):, '"Negligence' includes any failure to make a reasonable attempt to comply with the provisions of this title, and the term 'disregard" includes any careless, reckless or intentional disregard."

Although this definition of negligence is less than precise, courts have typically applied a common law definition: "Failing to do what a reasonable and ordinarily prudent person would do under the same or similar circumstances" [Cook, John, ''The Accuracy-Related Penalty (Partl)" The Tax Advisor April 2010, P. 250].

While the regulations do not define negligence, they do provide examples of negligent behavior, including failing to keep adequate books and records and to substantiate items properly [Regs. 1.6662-3(b)(l)].

The sophistication of the client and the utilization of professional advice are factors in determining negligence. As the IRM states, "Negligence is strongly suggested if a taxpayer fails to make a reasonable attempt to ascertain the correctness of a reported item which would seem to a reasonable and prudent person to be 'too good to be true' under the circumstances" [20.1.5.7.1(2)].

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