It’s important to make sure everything you report on your tax return is accurate to avoid paying unnecessary IRS penalties in addition to what you already owe for taxes.
A substantial understatement penalty is one example of this that can increase your tax liability significantly.
What Is a Substantial Understatement Penalty?
The substantial understatement penalty is one of the accuracy-related penalties assessed by the IRS. It is when you submit your tax return showing an amount lower than what you actually owe, resulting in underpayment of your taxes. This could be the result of understating your income or overstating your deductions.
For individuals, understating your tax liability by 10% of the true amount or by $5,000, whichever is higher, you could be subject to a substantial understatement penalty.
Businesses that claim a Qualified Business Income Deduction (Section 199A) can receive the penalty for understating tax liability by 5% of the true amount or $5,000, whichever is greater.
How Is The Penalty Calculated?
The substantial understatement penalty amount is calculated using the value of the amount understated on your tax return. The penalty equals 20% of the amount that was underpaid.
If your tax return shows a tax liability that is $20,000 under your actual amount owed, you could be responsible for a substantial understatement penalty.
In addition to the $20,000 additional taxes owed, you would also be responsible for a substantial understatement penalty of $4,000, bringing your total amount owed to the IRS to $24,000.
When Is It Assessed?
The substantial understatement penalty can be assessed at any point when the IRS catches the discrepancy after your taxes have been filed.
In general, the IRS has 6 years from the date of filing to impose any penalties or fees, unless there is suspicion of fraud, or a return wasn’t filed.
It’s important to note that the penalty amount is subject to interest charges which will start accruing from the date the understated tax amount was due.
Resolving a Substantial Understatement Penalty
The fastest way to resolve a substantial understatement penalty is to pay the amount in full to prevent any further interest from accruing. If that isn’t an option, the IRS might be willing to remove or reduce your penalty if you can prove you were acting in good faith and the underpayment was correct by your understanding.
In this case, you’d ask the IRS to consider substantial understatement penalty abatement for reasonable cause. This could be due to an overly complex tax situation, unfruitful attempts to understand the situation correctly, or through the use of a tax professional.
The IRS will consider your personal knowledge of tax law along with whether you provided any advisors with all the information needed.
If you receive penalty relief of some kind, make sure to pay the underpayment immediately or review the various tax relief options to resolve the situation.
What If I Disagree With The Penalty?
If you disagree that there was a discrepancy and believe you have been charged with the substantial understatement penalty in error, you also have the option to dispute it.
You’ll need to include the penalty notice you received in the mail, information on the penalty you’re disputing, and a detailed explanation as to why you believe it should be removed.
Avoiding a Substantial Understatement Penalty
The best way to avoid paying this, or any other penalty to the IRS, is to make sure your taxes are accurate when you file them and make your tax payments on time.
For this penalty, specifically, never underestimate your earnings or attempt to take deductions when you aren’t certain you meet the qualifying criteria.
Once your taxes are complete and ready to be sent out, go over them carefully to make sure there are no mistakes and to check for any missing information. Don’t sign off on your tax return before you know all the information included is accurate to the best of your knowledge.
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