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Underreported income, part 2: What are the tax penalties?

In the first part of this post, we began discussing the issue of underreported income. We noted that the IRS has a program that automatically sends out notices to taxpayers when information from other sources indicates that income may be underreported on a tax return.

In this part of the post, we will summarize the findings of a recent report by the Treasury Insepctor General for Tax Administration (TIGTA) on the Automated Underreporter Program (AUP). We will also address this question: What are the tax penalties for underreporting income?

TIGTA's audit found that overall the AUP works fairly well in notifying taxpayers about apparent underreporting of income. As a taxpayer, if you receive a CP2000 notice about underreported income, you have a choice about whether to accept the IRS's proposed changes in your return or to contest them.

But what are the tax penalties for underreporting income? There are actually two different penalties that may apply.

One is the negligence penalty. The other is the penalty for substantial understatement.

"Substantial" understatement sounds like a vague term, but it actually has a very specific definition. It refers to understatement of your tax liability by 10 percent or more. The penalty for this type of understatement is 20 percent of the portion of tax related to the understated income.

The negligence penalty is also 20 percent of the tax related to the understated income. Unlike the substantial understatement penalty, there is no set threshold for when it applies. But in practice, it is for misstatements of tax liability of less than 10 percent. (The substantial understatement penalty kicks in at 10 percent or more.)

The IRS often waives tax penalties for underreporting income. The IRS may do this if a taxpayer can show that there was reasonable cause for the understatement of income.

In its report, TIGTA asserted that the IRS has been too free with these waivers. The IRS responded that penalty waivers are appropriate in many cases in order to encourage tax compliance, particularly among taxpayers who have understated their tax liability for the first time.

Of course, underreporting income is quite another matter when willful tax evasion becomes an issue. But our primary point in this post is that when underreporting is not willful, waiver of tax penalties may be possible.

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