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You filed your return, the IRS audited it, and now there is a penalty on top of the extra tax they say you owe. That penalty is almost certainly the substantial understatement penalty under IRC § 6662, a 20% add-on that shows up without much warning and catches a lot of people off guard.
Here is what it is, when it applies, and how to get rid of it.
Key Takeaways
- The IRS can add a 20% penalty on any underpayment it deems substantial, meaning the error meets a specific dollar or percentage threshold.
- For individuals, an understatement is substantial when it exceeds the greater of $5,000 or 10% of the tax required to be shown on the return.
- The penalty is not negotiated down through an installment agreement or OIC. It must be separately disputed or abated.
- Three defenses can eliminate or reduce it: substantial authority, adequate disclosure, and reasonable cause with good faith.
- First Time Abatement (FTA) does NOT apply to accuracy-related penalties. You need reasonable cause.
What Is the Substantial Understatement Penalty?
The substantial understatement penalty is one category of the broader accuracy-related penalty under IRC § 6662. The IRS imposes it when an audit or examination reveals that you understated your income tax by a significant enough amount to cross their threshold.
The penalty rate is 20% of the underpayment of tax attributable to the substantial understatement.
That is on top of the additional tax you owe. So if an audit says you owe $30,000 more than what you reported, the penalty adds another $6,000 before interest starts running.
I have seen cases where the client understood they might owe some extra tax going into an audit. They had no idea there was a separate penalty that would be stacked on top. By the time interest compounded over two or three years, the original $30,000 discrepancy turned into a $45,000 bill. The penalty is not a minor footnote.
When Does the IRS Trigger This Penalty?
The IRS does not apply this penalty to every underpayment. There is a specific mathematical threshold.
For individual taxpayers, under IRC § 6662(d)(1)(A), an understatement is substantial when it exceeds the greater of:
- $5,000, OR
- 10% of the tax required to be shown on the return for that year
Whichever is larger is the threshold. If your correct tax liability was $40,000 and you reported $33,000, the understatement is $7,000. That exceeds both $5,000 and 10% of $40,000 ($4,000). Substantial understatement penalty applies.
If your correct tax was $80,000 and you reported $76,000, the understatement is $4,000. That is under 10% of $80,000 ($8,000), so the 10% threshold is the controlling one. No substantial understatement.
For C corporations, the threshold calculation is different under IRC § 6662(d)(1)(B). A corporate understatement is substantial when it exceeds the lesser of $10,000 or 10% of the tax required to be shown on the return, subject to a $10 million cap.
These are not the same rule. If you have a business entity question, the analysis changes.
How Is the 20% Calculated?
The penalty applies to the portion of the underpayment attributable to the substantial understatement. Take the extra tax the IRS says you owe, multiply by 20%.
Example: Audit closes. IRS determines you owe $25,000 in additional tax. The entire $25,000 is attributable to the substantial understatement. Penalty: $5,000.
Interest on both the tax and the penalty runs from the original due date of the return. That is where the bill gets painful fast.
One flag worth knowing: if the understatement involves a gross valuation misstatement (say, you claimed a property was worth $1 million for deduction purposes and it was actually worth $250,000), the penalty doubles to 40% under IRC § 6662(h). Different category, much higher stakes.
Three Ways to Fight It
The substantial understatement penalty is not automatic. It can be reduced or eliminated entirely if you meet one of three defenses.
1. Substantial Authority (IRC § 6662(d)(2)(B)(i))
If there was substantial authority for the tax treatment you claimed, the portion of the understatement attributable to that position is excluded from the penalty calculation. Substantial authority means there was a reasonable legal basis for your position based on applicable authorities: court cases, IRS rulings, regulations, legislative history. It does not mean you need to win on the merits. It means the position was defensible.
This defense is most useful when the understatement relates to a gray-area deduction or an item with conflicting court opinions. A qualified professional can document the authority trail.
2. Adequate Disclosure (IRC § 6662(d)(2)(B)(ii))
If you adequately disclosed the relevant facts about the tax treatment on the return (generally via Form 8275 or Form 8275-R), and there was a reasonable basis for your position, the IRS cannot sustain the penalty on that item. Disclosure plus reasonable basis is enough. Note that this only works for items that are not tax shelters.
If your preparer saw a questionable deduction coming and attached a Form 8275 to the return, that is exactly what those forms are for. A lot of people file them without fully understanding how much protection they provide.
3. Reasonable Cause and Good Faith (IRC § 6664(c))
This is the most flexible defense and the most commonly used one in practice. The IRS will not impose the penalty if the taxpayer demonstrates that any portion of the underpayment was due to reasonable cause, and the taxpayer acted in good faith with respect to that portion.
What counts as reasonable cause? Reliance on the advice of a qualified tax professional is the most common and successful argument. The key word is qualified. You cannot hand your return to someone unqualified, have them miss something significant, and then claim professional reliance. The IRS looks at whether the professional had the relevant facts, whether the advice was reasonable, and whether you actually followed it.
Other reasonable cause arguments include: complex legal questions with no clear answer, unforeseen events that made accurate reporting impossible, and inability to obtain records through no fault of your own. Generic claims of not knowing the rules generally do not qualify.
The IRS evaluates reasonable cause using the standard in IRM 20.1.1.3.2. They look at the taxpayer’s experience, sophistication, whether the position was consistent with prior returns, and whether the person sought professional help. More sophisticated taxpayers get less benefit of the doubt on the same facts.
What Does NOT Work
First Time Abatement (FTA) does not apply to accuracy-related penalties. FTA is available for failure-to-file and failure-to-pay penalties under IRC § 6651, and for the failure-to-deposit penalty under § 6656. The substantial understatement penalty under § 6662 is not on that list.
I have had clients come in after being told by someone that they could use FTA to wipe the accuracy penalty. They wasted time preparing a request that was going to be denied on procedural grounds before it was ever evaluated on the merits. Go straight to reasonable cause.
Installment agreements and OICs address the underlying tax debt and associated underpayment interest. They do not remove accuracy-related penalties. The penalty accrues, gets added to the balance, and gets paid off as part of the overall resolution unless you separately contest or abate it.
If you are negotiating an OIC or installment agreement AND you have a legitimate reasonable cause defense, file both in parallel. The resolution track does not handle the penalty fight. For more on how IRS penalties stack, see our breakdown of IRS failure-to-file vs. failure-to-pay penalties.
How to Request Penalty Abatement
If you have a valid defense, you need to formally request abatement. There are two main paths:
During the audit: Raise the defense with the examining agent before the audit closes. If the issue is substantial authority or adequate disclosure, bring the documentation. If it is reasonable cause, prepare a written explanation and submit it with supporting evidence. Settling the penalty issue before the audit closes is cleaner than fighting it after.
After the audit closes: You can file a formal protest to the IRS Office of Appeals. Frame the argument clearly: which defense applies, what facts support it, what authority you are relying on. Appeals officers are experienced and this conversation is productive when the argument is well-documented.
After a notice of deficiency: You have the right to petition the U.S. Tax Court to challenge both the additional tax and the penalty. This is the path when the IRS has not been persuaded at the agent level or at Appeals.
Whatever path you take, the burden is on you to demonstrate the defense. The IRS does not go looking for reasons to waive the penalty. You have to put the argument in front of them.
The Bottom Line
The substantial understatement penalty is a 20% addition on top of whatever extra tax the IRS says you owe after an audit. It is not automatic, but the IRS does not go out of its way to tell you it can be challenged.
If you received a notice proposing this penalty, or if you are currently in an audit where the numbers are trending toward the substantial understatement threshold, the time to prepare the defense is before the examination closes, not after.
Jon Call, EA | CLAW Tax Group
Schedule a consultation or call (651) 323-2255.
The content of this article is for informational purposes only and does not constitute legal or tax advice. Consult a qualified tax professional for guidance specific to your situation.
