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Ozzie Gomez
- March 15, 2024
Paying taxes can be a stressful experience. It’s sometimes hard to understand how much you owe, and it’s easy to lose track of deadlines. But if you don’t pay enough tax, there’s a risk the IRS could fine you for a “substantial understatement”.
These fines can have serious consequences for you, your business, and your financial stability. So, to help you avoid IRS fines, here’s a look at how substantial understatement penalties work.
What Is a Substantial Understatement Penalty?
A substantial underpayment penalty is an IRS fine issued for underreported income. The IRS believes you have underpaid income tax, whether carelessly or deliberately.
Every US taxpayer must complete their tax return with reasonable care. If your tax return is wrong, the IRS could argue that you acted negligently or disregarded relevant tax laws.
As a result, they could fine you and compel you to pay the tax owed.
When Does the IRS Issue a Substantial Understatement Penalty?
Put simply, the IRS issues a substantial understatement penalty if:
- You understate how much tax you owe; or
- You overstate your tax deductions.
This penalty is not quite the same as a late payment penalty. It’s issued when the IRS believes that you have withheld tax due in some way.
How Does a Penalty for a Substantial Understatement Work?
The IRS will charge an understatement penalty if you understate your tax by either:
- $5,000; or
- 10% of the true amount (whichever is greater).
The IRS will send a letter informing you of the penalty. The amount you owe is 20% of the understated tax on the return. You will also be charged interest on the penalty.
Substantial Understatement Penalty Example
Say you owe $8,000 in tax but you only pay $2,000. You understated by more than $5,000.
You’ll be charged 20% of $6,000 – the understated amount – plus penalty charges. If you had paid, say, $7,000, the penalty may not apply.
Our team will help you understand how understatement penalties work and how they’re calculated.
Do I Need to Pay a Substantial Understatement Penalty?
Usually, the answer is yes. If there’s a substantial understatement of income, then fines apply. However, this is not always the case. You may be able to avoid paying the penalty if you can show that:
- You missed a payment as a result of a disaster or other highly unusual circumstance.
- During the current or previous tax year, you retired or turned 62.
- You can prove there’s a reasonable cause for underpaying tax and it’s not the result of neglect.
There’s also the possibility to rely on “safe harbor” principles. Typically, this means you won’t pay a penalty if you meet certain legal conditions. In this context, you can avoid a substantial underpayment penalty if:
- You owe less than $1,000 in tax;
- You’ve paid at least 90% of the tax owed for this year or 100% of tax owed for the previous year (whichever is smaller).
The IRS requires you to show evidence to support your claim if you’re challenging the penalty.
How to Avoid Substantial Understatement of Tax Penalties
Whether you’re facing an IRS penalty or you’re worried you might get a fine, here’s how to handle tax penalties.
Know Your Tax Liability
It might seem obvious, but remember – everything you earn is taxable! And even if you can claim deductions, you still need to understand exactly how much tax you owe.
- Record and report all taxable income.
- Double-check your entitlement to a deduction before you apply it.
- Get tax advice if you’re unsure how much tax you owe.
The easiest way to avoid a substantial payment of tax penalty is to pay the right tax. We can help if you need advice on what amount of tax you should pay.
Know the Tax Laws
Yes, tax laws can be confusing. But you must show that you’ve made an honest and careful effort to comply with the relevant laws. If the IRS suspects you of negligence or disregarding tax laws, they could fine you.
- Always act in good faith.
- Check over your return for typos or errors before filing.
- Contact the IRS immediately if there’s an error in a submitted return.
Explore Every Relief Option
When you try to comply with the rules and regulations, but you make a mistake, the IRS may waive the penalty. This is only if you can show you made an honest error or mistake and tried to correct it. So, the IRS may lift the penalty if you can show, for example, that:
- You contacted the IRS immediately upon spotting an error.
- For whatever reason, your tax return is particularly long or complex.
- You got help from a tax professional or attorney before filing your return.
Our team can assist if you need help approaching the IRS regarding an inaccurate tax return.
File Your Tax Return on Time
Accuracy matters, but so does filing your tax return on time – even if you can’t pay your tax in full.
Filing an accurate return, on time, is part of acting in good faith. It shows that you take your tax liability seriously. The more you comply, the better chance there is of the IRS reducing or waiving a penalty.
Dispute the Penalty
You have the right to appeal or dispute an IRS penalty. You can do this by calling the toll-free number at the top of your letter.
However, it’s best to get advice from tax specialists before calling the IRS. A tax specialist can help you understand your options for settling the tax debt and paying what you owe. They’ll also handle negotiations for you, if necessary.
Get a Free Consultation on Your Substantial Understatement Penalty
Tax penalties are frightening, but the worst thing you can do is ignore them. Instead, contact Innovative Tax Relief for help. Our tax specialists will help you negotiate a payment plan with the IRS and, where possible, appeal tax penalties. We’ll also explain how you can avoid future tax debt – so you can move forward with confidence.
Don’t struggle with tax penalties alone. Contact us now for a free tax consultation.
