How the 20% Accuracy-Related Penalty Is Calculated Under IRC 6662

After an audit or an underreporter case, the IRS often adds a penalty equal to one-fifth of the extra tax. People see that line and assume it is automatic. It is not. For the most common version, there is a threshold test, and you can run it yourself in about two minutes.

The penalty

IRC 6662(a) adds 20 percent of the portion of an underpayment to which the section applies. IRC 6662(b) lists the grounds. The two that show up most often for individuals and small businesses are:

• Negligence or disregard of rules or regulations (6662(b)(1)). Under 6662(c), negligence includes any failure to make a reasonable attempt to comply.
• A substantial understatement of income tax (6662(b)(2)). This one is pure math.

Other grounds include substantial valuation misstatements and undisclosed foreign financial asset understatements. Some of them, like gross valuation misstatements under 6662(h), raise the rate to 40 percent. The penalty does not apply to any portion of an underpayment already hit with the 75 percent civil fraud penalty under IRC 6663.

Step 1: compute the understatement

IRC 6662(d)(2)(A) defines the understatement as the tax required to be shown on the return minus the tax shown on the return, reduced by any rebate. For a typical individual whose return was audited once, that is simply the extra tax the IRS assessed.

Step 2: compare it to the threshold

IRC 6662(d)(1) sets the line for substantial:

The 199A rule matters more than people realize. If you claimed the qualified business income deduction, even a small one, the percentage test drops from 10 percent to 5 percent under 6662(d)(1)(C).

Worked example: substantial

Worked example: not substantial

That is why the $5,000 floor matters. For anyone whose total tax is $50,000 or less, the floor is the controlling number. An understatement of $5,000 or less cannot be substantial for an individual.

Worked example: the 199A effect

A sole proprietor claims a section 199A deduction. After audit, tax required to be shown is $200,000. Tax shown was $189,000. Understatement: $11,000.

Step 3: reduce for authority and disclosure

IRC 6662(d)(2)(B) reduces the understatement by the portion attributable to (i) any item for which there is or was substantial authority, or (ii) any item whose relevant facts were adequately disclosed on the return or an attached statement and that has a reasonable basis. Disclosure is often made on Form 8275. The reduction does not apply to tax shelter items under 6662(d)(2)(C).

Do the reduction before the threshold test. Sometimes one well-supported position is enough to drop the whole understatement under the line.

One penalty, not several

If the same dollars are both negligent and part of a substantial understatement, you do not pay 40 percent. The accuracy-related penalty is one penalty with several grounds. Under Treas. Reg. 1.6662-2(c), the maximum on any portion of an underpayment is 20 percent, or 40 percent where a gross valuation misstatement or other 40 percent ground applies.

Interest on the penalty starts early

Most penalties do not draw interest until the IRS bills them. The accuracy-related penalty is an exception. IRC 6601(e)(2)(B) says interest on additions to tax under part II of subchapter A of chapter 68, which includes section 6662, runs from the due date of the return, including extensions, until paid. See interest on penalties.

Add that to interest on the underlying $12,000 of tax, also from April 15, 2025, and an audit two years after filing carries a lot of back interest. The daily compounding guide shows the method.

Defenses that change the math

Beyond the threshold and the reductions, IRC 6664(c) excuses any portion of an underpayment where the taxpayer shows reasonable cause and good faith. IRC 6751(b) requires written supervisory approval of the initial penalty determination for many penalties, including this one. Those are legal defenses rather than arithmetic, and they belong in the audit or appeal, before the penalty is assessed. See IRS Appeals: How to Challenge a Decision.

Checklist

1. Compute the understatement: tax required to be shown minus tax shown.
2. Subtract any portion supported by substantial authority, or adequately disclosed with a reasonable basis.
3. Compute the threshold for your taxpayer type, using 5% if you claimed a 199A deduction.
4. If the reduced understatement exceeds the threshold, the penalty is 20% of it. If not, the IRS needs the negligence ground or another ground.
5. Add interest from the return due date.

Worked example: two items, one disclosed

Most audits produce more than one adjustment, and the reduction rules apply item by item. Say an individual's tax required to be shown after audit is $150,000 and the understatement is $30,000. Of that, $18,000 comes from unreported consulting income with no authority behind the omission. The other $12,000 comes from a deduction the taxpayer disclosed on Form 8275 and that had a reasonable basis.

Under IRC 6662(d)(2)(B)(ii), the disclosed item comes out of the understatement, leaving $18,000. The threshold is the greater of 10 percent of $150,000 or $5,000, which is $15,000. The reduced understatement still exceeds it, so the substantial understatement penalty applies to the $18,000 portion: 20 percent, or $3,600. The disclosed $12,000 does not carry the substantial understatement penalty. Had the unreported income been $14,000 instead, the reduced understatement would have fallen below $15,000 and the substantial understatement ground would have failed entirely.

Worked example: the negligence ground on a small adjustment

Now an understatement of $4,500 from a missed Form 1099-NEC. That is under the $5,000 floor, so it cannot be a substantial understatement for an individual. The IRS can still assert the penalty on the negligence ground under IRC 6662(b)(1) if the facts show no reasonable attempt to comply, such as ignoring an information return that was mailed to the taxpayer. If it does, the penalty is 20 percent of the portion attributable to negligence, or $900. The arithmetic is the same; the burden is different, because negligence is a factual finding rather than a threshold test.

The corporate threshold in numbers

For a C corporation, IRC 6662(d)(1)(B) uses the lesser of 10 percent of the tax required to be shown (or $10,000 if greater) or $10,000,000. A corporation with $50,000,000 of tax required to be shown has a threshold of $5,000,000, because 10 percent is less than the cap. A corporation with $200,000,000 of tax has a threshold of $10,000,000, because the cap is less than 10 percent. Very large corporations hit the fixed dollar cap long before they hit the percentage.

Reading the penalty on an audit report

Examination reports usually show the accuracy-related penalty as a separate line, with the ground asserted and the underpayment it applies to. Check three things. First, whether the base is the full underpayment or only a portion; items with substantial authority or adequate disclosure should be carved out before the 20 percent is applied. Second, whether the threshold was computed with the right percentage: 10 percent generally, 5 percent if any section 199A deduction was claimed. Third, whether the penalty was asserted on more than one ground for the same dollars, which should never produce more than 20 percent on any portion under Treas. Reg. 1.6662-2(c).

Then check the interest. Because IRC 6601(e)(2)(B) runs interest on this penalty from the return due date, including extensions, a three-year-old return can carry a penalty whose interest is already more than 15 percent of the penalty itself. If the penalty comes off on appeal, that interest comes off with it.

The bottom line

The accuracy-related penalty is 20 percent, but the substantial understatement version only applies when the understatement clears a specific bar. Run the threshold test before you accept the penalty. If the numbers are close, the reductions and defenses decide it, and that is worth a professional look.