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Underreported income, part 2: Are you at risk for a tax penalty?

In the first part of this post, we noted that the IRS uses a computer program that tries to detect the underreporting of income. The Automated Underreporter Program (AUR) seeks to identify discrepancies between the income you have reported on your tax return and income reflected in reports from third parties such as banks and employers.

Given the IRS's limited resources, only about 1 in 5 of the returns with these discrepancies is reviewed by a human being. This means that in most cases a CP2000 Notice asking for more information is generated without a human signing off on it.

Receiving such a notice does not mean have been accused of willful tax evasion. But when are you at risk of a civil tax penalty for substantial or negligent underreporting?

We will discuss this question in the context of a recent report by the Treasury Inspector General for Tax Administration (TIGTA) on tax penalties for underreporting income.

The penalty for negligently underreporting your income is 20 percent. There is no exact percentage of underreporting that triggers this penalty.

But there is such a threshold for "substantial" understatement of taxable income. If you underreported your income such that you understated your tax liability by 10 percent or more, the penalty is 20 percent.

TIGTA found that IRS auditors working in the AUR program were often quick to waive penalties for substantial understatement or for negligent understatement. TIGTA suggested that the IRS could be more assertive with these penalties.

In its response to TIGTA's report, the IRS defended its policy of frequently waiving tax penalties for small accuracy-related errors.

To answer our original question, then, it is clear that a negligent or substantial underreporting of income puts you at risk of a tax penalty. But you may be able to avoid any penalty by showing the IRS you had reasonable cause for the error.

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