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How to Avoid IRS Audit Penalties

Anyone who has undergone an IRS audit can tell you how painful the IRS makes the examination process.  If the taxes and interest due after an audit are not bad enough, increasingly, the IRS has been piling on additional 20% penalties.  What are these penalties and how are taxpayers fighting back?

Internal Revenue Code § 6662 provides for an accuracy-related penalty of 20% of the additional tax due on a return in cases where the tax due is from a substantial understatement of income tax (defined as 10% of the tax required to be shown on the return or $5,000), or negligence, or disregard of the tax rules. Internal Revenue Code § 6662 contains exceptions to this penalty if the taxpayer reasonably relied upon the advice of a tax professional.

In addition to these statutory exceptions, taxpayers and their attorneys have been creating new avenues to avoid IRS accuracy-related penalties through Tax Court litigation. Most recently, in a case known as Graev III, the Tax Court held that all auditors must obtain prior written approval from their manager in order to assert an accuracy penalty in an audit. Prior to this ruling, many auditors were simply asserting accuracy-related penalties in all of their cases, instead of applying them on a case by case basis and only after careful consideration of the facts.  The Tax Court ruled that this IRS audit practice is not permitted.

So where does that leave a taxpayer in an audit? In our experience, IRS auditors are still asserting accuracy-related penalties without prior written approval from their managers because most taxpayers do not know their rights.  This is just one more reason it is extremely important to have a seasoned tax professional on your side who knows the rules and will hold the IRS accountable.