Substantial Understatement Penalty refers to a penalty imposed by the Internal Revenue Service (IRS) on taxpayers who underreport their taxable income significantly.
A substantial understatement occurs when the amount of tax reported is less than 75% of the correct tax liability. This penalty is typically 20% of the underpayment attributable to the substantial understatement.
For example, if a taxpayer’s correct tax liability is $10,000 but only reports $5,000, they have substantially understated their income, resulting in a potential penalty of $1,000 on the amount underreported (20% of the $5,000 understatement). Taxpayers may avoid this penalty if they can demonstrate reasonable cause for the understatement or if they meet certain conditions, such as adequately disclosing the relevant facts on their tax return.
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