(1) A taxpayer who substantially understates tax due is subject to a substantial understatement of tax penalty in an amount equal to 20 percent of the understatement.

(2) For individuals, estates, and trusts, the penalty does not apply to understatements of tax that are less than or equal to $3,000. For understatements larger than $3,000, the penalty applies when the understatement exceeds the greater of:

(a) 10 percent of the tax the taxpayer is required to show on the return; or

(b) $3,000. 

(3) Examples of how the substantial underpayment penalty is calculated for individual, estate, and trust taxpayers are as follows:

(a) A taxpayer reports $2,000 of tax on their original return; however, the taxpayer was required to report $6,000. The taxpayer understated their tax by $4,000. To determine whether the taxpayer's understatement was substantial, the understatement has to exceed the greater of $3,000, or 10 percent of the tax required to be paid. Because the understated amount of $4,000 exceeds both $3,000 and 10 percent of the required tax to be paid ($6,000 x 10 percent is $600) the substantial understatement penalty applies. The taxpayer would be assessed a penalty of $800 (20 percent of $4,000).

(b) A taxpayer reports $3,500 of tax on their original return, however, the taxpayer was required to report $6,000 of tax. The taxpayer understated their tax by $2,500. The understatement does not exceed $3,000. As a result, the taxpayer is not subject to the penalty.

(4) For taxpayers, other than individuals, estates, and trusts, the penalty does not apply to understatements that are less than or equal to $10,000. For understatements greater than $10,000, the penalty applies when the understatement of tax exceeds the lesser of:

(a) 10 percent of the tax required to be shown on the return; or

(b) $500,000.

(5) Examples of how the substantial underpayment penalty is calculated for taxpayers other than individuals are as follows:

(a) A corporate taxpayer reports $5,500,000 of tax on their original return; however, the taxpayer was required to report $6,250,000 of tax. The taxpayer understated its tax by $750,000. Because $500,000 is less than 10 percent of the tax required to be shown on the return ($625,000), $500,000 is used to determine whether the taxpayer substantially understated its tax. Here, the taxpayer substantially understated its tax ($750,000 is greater than $500,000) and is assessed a $150,000 penalty ($750,000 x 20 percent).

(b) A corporate taxpayer reports $750,000 of tax on their original return; however, the taxpayer was required to report $1,000,000 of tax. The taxpayer understated its tax by $250,000. Because $100,000 (10 percent of the tax required to be shown on the return) is less than $500,000, $100,000 is used to determine whether the taxpayer substantially understated its tax. Here, the taxpayer substantially understated its tax ($250,000 is greater than $100,000) and is assessed a $50,000 penalty ($250,000 x 20 percent).

(c) A corporate taxpayer reports $901,000 of tax on their original return; however, the taxpayer was required to report $1,000,000 of tax. The taxpayer understated its tax by $99,000. Because $100,000 (10 percent of the tax required to be shown on the return) is less than $500,000, $100,000 is used to determine whether the taxpayer substantially understated its tax. The taxpayer did not substantially understate its tax because its understatement is less than $100,000. The taxpayer is not subject to the penalty.

(d) A corporate taxpayer reports $991,000 of tax on their original return; however, the taxpayer was required to report $1,000,000 of tax. The taxpayer understated its tax by $9,000. Since the understatement does not exceed $10,000, the taxpayer is not subject to the penalty.

(6) The burden of proof is on the taxpayer to establish the existence of substantial authority or a reasonable basis for the tax treatment of an item taken on the return.

(7) For the purposes of determining a reduced penalty, the penalty is first calculated based on the understatement as a whole. Reductions are separately calculated by item and then subtracted from the penalty. For example:

 

 

Understatement subject to penalty	$ 11,000
Substantial understatement penalty before reduction	$ 2,200
Penalty reduction	$ (500)
Total substantial understatement penalty	$ 1,700

 

(8) For the purposes of this rule, the following definitions apply:

(a) "Adequate disclosure" means a clear and comprehensive disclosure through statements, footnotes and/or supplemental schedules, which provides a comprehensive and clear description of the taxpayer's position.

(b) "Reasonable basis" means a well-reasoned construction of applicable statutory provisions and/or rules that provide substantial authority applied in good faith to support the taxpayer's position.

(c) "Substantial authority" means an objective standard that is more stringent than the reasonable basis standard, where the weight of the authorities' supporting treatment is substantial in relation to the weight of the authorities' supporting contrary treatment.