In the case that a substantial understatement of income tax is evident on a tax return, a 20% penalty will be imposed according to IRC Sec. 6662(b)(2). There are however, a few defenses that can be used against the 20% penalty, these defenses include:
1. Insubstantial understatement defense
2. Substantial authority defense
3. Adequate disclosure defense
4. Reasonable cause/good faith defense
In most cases, the best defense in the disclosure defense. In order to use the disclosure defense, the disclosure must be sufficient enough to avoid both the substantial understatement penalty and the disregard penalty. The disclosure defense does not apply to the negligence penalty or tax shelter items.
Other Substantial Understatement Defenses
There are a few other defenses that can be used against the substantial understatement penalty, these include:
1. Expiration of the three/six year statute of limitations on assessment
2. Innocent spouse relief
3. In some cases, if the penalty has been assessed, abatement can be requested
As you can see, there are many defenses for an honest professional to use in the case of a substantial understatement of income tax on a tax return. These defenses should be used with adequate proof and an ability to convey the proof in the correct way.