Tax Brake with Robert G. Nath, Esq.

The penalty involved is the "substantial understatement" penalty. This is a 20% penalty if you substantially understate the true amount you owe. An example could be overstating a medical deduction (which results in lower taxable income), or claiming a casualty loss (storm, fire, etc.) when you were not entitled. It’s the IRS that will tell you the deduction was wrong; it’s you who will tell the IRS you should not be penalized for this penalty because you made "adequate disclosure."

BIG CAVEAT: The substantial understatement penalty is the only penalty excused. The IRS can still assert others, such as negligence or "substantial disregard" of IRS rules, or even fraud. So what good does the excusal do? That’s questionable in the real world, since the IRS will often assert negligence simply because you made an error.

What’s "adequate" disclosure. It’s done two ways. First, there is a safe harbor: If you report certain expenses "in a clear manner and in accordance" with instructions, and the money amounts are "verifiable" on the IRS’ forms, that’s adequate disclosure. The "safe harbor" expenses are the most common types: medical and dental expenses, taxes, interest expense, contributions, moving expenses, employee business expenses, investment credit, casualty and theft losses, certain trade or business expenses, legal expenses (whew!), and others.

If it’s not one of these, you MUST file Form 8275, an IRS disclosure statement, to obtain penalty "insurance." Many people ask whether flagging an issue in this way attracts the IRS’ interest. The official answer is no, and experience in fact agrees that using Form 8275 does not alert the IRS any more than other scoring the IRS may do to your tax return.

So if you want to avoid some IRS penalties, consider telling Uncle, but in an "official" way.

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