Franchise Tax Board Penalties: Accuracy-Related Penalties, Part III: Substantial Misstatements

We continue our discussion of Franchise Tax Board (FTB) accuracy-related penalties with penalties relating to substantial understatements or misstatements of income and asset values.

Substantial understatement of income tax obligations

Individual taxpayers who understate their tax liabilities by more than 10% of the correct amount or $5,000, may be subject to an accuracy-related penalty for a substantial understatement of income tax obligations. The threshold for corporations (other than S corporations) is the lesser of 10% of the tax required to be shown on the return (or $2,500, whichever is greater), or $5 million.

Under IRC Section 6662(e)(1) and California Revenue and Taxation Code (R&TC) Section 19164.5, a “substantial misstatement” is:

  • Where the value or adjusted basis of an asset has been misstated by 150% or more of the correct amount.
  • Where the price of a transaction (property or services) claimed on a return is 200% or more (or 50% or less) of the correct amount.
  • Where the increase in a net section 482 (transfer price) adjustment exceeds $5 million or 10% of gross receipts (whichever is less).

The penalty is currently 20% of the portion of the underpayment of tax attributable to the misstatement on the tax return.

Gross valuation misstatements

Note that the penalty increases to 40% of the underpayment amount under IRC Section 6662(h) and R&TC Section 19774 if there is a “gross valuation misstatement”, which is:

  • Where the value or adjusted basis of an asset has been misstated by 200% or more of the correct amount.
  • Where the price of a transaction (property or services) claimed on a return is 400% or more (or 25% or less) of the correct amount.
  • Where the increase in a net section 482 (transfer price) adjustment exceeds $20 million or 20% of gross receipts (whichever is less).

There is no penalty if the underpayment is less than $5,000 ($10,000 for corporations other than S corporations and personal holding companies).

How to get these penalties abated

Substantial misstatement and gross valuation misstatement penalties may be abated if you can show reasonable cause and good faith. That is generally accomplished by showing that you relied on substantial authority and the method you used to value the asset was reasonable and in accordance with standard pricing methodology. (e.g., for real estate or estate valuations, you used a qualified, independent appraiser with good credentials).

Keep good books and records, calculate your taxes correctly, be able to substantiate claims on your returns, and you are unlikely to have to pay an accuracy-related penalty. For high quality tax law assistance, contact our San Francisco offices.

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