The Internal Revenue Service doesn’t have the resources to verify every deduction reported on the tax returns it receives, and as a result, there are opportunities for taxpayers to increase their tax savings with false deductions. Honest mistakes happen, but for situations where taxpayers intentionally evade taxes or negligently disregard the laws when reporting deductions, the tax code has some stiff penalties in place to punish those who take advantage and deter others from doing the same thing.
If you take a deduction that you’re not entitled to claim and it causes you to substantially underpay your income taxes; the IRS will increase the amount you owe by 20 percent of the underpayment. For individuals, an underpayment is considered substantial if it’s more than the larger of 10 percent of the correct amount of tax that an accurate return would’ve reported or $5,000. One way to avoid this penalty when reporting a questionable deduction, but for which there is substantial legal authority that gives you a reasonable basis for taking it, is to disclose your position on Form 8275 and attach it to your return. If the IRS ultimately disallows the deduction at some point, you’re still responsible for the underpayment, but at least you can avoid having it increased by 20 percent.
Negligence or Disregard
A 20-percent penalty may apply to any tax underpayment that’s the result of reporting a false deduction or other incorrect tax item if it’s due to your negligence or disregard of the tax law. Regardless of the amount of your underpayment, the penalty may be imposed when you fail to make reasonable attempts to comply with the tax code, don’t exercise ordinary and reasonable care when preparing your tax return or fail to keep accurate records that support your return. However, if you make a mistake with any of your deductions but your tax return was prepared in good faith, the penalty may not apply. In addition, convincing the IRS that there was reasonable cause for taking the false deduction can eliminate penalty charges.
Gross Valuation Misstatements
Some deductions, such as the charitable deduction for property donations, use estimated property values as the deduction amount. Therefore, if you overestimate a property’s value, your deduction will be higher than it should be. Your valuation estimate doesn’t have to be perfect to the penny, but if it’s 150 percent or more than the property’s true value and it causes you to underpay your taxes by more than $5,000 -- the underpayment is the result of a gross valuation misstatement and will be increased by 20 percent. If, however, a property’s value is reported at 200 percent or more of its actual value, the penalty increases to 40 percent.
Additional Interest Charges
It is standard practice for the IRS to charge taxpayers interest for as long as their taxes remain unpaid. However, if you’re charged a penalty related to taking a false deduction, you should also keep in mind that interest will accrue on penalty charges in addition to the tax underpayment you owe.
Jeff Franco's professional writing career began in 2010. With expertise in federal taxation, law and accounting, he has published articles in various online publications. Franco holds a Master of Business Administration in accounting and a Master of Science in taxation from Fordham University. He also holds a Juris Doctor from Brooklyn Law School.