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Underreported income, part 2: penalties and possible prosecution

In the first part of this post, we discussed the scenario of getting a computer-generated notice informing you that the IRS is proposing changes to your return. This can happen when the income you reported doesn't match information the IRS has received about your income from employers, banks or other third parties.

In this part of the post, we'll follow up with two points, one on tax penalties and one on possible criminal prosecution.

Two types of penalties

Let's start with tax penalties. If the IRS determines that you underreported your income, there are two types of tax penalties that can apply. One is the negligence penalty. The other is the penalty for substantial understatement of your tax liability.

"Substantial" understatement is defined as understating your tax liability by at least 10 percent. "Negligent" understatement does not involve a set percentage, but refers to disregarding applicable rules.

Both penalties are for 20 percent of the underpayment of tax resulting from the underreporting of income. And they aren't "stackable," which means the IRS cannot hit you with both of them, even if the underreporting was more than 10 percent.

The IRS is supposed to waive these penalties, however, if you have reasonable cause. If you made a few small, unintentional errors, there is a strong argument for getting a break on the penalties.

If you did underreport your income by a substantial amount, the issues of course become more difficult. Was the underreporting the result of a good faith mistake, for which the IRS can waive any tax penalties. Or was the underreporting the result of willful tax evasion?

When authorities allege underreporting is "willful"

It is of course another situation entirely when underreporting income involves allegations of willful tax evasion.

For example, in a current case in Minnesota, prosecutors have charged a former corporate executive with filing a false tax return that fraudulently underreported income. The case concerns the former chief operating officer for an affiliate of Starkey Laboratories, one of the nation's biggest hearing-aid companies.

Prosecutors contend that the underreported income was in the form of golf membership fees paid by equipment suppliers. The Starkey case also involves felony tax evasion charges against others at the company, as well as other charges.

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