What is the penalty for a substantial understatement?

The penalty for a substantial understatement of income tax is 20% of the underpayment. This penalty applies when a taxpayer fails to report income or exceeds the proper amount in deductions, resulting in an understatement of tax. The IRS defines a substantial understatement as an amount that exceeds a specific percentage of the tax required to be shown on the return or a specific dollar amount, whichever is greater.

This penalty is designed to encourage accurate reporting of income and deductions. It targets taxpayers who should be aware that they are not complying with tax laws, thereby incentivizing them to approach their filings with greater diligence. It also serves as a deterrent against willful noncompliance or negligence.

The percentages cited in the other options do not align with IRS regulations on substantial understatements, as a 5% or 10% penalty would not appropriately address the severity of failures in reporting tax liability accurately according to the IRS guidelines.