IRS Audit Penalties: What They Are and How to Fight Them

When an IRS audit ends with adjustments, the bill is rarely just the additional tax. Penalties and interest stack on top — and in many cases the penalties exceed the original tax. Understanding which penalties the IRS can assess (and how to fight each one) is essential to limiting your exposure.

Accuracy-related penalty — 20%

Under IRC § 6662, the accuracy-related penalty is 20% of the underpayment. The IRS most commonly asserts it on one of three grounds: negligence, substantial understatement of income tax, or substantial valuation misstatement. The substantial-understatement threshold is the greater of 10% of the tax required to be shown on the return or $5,000 (different rules apply to corporations).

The most effective defense is reasonable cause and good faith under IRC § 6664(c). Reliance on a qualified tax professional — if you disclosed all relevant facts and reasonably relied on the advice — is the classic example.

Substantial-valuation-misstatement penalty — 20% or 40%

If a property valuation on the return is 150% or more of the correct value, the 20% penalty applies. At 200% or more, the penalty doubles to 40%. This is the IRS’s primary weapon against syndicated conservation easement claims and aggressive cost-segregation positions.

Civil fraud penalty — 75%

The civil fraud penalty under § 6663 is 75% of the underpayment attributable to fraud. The IRS bears the burden of proving fraud by clear and convincing evidence — a much higher bar than the negligence standard. Indicators include consistent underreporting over multiple years, false documents, and concealment of assets. Fraud is also the only deficiency that has no statute of limitations.

Failure-to-file and failure-to-pay penalties

The failure-to-file penalty is 5% of the unpaid tax per month, capped at 25%. The failure-to-pay penalty is 0.5% per month, also capped at 25%. When both apply in the same month, the failure-to-file penalty is reduced by the failure-to-pay amount, so combined they max out at 5% per month.

If you’re more than 60 days late filing, the minimum failure-to-file penalty kicks in (currently the lesser of $485 or 100% of the tax due — indexed for inflation).

Information-return penalties

Failing to file required information returns (1099, W-2, K-1, FBAR, Forms 5471/8938/3520) carries its own penalty regime. International information-return penalties under §§ 6038 and 6038A can run $10,000 per form per year, with continuation penalties if not corrected.

Trust fund recovery penalty (TFRP)

For businesses that don’t remit withheld payroll taxes, the IRS can assess the trust fund portion personally against any “responsible person” who willfully failed to pay. The penalty equals 100% of the unpaid trust fund taxes — and follows the individual personally, even if the business closes.

Interest

Interest is not technically a penalty, but it functions like one. It runs from the original return due date until the tax is paid — at the federal short-term rate plus 3% (compounded daily). Over a multi-year audit cycle, interest alone can rival the original tax.

How to fight penalties

Three lines of defense are worth knowing:

1. Reasonable cause — documented reliance on a tax professional, serious illness, natural disaster, or other circumstances beyond your control.
2. First-time abatement (FTA) — administrative relief available if you have a clean compliance history for the prior three years. Available for failure-to-file, failure-to-pay, and failure-to-deposit penalties.
3. Procedural challenges — the IRS must obtain written supervisory approval before assessing certain penalties under § 6751(b). Procedural defects can defeat a penalty entirely.

If the auditor proposes penalties at the close of an audit, that is the moment to challenge them — before the case goes to Appeals or to assessment. For more on the audit process generally, see What Happens During an IRS Audit and How to Appeal an IRS Audit.