Earlier this week the U.S. Tax Court issued a court-reviewed opinion finding that the IRS has been improperly calculating accuracy-related penalties in certain cases involving refundable credits (i.e., the earned income credit, the additional child tax credit, and the recovery rebate credit). Rand v. Commissioner, 141 T.C. No. 12.

In Rand, the taxpayers reported wage and self-employment income in the total amount of $18,148, which income was reduced to zero by way of the standard deduction and personal exemption deduction. This resulted in zero taxable income and zero tax on line 44 of the taxpayers’ Form 1040 (U.S. Individual Income Tax Return), leaving the taxpayers with a small self-employment tax of $144. The taxpayers reduced the self-employment tax with the earned income credit, the additional child tax credit, and the recovery rebate credit, and received a refund of $7,327.

The IRS audited the taxpayers and proposed to disallow to the refundable credits, and proposed an accuracy-related penalty under I.R.C. sec. 6662(a). After the case was brought before the Tax Court, the only issue remaining in dispute was the correct calculation of the penalty. The parties all agreed that the taxpayers were not entitled to the $7,327 refund that they had received. The IRS believed that, for purposes of calculating the 20% penalty, the “underpayment” of tax should include the $7,327, which was attributable to the refundable credits, in addition to the $144 of self-employment tax.

The Court rejected the IRS position, instead finding that in this case the 20% penalty was to be calculated only based upon the $144 in self-employment tax, resulting in a penalty of $29. Taxpayers and practitioners who receive audit computations from the IRS in cases involving refundable credits should closely review them to ensure that the penalty is properly computed in accordance with Rand.