When a crypto client first sees an IRS computation, the reaction is usually the same: how can there be this many penalties? Sometimes the answer is that the computation is right. Sometimes it is that the Code does not allow some of those penalties to apply to the same dollars, and someone needs to say so.

Here is how the main penalties in crypto cases fit together.

The players

Five provisions show up in most crypto penalty computations.

  • Failure to file, IRC 6651(a)(1): 5 percent per month or fraction, up to 25 percent of the net tax required to be shown.
  • Failure to pay tax shown on the return, IRC 6651(a)(2): 0.5 percent per month or fraction, up to 25 percent.
  • Failure to pay tax after notice and demand, IRC 6651(a)(3): 0.5 percent per month or fraction, up to 25 percent, on tax not shown on the return and not paid within 21 calendar days of notice and demand (10 business days if the amount is $100,000 or more).
  • Accuracy-related penalty, IRC 6662: 20 percent of the portion of an underpayment attributable to negligence, substantial understatement or another listed ground.
  • Civil fraud penalty, IRC 6663: 75 percent of the portion of an underpayment attributable to fraud. For non-filers, the fraud version is IRC 6651(f), which raises the failure to file rate to 15 percent a month and the cap to 75 percent.

Rule 1: fraud and accuracy cannot share the same dollars

The last part of IRC 6662(b) says the accuracy penalty “shall not apply to any portion of an underpayment on which a penalty is imposed under section 6663.” For a given portion, it is 20 percent or 75 percent, not both.

That is why the IRS often asserts fraud and, in the alternative, the accuracy penalty. If the fraud finding fails for a portion, the 20 percent penalty may still apply to it.

Rule 2: no accuracy or fraud penalty on an IRS-prepared return

IRC 6664(b) says the penalties in this part, which include 6662 and 6663, “shall apply only in cases where a return of tax is filed (other than a return prepared by the Secretary under the authority of section 6020(b)).”

So for a true non-filer whose return the IRS prepared, the 20 percent and 75 percent underpayment penalties do not apply. The 6651 additions do, including 6651(f) if the failure to file was fraudulent. See the fraudulent failure to file penalty.

Rule 3: failure to file and failure to pay overlap is reduced

IRC 6651(c)(1) says the failure to file addition under (a)(1) is reduced by the failure to pay addition under (a)(2) for any month to which both apply. The two do not run at their full rates in parallel for the same month. The statute keeps the minimum failure to file addition for returns more than 60 days late from being reduced below its floor.

Rule 4: the IRS-prepared return counts for failure to pay

IRC 6651(g) says a return made by the IRS under 6020(b) is disregarded for computing the failure to file addition but treated as the return filed by the taxpayer for the failure to pay additions. A substitute return can start failure to pay accruals even though it does not count as your filed return for 6651(a)(1).

Rule 5: payment plans and levy notices change the pay rate

Two adjustments to the failure to pay rate matter once a crypto liability is assessed.

  • Installment agreement. IRC 6651(h) reduces the failure to pay rate under (a)(2) and (a)(3) to 0.25 percent for any month an installment agreement under IRC 6159 is in effect, for an individual who filed the return on or before the due date including extensions.
  • Levy notice. IRC 6651(d) increases the rate to 1 percent for months beginning after the earlier of 10 days after notice of intent to levy under IRC 6331(d), or the day notice and demand for immediate payment is given under the last sentence of IRC 6331(a).

The installment agreement reduction requires a timely filed return. That is one more reason to file crypto years on time even when you cannot pay.

A checklist for reviewing an IRS penalty computation

When a crypto client brings me an examination report, a CP2000 or a notice of deficiency, I run through these questions before arguing anything on the merits.

  • Is the underlying tax right? Every penalty is computed from it, so every basis correction flows through.
  • Is any portion hit with both the 20 percent and the 75 percent penalty? IRC 6662(b) forbids that.
  • Was the return filed by me or prepared by the IRS under IRC 6020(b)? If the latter, IRC 6664(b) takes the 6662 and 6663 penalties off the table.
  • For each month, are failure to file and failure to pay additions coordinated under IRC 6651(c)(1)?
  • Was an installment agreement in effect for any months, and was the return timely, so that IRC 6651(h) applies?
  • For 6662 and 6663, was timely written supervisory approval obtained under IRC 6751(b)?
  • Is there a reasonable cause defense for any portion or any addition?

Each yes or no either confirms the computation or moves money. In my experience the first question, whether the tax is right, moves the most.

Do the review in writing and keep it. If the case goes to Appeals or Tax Court, the same list becomes the outline of your penalty argument. See appealing a crypto audit.

A worked example

Take a taxpayer who filed on time, reported wages, and left off $90,000 of crypto gains, producing a $20,000 underpayment. The IRS asserts the 75 percent fraud penalty on the whole underpayment and, in the alternative, the 20 percent accuracy penalty.

If the IRS proves fraud by clear and convincing evidence, the fraud penalty is $15,000, and under IRC 6662(b) there is no accuracy penalty on the same dollars. If the IRS fails to prove fraud, the fraud penalty falls away and the alternative 20 percent penalty, $4,000, is tested on its own merits, including reasonable cause and supervisory approval.

Either way, the taxpayer also owes the $20,000 of tax and interest, and possibly a failure to pay addition under IRC 6651(a)(3) if the assessed amount is not paid after notice and demand. These are illustrations of how the statutes interact, not computations for any real case.

Interest is separate

Interest is a separate charge from everything on this page. The reasonable cause language in IRC 6651 and IRC 6664(c) is written for additions to tax and penalties, so a winning penalty defense does not by itself remove interest on the tax. The practical effect is simple: the longer a crypto liability sits unresolved, the more it costs, whatever happens to the penalties.

Putting it together: three crypto patterns

Here is how the rules typically sort out.

  • Filed on time, left off crypto gains, no fraud. Tax, interest, and possibly the 20 percent accuracy penalty. Possibly failure to pay under (a)(3) if the assessed amount is not paid after notice and demand. Defenses: basis, reasonable cause, supervisory approval. See the accuracy penalty.
  • Filed on time, intentionally omitted crypto. Tax, interest, and the IRS may assert the 75 percent fraud penalty with the 20 percent penalty in the alternative, plus an unlimited assessment period under IRC 6501(c)(1). See the fraud penalty.
  • Never filed. If the IRS prepares the return, 6651 additions for failure to file and pay, potentially 6651(f) if fraudulent, and no 6662 or 6663 under 6664(b). If you file late yourself, the 6651 additions still apply to the late period, and 6662 or 6663 could apply to any underpayment on the return you file.

The bottom line

Do not accept a penalty computation at face value. Check which penalties can legally apply to which dollars, whether the IRS has met its approval and proof requirements, and whether reasonable cause applies. Then check the arithmetic. In crypto cases, I find something to fix more often than not.