Suppose you forget to report a W-2, 1099-MISC, 1099-R, etc that has federal tax withheld. The IRS imposes the IRC 6662 penalty.
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(a) Imposition of penalty If this section applies to any portion of an underpayment of tax required to be shown on a return, there shall be added to the tax an amount equal to 20 percent of the portion of the underpayment to which this section applies.
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penalty 20% of the increase in tax, but they didn't consider the federal tax withheld, or the itemized deduction from state tax withheld. In other words, the income of the missing form results in an increase of the tax of say $10,000 (because income is higher so tax is naturally higher, but credits etc are phased out more too because of increased AGI). It looks like the penalty is then $2,000. However the form also had federal and state tax withheld. In fact, if 10k federal were withheld then I think the penalty should be 20% of $0 or $0 -- and after you consider deduction for state taxes paid the federal tax is lowered further.
So who's right?