Yes, the auditor can assess those penalties (and any other they feel may be applicable). You can also appeal. The auditor is not the decision maker, the tax court is. As my colleagues have noted, this can often be abated.
Evan A. Nielsen is licensed to practice law in California and handles federal tax matters throughout the U.S. The information provided here is for educational purposes only and is not intended as legal advice for a particular matter. This response does not create any attorney-client relationship with the author. For specific advice about your particular situation, please consult an attorney.
This is an issue of record keeping - an obligation the taxpayer must comply with in order to substantiate a deduction. "Fraud" penalty is possible....What % is the penalty and what amount of deduction was denied?