IRS and outrageous penalties?

Could be all sorts of reasons, including penalties.

Another is that they may be assuming a zero cost basis. If so he should indeed contest that part.

Had this happen to me last year. Said I owed 50k because I did not file my trades. When fidelity reported all of my trades it looked like I sold a bunch of stock in the amount of around 180k or so. But they do not take into account all of the buys and whether it was a loss or a gain. All he has to do is fill out a schedule D form with all of the buys and sells submit and they will adjust. I ended up oweing 600 bucks. Its a pain in the arse though.

Blame Congress, not the IRS, for penalties and interest.

But, like previous posters have stated, the IRS just got an information return showing what he collected. They have no information in basis. So, given that your friend did not file a Sch. D, what else would you like to the IRS to do ... just make up a basis using a psychic? They gave him a zero basis. Now, he'll have to go to them and show them his basis.

Also, I'd bet that they didn't give him the capital gains rates as there is no way of telling his holding period.

So, for IRS computational purposes, the entire amount is being taxed, and it's being taxed at his marginal rate. There's pretty much nothing else the IRS could do. It's your friend's fault.

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he didn't report his stock investments and earnings from them. Said he earned about 5k last year, but the letter said they're looking as far back as 2010. So let's assume that he earned about 10k in those two years. At 15%, that should be around $1500 dollars right?

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If your friend did not report the gains/losses from stock transactions, then the IRS simply took the amounts of sales proceeds reported to them on Form 1099-B and treated them as short-term gains. The IRS didn't just make up a number. It took the information it had that was not on the tax return and added that information to see what the result would be.

Your friend can file an amended return that reports the proceeds from his stock transactions as well as the purchase prices. This should reduce the amount of gain to the 5K range you mentioned. The tax impact will depend on whether the gains were long-term or short-term.

Your friend could also see the penalties go down significantly if the IRS is assessing penalties for substantial understatement of income, and the changes get him out of that situation.

Those numskulls sent me a letter a couple years ago charging me interest and telling me I failed to pay. Of course this was on a Saturday, so I let it stew all weekend, and unleashed holy hell on the poor agent I spoke with on the phone the following Monday.

Turns out they mispelled my name and my payment didn't go to the correct place in their system.