Penalties

Pursuant to the Internal Revenue Code (IRC), the IRS can assess penalties for failure to file a tax return timely, failure to pay the tax liability when due (normally, the due date for the return, a deposit due date for employment taxes, and other situations), for filing an inaccurate return (accuracy related penalty), of for a fraudulent return (IRC 6663 - intentional underreporting of income or overstating expenses).  There are numerous penalties that Congress defined in the IRC that can be assessed.  This page will discuss the most common types of penalties.

Generally, a penalty that is assessed can be abated (removed) if reasonable cause can be established as the cause of the non-compliance.  Proving reasonable cause can be very challenging.  Therefore, a tax professional should be retained to maximize the probability of relief from penalties.

A NOTE FOR PREPARERS:  If your client is being assessed a penalty based upon YOUR mistake, it may be wise for you to retain another tax professional to represent your client.  This representative can more effectively argue detrimental reliance by your client on your professional services and advice.   If you attempt on your own to get the penalty abated because of your mistake, the IRS may view your efforts as self-serving and not seriously consider the facts and circumstances.  Getting your client relieved of the penalty will generally reduce the potential out-of-pocket cost to you for your mistake (or preclude you from having to file a claim with your professional liability company to reimburse the client). 

Failure to File Penalty. This is calculated based on the time from the deadline of your tax return (including extensions) to the date you actually filed your tax return. The penalty is 5% for each month the tax return is late, up to a total maximum penalty of 25%. The percentage is of the tax due as shown on the tax return.  NOTE:  If the Failure to Pay penalty is also being assessed, then the Failure to File penalty is reduced to 4.5% for each month the Failure to Pay applies as well.  In other words, the MAXIMUM combined Failure to File and Failure to Pay penalties is 5% per month. 

Failure to Pay Penalty. This is calculated based on the amount of tax you owe. The penalty is 0.5% for each month the tax is not paid in full.  The penalty runs for 48 months maximum (from the due date of the return).

Estimated Tax Penalty.  There is an estimated tax penalty that has to be paid if you underpay your estimated tax. This penalty is in the form of interest on the underpayment for the period the underpayment took place. Each payment incurs different penalties; so you may have to pay tax penalties on an earlier payment even if you had paid enough to cover the underpayment prior to that. In fact, if you don't pay sufficient tax by the due date of each payment period, you may have to pay a penalty even if the IRS has to pay you a refund on your filing your tax return.

Accuracy-Related Penalty – IRC § 6662

In General, IRC § 6662 imposes an accuracy-related penalty on any portion of an underpayment attributable to one or more of the following:

(1) negligence or disregard of the rules or regulations;
(2) any substantial understatement of income tax;
(3) any substantial valuation misstatement under Chapter 1 of the Code;
(4) any substantial overstatement of pension liabilities; and
(5) any substantial estate or gift tax valuation understatement.

The accuracy-related penalty applies only if a return is filed, except that the penalty does not apply in the case of a return prepared by the Secretary under IRC § 6020(b). IRC § 6664(b); see also Treas. Reg. § 1.6662-2(a). The taxpayer also may not be subject to the accuracy-related penalty if the taxpayer had reasonable cause and acted in good faith under IRC § 6664(c). The reasonable cause and good faith exception under IRC § 6664(c) applies to all components of the accuracy-related penalty, with special rules for a substantial understatement attributable to a tax shelter item of a corporation.

The accuracy-related penalty does not apply to any portion of an underpayment on which a penalty is imposed for fraud under IRC § 6663.

Penalty Amount

The amount of the accuracy-related penalty is 20 percent of the portion of the underpayment resulting from the misconduct. The penalty rate is increased to 40 percent in certain circumstances involving gross valuation misstatements.  Stacking of the accuracy-related penalties is not permitted. The maximum amount of the accuracy-related penalty imposed on a portion of an underpayment of tax is 20 percent (or 40 percent in the case of a gross valuation misstatement) of that portion of the underpayment, even if that portion of the underpayment is attributable to more than one type of misconduct proscribed under IRC § 6662. The Service may, and should, however, assert the penalty for the underpayment based on each prohibited behavior, in the alternative, that applies. For example, if a portion of an underpayment is attributable to both negligence and a substantial understatement of income tax, the Service may rely on both theories (asserting the second theory in the alternative) in imposing the penalty, although the maximum accuracy-related penalty that may be imposed is 20 percent of that portion of the underpayment. Treas. Reg. § 1.6662-2(c).

The accuracy-related penalty also does not apply to any portion of an underpayment on which a penalty is imposed for fraud under IRC § 6663.

Interest. This is calculated based on how much tax you owe. Interest rates change every three months. As of January 1, 2008, the IRS interest rate for underpayments of tax is 7% per year.

The IRS has issued a NOTICE that discusses interest and penalties.  You can read that notice here.

Reasonable Cause-IRC 6664

Reasonable cause relief is generally granted when the taxpayer exercises ordinary business care and prudence in determining their tax obligations but is unable to comply with those obligations. Essentially, this means something beyond the control of the taxpayer has occurred that has caused the failure to file or not pay taxes timely. It also must be demonstrated that the taxpayer took reasonable steps to "counter" the events and were still unable to pay and or file timely.

Although many of these circumstance evoke great "empathy when heard," sympathy is not going to cause the IRS to abate penalties. The case for abatement must be supported with logical and or legal arguments.  Additionally, each case is weighed on its individual merits not on precedents of other cases.  No precedence can be cited on penalty abatements.

Definition of Reasonable Cause

The IRS gives a long list of events that will be considered for reasonable cause. They are:
 

  • Ignorance of the Law (you must demonstrate you made a reasonable effort to learn the law though)
  •  Error or Mistake was Made, but you must still show "due diligence, ordinary business care and prudence" have been exercised.
  • Forgetfulness, but you must still show "ordinary business care and prudence"
  • Serious Illness, Death, or Unavoidable Absence
  • Unable to Obtain Records
  • Incorrect Advice from a competent tax professional
  • Incorrect advice directly from the IRS, written or oral.
  • Fire, Casualty, Natural Disaster, Other Disturbance
  • Acts of God

The Internal Revenue Manual goes on to say that any reason will be accepted as reasonable cause if it can be shown that the taxpayer exercised ordinary business care and prudence and, despite that, was still not able to comply with their tax obligations.

The following list is taken from the IRM or Internal Revenue Manual that gives the guidelines of what IRS agents are instructed to look at when considering penalty abatement:

  • What are the events that happened, when did it happen, and why did these events prevent you from complying with the tax law?

  • How were your other affairs handled during this time? Did the you (or does it appear) single out the IRS not to be but paid other creditors? What steps were taken to try and mitigate your circumstances? Ordinary business care and prudence is closely looked at here.

  • Is there a direct "timeline" correlation between what happened and the taxes being file late or not paid?

  • Is there a history of filing and or paying late? The IRS is going to look at your  history; repeat offenders will have a tougher job convincing the IRS that this was not intentional.

  • Were the circumstances "beyond the control of the taxpayer" truly unavoidable, and could not be anticipated? If so, this generally establishes reasonable cause.

  • Documentation will be critical to make your case. Provide as much proof of what you are arguing as possible. The greater the amount of "third party" evidence that can be produced,   the better the chances for relief.

How to Request Abatement of a Penalty

There are several ways to request a penalty abatement:

  • A written protest, which is the most common method and goes directly to an appeals          officer generally) who has settlement authority.

  • Verbally in person or over the telephone

  • IRS Form 843 - Usually a Form 843 is filed with a written "brief" or protest

Typically, a protest will comprise of a formally structured letter with an introduction, the request for penalty relief under which relief program(s).

This would be followed by a statement of the facts surrounding the case demonstrating the "reasonable cause" and " ordinary business care" and as much third party documentation of the facts.

Finally, any legal or code related facts that would bolster your claim.

If you submit a Penalty Abatement request and it is denied, you cannot make a request on the same grounds again. Therefore it is very important that you put forth the best case possible when you submit. This is why it is important to have professional representation.

Recent Tax Court Case:

Failure to timely file returns penalties were upheld against married business owners for years they filed well past applicable deadlines: IRS met its burden of production with proof of taxpayers' delayed filings; and fact they suffered some medical problems in subject years wasn't reasonable cause where problems weren't so sever as to keep them from timely filing. (Douglas Bynum, Jr., et ux. v. Commissioner, (2008) TC Memo 2008-14 , 2008 RIA TC Memo ¶2008-14 )

Revised 2/6/2008