Our tax system is based on voluntary reporting. There are over 150 civil penalties in the Tax Code. They cover everything from the failure to file a tax return or pay a tax, to failure to provide required notices, to accuracy-related penalties, to filing fraudulent information returns, to the activities of tax return preparers, to tax shelter activities, and more. The penalty provisions encourage accurate voluntary reporting by penalizing those that do not. Even if all you did was fail to timely file your return and timely pay the amount shown on your return, you could be facing penalties of as much as 45% of the tax that you owe. But don't despair; there are several ways to alleviate penalties. This article will focus on the three most common penalties: failure to file, failure to pay, and accuracy-related penalties.
The Three Most Common Penalties
The three most common penalties that I see are failure to file, failure to pay, and accuracy-related penalties. Each penalty is addressed below.
Failure to File - I.R.C. § 6651(a)(1)
A failure to file penalty will apply when you do not timely file your return by its due date, or by its extended due date. Although this is typically referred to as a penalty, the Tax Code calls it an “addition to tax,” rather than a penalty. This penalty is calculated at 5% of the unpaid tax that was required to be reported on your return. It is charged for up to 5 months, meaning that the total penalty could be as much as 25% of the unpaid tax. Notice that the penalty is calculated on the unpaid tax. If you file your return late, and there is no tax due, there is no failure to file penalty. But beware: there may be other consequences to filing your return late, including forfeiting a refund that you are due.
The failure to file penalty is reduced by any failure to pay penalty asserted (discussed below). This means that if you failed to file and pay for the first five months, the failure to file penalty will be 20%, calculated at 4.5% per month (5% less the .5% failure to pay penalty).
If your return is one day late, you may still be assessed a failure to file penalty for an entire month, and a minimum penalty applies to income tax returns received 60 or more days late. The minimum penalty is the lesser of the unpaid tax or:
$205 – Returns due on or after Jan. 1, 2016. This penalty rate is subject to an annual adjustment for inflation in $5 increments.
$135 – Returns due between Jan. 1, 2009 and Dec. 31, 2015, or
$100 – Returns due before Jan. 1, 2009
The failure to file penalty highlights the importance of requesting a 6-month extension to file if you are not able to file your return on April 15. Even if you do not think expect that a tax will owe when you file your return, it is a good practice to request the 6-month extension anyways. The failure to file return is generally more than the failure to pay penalty because it is assessed at a higher amount meaning that you should focus your efforts on timely filing your return even if you know you cannot timely pay.
Failure to Pay – I.R.C. § 6651(a)(2)
A failure to pay penalty will apply when you do not timely pay the amount shown on your return by its due date. Although this is typically referred to as a penalty, the Tax Code calls it an “addition to tax,” rather than a penalty. This penalty is calculated at .5% of the unpaid tax. It is charged for up to 50 months, meaning that the total penalty could be as much as 25% of the unpaid tax. Although you may obtain an extension to file your return, an extension to file is not an extension to pay.
The failure to pay penalty is reduced from .5% per month to .25% per month during an approved installment agreement (if the return was filed on time, and the taxpayer is an individual). But the penalty is increased to 1% of the unpaid tax that is not paid within 10 days of the IRS issuing a Notice of Intent to Levy. The IRS computers sometimes error in calculating penalties and interest—taxpayers should always recalculate these amounts themselves and verify that the proper amounts are being assessed.
The failure to pay penalty is not pro-rated. If you fail to pay for one day during a month, the penalty will apply for the entire month.
The failure to file and failure to pay penalties provide for a maximum penalty of 45% of the unpaid tax. Although each penalty separately provides for a maximum of 25%, the failure to file penalty is reduced by the failure to pay penalty—meaning a total maximum of 45%.
Accuracy-Related Penalties – I.R.C. § 6662(a)
An accuracy-related penalty will apply when you fail to report an underpayment of tax on your income tax return. Note that the penalty only applies to underpayments. Even if you understate your income tax obligation, the penalty will not apply if you timely paid the corrected tax obligation since there would be no underpayment. This penalty applies to the following situations:
- Negligence or disregard of rules or regulations.
- Any substantial understatement of income tax.
- Any substantial valuation misstatement under chapter 1.
- Any substantial overstatement of pension liabilities.
- Any substantial estate or gift tax valuation understatement.
- Any disallowance of claimed tax benefits by reason of a transaction lacking economic substance (within the meaning of section 7701(o)) or failing to meet the requirements of any similar rule of law.
- Any undisclosed foreign financial asset understatement.
- Any inconsistent estate basis.
We will focus on the first two situations, since they are the most common.
I.R.C. § 6662(c) defines both negligence and disregard of rules or regulations. Negligence includes any failure to make a reasonable attempt to comply with the provisions of the tax law, exercise ordinary and reasonable care in tax return preparation, or keep adequate books and records. Negligence is strongly indicated where a taxpayer fails to make a reasonable attempt to ascertain the correctness of a deduction, credit or exclusion on a return which would seem to a reasonable and prudent person to be “too good to be true” under the circumstances.
The IRS bears the burden of production with respect to any accuracy-related penalty under section 6662(a). See I.R.C. § 7491(c); Higbee v. Commissioner, 116 T.C. 438, 446-447 (2001). This means that the IRS must come forward with “sufficient evidence indicating that it is appropriate to impose” the penalty. See Higbee v. Commissioner, 116 T.C. at 446. Therefore, before the IRS will determine that an accuracy-related penalty applies due to negligence, the IRS must have considered the facts and circumstances and determined that the taxpayer was negligent. Because this requires more than a simple calculation, the IRS most often asserts accuracy-related penalties due to a substantial understatement (addressed below), and will only assert negligence penalties if its personnel, typically a revenue agent or tax compliance officer, determines that the facts support negligence.
An understatement of tax is the excess of the amount required to be shown on the return for the tax year less the amount of tax actually shown on the return, reduced by any rebates. For measurement purposes, the understatement is reduced to the extent that either: (1) the position taken in the return that generated the understatement was supported by substantial authority; or (2) the taxpayer disclosed in the return all relevant facts relating to the position and the taxpayer has a reasonable basis for the tax treatment of the disclosed item. Thus, the tax attributable to items for which there is substantial authority or adequate disclosure is not included in the amount of understatement.
A corporate understatement is substantial if it exceeds the lesser of (1) 10% of the tax required to be shown on the return for the tax year (or, if greater, $10,000), or (2) $10,000,000. If the understatement is determined to be substantial, then the understatement is redetermined to exclude the tax attributable to a listed or reportable transaction. The 20% penalty applies to the redetermined understatement.
An individual understatement is substantial if it exceeds the greater of (1) 10% of the tax required to be shown on the return for the tax year, or (2) $5,000.
The Tax Cuts and Jobs Act, the recent tax reform act passed in December 2017, modifies the definition of substantial understatement in certain situations, reducing the threshold from 10% of the tax required to be shown on the return to 5%.
The IRS is most likely to assert an accuracy-related penalty due to a substantial understatement because it bears the burden of production with respect to any accuracy-related penalty under section 6662(a), and it can prove a substantial understatement using only the return and its determination of what should have been reported.
How do I get rid of penalties?
There are two ways to rid the penalties: pay them, or request that they be abated. Obviously nobody wants to pay penalties, so let's look at the different ways to request abatement.
First-Time Abate (FTA) Program
If a taxpayer has a history of compliance—timely filing and timely paying—they may be eligible for the IRS's first-time abate program. There is no statutory requirement for this program, so it is subject to change at any time. The program was first implemented in 2001. As of January 2018, the following requirements must be met to request penalty abatement under FTA:
- The tax period for which penalty abatement is sought ends after December 31, 2000;
- The taxpayer has filed, or filed a valid extension for, all required returns currently due;
- The taxpayer has paid, or arranged to pay (through an open installment agreement), any tax currently due; and
- The taxpayer has not been required to file the same return for the preceding three years, or
- If the taxpayer was required to file the same return for the preceding three years, the taxpayer has no unreversed penalties for those years (except an estimated tax penalty) and no penalties were manually suppressed or reversed.
Although there are some obscure requirements, the general rule is that you may receive FTA for the first year where penalties are assessed if there were no penalties assessed in the three preceding tax years. This means that if you have penalties assessed for 2015, 2016, 2017, and 2017, you could request FTA for 2015, but the remaining years would not be eligible. If the earlier penalties are inappropriate, a taxpayer should seek their reversal before requesting FTA. For example, if penalties should not have applied for 2015, the taxpayer should request abatement of the 2015 penalty, and then request FTA for 2016—potentially eliminating two years worth of penalties when cause exists for only one year. If the taxpayer eliminated penalties for 2015 using FTA when the taxpayer could have argued that the penalties were not applicable, he or she would lose out on the opportunity to use FTA for 2016.
Once the FTA waiver is used, it should be used on any later assessed penalties for the same year. For example, if the taxpayer enters into an installment agreement, and then requests FTA, the IRS may grant FTA, but the IRS will continue to assert failure to pay penalties. The taxpayer may request abatement of the continuously asserted failure to pay penalties for the same year under the FTA program, but the IRS will not automatically abate the future penalties. A careful analysis of all years with balances due and penalties assessed should be performed before FTA is requested.
Taxpayers may still ride themselves of penalties where they do not meet the FTA requirements by showing reasonable cause. The reasonable cause case law is vast, but the most common examples of reasonable cause are as follows:
- Reliance on others
- Reliance on tax professionals
- Death, serious injury, unavoidable absence
- Lack of records due to fire, theft, casualty loss or natural disaster where the taxpayer took reasonable steps to obtain the information necessary to prepare the return(s)
- Financial difficulties
- Substantial authority supports the return position(s)
- Disclosure on the return
- Matter of first impression
When To Challenge Penalties
A taxpayer may challenge a penalty at any time by filing a Form 843, Claim for Refund and Request for Abatement, or when during a collection due process (CDP) hearing. A taxpayer may prefer to wait to request penalty abatement through a CDP hearing because that hearing will be subject to judicial review, meaning that the taxpayer may have an opportunity for the Tax Court to consider whether the penalty is appropriate. If a taxpayer submits a Form 843, and the IRS ultimately denies the abatement and the taxpayer has an opportunity to appeal the denial, the taxpayer may be precluded from later arguing the penalty in a CDP hearing. Careful consideration should be given to the likelihood of success through an administrative abatement request, and whether the taxpayer has the ability to pay the penalty before challenging it. If the stakes are high and the taxpayer cannot afford to pay the penalty upfront, it may be best to challenge the penalty through a collection due process hearing and have the potential for judicial review.
If you have been assessed penalties, call Brandon Keim at (602) 892-1500 to discuss your penalty abatement options.
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