The IRS can assess many types of penalties against taxpayers: late-filing penalties, late-payment penalties, estimated tax penalties, accuracy-related penalties, and the list goes on. This item summarizes common IRS penalties that tax practitioners see on almost a daily basis, and procedural and practical ways to obtain a penalty abatement.
Failure-to-File and Failure-to-Pay Penalties (Sec. 6651)
Each year many taxpayers file a return late and/or make a payment late. The IRS sends out countless notices (using an automated process) to propose failure-to-file and failure-to-pay penalties, often referred to as late-filing and late-payment penalties—and the IRS abates many of these penalties.
First-time penalty abatement is an easy "get-out-of-jail-free card" for taxpayers who have a clean compliance history, i.e., a history of filing and paying on time as well as no prior penalties (except an estimated tax penalty) for the past three years. And the reasonable-cause (facts and circumstances) defense can also be successful. Refer to Internal Revenue Manual (IRM) Section 188.8.131.52.2 for a list of the IRS's criteria for evaluating the most frequently raised defenses for these penalties. Death, serious illness, fire/casualty, erroneous advice, forgetfulness, and even ignorance of the law are among the defenses discussed in the IRM. In addition, administrative waivers granted by the IRS, discussed in IRM Section 184.108.40.206.3.2, may apply to provide relief for certain taxpayers, such as disaster area victims.
Here are penalty abatement tips for failure-to-file and failure-to-pay penalties:
- If a client meets penalty abatement criteria, practitioners can attach a penalty nonassertion request to a late-filed return. This way, a practitioner could potentially avoid a notice stream altogether.
- Practitioners should cite the law and authority, including the IRM when requesting a penalty abatement. It is useful to quote the IRS's employee handbook (the IRM) because it can help IRS personnel do their job (and help taxpayers timely receive penalty relief).
- Under Sec. 6651(h), the failure-to-pay penalty is reduced when a taxpayer establishes an installment agreement. And, if a client meets penalty abatement criteria, a practitioner should request penalty abatement at the beginning of the installment agreement and again at the very end (i.e., after the debt is paid in full). If the IRS removes penalties at the beginning of the agreement, and the taxpayer adheres to the terms of the agreement, the IRS can also remove the penalties that continued to accrue until the tax was paid in full.
- Often, qualifying for relief under the reasonable-cause criteria is subjective, depending on the IRS agent who considers the case. If the IRS originally denies penalty abatement, consider using the Office of Appeals. Appeals may come to a different conclusion based on the hazards-of-litigation standard. At the very least, Appeals officers may be more willing to negotiate and make a compromise than IRS agents.
- Due to IRS budget cuts and service level issues, more practitioners are finding relief for their clients via Appeals. It may take over a year to resolve the issue, but it can be worth the wait. Some practitioners have even seen Appeals remove penalties based on first-time penalty abatement criteria, even if the taxpayer did not exactly meet the criteria.
Estimated Tax Penalty (Sec. 6654)
Individual taxpayers must adequately withhold from their wages and/or pay estimated tax payments evenly throughout the year. When they do not, the IRS may impose the estimated tax penalty, commonly referred to as the underpayment penalty. Tax preparation software typically calculates this penalty on Form 2210, Underpayment of Estimated Tax by Individuals, Estates, and Trusts. If the penalty is not paid with the return, the IRS will later send a notice to the taxpayer assessing it.
There is no general reasonable-cause exception for the estimated tax penalty; therefore, it is often more difficult to get the penalty removed, but it is not impossible. The IRS may abate it if the taxpayer (1) proves that the IRS incorrectly charged the penalty or made an error, (2) shows that calculating the penalty under a different method reduces or eliminates it, or (3) proves that he or she meets the waiver criteria (i.e., unusual circumstances) discussed in Sec. 6654(e)(3).
Here are penalty abatement tips for the estimated tax penalty:
- It is fairly common for the IRS to credit a payment to the wrong tax period, causing an estimated tax penalty. Simply getting the IRS to move a payment to the correct year/period can save a client from paying this penalty. It is advisable to request transcripts from the IRS each year to determine how payments and refunds are applied (as well as to see all information already reported to the IRS). Most likely, a practitioner would need to call the IRS Practitioner Priority Service line at 866-860-4259 to address any payment issues.
- Be aware of the different methods to calculate the penalty. For example, at times the penalty could be reduced or eliminated if it was calculated using the annualized income installment method. This method is often used if a taxpayer's income varies during the year, as is the case for many sole proprietors. Form 2210 and its instructions provide more guidance on this issue.
- Use the safe harbor. Individual taxpayers will avoid the penalty altogether when they pay 90% of the tax shown on the current year's return or 100% of the tax shown on the prior year's return (110% if the taxpayer had adjusted gross income in the previous year greater than $150,000 ($75,000 if filing married filing separately)).
Note: For corporate clients, refer to Sec. 6655.
Accuracy-Related Penalty (Sec. 6662)
The IRS may impose an accuracy-related penalty for many types of misconduct, such as negligence, substantial understatement of tax, etc. This penalty comes up frequently in an audit (almost automatically if the understatement exceeds the greater of 10% of the tax required to be shown on the return or $5,000), but it also comes up on notices, such as the common CP2000, which the IRS sends when underreported income is detected. A client could inadvertently fail to include a Form 1099-MISC, Miscellaneous Income, on his or her return, triggering a CP2000 notice and an accuracy-related penalty.
The accuracy-related penalty cannot be imposed if the return position being questioned meets certain tax authority standards (e.g., the "more likely than not" standard or "substantial authority" standard), or if a taxpayer proves he or she has reasonable cause for the compliance issue.
Regs. Sec. 1.6664-4 provides guidance to help practitioners determine whether clients meet reasonable-cause criteria to avoid an accuracy-related penalty. It boils down to facts and circumstances and proving that the client exercised ordinary business care and prudence.
Here are penalty abatement tips for the accuracy-related penalty:
- The IRS cannot impose the accuracy-related penalty when a return position is properly disclosed, assuming that the return position had a reasonable basis (i.e., at least an approximately 20% chance of success if challenged by the IRS). Consider disclosing certain return positions with Form 8275, Disclosure Statement, or 8275-R, Regulation Disclosure Statement,where applicable.
- Common reasonable-cause defenses for the accuracy-related penalty discussed in IRM Section 20.1.5 include reliance on an incorrect information statement (Form W-2, K-1, 1099, etc.), reliance on a competent tax adviser, and an isolated computational error.
- Heavily substantiate a client's reasonable-cause defense. Attach ample documentation to support the facts and circumstances and clearly spell out how a client exercised ordinary business care and prudence.
Remember: Those who do not ask will not receive. Large, and sometimes even small, penalties are worth fighting to get removed. A simple phone call or letter may be all that is necessary to save a client thousands of dollars. And do not be afraid to turn to the IRS Office of Appeals. It is more and more common for penalty cases to be resolved through this channel.
The AICPA Tax Section offers many resources to help practitioners obtain penalty abatement:
- IRS First-Time Penalty Abatement(www.aicpa.org): Contains guidance on first-time penalty abatement qualifications and tips on how to effectively request an abatement using the waiver.
- IRS penalty abatement request letter(www.aicpa.org, AICPA Tax Section member login required): Use the letter to compose a written request for penalty abatement based on the first-time penalty abatement criteria. This letter is formatted in an optimal way for the IRS to process the request; it contains IRM citations to substantiate the relief and can help practitioners bill for their work.
Valrie Chambers is an associate professor of accounting at Stetson University in Deland, Fla. Susan Allen is a senior technical manager with the AICPA Tax Division and is the staff liaison to the AICPA Tax Practice & Procedures Committee. For more information about this column, contact firstname.lastname@example.org.