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 column summarizes common IRS penalties that tax practitioners see almost daily, and practical ways to obtain a penalty abatement.
FAILURE-TO-FILE AND FAILURE-TO-PAY PENALTIES (SEC. 6651)
Many taxpayers file a return late and/or make a payment late. The IRS sends out automated notices proposing failure-to-file and failure-to-pay penalties, often referred to as late-filing and late-payment penalties—and abates many of them.
First-time penalty abatement is an easy "get-out-of-jail-free card" for taxpayers who have a clean compliance history of filing and paying on time with no prior penalties (other than an estimated tax penalty) for the past three years. The reasonable-cause (facts and circumstances) defense can also be successful. Refer to Internal Revenue Manual (IRM) Section 18.104.22.168.2 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, other administrative waivers could apply to certain taxpayers, such as disaster 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 applicable law and authority, including the IRM, when requesting a penalty abatement.
- Under Sec. 6651(h), the failure-to-pay penalty continues to accrue but at a reduced rate when a taxpayer establishes an installment agreement. However, if a client meets penalty abatement criteria, the practitioner can request penalty abatement at the beginning of the installment agreement and again at the 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 agreement's terms, 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 a 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 compromise than IRS agents.
- Due to IRS budget cuts and service 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 make 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.
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 discussed in Sec. 6654(e)(3) (i.e., by reason of casualty, disaster, or unusual circumstances, or the taxpayer retired or became disabled during the tax year or the preceding year and the underpayment was due to reasonable cause and not willful neglect).
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 or 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). A practitioner likely 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 used to calculate the penalty. For example, the penalty sometimes could be reduced or eliminated by using the annualized income installment method, which is often used if a taxpayer's income varies during the year, as is the case for many sole proprietors. Form 2210, Underpayment of Estimated Tax by Individuals, Estates, and Trusts, 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 greater than $150,000 ($75,000 if married and filing separately)). 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.
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 the "substantial authority" standard), or if a taxpayer proves he or she has reasonable cause for failing to comply.
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 that the taxpayer did not know or had no reason to have known was incorrect (Forms W-2 or 1099, Schedules K-1, 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 increasingly common for penalty cases to be resolved through this channel.
The AICPA Tax Section offers many resources to help practitioners obtain a penalty abatement:
- IRS First-Time Penalty Abatement page: 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 (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 optimally for the IRS to process the request; it contains IRM citations to substantiate the relief and can help practitioners bill for their work.
Editor's note: A version of this column appears in the January 2017 issue of The Tax Adviser as "Tax Practice & Procedures: Pesky IRS Penalties: How to Get Them Abated for Clients."
Susan C. Allen (email@example.com) is senior technical manager, AICPA Tax Practice & Ethics, in Durham, N.C.
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