By: Thomas Nowak, Principal
Typically, when taxpayers receive a notice and are assessed penalty and interest related to their federal income and informational tax returns, there is a tendency to just pay it. Not so fast! If you have knowledge of the federal system and share your notice and assessment with your tax professional, penalties can in many cases be abated. Interest is rarely abated, but let’s discuss the types of federal penalties and how abatement can occur when a penalty is assessed through Statutory Exception, First-Time Penalty Abatement (FTA), or Reasonable Cause.
Below is a limited summary and overview of complex regulation for each type of assessment; contact your tax professional for specific instances you may incur.
The most common Federal tax penalty assessments related to individuals include:
- Late-filing or Failure-to-File tax returns
- Late-payment or Failure-to-Pay of tax due with return filings
- Estimated Underpayment Penalty for not withholding or paying estimates
- Accuracy-related Penalty
Approved Methods to Request Abatement:
There is one statutory exception for penalty assessment. This occurs when a taxpayer receives incorrect written advice directly from the IRS. If it occurs, file Form 843 to request penalty relief documenting the erroneous written advice you relied on that was furnished to you by the IRS. Absent the statutory exception, penalty abatement occurs only under the IRS First-Time Penalty Abatement Program or if for Reasonable Cause.
The First-Time Penalty Abatement (FTA) Waiver has been in existence for over 20 years and can be used by a qualifying taxpayer to abate Failure-to-File, Failure-to-Pay, and Failure-to-Deposit Penalties. The taxpayer may claim FTA for only a single tax period (one tax year for individual and business income taxes and one quarter for payroll taxes). Qualifying taxpayers must not have been assessed any other penalties of a “significant amount” on the same type of return within the past three years and must currently be in compliance with all filing and payment requirements.
In effect, the IRS is rewarding typically compliant taxpayers with a one-time penalty amnesty. Although an FTA can be requested via phone or e-services with the IRS, the most typical method of FTA request is in writing in response to an attached notice/assessment.
The IRS provides Reasonable Cause relief from a penalty when the taxpayer has exercised ordinary business care and prudence in determining his or her tax obligations but was nevertheless unable to comply with those obligations. The taxpayer must explain the facts and circumstances that caused the noncompliance in a clear and concise manner and how ordinary business care and prudence was exercised to handle their affairs during this time.
Additionally, once the facts and circumstances changed, how the taxpayer attempted to comply with tax requirements. Some typical situations include fire, casualty, or natural disaster; inability to obtain records; death, illness, or incapacitation of the taxpayer; any other reasons which will establish you utilized all ordinary business care and prudence to meet your tax obligation. The Reasonable Cause relief is typically requested in writing in response to an attached notice/assessment.
Common Tax Penalty Assessments:
Late-filing or Failure-to-File Penalties occur when you file a return after the original due date plus valid extensions. For Forms 1040, 1041, 706, 709 and 1120 Late-Filing Penalties only occur when you owe a balance due with the return. If the return is in an overpayment/refund position, no penalty is assessed.
If an amount is due and not filed timely including valid extensions, the penalty assessed is 5% of the balance due per month or part of a month a return is late up to five months (maximum penalty 25% of tax due). If the failure to file is deemed fraudulent, the penalty is 15% of the tax due per month, up to a maximum of 75% of the amount owed. Either IRS First-Time Penalty Abatement or Reasonable Cause can be utilized to abate an assessed Late-filing Penalty.
For Form 1120S, if an amount is due and not filed timely including valid extensions, the penalty is $195 (indexed for inflation annually) multiplied by the number of shareholders during the year. For a return with no tax due, the penalty is assessed for each month or partial month that the return is late up to a maximum of 12 months. If tax is due, an additional penalty is assessed equal to 5% of the unpaid tax for each month or partial month that the return is late, up to a maximum of 25% of the unpaid tax.
For Form 1065, if an amount is due and not filed timely including valid extensions, the penalty is $195 (indexed for inflation annually) multiplied by the number of partners during the year. The penalty is assessed to the partnership for each month or partial month for which the return is late, up to 12 months.
For International Information Returns and Foreign Bank and Financial Account Filings, the IRS may assert a $10,000 penalty for each failure for each applicable period, plus an additional $10,000 for each month the failure to file continues, to a maximum of $60,000. The penalties related to foreign informational reporting are very substantial so discussion on any potential filings of foreign income and assets is essential.
Late-payment Penalties occur when a return is due and appropriate tax withholding or estimates have not paid in at least 90% of the current year tax or 110% of the prior year tax. The penalty is equal to 0.5% of the tax due and accrues each month or partial month that there is a balance due, until reaching the maximum amount of 25% of the unpaid tax. Either IRS First-Time Penalty abatement or reasonable cause can be utilized to abate an assessed late-filing penalty.
Estimated Underpayment Penalties occur when a taxpayer does not make payments during the year on the tax created for earned income through withholdings or quarterly estimated tax payments. This penalty is assessed on your Individual Income Tax Return with Form 2210. There is limited abatement for this penalty unless there is an error in calculation. There is an annualized income method available to determine penalties that should be utilized if income is not earned evenly throughout the year.
The IRS is allowed to assess an Accuracy Penalty if the service determines an underpayment of tax is attributable to negligence, the understatement of tax was substantial, or a substantial valuation misstatement within an estate or gift tax valuation. The Accuracy Penalty is typically a flat 20% of the underpaid tax and in certain situations can be increased. Reasonable Cause is the only method of abatement to be contested if an Accuracy Penalty is assessed.
Even if you have been assessed and paid one of the above-discussed penalties and feel you may qualify for abatement, the taxpayer can still request a refund using IRS Form 843 filing the claim within three years of the return due date or filing date, or within two years of the date the penalty was paid.
If you request abatement of an assessed penalty using one of the methods discussed above and are denied, remember, you may appeal a penalty abatement determination by the IRS to allow a live person to hear your circumstances and make an informed decision.
Hopefully, as a taxpayer, you will never have the need to understand the IRS penalties and abatement process by always filing and paying timely. But if you do, hopefully, this summary can be saved for reference and assist you in the unfortunate circumstance that you may find yourself in and will allow you to understand IRS penalties and methods to abate them before just paying an assessment.
If you have further questions, please contact your local Blue and Co. advisor.