For those of us inclined to the proverbial ‘head-bury’ strategy with Big Brother, it is best to understand the civil penalties assessed when IRS systems catch up – as measured in tangible $$ out the pocket. For the brave of heart, navigating the shoals of IRS Penalties can be intimidating to comprehend but it is far from rocket science.
Understanding IRS civil penalties starts with picking up Part 20.1 of the Internal Revenue Manual (IRM). Here you will find guidance on all areas of civil penalties imposed by the Internal Revenue Code (IRC).
Criminal penalty provisions are contained in IRM 9.1.3 and beyond the scope of this post.
Being able to lean back on civil penalties though is important and often can be life changing for people digging themselves out of that hole.
So why does the IRS seem so cruel? From our government’s perspective “penalties are intended to enhance voluntary compliance.”
What does that mean?
In order to make the most efficient use of penalties, the Service will design, administer, and evaluate penalty programs based on how those programs can most efficiently make an example out of you so that all your friends and family get scared. Obviously they invest most enforcement resources in high profile taxpayers.
High profile cases can be easily sensationalized. Inside of that sensationalized fear lies compliance, or so the theory goes.
To instill that often times false sense of fear IRS examiners and their managers consider the elements of each claim and each corresponding penalty and then fully develop facts to support the application of the penalty. The job of the Enrolled Agent – my job – is to establish that the penalty does not or should not apply.
In fact, full development of the penalty issue is important when navigating a file through the IRS Examination and Appeals functions.
Those penalties quickly mount over time and it usually takes a long time to settle any disputed matters.
So if you are interested in confronting IRS Penalties and prospectively overcoming the fears they bring, check out this drill down.
Penalties are either system-generated or manually generated.
With system-generated penalties the IRS computers assess the penalty with no manager approval. Examples of system-generated penalties include:
- Failure to file
- Failure to pay
- Failure to deposit
- Bad check
- Estimated tax
With manually generated penalties the IRS compliance personnel assess the penalty and a manager approves the penalty assessment under §6751(b)(1). Examples of manually generated penalties assessed against taxpayers include:
- Fraudulent failure to file.
Interestingly enough however, as a random side note, the IRS does not need manager approval for an accuracy-related penalty associated with a CP2000 Notice issued by the Collections function.
The three most common penalties for taxpayers are:
- Failure to file penalty.
- Failure to pay penalty.
- Accuracy-related penalty.
Failure to File Penalty Facts
- Section 6651(a)(1) imposes a penalty for failing to timely file a tax return.
- The penalty is 5% of the net tax due for each month or part of a month the return is late.
- The maximum penalty is 25% of the net tax due.
- This means the penalty can apply for up to five months.
- If you do not file the return within 60 days of the due date, the minimum failure to file (FTF) penalty is the lesser of $205 or 100% of the net tax due [§6651(a)(3)].
- If both penalties apply to the same month, the FTF penalty is reduced by the FTP penalty §6651(c)(1).
- For each month the FTF and the FTP penalties apply, the FTF penalty is only 4.5% (FTF 5% minus FTP .5%).
- The penalty period begins after the due date of the return (including valid extensions) and ends on the date the IRS receives the return.
- The penalty applies for each month or portion of month the tax return is late.
- If the due date of the return is the last day of the calendar month, each calendar month (or partial calendar month) is considered a month [Reg. §301.6651-1(b)(1)].
- If the due date is not on the last day of a calendar month, the period that terminates on the corresponding date of the following calendar month is considered a month.
- For example, if a tax return is due on April 15, the month begins April 16 and ends May 15.
- Since the IRC bases the FTF penalty on the net tax due, it only applies if the taxpayer owes tax when filing.
- For measuring the number of months a tax return is late, the fact that the due date falls on a Saturday, Sunday, or legal holiday is immaterial [Reg. §301.6651-1(b)(3)].
- For assessment purposes, the period begins on the actual due date of the return even if the due date is a Saturday, Sunday, or legal holiday.
- The IRS can abate the FTF penalty when the taxpayer shows that the failure to file was due to reasonable cause and not to willful neglect.
- According to Reg. §301.6651-1(c) (1), reasonable cause exists only if the taxpayer exercised ordinary business care and prudence.
Fraudulent Failure to File Penalty Facts
- The FTF penalty increases to 15% of the net tax due if the failure to file the return is fraudulent [§6651(f)].
- The maximum penalty increases to 75% of the net tax due.
- Generally, the IRS assesses the fraudulent FTF penalty against taxpayers who did not file their tax forms in an attempt to evade tax.
- In Abdalla Mohamed v. Commissioner, TC Memo 2013-255 we learn that the taxpayer must deliberately fail to file his return on the date due, knowing that, by doing so, he is concealing the fact that he has income subject to tax.
The IRS considers the following in assessing the fraudulent FTF penalty, so do NOT:
- Refuse to or is unable to explain the failure to file.
- Make statements that do not agree with facts of the case.
- Have the ability to pay with a history of failing to file or filing late.
- Fail to reveal or tries to conceal assets.
- Pay personal and business expenses with cash when cash payments are not typical.
- Cash business receipts instead of depositing them.
- The IRS has the burden of proving the fraudulent FTF penalty applies.
- The IRS must establish that the your failure to timely file was an intentional attempt to evade tax owed (TC Memo 2013-255).
Re: Pass-through Entities
- Generally, pass-through entities, such as partnerships and S corporations, do not owe tax.
- Since the FTF penalty is computed based on the tax owed, these pass through entities would not have a FTF penalty under §6651(a)(1).
- Consequently, §6698 and §6699 impose a penalty for failure to file when there is no tax due.
- Section 6698 imposes a penalty on partnerships for failing to timely file Form 1065, U.S. Partnership.
- The penalty is $195 [§6698(b)] per partner, per month (or fraction of month) the return is late and is limited to 12 months [§6698(a)].
- The penalty applies even if the partnership does not owe tax.
- As with the FTF penalty under §6651(a)(1), the IRS can abate the penalty under §6698 if the partnership can show reasonable cause for failing to timely file.
- IRS Rev. Proc. 84-35 provides partnerships with another exception to the FTF penalty.
The IRS considers domestic partnerships with ten or fewer partners (individuals or C corporations) to have met the reasonable cause test and not subject to the FTF penalty if the partnership (or partners) establishes that all partners have fully reported their share of income, deductions, and credits of the partnership on their timely filed tax returns.
In SCA 200135029, the IRS indicated it will abate the penalty if all partners, upon receipt of the assessment, sign the notice, include their full names and taxpayer identification numbers, and answer Yes to the following questions:
- Is this a domestic partnership?
- Are there 10 or fewer partners?
- Are all partners a natural person (other than a nonresident alien) or an estate?
- Is each partner’s share of each partnership item the same as his share of every other item?
- Have all the partners fully reported their share of income, deductions, and credits of the partnership on their timely filed income tax returns?
There is a new partnership audit regime out that is worth researching as well. Partnerships with fewer than 100 partners may be exempted from this regime.
Re: S Corporation
- Section 6699 imposes a penalty on S corporations for failing to timely file Form 1120S, U.S. Income Tax Return for an S Corporation.
- The penalty is $195 [§6699(b)] per shareholder, per month (or fraction of month) the return is late and is limited to 12 months [§6699(a)].
- The penalty applies if the S corporation does not owe tax.
- As with the FTF penalty under §6651(a)(1), the IRS can abate the penalty under §6699 if the S corporation can show reasonable cause for failing to timely file.
- Unlike partnerships, the IRS does not provide an exception for S corporations.
- Since an S corporation is limited to 100 shareholders, generally the maximum penalty is $19,500 per month.
- However, if there were shares transferred, the penalty would be higher because the IRS counts both the transferor and transferee when computing the penalty.
- Further §6699 does not provide that spouses or family members are treated as one shareholder for computation of the penalty.
- Count spouses and family members separately even though you do not count them separately for the 100-shareholder limit.
Failure to Pay Penalty Facts:
- Section 6651(a)(2) imposes a penalty for failing to pay the tax:
- reported on a tax return by the due date.
- assessed shown on a notice and demand payment within 21 calendar days or within ten business days if the amount is $100,000 or more.
- The penalty is 0.5% for each month or part of a month of the net tax shown on the return that the taxpayer does not pay by the due date.
- The maximum penalty is 25% of the net tax due.
- This means the penalty can apply for up to 50 months.
- An extension of time to file does not extend the time to pay (IRM 126.96.36.199.8.4).
- Thus, the FTP penalty applies even when there is a valid extension.
- The 25% maximum independently applies to both the FTF and FTP penalties.
- Although the FTF penalty stops at five months, the IRS can impose the FTP penalty for another 45 months.
- When coordinating the FTP penalty with the FTF penalty, the maximum combined penalty is 47.5% (five months of FTF penalty at 4.5% plus 50 months of FTP penalty at 0.5%).
- If the IRS issues a notice of levy or believes that the collection of tax is in jeopardy, the FTP penalty is increased to 1.0% [§6651(d)].
- The penalty is reduced to 0.25% for each month in which you have an installment agreement in effect §6651(h).
- Section 6651(h) applies only to individuals; the lower rate is not available to a corporation, partnership, trust, or exempt organization.
- The IRS cannot apply the reduced penalty under §6651(h) until an installment agreement is in effect.
- If you secure an installment agreement by telephone and the IRS accepts it immediately, the FTP penalty rate is reduced immediately under §6651(h).
- If you mail an installment agreement, the IRS may not accept the agreement for several weeks – the IRS does not reduce the FTP penalty rate until they accept the installment agreement several weeks later.
- THAT SUCKS!
- If you obtain an installment agreement approval by telephone you should have the reduced penalty rate sooner than applying for an installment agreements in writing.
- The IRS can abate the FTP penalty if you can show the failure to timely pay was due to reasonable cause and not to willful neglect.
- Failure to pay is due to reasonable cause if you can demonstrate a lack of funds occurred despite the exercise of ordinary business care as per IRM 188.8.131.52.2.
- You can indeed establish reasonable cause if undue hardship would have resulted from making the payment on the due date.
- According to Reg. §1.6161-1(b), undue hardship means more than an inconvenience.
- It must appear that substantial financial loss will result from making the payment on the due date. In certain instances, it may seem that an undue hardship would be easy to prove however you must consider.
- cash and all assets that are convertible into cash at current market prices [Reg. §1.6161-1(c)].
- ability to borrow funds unless the terms would inflict severe loss and hardship.
- If you are paying creditors and making loan repayments, undue hardship is difficult to establish.
Accuracy-related penalty facts
Section 6662 imposes a 20% penalty on the underpayment of tax that you are required to show on a return attributable to the following:
- Negligence or disregard of the rules or regulations.
- Substantial understatement of income tax.
- Substantial income tax valuation misstatement.
- Substantial overstatement of pension liabilities.
- Substantial estate or gift tax valuation understatement.
- Dis-allowance of claimed tax benefits due to a transaction lacking economic substance.
- Undisclosed foreign financial asset understatement.
- Inconsistent estate basis.
More Fun Facts About the Accuracy Related Penalty under Section 6662
- The most common reasons for the imposition of the accuracy-related penalty are due to negligence, disregard of the rules or regulations, or a substantial understatement of income tax.
- The maximum penalty imposed on an underpayment cannot exceed 20%, even if the underpayment is attributable to more than one type of misconduct.
- If the underpayment is attributable to a gross valuation misstatement or a nondisclosed noneconomic substance transaction, the penalty increases to 40% [§§6662(h)(1) and (i)(1)].
- A gross valuation misstatement occurs when either the value or adjusted basis claim is 200% or more of the correct value or adjusted basis, or there is a gross valuation misstatement based on §482 adjustments [§6662(h)(2)].
- A nondisclosed noneconomic substance transaction is a transaction that lacks economic substance and the taxpayer does not disclose the relevant facts affecting the tax treatment in the return or in a statement attached to the return [§6662(i)(2)].
- The accuracy-related penalty applies only if you file a return, and does not apply when the IRS prepares a substitute for return under §6020(b) where the taxpayer refuses to sign the return (IRM 184.108.40.206).
- The IRS can impose both the FTF penalty and accuracy-related penalty if you file a late return. However, the IRS does not take into account the fact that you filed the return late in determining if they should impose the accuracy-related penalty [Reg. §1.6662-2(a)].
- The accuracy-related penalty does not apply to any portion of an underpayment on which the IRS imposes the §6663 civil fraud penalty [§6662(b)].
- If different portions of an underpayment are subject to different penalty rates, an allocation is necessary. If an allocation is necessary, the IRS adjusts a return in the following order [Reg. §1.6664-3(b)].
- Those that are not subject to a penalty
- Those that are subject to a 20% penalty (accuracy-related penalty).
- Those that are subject to a 40% penalty (gross valuation misstatement and nondisclosed noneconomic substance transaction).
- Those that are subject to a 75% penalty (civil fraud penalty).
Three side notes worth mentioning:
- The Service will fully develop accuracy-related or fraud penalties in all cases where an underpayment of tax is attributable to a listed transaction defined under IRC §6011. I plan a blog post about this soon.
- In limited circumstances, where doing so will promote sound and efficient tax administration, the IRS may approve a reduction of penalties or a penalty waiver for a group or class of taxpayers as part of a strategy to encourage efficient resolution of cases.
- The IRS claims that penalties are not a bargaining point in resolving other tax adjustments – that is flat out bullshit – particularly in the Appeals function.
IF you’ve made it this far you are a brave soul and a true tax nerd. Thank you for your attention.
Have a question? Contact John Dundon.
Your comments are always welcome!