An Introduction to Tax Penalties
When you receive an IRS tax bill, it is usually accompanied by interest and penalties, which may be significant. Part of any comprehensive tax strategy is addressing, and minimizing any potential tax penalties.
Types of tax penalties
There are numerous tax penalties that the IRS may impose for tax code violations. Here are the four most common ones:
- Accuracy-related penalty – Under 26 U.S. Code § 6662, the IRS can impose a tax penalty for negligence, for any substantial understatement of tax or valuation misstatement, or for overstating pension liabilities. The accuracy-related penalty may also be imposed for undisclosed foreign financial asset understatements and for reporting transactions that lack economic substance. The penalty is equal to 20% of the amount of the underpayment.
- Late filing – The failure-to-file penalty under 26 U.S. Code § 6651(a)(1) is imposed when a taxpayer does not file their taxes on time. The penalty is 5% of the unpaid taxes per month (or part of the month) that the return is filed late, up to 25% of the unpaid taxes due.
- Late payment – The failure-to-pay penalty under 26 U.S. Code § 6651(a)(2) is imposed when a taxpayer does not pay their taxes by the due date, and amounts to 0.5 to 1% of the unpaid tax bill for each month (or part of the month) that the taxes are not paid, up to 25% of the unpaid taxes due.
- Civil fraud - If the IRS finds that income has been underreported with fraudulent intent (meaning, not an honest mistake) the fine per 26 U.S. Code § 6663 is 75%. This civil tax fraud penalty is applied to less than 2% of audits – among that 2%, a handful of taxpayers may be charged with criminal tax fraud as well.
Note that where both late filing and late payment penalties apply, the failure-to-pay penalty will be reduced. However, if a return is filed more than 60 days after the due date, the minimum penalty is $135 or 100% of the unpaid tax, whichever is less, unless the taxpayer can show that the failure to file or to pay is due to “reasonable cause” or has other grounds to defend against the penalty.
Contesting tax penalties: Abatement
The Internal Revenue Manual specifies four general criteria for relief from tax penalties: (1) reasonable cause, (2) statutory and regulatory exceptions, (3) administrative waivers and (4) correction of IRS error:
(1) Abating tax penalties for "reasonable cause"
Tax penalty relief on account of “reasonable cause” is generally granted in the following circumstances:
- The taxpayer or a member of their immediate family died or suffered a serious illness very close to the filing deadline.
- The taxpayer exercised ordinary business care and prudence but could not comply with filing requirements or payment demands within the prescribed time limits (e.g., the records were in control of a third party and were not returned in time to file on the due date) and/or the taxpayer is currently suffering from a lack of funds.
- The business or tax records were destroyed (e.g., by fire, natural disaster or other casualty).
- The taxpayer was unable to properly file or pay due to circumstances beyond their control.
Reasonable cause abatement of tax penalties is determined following an analysis of all the facts and circumstances of the individual situation. Treasury Regulations provide some examples to help determine if reasonable cause has been established (see Treas. Regs. 1.6664–4 and 301.6651–1(c)). Note that reasonable cause abatement is not available for all penalties.
(2) Statutory and regulatory exceptions
The tax law provides for specific statutory exceptions such as:
(3) Administrative waiver
IRS administrative waivers are generally granted where the IRS has experienced a delay in the printing or mailing of forms, or publishing guidance on a specific topic or issue. These are also made available where there has been a natural disaster or other catastrophic event in the region.
(4) Correction of IRS error
Assessments that can be attributed to an IRS mathematical error, other error, IRS delay or bad advice, may be abated under 26 U.S. Code § 6404(d), (e) or (f). Interest and penalties may also be suspended where the IRS has failed to contact the taxpayer.
Contesting International Information Return Penalties
Please see here for more information regarding contesting or minimizing FBAR penalties or International Information Return penalties.
Contesting (Mitigation)Tax Penalties: Hazards of Litigation
One of the benefits of asserting our clients' rights and formally disputing tax assessments in Tax Court or Federal District Court is that the government will consider the hazards of the litigation at hand. This allows us to obtain some great deals for our clients. Many of the deals we obtain include the government's waiver of any tax penalty.