Federal tax penalties have always been an IRS priority. But, perhaps more so today than three decades ago. For example, in 1987, the IRS reported that it had assessed penalties of approximately $14 billion. Compare that figure with fiscal year 2019—a year in which the IRS assessed over $40 billion in penalties. The number of penalty assessments (and corresponding government revenue) against taxpayers is only expected to grow in the near future.
IRS priority alone, however, has not been the sole cause of the staggering rise in penalties. Indeed, congressional action has only buttressed this phenomenon. In 1955, the Internal Revenue Code (the “Code”) housed approximately 14 penalties. Today, the number of penalties hovers closer to 150. Put simply, the IRS has an arsenal of various statutory provisions to use and penalize unwanted taxpayer conduct, from the late filing of a return or information return to the late payment of tax or even the negligent filing of a return.
Nevertheless, taxpayers and tax professionals are not helpless. Rather, there are a multitude of penalty defenses against proposed or already assessed penalties. This Insight discusses some of those defenses. It further provides some helpful background information regarding the IRS’ administrative guidance for the imposition of penalties.
IRS Policy Statement 20-1 and the IRS Penalty Handbook.
In November 1987, the IRS established a task force to study civil penalties imposed against taxpayers. The task force eventually issued a report, which made several recommendations. Chief amongst them were: (1) the IRS should develop and adopt a single penalty policy statement emphasizing that penalties exist for the purpose of encouraging voluntary compliance; and (2) the IRS should develop a single consolidated penalty handbook for use by its employees.
Both of these recommendations were adopted and put into practice. First, the IRS adopted IRS Policy Statement 20-1. That statement recognizes that the IRS has a statutory responsibility to collect the proper amount of tax revenues in the most efficient manner feasible. Given this responsibility, the IRS further recognizes in Policy Statement 20-1 that penalties provide the IRS with important tools to meet that responsibility.
Policy Statement 20-1 also provides guidance to examiners and managers regarding examinations and penalty determinations. It states: “In order to effectively use penalties to encourage compliant conduct, examiners and their managers must consider the applicability of penalties in each case, and fully develop the penalty issue when the initial consideration indicates that penalties should apply.” In sum, the IRS statement specifically instructs examiners and managers to carefully look for potential penalties during the work up of their cases.
Second, the IRS adopted a Penalty Handbook, which is located now in the Internal Revenue Manual. See I.R.M. pt. 20.1. The Penalty Handbook serves as the primary source of authority for civil administration of penalties by the IRS. Indeed, it includes guidance on almost any civil penalty in the Code, including:
i. Failure to File / Failure to Pay Penalties under I.R.C. §§ 6651, 6698, and 6699.See I.R.M. pt. 20.1.2.
ii. Estimated Tax Penalties under I.R.C. § 6654 (individual) and I.R.C. § 6655 (corporation).See I.R.M. pt. 20.1.3.
iii. Failure to Deposit Penalty under I.R.C. § 6656.See I.R.M. pt. 20.1.4.
iv.Return Related Penalties under I.R.C. §§ 6662, 6662A, 6663, and 6676.See I.R.M. pt. 20.1.5.
v. Preparer, Promoter, and Material Advisor Penalties under I.R.C. §§ 6694, 6695, 6700, 6701, 6707, 6707A, 6708, 6713.See I.R.M. pt. 20.1.6.
vi. Information Return Penalties under I.R.C. §§ 6011, 6721, 6722, 6723, and 6724.See I.R.M. pt. 20.1.7.
vii. Employee Plans and Exempt Organizations Miscellaneous Civil Penalties under I.R.C. §§ 6652, 6684, 6685, 6690, 6692, 6693, 6704, 6710, 6711, and 6714.See I.R.M. pt. 20.1.8.
viii. International Penalties under I.R.C. §§ 6038, 6038A, 6038D, 6039E, 6039G, 6039F, 6652(f), 6677, 6679, 6683, 6686, 6688, 6689, and 6712.See I.R.M. pt. 20.1.9.
ix. Miscellaneous Penalties under various Code provisions.See I.R.M. pt. 20.1.10.
x. Excise Tax and Estate and Gift Tax Penalties under various Code provisions.See I.R.M. pt. 20.1.11.
xi. Penalties applicable to incorrect appraisals.See I.R.M. pt. 20.1.12.
Commonly Imposed IRS Penalties
Although there are many civil penalties available, the IRS tends to impose some more than others. A brief discussion of the more commonly imposed IRS penalties follows.
Failure-to-File (I.R.C. § 6651(a)(1)).
The failure-to-file penalty under I.R.C. § 6651(a)(1) applies to a variety of different returns. But, it is more common to see this penalty imposed on a taxpayer for failure to file an income tax return, estate return, gift tax return, or employment tax return.
The penalty for late filing is generally 5% of the amount of tax required to be shown on the return, if the failure is not more than one month. Each additional month the return is not filed results in an additional 5% penalty. However, the penalty cannot exceed 25% in the aggregate (and is adjusted to 4.5% in the event both this and the failure-to-pay penalty discussed below are applied for the same month).
Failure-to-Pay (I.R.C. § 6651(a)(2)).
As the name suggests, the failure-to-pay penalty is imposed when a taxpayer makes a late payment of tax. If the taxpayer fails to pay tax due by the deadline, I.R.C. § 6651(a)(2) permits the IRS to impose a penalty of 0.5% of the amount of tax shown on the return, if the failure is for not more than one month. For each additional month, a penalty of 0.5% continues to apply until the tax is paid or until the penalty reaches an aggregate of 25%.
Fraudulent Failure to File (I.R.C. § 6651(f)).
The Code has higher penalties if the IRS is able to show a return was not filed due to fraud. In these instances, the penalty is increased from 5% each month to 15% each month, not to exceed 75%. To prove this penalty applies, however, the IRS must show fraud by clear and convincing evidence. See, e.g., Mohamed v. Comm’r, T.C. Memo. 2013-255 n.7; Harrington v. Comm’r, T.C. Memo. 2011-73. Negligence or even gross negligence resulting in late filing is not sufficient to prove fraud. See Estate of Windsberg v. Comm’r, T.C. Memo. 1978-101.
Failure to Pay Estimated Taxes (I.R.C. § 6654).
If an individual taxpayer fails to pay in sufficient axes at various intervals throughout the year, such taxpayer may be liable for the failure-to-pay estimated tax penalty. The penalty is based on the underpayment and the period of the underpayment. For these purposes, the underpayment means the excess of the required installment over the amount (if any) of the installment paid on or before the specified due date. On the other hand, the period of the underpayment means the period which runs from the due date of the installment until the earlier of: (1) the date on which such portion is paid; or (2) April 15 of the following year. The penalty amount—or the underpayment rate—is established under I.R.C. § 6621(a)(2). Generally, this amount is 3% points over the federal short-term rate established under I.R.C. § 1274(d).
Failure to Deposit Taxes (I.R.C. § 6656).
Employers who fail to timely deposit employment taxes are subject to penalties for failure to deposit. The penalty amount generally depends on when the deposit is made. For example, the penalty can be as low as 2% of the underpaid deposit if made within 5 days or less of the deadline up to 10% if made more than 15 days past the deadline. The penalty is increased to 15% in certain instances where the deposit has not been made and the IRS issues a delinquency notice to the taxpayer.
Accuracy-Related Penalty (I.R.C. § 6662).
The accuracy-related penalty under I.R.C. § 6662 seeks to penalize taxpayers for certain incorrect reporting positions claimed on a tax return. For example, an accuracy-related penalty may be imposed against a taxpayer for filing a negligent return or a return that disregards rules or regulations. See I.R.C. § 6662(b)(1). In addition, an accuracy-related penalty may be imposed, regardless of negligence or disregard of rules or regulations, if there is a substantial understatement of income tax. See I.R.C. § 6662(b)(2). In all of these instances, the accuracy-related penalty is 20% of the underpayment.
Fraud Penalty (I.R.C. § 6663).
The accuracy-related penalty may be increased if the underpayment is due to fraud. In these circumstances, the fraud penalty is 75% of the part of the underpayment attributable to fraud. Similar to the penalty under I.R.C. § 6651(f), the IRS must establish by clear and convincing evidence that a portion of the underpayment is attributable to fraud. If the IRS meets this burden, the entire underpayment is presumed attributable to fraud unless the taxpayer can show by a preponderance of the evidence that a portion is not attributable to fraud.
International Reporting Penalties.
Title 31 and the Code both contain penalty provisions related to a taxpayer’s failure to file international information returns. For example, U.S. persons who have a financial interest in or signature authority over one or more financial accounts with an aggregate value of more than $10,000 at any time during the calendar year are required to file FinCEN Form 114. See 31 U.S.C. § 5314; 31 C.F.R. § 1010.350.
A taxpayer’s failure to timely file a proper FBAR can result in either willful or non-willful penalties. For willful violations, the IRS may impose a penalty equal to the greater of: (1) $100,000 (adjusted for inflation); or (2) 50% of the balance of the account at the time of the violation. 31 U.S.C. § 5321(a)(5)(C). For these purposes, the term “willfulness” means a voluntary, intentional violation of a known legal duty. But, willfulness can also be found if the taxpayer acts with “willful blindness.” If the failure to timely file a proper FBAR was non-willful, the IRS may impose a penalty of up to $10,000 (adjusted for inflation). 31 U.S.C. § 5321(a)(5).
There are other penalty provisions in the Code related to foreign transactions. These include:
i. Certain Events Related to Foreign Trusts / Receipt of Foreign Gifts (IRS Form 3520);
ii.Grantor Foreign Trusts (IRS Form 3520-A);
iii. Ownership/Officer Positions with Foreign Corporations (IRS Form 5471);
iv. Domestic Corporations Owned by 25% or More Foreign Shareholders (IRS Form 5472);
v. Transfers of Property to Foreign Corporations in Certain Tax-Free Exchanges (IRS Form 926);
vi. U.S. Persons Ownership of Certain Foreign Financial Assets (IRS Form 8938);
vii. Ownership of Foreign Partnerships (IRS Form 8865)
Failure to file these forms at the proper time and in the proper form can also result in significant civil penalties.
The primary defense against most IRS penalties is the defense of reasonable cause. Generally, this defense requires the taxpayer to show that he or she exercised ordinary business care and prudence with respect to the filing, reporting, or payment obligation but nevertheless was unable to comply. See, e.g., U.S. v. Boyle, 469 U.S. 241 (1985).
By way of example, assume a taxpayer missed the filing deadline to file an individual income tax return by 2 months. Under I.R.C. § 6651(a)(1), the IRS could impose a penalty for the late filing. But, if the taxpayer can show he or she exercised ordinary business care and prudence and was unable to file the return by the filing deadline, the taxpayer can assert reasonable cause as a defense to the late-filing penalty. For late filings, federal courts and the IRS have recognized a taxpayer has reasonable cause for: (1) deaths, serious illness, or unavoidable absences; (2) fires, casualties, natural disasters, or other disturbances; (3) a taxpayer’s inability to obtain necessary records; and (4) bad legal advice regarding the proper filing deadline.
Reasonable cause can also be used as a defense to the accuracy-related penalty under I.R.C. § 6662. In this context, the most important factor is generally the extent of the taxpayer’s efforts to assess his or her proper tax liability. Treas. Reg. § 1.6664-4(b). Circumstances that may constitute reasonable cause here include an honest misunderstanding of fact or law that is reasonable in light of all the facts and circumstances as well as honest mistakes. Id.; see also Hummer v. Comm’r, T.C. Memo. 1988-528 (reasonable cause for negligence penalty where correct treatment of a deduction was not settled); Larotonda v. Comm’r, 89 T.C. 287 (1987) (taxpayers reasonable but erroneous belief that retirement income should not be included in gross income constituted reasonable cause for purposes of negligence penalty).
In many cases, a taxpayer may rely on a tax advisor or tax professional to prepare the return. So, what happens when the tax advisor or tax professional is wrong on a reporting issue? There is good news. Federal courts and the IRS have recognized the defense of reasonable cause in these circumstances provided the taxpayer can show: (1) the adviser was a competent professional who had sufficient expertise to justify reliance; (2) the taxpayer provided necessary and accurate information to the adviser; and (3) the taxpayer actually relied in good faith on the adviser’s judgment. See Neonatology Assocs., P.A. v. Comm’r, 115 T.C. 43 (2000), aff’d, 299 F.3d 221 (3d Cir. 2002).
I.R.C. § 6751(b) provides that the IRS may not assess certain penalties “unless the initial determination of such assessment is personally approved (in writing) by the immediate supervisor of the individual making such determination or such higher level official as the Secretary may designate.” I.R.C. § 6751(b) applies to most penalties, but it does not apply to penalties under I.R.C. § 6651 (late-filing or late-payment penalties); I.R.C. § 6654 (failure to pay estimated tax of individual); I.R.C. § 6655 (failure-to-pay estimated tax of corporation); and “any other penalty automatically calculated through electronic means.”
In Clay, the Tax Court held that the IRS must obtain written managerial approval of a penalty in a deficiency case no later than when the IRS Revenue Agent Report (RAR), coupled with the 30-day Appeals letter, are sent to the taxpayer. See 152 T.C. 223 (2019). In that case, because the IRS obtained written managerial approval after the RAR and 30-day Appeals letter was issued, the Tax Court concluded that the IRS was prohibited from assessing the penalty.
For more on the I.R.C. § 6751(b) penalty defense, see Penalty Defenses and the Supervisory Approval Requirement.
Disclosure of Tax Items.
A taxpayer may avoid certain accuracy-related penalties under I.R.C. § 6662 if the taxpayer: (1) had substantial authority for the item; or (2) the item was adequately disclosed on the return or in a statement attached to the return, provided there was a reasonable basis for the tax treatment of such item. I.R.C. § 6662(d)(2)(B).
The substantial authority standard is an objective standard, which requires the application of the law to the relevant facts. It is less stringent than the “more likely than not” standard (i.e., greater than 50% likelihood of being upheld on the merits) but more stringent than the “reasonable basis” standard. The tax authorities that may be considered as part of the substantial authority analysis are listed in Treas. Reg. § 1.6662-4(d)(3)(iii). Significantly, a taxpayer may have substantial authority for the tax treatment of any given item on a return based solely only a well-reasoned construction of the applicable statutory provision. Id.
On the other hand, a taxpayer meets the reasonable basis standard if the claim is more than arguable or colorable. Treas. Reg. § 1.6662-4(e)(2)(i). Thus, a return position that is reasonable and based on one or more authorities in Treas. Reg. § 1.6662-4(d)(3)(iii) will generally satisfy the reasonable basis standard.
But reasonable basis is not sufficient in itself to negate a reporting penalty. Instead, the taxpayer must have a reasonable basis and also adequately disclose the item on the tax return. Generally, the disclosure is made on IRS Form 8275 unless the position taken by the taxpayer is contrary to a regulation (the latter of which requires IRS Form 8275-R). Moreover, certain disclosures without an IRS Form 8275 may be sufficient, provided the disclosed item falls within the guidance of an annual revenue procedure permitting such disclosure on the return or in an attachment. Currently, that revenue procedure is Rev. Proc. 2020-54.
First-Time Penalty Abatement.
The IRS’ first-time penalty abatement procedures are an administrative waiver. To qualify, taxpayers must meet the conditions set forth in I.R.M. pt. 220.127.116.11.3.2.1 (10-19-20). Generally, the IRS will abate certain types of penalties under these procedures if the taxpayer had no penalties for the previous three tax years, and the taxpayer has filed—or filed a valid extension for—all required returns currently due and paid or arranged to pay any tax currently due.
To successfully request IRS penalty relief, a taxpayer must have a thorough understanding of the penalty (its statutory language, governing regulations, etc.) in addition to the applicability of potential penalty defenses. This Insight provides some tools for taxpayers in both respects. However, in many cases, the success of a penalty abatement or waiver request will depend largely on how the facts and applicable law are presented to the IRS. If the penalty amounts at issue are large, it may pay to engage a competent tax professional to prepare the request.