The U.S. tax system is based on “voluntary compliance,” meaning that taxpayers assess their tax liabilities against themselves and pay voluntarily. However, the IRS has several methods to encourage taxpayer compliance, such as passport revocation and criminal prosecution. The most frequent mechanism used is assessing penalties.
Per the Internal Revenue Manual (IRM), penalties encourage voluntary compliance by:
Failure to file
If a return designated under Sec. 6651(a)(1) (including income, estate, gift tax, and information returns) is not filed by the date prescribed, an addition to tax of 5% of the unpaid tax is required to be shown on the return for each month or fraction thereof while the failure continues. This amount is reduced by 0.5% if a failure-to-pay penalty is also assessed for the same month. This penalty can be removed if it is shown that the failure was due to reasonable cause and not due to willful neglect. This penalty is capped at a total of 25%.
Example 1: A taxpayer files Form 1040, U.S. Individual Income Tax Return, 15 days past the initial filing due date (without requesting an extension of time to file), reporting $100,000 in total tax. The taxpayer made $75,000 in estimated tax payments throughout the year and paid the remaining $25,000 of tax due 15 days late. The IRS can assess $1,250 (5% of $25,000 unpaid tax for one month), though this could be reduced by 0.5% if the IRS also assessed a failure-to-pay penalty for the same month.
Failure to pay
In the case of any failure to pay the tax required on or before the prescribed due date, Sec. 6651(a)(2) provides for an assessment of an additional 0.5% of the unpaid tax per month or fraction thereof while the failure continues, not to exceed 25% in the aggregate. This penalty can be removed if it is shown that the failure was due to reasonable cause and not due to willful neglect.
Example 2: Consider the same facts as in Example 1, except the taxpayer does not pay the remaining $25,000 of tax until month 2. The IRS can assess two months of failure-to-pay penalty for a total of $250 (0.5% of $25,000 × 2 months).
Failure to file partnership return
Sec. 6698 provides for a late-filing penalty for partnership returns required under Sec. 6031. The penalty is calculated by multiplying an inflation-adjusted amount ($235 for returns required to be filed in 2024) by the number of persons who were partners in the partnership throughout the tax year, for each month, not to exceed 12 months. This can be removed if the failure was due to reasonable cause.
Example 3: A partnership with 10 partners files its Form 1065, U.S. Return of Partnership Income, five months late in 2024. The resulting penalty is $11,750 (10 partners × $235 × 5 months).
Failure to deposit
Sec. 6656 applies a penalty for late employment tax deposits, unless it is shown that the failure was due to reasonable cause and not due to willful neglect. The penalty can also be applied if the payment is not made in the right amount or in the right way. The penalty is calculated based upon the number of days the deposit is late.
This penalty can increase to 15% if the deposit is still unpaid more than 10 days after the date of the first notice or letter.
Example 4: An employer withheld $10,000 that was due to the IRS on Aug. 12. The employer did not make the deposit until Aug. 20, eight days late. The IRS can assess a failure-to-deposit penalty of $500 (5% of $10,000).
Underpayment of estimated tax Sec. 6654 provides for an underpayment penalty if not enough estimated taxes are paid by individuals, estates, and trusts throughout the year. Sec. 6655 applies a similar penalty for corporations that fail to pay enough taxes throughout the year. The penalty may apply even if the IRS owes the taxpayer a refund. The penalty is calculated based on the amount of the underpayment, the period when the underpayment was due and underpaid, and the interest rate for underpayments that the IRS publishes quarterly. These penalties cannot be removed for reasonable cause.
Other penalties
The IRS can assess numerous other civil penalties for not complying with various filing requirements. Some of the more common ones include:
For when a penalty month begins and ends, see the sidebar “Tax Tip: Counting Penalty Months.”
Penalty relief
Notably, the penalty provisions noted above are only the most common of more than 100 in the Internal Revenue Code. With perhaps as much as two-thirds of the amount of these penalties being abated, as mentioned above, it is important to understand the various ways in which one can obtain penalty relief. Penalty relief under the IRM generally falls into four categories:
Correction of IRS error: Many IRS penalties are assessed on an automatic basis (i.e., a failure-to-file penalty is assessed automatically if the return is recorded as late in the IRS system). Although useful for effectively assessing penalties, this often leads to the assessment of erroneous penalties. For instance, if a taxpayer timely and correctly filed an extension to extend its income tax filing due date but the extension was not recorded to the taxpayer’s account properly, the IRS will assess a failure-tofile penalty.
As a result, whenever a penalty is assessed, taxpayers should review the applicable notice and confirm that nothing is amiss. Taxpayers should confirm that all extensions, payments, and total tax are reflected as expected on the notice. If something is missing, the taxpayer or its authorized representative should call the IRS to review its account or send correspondence noting the error. If the taxpayer can provide the missing information and proof of timely filing, the account will be updated and the penalty removed.
Statutory and regulatory exceptions: Tax law may provide an exception to a penalty. Specific statutory exceptions can be found in either the penalty-related Code sections or the accompanying regulations. One example of these exceptions is Sec. 6654(e), allowing a waiver for estimated tax penalties where the tax is less than $1,000, the taxpayer had no liability in the preceding tax year, or the taxpayer retired after reaching age 62 or became disabled. Another is Sec. 7508A, which allows the IRS the authority to postpone certain deadlines by reason of a federally declared disaster, significant fire, or terroristic or military action.
If a taxpayer believes that one of these exceptions should apply, the taxpayer should call or send correspondence requesting the exception be applied and provide any applicable proof showing that they fit the specific eligibility criteria as noted in the applicable statute or regulation.
Administrative waivers: The IRS may formally interpret or clarify a provision to provide administrative relief from a penalty that would otherwise be assessed under specific conditions (see IRM §20.1.1.3.3.2). Examples of these waivers include those for undue hardship; an official disaster area; fire, casualty, natural disaster, or other disturbance (i.e., a major disaster or emergency affecting a significant number of taxpayers); or erroneous written or oral advice from the IRS. One recent example of an IRS administrative waiver is provided in Notice 2022-36 issued on Aug. 24, 2022, granting administrative waivers from certain failure-to-file penalties, international information-return penalties, and certain information-return penalties for tax periods ending in 2019 through 2020 due to hardships caused by the COVID-19 pandemic.
The most valuable administrative waiver available is the first-time abatement. The IRS provides administrative relief, if certain criteria are met, from the failure-to-file penalty under Sec. 6651(a)(1), 6698(a)(1), or 6699(a)(1); the failure-to-pay penalty under Sec. 6651(a)(2) and/or Sec. 6651(a)(3); and the failure-to-deposit penalty under Sec. 6656. The required criteria include:
The first-time abatement is the most valuable and effective tool taxpayers have for penalty relief and should be considered a first line of defense if a valid penalty has been assessed. There is no cap on the amount that can be abated under this waiver, and it can often be applied to a taxpayer’s account simply by calling the IRS and requesting it over the phone.
Reasonable cause: As mentioned, many IRS penalties can be removed if the taxpayer can show that the failure was due to reasonable cause. Therefore, if a penalty is assessed and cannot be removed by the three other mechanisms listed above, the taxpayer should review the assessment and determine if the applicable penalty statute allows for penalty abatement due to reasonable cause and, if so, how the statute or regulation specifically defines reasonable cause for that particular failure.
Reasonable cause generally exists if the taxpayer exercised ordinary business care and prudence and was nevertheless unable to timely file the return or otherwise comply with a requirement. Ordinary business care and prudence is the level of care that a reasonably prudent person would use in conducting their business. Willful neglect, on the other hand, has been defined as a conscious, intentional failure, or reckless indifference (see IRM Exhibit 20.1.1-8). The Penalty Handbook in the IRM also provides guidelines in determining if a penalty should be abated based on reasonable cause:
Reasonable cause is based on all the facts and circumstances in each situation and allows the IRS to provide relief from a penalty that would otherwise apply. Reasonable cause relief is generally granted when the taxpayer exercised ordinary business care and prudence in determining their tax obligations but was nevertheless unable to comply with those obligations. [IRM §20.1.1.3.2(1)]
Ordinary business care and prudence includes making provisions for business obligations to be met when reasonably foreseeable events occur. A taxpayer may establish reasonable cause by providing facts and circumstances showing that they exercised ordinary business care and prudence (taking that degree of care that a reasonably prudent person would exercise), but nevertheless were unable to comply with the law. [IRM §20.1.1.3.2.2(1)]
The length of time of noncompliance may also be factored in when determining if reasonable cause exists. The IRM instructs the IRS employee to:
Consider the length of time between the event cited as a reason for the noncompliance and subsequent compliance. . Consider: (1) when the act was required by law, (2) the period of time during which the taxpayer was unable to comply with the law due to circumstances beyond the taxpayer’s control, and (3) when the taxpayer complied with the law. [IRM §20.1.1.3.2.2]
The reason for the mistake may be a supporting factor in establishing reasonable cause “if additional facts and circumstances support the determination that the taxpayer exercised ordinary business care and prudence but nevertheless was unable to comply within the prescribed time” (IRM §20.1.1.3.2.2.4).
Reasonable cause may be established if the taxpayer shows ignorance of the law in conjunction with other facts and circumstances, including whether there were recent changes in the tax forms or law that a taxpayer could not reasonably be expected to know, or the level of complexity of a tax or compliance issue (IRM §20.1.1.3.2.2.6(2)).
Courts have similarly looked to the facts and circumstances of a case to determine whether reasonable cause exists. In Boyle, 469 U.S. 241 (1985), the Supreme Court held that taxpayers cannot shift or delegate to an agent the ministerial duty to timely file tax returns; however, it further acknowledged that advice related to the necessity of a filing — rather than its timing — could establish reasonable cause. As noted below, subsequent decisions have held that if a return is omitted (i.e., and subsequently filed late) according to the advice of a tax return preparer, Boyle will not preclude a finding of reasonable cause.
The requirements for good-faith reasonable reliance on professional advice are: (1) the adviser is a competent professional who has sufficient expertise to justify reliance; (2) the taxpayer provided necessary and accurate information to the professional; and (3) the taxpayer actually relied in good faith on the adviser’s judgment (Neonatology Associates, P.A., 115 T.C. 43, 99 (2000), aff ’d, 299 F.3d 221 (3d Cir. 2002)). See also Estate of La Meres, 98 T.C. 294, 316–17 (1992) (stating that courts have found reasonable cause for failing to meet a filing deadline where a taxpayer made full disclosure to an expert, relied on the expert’s advice, and did not otherwise know the return was due).
To obtain relief based upon reasonable cause, taxpayers should put the request in writing and provide complete and clear background of the cause of the failure and evidence of the steps they took to establish reasonable cause. Statements should generally be signed under penalties of perjury.
Obtaining relief
Given the relief options as explained above, the IRS ultimately abates a substantial portion of the total penalties it assesses each year. Whenever a penalty is imposed, as a best practice, taxpayers should evaluate the circumstances and determine whether they may be eligible for penalty relief. These requests can be made in writing by sending correspondence to the address on the IRS notice and providing the necessary information supporting the applicable waiver.
Since the COVID-19 pandemic shutdown, the IRS has had a considerable lag time in reviewing taxpayer correspondence. As a result, it can take months for the IRS to review these requests and apply the relief. As such, taxpayers should consider whether the penalty waiver can be obtained by an oral request over the phone. If relief is applied over the phone, the IRS will issue a notice confirming the penalty removal.
Tax tip: Counting penalty months
Penalty months are counted based on the latest return due date. If that date falls on day N of the month, the period subject to the penalty begins on day N+1 of the same month. Each new month subject to the penalty begins on day N+1 of the relevant month and ends on day N of the next month, with the following exceptions:
Contributor
Sophie A. Pedersen, J.D., is senior manager, National Tax Controversy, with Ernst & Young LLP in Chaska, Minn., and a member of the AICPA Tax Practice and Procedures Committee. For more information about this column, contact thetaxadviser@aicpa.org.