Types of IRS Penalties

The Internal Revenue Code imposes upon taxpayers a variety of deadlines for filing tax returns and paying the underlying tax. They are straightforward and uncomplicated; yet, many taxpayers fail to meet them and, as a result, f ace a daunting array of potential monetary sanctions. In addition to accrued interest, the taxpayer can owe penalties for (1) late or non-filing of tax returns, (2) late or non-payment of taxes (referred to herein as the "late payment penalty"), and (3) not setting aside an adequate tax pre-payment amount during the year (referred to herein as the "estimated tax penalty"). Additional penalties apply where taxpayers substantially understate their tax liabilities (referred to herein as the "accuracy-related penalties"). These penalties pose an additional burden on a taxpayer who already may be in a difficult financial situation.

When a taxpayer files a return, the Service is authorized to assess the tax shown on the return automatically. If the return is filed late or if the amount of tax paid during the year does not meet the 90% requirement of section 6654, the Service may automatically assess appropriate penalties. Because the penalties are computed based on the information provided in the taxpayer's self-assessing tax return, they too are treated as self-assessing. As a result, taxpayers frequently learn that the Service has assessed a penalty for the first time when they receive a notice and demand for its payment.

Administratively, the taxpayer normally presents defenses to the penalties by letter, oral presentation, or a claim for refund. The "late filing" and "late payment" penalties can be avoided only upon a showing that the lateness for the filing or payment was reasonable under the circumstances and that the taxpayer did not willfully neglect his responsibilities. The taxpayer must be clear and correct on the facts when presenting a case for penalty avoidance. The most persuasive case has documentation or affidavits that support the reasonableness of the cause for the lateness. For example, if the taxpayer was trying to avoid a penalty because of an illness, hospital records, affidavits from doctors, and similar documents would be important supporting evidence.

Failure to File Penalty
These penalties can accrue rapidly. The "failure to file" penalty is imposed based on the number of months (including any fraction of a month) during which the failure to file continues. Thus, when the return is received by the Service, or treated as being received, is critical. Normally, the receipt date is the date the return reaches any Service office or Service Center-not the date the return is mailed. The failure to file penalty is calculated as a percentage of the "net tax amount required to be shown on the tax return." If there is no net amount due, there is no late filing penalty.

If the failure to file a return is due to fraudulent causes, the civil penalty is increased (15% per month, up to 75%). Fraudulent failure to file generally involves evidence of some type of intentional wrongdoing on the part of the taxpayer with the specific purpose of evading a tax known, or believed, to be owed. The Service bears the burden of proving civil fraud by clear and convincing evidence. If the Service is unable to sustain its burden of proof on the fraud issue, the basic failure to file penalty (5% per month up to a maximum of 25%) may still be imposed.

Failure to Pay Penalty
Other penalties can accrue at the same time, including the "failure to pay" penalty. A penalty is imposed on a taxpayer who fails to timely pay the amount shown as tax on any return, except if the failure is due to reasonable cause and not willful neglect. The late payment penalty is generally 0.5% of the unpaid tax for each month (or fraction of a month) that the payment is late, up to a maximum of 25% (or 50 months). If the return is unfiled, both the late payment, and late filing penalties can accrue simultaneously. As with the failure to file penalty, the failure to pay penalty is a percentage of the "net amount due."

The failure to pay penalty runs for the number of months (or part thereof) from the payment's due date (determined with regard to extensions of time to pay, but without regard of extension of time to file) through the date on which the Service receives payment. The due date of a tax payment is generally the date on which the return is required to be filed. If the last day prescribed for payment falls on Saturday, Sunday, or a holiday, the payment can be made on the next business day and will not accrue another month of penalty. A "month" is measured from the date in a calendar month to the date numerically corresponding to it in the succeeding calendar month.

Reasonable Cause Defense
Establishing reasonable cause will avoid both the failure to file and failure to pay penalties under section 6651. Reasonable cause determinations are based on the facts and circumstances of each case. The burden of proving reasonable cause is on the taxpayer. But abatement is possible with an experience tax attorney.

In addition to the reasons listed as "reasonable cause" for the abatement and nonassertion of penalties, in certain limited circumstances, taxpayers guilty of their first non-compliant act may be given relief from penalties solely for past good behavior. This particular relief is an administrative waiver based solely on the taxpayer's history of compliant behavior and not based on submitted reasons alleging that he had reasonable cause for the abatement of a failure to pay, file, or deposit penalty. The taxpayer, if he gets this administrative waiver from the penalty, should receive a letter of notification.

Estimated Tax Penalty
The IRS will also impose penalties for not making large enough quarterly estimated payments if self-employed, or withholding payments if an employee. As a general rule, taxpayers are required to pay their income and employment taxes during the year in which the income is earned on a "pay-as-you-go" basis. Most wage earners who complete an accurate Form W-4 will have enough taxes withheld at the source by the employer relative to those earnings to avoid the penalty. Taxpayers whose tax liabilities are not covered through withholding, or are under-withheld, are required to make their "pay-as-you-go" payments via estimated quarterly tax payments. For calendar year taxpayers, the due dates are April 15, June 15, and September 15 of the subject tax year, and January 15 of the following tax year. Taxpayers are generally required to pay 25% of their annual estimated taxes on or before each installment payment due date. When individuals, estates, and most trusts underpay any required installment of estimated income tax liabilities reportable on Forms 1040 or 1041, they are penalized.

Accuracy Related Penalties
Finally, many taxpayers facing the prospect of proposed adjustments to taxable income must also confront the possible imposition of a group of penalties commonly known as the "accuracy-related penalties." Accuracy-related penalties actually encompasses several separate and distinct penalties, including those imposed for reporting positions that are negligent, for reporting certain positions that do not have substantial authority and were not adequately disclosed, or for valuations that were substantially misstated.

The section 6662 penalty is imposed at the rate of 20% of that portion of an underpayment of tax required to be shown on a tax return and which is attributable to any of the following:

  • Negligence or disregard of rules and regulations;
  • Substantial understatement of income tax;
  • Substantial valuation misstatement;
  • Substantial overstatement of pension liabilities; and
  • Substantial estate or gift tax valuation understatement.

In addition, a 40% penalty may be imposed on any portion of an underpayment attributable to a "gross" valuation misstatement. The precise definition of "gross" valuation misstatement is beyond the scope of this summary.

The 20% accuracy-related penalty applies when there has been a "substantial understatement" of income tax. An understatement is substantial if the understatement exceeds the greater of ten percent of the tax required to be shown on the return for the taxable year, or $5,000 ($10,000 for corporations other than S corporations or personal holding companies).

It is vitally important to remember, that despite the added cost of these penalties, they can be abated in many cases. Whether they can be abated or not is a fact specific inquiry that should be made be a qualified tax attorney. Contact Insight Law today for a free consultation in how to approach these and other penalties imposed by the IRS. Insight Law can prepare a top-quality penalty abatement that allows you to pay what you really owe and nothing more.