The Penalty Box
What every taxpayer needs
to know about IRS Penalties

Penalties are one of Uncle Sam’s most powerful compliance weapons. Most duties imposed under our federal tax laws are enforced by penalties. The IRS assesses penalties for failing to file a return, understating one’s tax liability, failing to pay tax when due, and failing to report required information.

Thanks to recent legislation (affecting 1999 returns and later), the IRS is barred from assessing a penalty unless it provides a notice to the taxpayer specifying the penalty and the basis for the penalty within 18 months of timely filing a return. This legislation has also shifted the initial burden of proof to the IRS in establishing an individual's liability for any penalty in any court proceeding arising from an audit.

The best way to avoid being assessed a penalty is to understand the government’s requirements and follow them to the best of your ability. If you are assessed a penalty and feel you have a reasonable excuse, the IRS may write-off your penalty upon appealing the assessment.

This article addresses 1) the penalties most often assessed by the IRS, 2) the grounds under which the IRS will abate a penalty, and 3) what to do if you are assessed a penalty.

PENALTIES MOST OFTEN ASSESSED BY THE IRS

Filing late - Failure to file a tax return is subject to a penalty of 5 percent of the net amount of tax due (correct tax liability minus timely payments made) for each month or partial month of late filing, up to 25 percent. Any fraudulent failure to file a return is subject to a late filing penalty of 15 percent for each month, up to a maximum penalty of 75 percent. The minimum penalty for failure to file an income tax return not filed within 60 days of its due date, including extensions, is the lesser of $100 or the amount of tax owed with the return. Late filers of returns on which refunds are due are not subject to the late filing penalty since the penalty is based upon the tax due. The failure to file penalty applies to most returns except information returns.

Errors and mistakes - An accuracy penalty of 20 percent is imposed on the portion of any underpayment of tax on a return due to negligence or substantial understatement of income tax. Negligence is usually defined as lack of due care or failure to do what a reasonable and ordinarily prudent person would do under the circumstances. An understatement of tax is substantial if it exceeds $5,000 or 10 percent of the tax required to be shown on the return, whichever is greater. The understatement penalty does not apply if there was substantial authority for the taxpayer's treatment of the item or if the relevant facts as to the understated item are adequately disclosed in the return.

Undervaluing estate assets - When an underpayment is caused by a gross valuation misstatement on an estate or gift tax, the accuracy penalty is raised to 40 percent. A substantial valuation misstatement exists when the value or basis of any property claimed on an income tax return is 200 percent or more the correct value or basis.

Paying late - Failure to pay a tax shown on a return when payment is due subjects the taxpayer to a penalty of one-half of one percent (0.5%) of the amount of the unpaid tax for each month of the late filing, up to a maximum of 25 percent. A similar penalty applies for failure to pay any tax, within 10 days after the date of the notice and demand for payment, if the tax is required to be, but is not shown on a return. The penalty increases to 1 percent per month after the IRS notifies the taxpayer that it will levy on his assets. Beginning January 1, 2000, the penalty is reduced to 0.25 percent per month, if an installment agreement is in effect and the individual has timely filed the return.

Estimated taxes - The penalty for failure to pay estimated tax when due is determined by multiplying the IRS’s standard interest rate (currently about 8%) by the amount of the underpayment for the period late. The penalty is computed using simple, rather than compound, interest. Generally, there is no reasonable cause exception applicable to this penalty, but the IRS may waive the penalty if its imposition would be against equity and good conscience because of a casualty, disaster or other unusual circumstances.

Payroll taxes - Taxpayers that file payroll and excise tax returns must deposit the taxes due with an authorized depositary (usually a bank) when the taxes owed reach a certain dollar amount. Depositary receipts play an important role in the collection of payroll and excise taxes, and the Internal Revenue Code imposes a substantial graduated penalty (10% if paid only 16 days late) for failure to make timely deposits of these taxes.

Responsible person - The Social Security "trust fund" penalty is imposed on persons who are responsible for paying payroll tax, and who willfully fail to do so. The penalty makes responsible persons personally liable for the unpaid tax. Responsible persons are usually corporate officials, but liability may attach to any person who has the responsibility of seeing that the taxes withheld are remitted to the government.

W-2’s and 1099’s - Failure to file a required information return or to supply information required on a return results in a penalty, usually $50 per failure. Similar rules apply to failures to supply a copy of the return—usually called a payee statement—to the taxpayer (employee, depositor, etc.). Stiffer penalties apply to intentional disregard of the filing or furnishing requirements.

GROUNDS FOR ABATEMENT

Late filing excuses - A taxpayer can avoid the late filing penalty by showing that the failure to file a return did not result from willful neglect and that the failure was due to reasonable cause. Willful neglect has been interpreted by the courts as a conscious, intentional failure or reckless indifference. If a taxpayer exercises ordinary business care and prudence and is nevertheless unable to file the return within the prescribed time, the delay is due to reasonable cause.

Accuracy-related excuses - Neither the accuracy-related penalty nor the fraud penalty is imposed with respect to any portion of an underpayment if it is shown that the taxpayer had reasonable cause for an underpayment and acted in good faith. Whether a taxpayer has reasonable cause and good faith is a facts and circumstances determination made on a case-by-case basis. The most important factor is the extent of the taxpayer’s effort to assess proper tax liability. Taxpayers are required to exercise ordinary business care and prudence, i.e., taking the degree of care that a reasonably prudent person would exercise.

Late payment excuses - The penalty for failing to pay a tax when it is due does not apply if the taxpayer can show that he was unable to pay the tax or would suffer an undue hardship if he paid the tax on the due date. The taxpayer must also show that ordinary business care and prudence has been exercised. In deciding whether the taxpayer exercised ordinary business care and prudence, consideration is given to all the facts and circumstances of the taxpayer's financial situation, including the amount of the taxpayer's expenditures and investments in speculative or illiquid assets in light of his income and other assets. The nature of the tax that the taxpayer failed to pay is also taken into account.

Extensions are a big help - A taxpayer does not have to pay the estimated amount of tax due in order to obtain an automatic extension to file and thereby can avoid the late filing penalty. This extra time allows the taxpayer to file a more accurate tax return that can prevent an accuracy penalty. If an individual taxpayer obtains an extension, he can avoid a late payment penalty if at least 90% of the total tax is paid by April 15^th and the balance due is remitted with the return.

Payroll tax waiver for first-timers - Provided that the taxpayer meets the net worth requirement and files a timely employment tax return, the IRS may waive the penalty for the first deposit a taxpayer is required to make after the taxpayer is required to change the frequency of payroll deposits. The IRS may also abate the failure-to-deposit penalty for first-time depositors who inadvertently send the deposit to the IRS instead of to the required government depository.

ASSESSED A PENALTY?

If you are assessed a penalty – don’t panic or get upset! The first thing to is to understand the rules and regulations that the IRS claims you have violated. Ignorance of the rules is never a sufficient defense. Second, determine whether you have complied with the rules and regulations. If you have, dispute the entire assessment. If you haven’t, gather the facts and circumstances surrounding your failure. Third, review the recognized penalty excuses to determine if your fact pattern fits any of them. Finally, pay the tax and interest properly assessed and write a letter to the IRS requesting an abatement of the penalty if you feel you have reasonable cause. It is very rare for the IRS to write-off interest, so it is usually better to pay the interest portion up front.

DON'T HAVE THE MONEY?

One reason many taxpayers do not file their returns on time is that they do not have the money to pay the tax. Since the failure to pay penalty is only one-tenth of the failure to file penalty, taxpayers should always file their returns on time even if they cannot pay.  Odd as it sounds, the government penalizes more for not filing than it does for not paying!

CONCLUSION

If you are assessed a penalty the best strategy is to try to fit your factual situation within one of the recognized reasonable cause exceptions.  You may wish to contact your tax advisor or hire a CPA.  Good intentions and a well-drafted letter may get you out of the penalty box!

 

Chart A

Penalties Most Often Assessed By The IRS
Nature of Penalty	Basis of Penalty	Penalty Rate	Maximum Penalty
Filing Late
Failure to file a tax return	Net amount of tax due	5% per month	25%
Fraudulent failure to file a return	Net amount of tax due	15% per month	75%
Failure to file information returns	Number of forms not filed	$50 per form	$350,000
Accuracy-related
Negligence or disregard of rules/regulations	Portion of tax under-reported due to negligence	20%	20%
Substantial understatement of tax	Portion of tax under-reported due to substantial understatement	20%	20%
Gross Valuation misstatement	Portion of tax under-reported due to gross valuation misstatements	40%	40%
Paying Late
Failure to pay income taxes	Amount of unpaid tax	0.5% per month	25%
Failure to pay payroll taxes	Amount of unpaid tax	2% if late < = 5 days 5% if late <= 15 days 10% if late > 15 days	15% if paid 10 days after deficiency notice

Chart B

Excuses Recognized By The IRS
Filing Late	Accuracy-related	Paying Late
Postal delays.	Valid reason for taking or failing to take the position or action in question.	The taxpayer was unable to determine the amount of tax due for reasons beyond his control.
Filing in the wrong IRS office.
Reliance on erroneous information given him by a IRS officer or employee.	The length of time between the event cited for noncompliance and subsequent compliance.	The taxpayer's ability to make payments was materially impaired by civil disturbances.
Death or serious illness.
Unavoidable absence of the taxpayer.	The taxpayer's compliance history.	Individual extension filers only Full waiver if the amount paid by April 15th is at least 90% of the total tax shown on the return and the balance due is remitted with the tax return.
Records destroyed by fire or other casualty.
Failure of the IRS to supply the proper forms in sufficient time to make a timely filing.	Noncompliance was due to circumstances beyond the taxpayer's control (whether the taxpayer could have anticipated the event).	Payroll taxes for first timers only Full waiver applies to first quarter if you meet net worth limits (<$2mil) and filed return on time.
The inability to secure information or aid from the IRS in the preparation of a return.

 

About the author:

Jay Hoover

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