Federal Tax Penalties
Overview of Federal Tax Penalties & Abatement in the Collection Defense Area of Practice
By Gary Bluestein
Although there are approximately 150 penalties contained in the Internal Revenue Code, the primary focus of this article is on the most common penalties dealt with by the tax practitioner in handling collection defense for a client. Excluded from the discussion below is the “trust fund recovery penalty” pursuant to IRC §6672. Although this involves an incredibly important part of tax practice, the trust fund recovery penalty is actually not a penalty at all, but a collection device for the Service to pursue individuals deemed to be both “responsible” and “willful” in the failure to collect and/or pay over the trust fund portion of payroll taxes. This type of liability cannot be handled though a “penalty abatement request” and is beyond the scope of this article.
What this article does focus on, however, is the penalties asserted pursuant to IRC §6651, for failure to file and failure to pay timely, as well as penalties asserted pursuant to IRC §6656 relating to delinquent deposits.
The failure to file penalty, pursuant to IRC §6651(a)(1) is perhaps the most common and unnecessary penalty. It involves a penalty that accrues at 5% of the tax per month, until the return is filed, to a maximum of 25%. Often clients fail to file the required tax returns, whether it be a 1040, 941 or some other required return, due to the inability to pay. This unfortunately often creates a significant liability that can be avoided merely by filing the return, even without payment.
The failure to pay penalty will be asserted under IRC §6651(a)(2) at a lesser amount, ½ of 1% of the outstanding balance per month, again, up to a maximum of 25%.
Unfortunately, when a return has not been filed, both penalties are asserted against the taxpayer, creating often a devastating increase in the liability. In addition to the penalties, there is also a further accrual of interest on the penalties.
Additionally, pursuant to IRC §6656, the IRS can assert a penalty for failure to timely deposit employment taxes. Again, the cumulative effect of these penalties, with the interest that accrues thereon, can be devastating. Grounds for abatement of these penalties can be found in the statute, Internal Revenue Manual, regulations and case law. Generally, these penalties may be abated if the taxpayer can establish that the failure to file was due to “reasonable cause” and not “willful neglect”. In relation to failure to pay, the taxpayer is required to establish that he or she exercised “ordinary business care and prudence in providing for payment of the tax liability, but was nevertheless either unable to pay the tax or would suffer undue hardship.” See also Treas. Reg. §301.6651-1(c ) and §1.6161-1(b). Additionally, case law has provided for relief from certain penalties based on “reasonable cause” where there has been a death or serious illness of the taxpayer, reliance on the legal advice of others, such as professionals and IRS agents or a variety of other extenuating circumstances.
It should be noted, however, that it is a common mistake for practitioners and/or taxpayers to argue in relation to the failure to file penalty that “reasonable cause” exists due to negligence of a tax professional in failing to timely file a return. The U.S. Supreme Court made it clear in the case of United States vs. Boyle, 469 U.S. 241(1985), that the requirement to file a return cannot be delegated and the negligence of a tax professional in failing to do so does not constitute “reasonable cause” for abatement.
In reference to failure to pay cases, there has been a line of cases following the reasoning in a Second Circuit opinion, Fran Corp. vs. United States, 164 F.3d. 814(2d Cir. 1999), which set forth the proposition that “reasonable cause” can exist for a penalty abatement if a business taxpayer is suffering severe financial distress and did not have the financial wherewithal to timely pay the tax.”1 This opinion is supported by Treas. Reg. §1.6161-1(b) which states that consideration will be given to all of the facts and circumstances of the taxpayer’s financial situation. See also East Wind Industries, Inc. vs. United States, 196 F.3d. 499(3d Cir. 1999), In Re: Pool and Varga, Inc. 60 B.R. 722, 725-28(E.B. Mich. 1996). This is in contrast, however, to the Sixth Circuit’s opinion in Brewery, Inc. vs. United States, 33 F.3d 589(6th Cir. 1994).
If “reasonable cause” and not “willful neglect” exists, penalty abatement should be pursued. Relief, however, is difficult to obtain and the client should be made aware that there is never any guarantee. The more documentary evidence and third party corroboration that can be submitted to support the basis for the abate request, the more likely the chances of success. It should also be made clear to the client that the interest on the tax, as opposed to the penalty and interest thereon, is not part of the abatement request. The Internal Revenue Service will not abate interest on the tax itself, except for the extremely rare circumstance in which the accrual of the interest was the result of an error made on the Service’s part.