The practitioner’s guide to Federal Tax Penalties and how and when to request abatement

By Deborah J. Weber

There are approximately 150 penalties contained in the Internal Revenue Code. This article is not intended to address every penalty contained in the Code, but rather, will focus on the more mainstream penalties encountered frequently in practice.

Civil penalties are obviously designed to deter taxpayer’s from understating their tax liabilities or from failing to pay their tax liabilities. Criminal penalties can also apply for more flagrant violations. No deduction is ever allowed to a taxpayer for the amount of any penalty paid.

Failure to File and Failure to Pay, Pursuant to IRC §6651.

The failure to file and pay penalties are probably most frequently encountered penalties. IRC §6651(a)(1) contains the provisions for failure to file and provide that the penalty accrues at a rate of 5% of the tax per month until the return is filed, or to a maximum of 25%. This penalty may be abated if the taxpayer can establish that the failure to file the return was due to reasonable cause and not willful neglect.

IRC §6651(a)(2) contains the provisions for the failure to pay penalty and provides that the penalty for failure to pay accrues at a rate of ½ of 1% of the outstanding balance due, to a maximum of 25%. Abatement of the penalty may be appropriate to the extent that the taxpayer can 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 an undue hardship.

Grounds for Abatement.

Sources for finding grounds for abatement of failure to file and failure to pay penalties are contained in the statute, the Internal Revenue Manual, Regulations and case law.

Reg. §301.6651-1(c) prescribes a general working definition of the reasonable cause standard. If the taxpayer exercised ordinary business care and prudence and was, nevertheless, unable to file the return within the prescribed time, then the delay is due to a reasonable cause. A failure to pay will be considered to be due to reasonable cause to the extent that the taxpayer has made a satisfactory showing that he exercised ordinary business care and prudence in providing for payment of his tax liability and was, nevertheless, either unable to pay the tax or would suffer an undue hardship. The ordinary business care and prudence standard set forth in the Regs. is applied to ordinary taxpayers, which means a taxpayer who is physically and mentally capable of knowing, remembering and complying with statutory requirements. If a taxpayer fails to meet the ordinary person standard due to incompetence, health or otherwise, the penalties can be abated.

Grounds for abatement have also evolved in case law. Some of the grounds that have been found to establish reasonable cause are death or serious illness of the taxpayer, reliance on the advice of others including professionals and IRS agents, honest belief, disputes or misunderstandings between spouses, problems with the mail and financial hardship, although mere inability to pay taxes does not constitute reasonable cause for abatement of penalties.

Accuracy Related Penalties.

IRC §6662 contains the five accuracy related penalties, which are as follows:

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

A uniform penalty of 20% applies to any portion of an underpayment of tax attributable to one or more of the accuracy related violations. No stacking of these penalties is permitted.

The accuracy related penalty will not be imposed if it is shown that there is reasonable cause for the understatement and the taxpayer acted in good faith. Additionally, it is important to note that the accuracy related penalties apply only where a tax return has been filed.

Underpayment Due to Fraud.

IRC §6663(a) provides that if any underpayment of tax is due to fraud, a penalty is imposed equal to 75% of the portion of the underpayment due to fraud. Like the accuracy related penalty, it only applies where a tax return has been filed.

An understatement will be considered due to fraud where it is the result of an intent to evade tax. IRC §7454 provides that the burden of proof is on the Internal Revenue Service to establish fraud by clear and convincing evidence.

Frivolous Tax Returns.

A frivolous return penalty of $500 is imposed, in addition to any other penalties provided by law, against any individual taxpayer who, to further a frivolous position or with a clear intent to impede administration of the law, files a purported return that either fails to contain sufficient information or clearly indicates that the tax liability reflected is substantially incorrect. This penalty, contained at IRC §6702, is directed to Tax Protestors.

Failure to Timely Deposit.

IRC §6656 provides a penalty for failure to timely deposit employment and other taxes. Generally, the same grounds for seeking abatement of failure to pay penalties apply to failure to deposit penalties.
Procedure for Seeking Abatement of Penalty.

Generally requesting abatement of penalties is done in a letter format, which contains both the factual and legal basis for penalty abatement, depending on the particular facts, circumstances and laws applicable in any given case. The request can be made at any time in the procedural process. It can be done as early as when the return is filed, to as late as after the penalties have been paid in full by seeking a claim for refund. In between, it can be made after a return has been filed and a first collection notice reflecting the penalty has been issued. It can also be made during the collection process by submitting a detailed letter requesting abatement to the Revenue Officer assigned to the case.
If the IRS issues a Notice of Deficiency that reflects penalties, the taxpayer can petition the United States Tax Court and dispute the penalty in the Petition by providing the facts in support of the taxpayer’s position that no penalty should apply.

If the penalty abatement is denied, the taxpayer is provided 30 days to file an appeal of the denial. The trend at the Internal Revenue Service is that appeals for penalty abatements are being centralized to particular areas of review within the Internal Revenue Service.
Where the taxpayer intends to request abatement of penalty, the taxpayer should specifically designate payments to tax and interest only to avoid the need to seek a formal claim for refund.

General Comments.

From a litigation standpoint, penalty abatements are difficult to obtain. Most of the cases that are actually litigated regarding penalty abatement result in decisions in favor of the Internal Revenue Service. Nevertheless, requests for penalty abatement may result in successful settlement as to some of the penalties, if the circumstances warrant settlement.

The taxpayer should always be advised that penalty abatement is not easy, nor is it even likely to occur. This provides the taxpayer with a reasonable expectation regarding the outcome of a request for penalty abatement. If the taxpayer understands that requests for penalty abatement are difficult to obtain and most cases go against the taxpayer, the taxpayer will be pleasantly surprised and pleased if penalties are abated in full or in part.

Finally, requests for penalty abatement should not be made in every case. If a practitioner develops a reputation for requesting penalty abatements in every case, the professional will lose credibility and lack of credibility adversely affects each taxpayer associated with the professional. Rather, the professional should consider the facts of each particular case and conduct research to determine if an appropriate argument for penalty abatement exists. In addition, the professional must consider the benefit of the time and effort in relation to the overall collection problem. If the taxpayer will be unable to pay the tax liability, even if all penalties are abated, submission of a request for penalty abatement is a waste of time and money. However, if the taxpayer is looking at a full pay situation, and also has circumstances which could constitute reasonable cause, a request for penalty abatement may be appropriate.