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 Internal Revenue Service (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.

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. The initial burden of proof is on 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

See chart A

Filing late - Failure to file a tax return is subject to a penalty of five 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 of 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 one percent per month after the IRS notifies the taxpayer that it will levy the taxpayer's assets. The penalty is reduced to 0.25 percent per month for individuals paying in installments after 1999.

Estimated taxes - The penalty for failure to pay estimated tax when due is determined by multiplying the IRS's standard interest rate by the amount of the underpayment for the late period. 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) or electronically to the IRS (EFTPS) 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-2s and 1099s - 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 he taxpayer (employee, depositor, etc.). Stiffer penalties apply to intentional disregard of the filing or furnishing requirements.

Grounds for Abatement

See chart B

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 or she was unable to pay the tax or would suffer an undue hardship if the tax was paid 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 the taxpayer's 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 obtain s an extension, he can avoid a late payment penalty if at least 90 percent of the total tax is paid by April 15 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 step 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 adviser or hire a CPA. Good intentions and a well-drafted letter may get you out of the penalty box!

Chart A

Chart B