The IRS has created a plethora of penalties that apply to partnerships and partners. This penalty structure is consistent with the IRS’s policy of self assessment and penalties for failing to properly apply the law.
Penalties directly paid by partnerships.
Penalties that relate directly to partnerships come in three distinct categories:
- accuracy-related and
Specifically, penalties are levied for:
- Failure to file a tax return
- Not supplying a taxpayer identification number
- Not furnishing information returns.
- Underpaying tax due to valuation misstatement
- Not furnishing information on tax shelters
- Promoting abusive tax shelters.
All penalties are defined as “additions treated as tax” and are collected in the same manner as regular taxes. They are nondeductible expenses on tax returns. Penalties are levied on the net amount of taxes due (the tax liability less any taxes already paid). Additionally, because partnerships are flow-through entities, any penalties levied on the partnership will indirectly affect individual partners based on their profit/loss ratios.
The applicable delinquency penalty for partnerships is tied to a partnership’s failure to file a tax return in a given year. Failure to file a return by a partnership will result in a fine of $195 for each month of delinquency and for each partner that is a partner during the tax year. This amount is capped at $2,340 per partner, the amount resulting after 12 months of delinquency.
This penalty is assessed at the partnership level. Therefore, each partner will have his or her basis in the partnership reduced by the amount of the penalty.
It is important to note that there is a way to abate these delinquency fees by showing reasonable cause for not filing a return. “Reasonable cause” is determined by the IRS and allows all facts and circumstances to be taken into consideration for the application of this penalty.
If three requirements are satisfied, the term “partnership” for the intent of this penalty does not apply. These three requirements are: 1) the partnership must be composed of ten or fewer partners, all of whom are natural or estates, 2) the partnership shares are equally divided, and 3) each partner fully reported his or her shares of income, credits, or other deductions in a timely manner to the IRS. As a result, if all three requirements are met, reasonable cause is deemed to have been met for the partnership and the fee is waived in its entirety.
When a partnership fails to supply a taxpayer identification number (TIN) or correct information return, a $100 penalty is assessed for each tax return to which the information applies, up to an amount of $1,500,000 per person per calendar year.
To promote timely corrections, the IRS reduces these penalties if information is corrected and resubmitted. If the data is corrected and sent within 30 days of the filing date, the penalty is reduced to $30 with a limit of $250,000 per person. If the correction is sent after 30 days but before August 1 of the calendar year in which the filing date occurs, the penalty is set at $60 with an individual limit of $500,000.
This relatively small penalty can add up when a partnership has a large number of partners or if the partnership is required to supply a large amount of information to the IRS on a yearly basis. Large partnerships, in particular, will have to be aware of this penalty and make sure that all the relevant information is supplied to the IRS in a timely matter.
Another penalty that may be levied against partnerships is for the underpayment of tax due to a valuation misstatement. (It should be noted that a valuation misstatement will change each partner’s inside basis and can have an impact on their tax liabilities.) The amount of the penalty is 20% of the underpayment if the valuation misstatement is substantial.
Misstatement in this instance does not mean fraudulent misstatement, but rather improper misstatement due to omission, error, or negligence. If fraud has taken place, either civil or criminal fraud penalties would be assessed to the individual partner(s) responsible.
Partnerships are also liable for any penalties related to information or promotion of abusive tax shelters. If a partnership exists solely to create a tax shelter, a penalty will be assessed for the lesser of $1,000 or 100% of the gross revenue generated per activity if the tax shelter is promoted by the partners. (Code Sec. 6700(a))
If specific (i.e., listed) transactions within the partnership promote abusive tax shelters and information about these shelters is not provided to the IRS, the penalty will be in the amount of the greater of $200,000 or 50% of the revenue generated in the transaction.
Partnerships would be liable for the above penalties. They would not be attributable to any specific partner since the IRS is trying to punish in proportion to each partner’s involvement. Each partner should be aware that the actions of one partner (likely the tax matters partner) can affect them, especially if they have a large interest in the partnership.
Penalties directly paid by partners.
Along with the delinquency and accuracy-related penalties (covered above) at the partnership level, partners are also subject to an additional category of civil and criminal penalties, which arise from fraudulent claims.
The penalties levied on individual partners are:
- Failure to file a tax return
- Failure to pay tax
- Failure to pay estimated tax
- Underpayment or understatement of tax
- Transaction lacking economic substance
- Civil fraud
- Criminal fraud.
The only difference for partnership purposes is who pays the penalties. A partnership penalty affects each partner based on his or her profit/loss ratio while a partner penalty is paid by an individual partner. These partner penalties relate to specific actions taken or omitted by the partner in question.
The penalty for failure to file a tax return is levied (for example) when a calendar-year individual does not file his or her return on or before the due date of April 15, or October 15 if an extension has been filed. The penalty is 5% of the net tax due for each month not filed, up to a limit of 25% of that net amount of tax liability.
The reason that this penalty is so onerous is to encourage high net-worth individuals to file timely returns. If a taxpayer did not file a tax return due to a reasonable cause and not willful neglect, the fee may be waived.
Failure to pay tax is another penalty applied to the individual partner. Taxes are due to the IRS from the taxpayer as of the due date of the return (extensions do not extend the time to pay). The penalty is 0.5% (.005) of net tax due for each month, up to a limit of 25% of the net amount of tax liability.
There are exceptions to the failure-to-pay estimated tax rule. A taxpayer who has paid at least 90% of his or her tax liability by the original due date will not be subject to this penalty. The penalty will also not be imposed if the taxpayer can show reasonable cause. This penalty will also reduce the failure-to-file penalty by 0.5% each month they are both in effect (so the total amount of the two penalties is 5%). Neither penalty will be imposed if a civil fraud penalty has been assessed against the taxpayer.
An accuracy-related penalty is levied whenever an underpayment or understatement of tax liability is due to negligence or is substantial in nature. Negligence occurs whenever a taxpayer fails to report income when filing his or her return or recklessly fails to comply with tax laws. The criterion for an understatement to be substantial is that the amount of the understatement must be more than the greater of $5,000 or 10% of the overall tax liability. There is also a relatively new penalty (added in 2010) levied against transactions that lack economic substance.
The penalty for negligence or substantial understatement of tax liability is 20% of the understated portion of the tax, while the penalty for a lack of economic substance is 20% of the tax liability from the income. The penalty is increased to 40%, if proper disclosure of the transaction was not given to the IRS.
Civil and criminal fraud is solely attributable to partners for tax purposes. The IRS has the burden of proof when claiming civil fraud by the taxpayer, and must prove that there was intent to defraud. The penalty is severe: 75% of the entire underpayment of tax liability, limited to the amount attributable solely to fraud if the taxpayer can prove the entire underpayment should not be subject to the penalty. Once again, reasonable cause may be used to negate this penalty.
Whenever a taxpayer commits a felony in relation to his or her interest in a partnership, the taxpayer will be subject to criminal fraud charges. The amount of the penalty depends on how severe the crime turns out to be on investigation. Additionally, because it is a criminal offense, the IRS would have to prove beyond a doubt that the partner willfully tried to evade his or her tax liabilities.
The penalties that are discussed in this section are at the partner level because of the flow-through nature of the partnership. Each partner must report his or her own portion of partnership income, and is subject to any penalties that result from his or her direct delinquency, accuracy-related understatements, fraud, and intentional omissions.
If you have any questions regarding this penalty structure, please do not hesitate to contact us.