The IRS has many types of penalties (both civil and criminal) in its arsenal of tools intended to, on the one hand punish and deter misconduct, and on the other to encourage voluntary tax compliance among the general taxpayer populace. Under the current scheme, the imposition of penalties for a myriad of offenses (failure to file, failure to pay, under reporting of tax, civil fraud, promotion of abusive tax schemes, failure to report foreign financial assets, and more) has become increasingly common and, in many cases, has become automatic within normal IRS assessment practice. We are often asked how to abate or avoid penalties imposed by the IRS.
Here are the most common ways to get a penalty abated:
First time penalty abatement
A taxpayer who has enjoyed a clean tax record for at least three years prior to the penalty’s imposition may apply to the IRS for an abatement of tax penalties for a single tax period (for failure to file and/or failure to pay only) through the First-Time Penalty Abatement (FTA) administrative waiver. Employers may also apply for an FTA waiver of penalties for failure to deposit payroll taxes.
To demonstrate a clean three-year compliance history, the taxpayer must have filed all required tax returns (or obtained an extension of time to file) and must have paid any tax due (or arranged to pay it through an installment agreement). In addition, the taxpayer must not have had any penalties of a “significant” amount assessed during the past three years.
The IRS has not defined what it means by “significant,” and some practitioners have observed that even small assessments may result in an abatement request’s denial. In such cases, a taxpayer representative might try directly communicating with the IRS examiner to explain the circumstances behind the penalty and to remind the examiner that only “significant” assessments are meant to disqualify taxpayers from receiving an FTA.
The FTA waiver is a highly under-used tool, according to a 2012 report by the Treasury Inspector General for Tax Administration (TIGTA), which stated that many taxpayers and practitioners are unaware of its availability. FTA abatements are not granted unless requested, meaning many of the qualified taxpayers who do not know about the waiver do not receive it, TIGTA observed. TIGTA reported that out of a statistically valid sampling of 500 taxpayers, who would have qualified for an FTA waiver of failure to file and failure to pay penalties, approximately 91 percent had not received an abatement.
In an ideal situation going into an exam, the taxpayer would have both a valid, reasonable cause for the failure that led to the penalties and the documentation required to prove it. If you can document that the failure was really out of the taxpayer’s hands, you’ll have a good chance of getting the penalties abated. For example, a taxpayer with a complicated tax situation, who lived abroad, and who had received an extension of time to file. After the taxpayer’s preparer notified him by email in August that he had fallen ill and would be unable to prepare the tax return, the taxpayer quickly found a U.S. firm to prepare his return; but the firm informed the taxpayer that it could not complete the return by October 15. Nevertheless, because the taxpayer was able to show the Appeals officer an entire email history documenting the reason behind his late filing, the Appeals officer threw out the failure to file penalty.
In most cases, however, you must assume that the IRS will persist in imposing penalties and should prepare the case accordingly. Even if the IRS examiner makes adjustments to tax, a taxpayer may be able to use a good set of facts as a bargaining chip in the appeals or litigation phases to avoid any accompanying penalties.
Collect all the facts of the case early on, so as not to be caught off guard during the first communications with the examiner; nor to allow the examiner to be the sole source of facts within the case file. It is also important to build a good rapport with the IRS examiner. By cooperating with the examiner in a timely, transparent, and professional manner, taxpayers and their representatives may be able to avoid creating an adversarial relationship with the IRS, which could poison (or at least drag out) the entire examination process from its onset and increase resistance to any future abatement request.
Preparing for Appeals
In building a good, defensible story that might enable the taxpayer to prove he or she had reasonable cause, the representative should consider several questions. For example, do the taxpayer’s facts show the failure to file, pay, report income, or other error was an honest mistake? Did the taxpayer display ordinary business care and prudence in trying to set aside funds sufficient to pay tax? Could the taxpayer have avoided non-compliance? In taking a particular tax position, did the taxpayer reasonably rely on a tax opinion from a professional tax advisor? Make sure your story matches the available documentation.
In general, a taxpayer cannot use insufficient funds as a defense to show reasonable cause for a failure to pay tax. A taxpayer is expected to exercise “ordinary business care and prudence” when handling his or her finances (or business payroll), so as to be able to pay any tax due.
When an employer has failed to pay its payroll taxes due to lack of funds, the IRS will generally seek the Code Sec. 6672 penalty (the “trust fund recovery penalty”) on individuals responsible for the failure to pay. The liability of such individuals is joint and several with the company, and the IRS is not required to pursue the company first.
If you have any questions or need any assistance with the abatement of penalties, please do not hesitate to contact us.