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IRS Penalty Abatement-What You Need to Know

You just got a letter from the Internal Revenue Service. It says that you owe penalties and interest on tax debt.

If this is your first time facing tax penalties, good news! You might be eligible for IRS penalty relief under a program called, IRS First Time Penalty Abatement.

Even it’s not your first time, there are still some other ways that you might be eligible for penalty relief.

This article will walk you through the IRS’ first time tax penalty abatement policy, discuss other sources of administrative relief, and outline the procedures involved.  

What types of penalties are eligible for relief? 

According to the Internal Revenue Manual, there are 9 types of IRS tax penalties that are eligible for relief.

Information return penalty

Information return penalties apply to taxpayers who do not file information returns or provide payee statements in a timely manner.

A penalty is assessed for each unfiled information return or payee statement. The penalty amount depends on how long the return or statement remains unfiled.

Failure to file penalty

Failure to file penalties apply to taxpayers who do not file their income tax return by the due date. This does not apply to taxpayers who may have applied for (and received) an extension on their tax return.

The failure to file penalty is 5% of the outstanding tax liability per month that the tax return remains unfiled. The maximum penalty is 25% of the total tax bill.

If you’re owed a refund on your tax return, you’ll receive no failure to file penalty.

If you’re having problems getting together required documents, your tax professional might file for an extension to avoid the failure to file penalty.

Failure to pay (FTP) penalty 

The failure to pay penalty applies to taxpayers who do not pay their income tax by the due date of their tax return. If the taxpayer filed an automatic extension, failure to pay penalties do not apply until after the end of the extension.

The failure to pay penalty is 0.5% of the unpaid balance per month that the taxes remain unpaid. The maximum penalty is 25% of the total tax bill.

In any month that failure to file and failure to pay penalties apply, the failure to pay penalty will offset the failure to file penalty for that month. The total of the combined penalties will not exceed 5% for the month, until the failure to file penalty reaches a maximum of 25%.

Accuracy-related penalty 

Accuracy-related penalties apply to taxpayers who underpay their tax liability because they either:

  • Failed to report all sources of income
  • Claimed credits or deductions not entitled to

There are two types of accuracy-related penalties:

Negligence or disregard of the rules or regulations

Negligence happens when the taxpayer fails to make reasonable efforts to follow the tax laws when filing a tax return.

Disregard is when the taxpayer carelessly, recklessly, or intentionally ignores IRS rules or regulations.

According to the IRS, examples of negligence include:

  • Not keeping records to prove you qualify for the credits or deductions you claim
  • Not including income on your tax return that was shown in an information return, like income reported on IRS Form 1099
  • Not checking the accuracy of a deduction or credit that seems too good to be true

The accuracy-related penalty for negligence or disregard is 20% of the underpayment due to negligence or disregard.

Substantial understatement of income tax

For individual taxpayers, a substantial understatement of income tax penalty applies if the tax return underreports a tax liability by the greater of:

  • 10% of the tax required to be shown on the tax return, OR
  • $5,000

The accuracy-related penalty due to substantial understatement of income tax is 20% of the underpaid tax.

Failure to deposit penalty

Failure to deposit penalties (also known as payroll penalties) apply to employers who do not correctly pay employment tax. Employment taxes must be submitted on time, in the right amount, and in the right way.

Employment taxes include:

Payroll taxes must be paid on either a monthly or semi-weekly schedule, as determined by IRS Publication 15, the Employer’s Tax Guide.

Failure to deposit penalties are calculated as a percentage of the undeposited taxes. This percentage depends on how long the taxes remain unpaid.

Dishonored check penalty

The dishonored check penalty applies to taxpayers whose checks do not clear due to insufficient funds.

If the bad check is less than $1,250, then the dishonored check penalty is the lesser of:

  • 2% of the underpayment amount, OR
  • $25

If the dishonored payment is for $1,250 or more, then the penalty is 2% of the amount of the check.

Underpayment of Estimated Tax by Corporations penalty

The underpayment of estimated tax penalty is assessed to corporations who do not pay estimated taxes on schedule. Generally, corporations who expect to owe $500 or more when filing a tax return are expected to make quarterly estimated tax payments.

The IRS penalty for underpayment is calculated based on:

  • The amount of the underpayment
  • The period when the underpayment was due and underpaid
  • The interest rate for underpayments that the IRS publishes quarterly

Underpayment of Estimated Tax by Individuals penalty

This penalty is assessed to individuals who do not pay estimated taxes, or if they are paid late. The IRS may assess an underpayment penalty even if the IRS owes the taxpayer a refund.

Similar to the corporation underpayment penalty, this penalty is calculated based upon the amount of unpaid taxes, how long they were unpaid, and the prevailing interest rate.

Other penalties as applicable

Nice catch-all for other, less common IRS penalties.

When does the first-time penalty abatement apply?

Technically, the first-time abatement is available only for one penalty on a single return. And it only includes the following penalties:

  • Failure to file (FTF) penalty 
  • Failure to pay (FTP) penalty 
  • Failure to deposit (FTD) penalty 

For first time abatement, the eligibility criteria is pretty clear, from the website. The taxpayer must meet the following criteria: 

  • Not had prior penalties for the 3 tax years before the tax year in which you received a penalty.   
  • Filed all currently required returns or legitimate extensions.   
  • You have paid, or arranged to pay, any tax due.  This could include a payment arrangement or installment agreement.

In other words, if it is April 20, and you did not file the most recent tax return, the IRS will not consider approving your FTA request. You have to file the return (or have filed an extension). If your tax returns for other years are on file and properly filed, then you will have met this criteria. 

If you owe unpaid taxes, you must either be brought current by paying the balance (including penalty), or have entered into a payment plan that the IRS has approved.

In other words, before abating any penalties, the IRS wants to make sure you’re paid up, or have a legitimate payment arrangement in place that will pay off your debt. 

If you owe penalties for more than one tax year, you might still be able to seek penalty relief. However, the first time abatement will probably be applied to the first applicable tax period.   

Subsequent tax periods could be granted under other relief provisions, the most likely of which would be reasonable cause. 

For reasonable cause, it’s a little less clear.  Since reasonable cause is based upon all of the relevant facts, each case will be a little different.   

What is reasonable cause? 

The IRS’ website describes reasonable cause as: 

Reasonable cause is based on all the facts and circumstances in your situation.  Any reason which establishes that you used all ordinary business care and prudence to meet your federal tax obligations, but were unable to do so, will be considered.”

IRS Website

The website also includes typical situations as sound reasons for reasonable cause. This list includes unforeseen circumstances like fire or natural disaster, death or disability in the immediate family, or inability to obtain records, among other reasons.  

The IRS also states that a taxpayer may present any other sound reason that showed good faith, business care, and prudence to meet their tax obligations.

In its guidance to employees, the IRS indicates: 

  • Taxpayers generally bear the burden of proof to establish reasonable cause
  • Each reasonable cause request must be evaluated on its own merit 
  • IRS must determine if the reason addresses the imposed penalty 
  • Review previous periods for payment patterns and penalty history—in other words, someone who is eligible for FTA might get the benefit of the doubt over someone who has had to go through this before 
  • Consider the length of time between events 
  • Consider whether the taxpayer could have anticipated the event that caused noncompliance 

It’s also worth noting that the type of penalty matters.  For example, the IRS specifically states: 

A lack of funds, in and of itself, is not reasonable cause for failure to file or pay on time. However, the reasons for the lack of funds may meet reasonable cause criteria for the failure-to-pay penalty.   

In other words, not having money won’t stop you from having to pay the failure-to-file penalty. After all, you can file your tax returns for free.  

But if you happen to not have money due to circumstances beyond your control, the IRS would consider the circumstances that caused your money shortfall in its determination to grant or deny reasonable cause abatement. 

Does this policy cover interest? 

Technically, no and yes. 

No, with respect to interest on back taxes owed. The IRS will only reduce interest owed if the interest is due to an unreasonable error or delay by an IRS officer or employee in performing a ministerial or managerial act.  

In IRS Publication 556, Examination of Returns, Appeal Rights, and Claims for Refund, the IRS specifically defines these as either a ministerial act or a managerial act.

Ministerial act 

A procedural or mechanical act, not involving the exercise of judgment or discretion, during the processing of a case after all prerequisites have taken place. This would include conferences and review by supervisors.

For example, if an audit letter is sent to an old mailing address, then forwarded to the taxpayer’s new address. The taxpayer’s response includes a request for the audit to be forwarded to an IRS office closer to the new address. At its discretion, the IRS could choose to waive any undue interest incurred during this process.

Managerial act 

An administrative act during the processing of a case that involves the loss of records or the exercise of judgment or discretion concerning the management of personnel.  

For example, you’re in the middle of an audit.  Your auditor is sent to an extended training course, and their supervisor does not reassign your case.  Instead, your case waits until the agent returns.  

The interest that accrued during that unreasonable delay could be reduced in this circumstance. 

In other words, there are few scenarios where the IRS would waive interest.

Abatement of penalty

However, if you are successful in waiving penalties, any interest that has accrued on those penalties will automatically be reduced.  

That means not only is the penalty abated, but the interest goes away.  This is automatically calculated for you by the IRS. 

Submitting a penalty abatement request 

Submitting penalty abatement request is an easier process than you might think it is. We’ve broken this process down into five simple steps.

Step 1: Review your correspondence 

If you’ve gotten this far, then you probably have received a lot of written correspondence from the IRS. On your notices, there should be a toll-free number that you can call to discuss your options. 

Step 2: Contact the Taxpayer Advocate Service

If Step 1 doesn’t work, then you might want to enlist the help of the taxpayer advocate service.  There are several options here: 

However, the taxpayer advocate service cannot help you until you’ve laid all your cards on the table.   

Step 3: Educate yourself & submit the paperwork

Understand that there is a difference between FTA, and other forms of penalty relief, such as reasonable cause.  

Doing this will help you understand how to properly fill out the paperwork. In turn, that will help you navigate the process a little more efficiently.

Knowledgeable IRS employees will know exactly what blocks to fill, and how to walk you through the paperwork. But the more that you know, and the more good faith that you demonstrate, the more likely that employee is to work with you.

Also, detailed notes are kept for each conversation, so you shouldn’t have to reinvent the wheel with each phone call.   

Step 4: Once the paperwork is approved, ask for your written tax bill.

Once the penalty abatement is approved, ask for written notification of the change to your tax bill.

The IRS agent should be able to tell you the new balance over the phone (taxes owed, interest, any remaining penalties). However, you should ask for your tax bill in writing.

That way, you can have it for your records. 

Step 5: Appeal (if necessary)

If your request for abatement was denied, you can appeal.  The IRS offers a penalty appeal self help tool. This tool outlines conditions under which an appeal might abate your penalty.  

Some of these reasons include: 

  • Reasonable cause:  This is kind of a catch-all for tax penalties could be abated, but don’t technically qualify for FTA.  Usually, this is what you would request, in addition to FTA, when working with the taxpayer advocate, in cases where your tax issues are your fault. 
  • Statutory exceptions:  In some cases, the law allows for certain exceptions.  If this applies to your situation, then you would have grounds for an appeal. 
  • Administrative waiver:  There might be a formal government directive providing penalty relief because of a catastrophic event or natural disaster.  

Keep in mind that you have 30 days from the date of your rejection letter to file your appeal.  You will want to contact the IRS well in advance, so you can best prepare yourself to request the appeal

Conclusion

Tax penalties can be scary and daunting. But if you believe that you have reasonable cause, the penalty abatement process will help you avoid them.

The only thing that will make your tax problems go away is to educate yourself on the process.