"In 1955, there were approximately 14 penalty provisions in the Internal Revenue Code. There are now [in 2011] more than ten times that number." Internal Revenue Manual ("IRM") part 20.1.1.1.1.
Whenever I am asked why it is that I speak so often about penalties, I highlight the above quote from the IRS's employee handbook. Whereas there were 14 penalty provisions in 1955, approximately 150 were listed by 2011; there are even more now, 13 years later. But it's not just the sheer number of penalties contained in the Internal Revenue Code (the "Code") that makes penalties more relevant now than ever before; it's the IRS's enforcement of those provisions.
I have enough gray hair to credibly say that, when I first started practicing tax controversy, getting penalties abated on grounds of reasonable cause often took little more than some magic citations and a heartfelt "please?" I'm not sure how, 20 years later, we find ourselves in a place where even the most reasonable of causes will not be respected until an Appeals protest or Tax Court petition has been filed—but here we are. And it highlights the importance of understanding exactly where the IRS's current penalty philosophy stands.
To properly put IRS penalty enforcement into context, it's useful to understand three key concepts:
- Systematic/automatic versus manual/discretionary
assessment. That is, was the penalty imposed by a computer
with little to no human involvement, or was it imposed through the
efforts of an IRS employee, usually during an
audit?1
- Assessable penalties versus those subject to deficiency
procedures. Penalties that are automatically assessable
generally may not be challenged in Tax Court; any judicial
challenge to such penalties must be made in the form of a refund
suit once the penalty has been paid and the taxpayer has requested
a refund from the government.2 Penalties subject to
deficiency procedures may be challenged in Tax Court on a
pre-payment basis.
- Type of abatement available. Many penalties contain a provision allowing for abatement if the failure that triggered the penalty was due to "reasonable cause." Others may also be abatable under the IRS's first-time abatement ("FTA") policy; still others are not abatable at all. Before putting in the time to craft a penalty abatement request, it is important to know which type of penalty you are dealing with.3
With the above in mind, below are some suggestions that you may find useful.
First-Time Abatement
The IRS's FTA policy, implemented in 2001, is a creation of "administrative grace," meaning that there is no Code section or regulation that requires the IRS to offer abatement of first-time penalties; rather, the rules regarding when a penalty may be abated under FTA are found entirely in the IRM. The IRS could theoretically suspend the program whenever it likes. Thus, when practitioners (often reasonably) complain that FTA should cover a wider range of penalties, the IRS simply shrugs: "Would you rather have no FTA at all?"
Found in IRM part 20.1.1.3.3.2.1, FTA, by its terms, only applies to penalties imposed under Code sections 6651 (failure to timely file or pay tax due), 6698 (failure to timely file partnership return), 6699 (failure to timely file S corporation return), or 6656 (failure to timely deposit). It does not apply to returns that are filed once (e.g., Form 706) or infrequently or to most information returns that are attached to other return (e.g., Forms 3520 and 3520-A). It further does not apply to the late filing of Forms 709 or 990, or other "daily delinquency" penalties.
To qualify for FTA, a taxpayer must satisfy all three of the following criteria:
- The taxpayer has filed (or has a valid extension for) all required returns currently due;
- The taxpayer has paid (or arranged to pay) all tax currently due; and
- The taxpayer has no unreversed penalties in the preceding three tax years, other than estimated tax penalties.
Under IRM parts 20.1.9.3.5 and
20.1.9.5.5,
penalties imposed for the late filing of Forms 5471 or 5472 (which
would otherwise not qualify for FTA) may be abated if the failure
to file penalty on the related Form 1065 or 1120 is abated under
FTA (or would have been abated, had a failure to file penalty been
assessed) and the taxpayer has not had any similar penalties
imposed for the prior three tax years.
It is important to remember that FTA, if it applies, will be applied before reasonable cause abatement. What does this mean in practical terms? Taxpayers cannot save their "get out of jail free" card to use when they really mess up by simply claiming "reasonable cause" for their other failures. If FTA applies, no matter how reasonable the failure was, FTA will be applied and will not reset until another three years of penalty-free compliance passes. While this may seem unfair, remember what was just explained above: FTA is a matter of administrative grace.
One more practical note on FTA: often, this kind of abatement can be obtained over the phone, unless the penalty is above the "oral request" threshold,4 in which case the IRS customer service rep (CSR) will instruct you to mail in a request signed under penalties of perjury. As a best practice, a suggestion is to have a written abatement request ready to go when you make calls to request FTA so that if you are asked for a written request, you can offer to fax one over right then and there. Sometimes, the CSR will accept and log the written request on the spot and grant the relief. Sometimes, they'll say "thanks, someone will review and get back to you." And sometimes, the CSR will refuse to take something via fax. Depending on how time sensitive your client's request is, you may want to request to speak with a supervisor if immediate attention to the matter is important.
Reasonable Cause
If FTA isn't available, the next question is whether the relevant statute provides for abatement if the failure at issue was due to reasonable cause. Sometimes the statute also requires that the failure not be due to willful neglect. While it may be somewhat unnecessary (in that a failure caused by willful neglect will practically never be "reasonable"), the contrast of the standards for willful neglect can sometimes be useful in cases where you can say more about what your client did not do ("He didn't ignore the due date!" "She didn't put down numbers she knew were wrong!") than what he or she did...a straw man, if you will.
While most statutes and regulations do not specifically define what reasonable cause means, the definition found in Treas. Reg. § 301.6651-1(c) is generally cited as the applicable standard in penalty cases: "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." This definition is in contrast to that of "willful neglect," which the U.S. Supreme Court has defined to mean "a conscious, intentional failure or reckless indifference." U.S. v. Boyle, 469 U.S. 241, 245 (1985).
A detailed analysis of cases where reasonable cause has been found (or not) is beyond the scope of this discussion; however, five tips and tricks are worth sharing:
- Your reasonable cause statement should cite the relevant legal standards and very clearly describe how your client meets those standards.
- The more facts, the better (usually); if those facts can be backed up by documents or signed affidavits, even better.
- You may need to make the same request for abatement multiple times and/or to multiple audiences. Putting together the strongest possible case for abatement the first time means that latter revisions will only need to focus on new developments or modifying the message to the audience. It will also ensure that your client's message is consistent!
- Feel free to cite liberally from the IRM. Part 20.1 is called the "Penalty Handbook" for good reason. It contains a multitude of guidance on how the IRS should evaluate reasonable cause cases that sound, at least in print, very taxpayer friendly.
- Under The IRS will often argue that the Supreme Court's Boyle opinion precludes reliance on a tax professional to determine when a return is due. While that may be largely true, there is an important distinction between when a return is due and whether a return is due. A Form 3520 may be filed late not because the taxpayer relied on their professional to tell them when the return was due, but because they had no idea what the form was and needed a professional to inform them of the need to file the form in the first place.
Speaking of reliance, if your client is relying on the advice of a
professional to build their reasonable cause case, the clearest
statement of the relevant requirements can be found in
Neonatology Associates, P.A. v. Commissioner, 115 T.C. 43,
99 (2002):
- "The adviser was a competent professional who had sufficient expertise to justify reliance,
- The taxpayer provided necessary and accurate information to the adviser, and
- The taxpayer actually relied in good faith on the adviser's judgment."
Here, too, it is well worth your time to fully address each requirement in detail, providing information regarding the professional's education, experience and qualifications; the information the taxpayer conveyed to the professional; and the fact that the taxpayer, as a lay person, relied on the professional and had no reason to question their advice.
IRS Penalty Priorities
Even armed with the knowledge of how to effectively request penalty abatement, it is important to understand the IRS's current priorities in terms of penalties, not only so that you can craft the best defense, but also so that you can set client expectations. Here, an example is useful.
I often receive referrals from CPAs of clients of theirs who have failed to timely file international information returns. Knowing how steep those penalties can be, especially if there are multiple kinds of missing forms, or several years involved, engaging a specialist is often the right call. My first question is always: "Are there any missing 3520s or 3520-As?" Why? Because I know that right now, the IRS's policy is to automatically assess penalties for any late filed Forms 3520 or 3520-A, regardless of how late, regardless of how reasonable the cause is, and regardless of whether the taxpayer attempts to use the Delinquent International Information Return Submission Procedures (DIIRSP). I also know that these penalties are treated by the IRS as immediately assessable,5 meaning that if administrative abatement is not possible, the client will have to pay the penalty and sue for a refund to obtain relief. Lastly, I know that there's no way I will have any shot at abating the client's penalties short of going to Appeals, where any settlement recommended by the Appeals Officer will have to be approved by an "issue coordinator" within the IRS whom I will never meet or have the opportunity to talk to. Sounds promising, right? (To be fair, going through these procedures can be successful, but a client needs to understand the process they're signing up for!)
Contrast that with someone with a couple of missing Forms 8938 and a delinquent Form 5471 for a single year. The recommendation may be to either use DIIRSP, or–if they owe any tax because they omitted income from the nonreported assets–explore whether the Streamlined program makes sense for them. One might also consider whether a "quiet disclosure"– i.e., simply filing amended returns with the missing forms attached–might be the best option. Why? Because I know that, at least as of today, the IRS doesn't automatically impose penalties for late Forms 8938 or Forms 5471 filed by an individual,6 so long as the taxpayer makes the filing before the IRS realizes that the forms should have been filed.
But any of the above could change tomorrow, because so much depends on which penalties are being prioritized by the IRS at any given time. And it did in fact change unexpectedly just before the pandemic, when tax controversy practitioners started talking among themselves and noticing a pattern of Form 3520 penalty assessments, even when the traditional, tried-and-true disclosure methods were being employed.
What's my parting advice to you, fearless reader? When it comes to penalties, especially ones with automatic $10,000 or $25,000 penalties, it pays to seek expert advice. Unless and until the pendulum swings back to the "pretty please?" era of penalty abatement, this particular area of tax procedure will remain difficult, detailed and expensive.
Originally published in New York State Society of Certified Public Accountants
Footnotes
1 Among other things, this question is useful when considering whether the penalty at issue required supervisory approval under Code section 6751(b), without which the assessed penalty is invalid.
2 A taxpayer may obtain limited review of assessable penalties if they are otherwise in the Tax Court in the context of a Collection Due Process (or "CDP") hearing, but a discussion of such procedures is beyond the scope of this article.
3 Another helpful reminder, because clients will inevitably ask: interest on late tax payments is never abatable.
4 The oral request threshold, while contained in the IRM, is redacted, so it is unclear exactly how large a penalty must be before a written request is necessary.
5 A recent pair of cases out of the Tax Court suggest that such penalties are not necessarily immediately assessable, and are worth exploring if you have late-filed international information returns that have already been penalized. See Farhy v. Commissioner, 160 T.C. 6 (2023) and Mukhi v. Commissioner, 162 T.C. 8 (2024).
6 The same is not true for business filers. Late-filing penalties will be automatically imposed if the late Form 5471 is attached to a return other than a Form 1040. The same is true for Form 5472 penalties, which are automatically assessed.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.