What is IRS penalties and penalty relief?

Taxpayers who file or pay late, or file inaccurate returns, can face IRS penalties.  The most common penalties are failure to pay, estimated tax, failure to file, and the accuracy penalty.  There are five reasons that the IRS provides penalty relief.  The two most common reasons used for penalty relief are the administrative waiver for first time abatement and reasonable cause.

What do you need to know about IRS penalties and relief options?

  • Penalty rates vary based the type of penalty assessed.   For the most common penalties, here are the rates:
  • Failure to pay:  0,5% per month, up to a maximum of 25%.   this penalty will increase to 1% if the IRS has to enforce collection of the balance owed.
  • Failure to file:  5% per month, up to 25%.  fraudulent failure to file increases the penalty to 15% per month, up to a maximum of 75%.
  • Estimated tax:  equivalent to the amount of interest lost to the IRS by not making timely payments throughout the year.
  • Accuracy:  20% of the understatement of tax.  Fraud increases the penalty to 75%.

The most common abatable penalties are failure to file and pay penalties:  taxpayers have several options to request abatement (relief after the penalty is assessed) for the failure to file and pay penalties, including first-time abatement and reasonable cause arguments.

Disaster penalty relief is usually applied automatically by the IRS:  taxpayers who live in Presidentially declared disaster areas (identified by zip code) will automatically receive the stated late filing and payment relief.  If this relief is not provided automatically, the taxpayer can contact the IRS to request relief.

Most penalty abatement requests are for first-time abatement:  taxpayers with a clean compliance history (no penalties in prior three years (except for estimated tax penalty), all required returns filed, compliant with any payment agreement related to any debt owed) can use first time abatement to remove the failure to file or pay penalty. First time abatement does not apply to accuracy penalties.

There are do’s and don’ts when requesting relief due to reasonable cause:   there are certain arguments that are a non-starter for reasonable cause abatement.   For example, using “reliance on my tax preparer” is never a good excuse for late filing.  The IRS will always deny it.   However, an unforeseen illness, lack of records, and other reasonable cause arguments can be successful.   Taxpayers using any reasonable cause argument should always show how they made a reasonable attempt to comply but could not because of circumstances that were outside of their control.

Many penalty abatement requests are denied – requiring the taxpayer to appeal the adverse decision:  the IRS uses an automated decision-making tool to make penalty relief determinations.  This tool is flawed and often produces incorrect adverse penalty determinations.  Taxpayer often receive adverse penalty abatement determinations that appear not to consider all of the facts and circumstances.   Taxpayers should appeal their decision to the IRS in order to have the entirety of their circumstances considered.

Questions we hear often:

Background on IRS penalties and penalty relief

How often does it happen?  The IRS assesses 40 million penalties in 2018 to approximately 27 million taxpayers.  The most common penalty is the failure to pay penalty (56% of all penalties in 2018 were for failure to pay).   Other common penalties include the estimated tax penalty (32% of all penalties), failure to file (8% of all penalties), and the accuracy penalty (2% of all penalties).   

How long does it take to resolve? 1 day to 12 months, depending on the type of penalty and which type of penalty relief is requested.  First-time abatement can be completed in one phone call to the IRS. However, reasonable cause abatement requests can take months to resolve.   Contesting accuracy penalties are part of the audit or CP2000 process- and often take a few months to resolve and/or appeal.

How are penalties assessed?  Penalties are either assessed electronically (i.e. automatically by IRS computers for late filing and/or late payment)) or manually (such as accuracy penalties from an audit or other compliance enforcement action).   When a taxpayer files late or pays late, IRS systems automatically assess the appropriate failure to file and/or pay penalties.   However, in an audit, an IRS auditor must propose and assess the penalty based on the specific facts of the case.  In CP2000 underreporter inquiries, the IRS can apply and assess an accuracy penalty if the taxpayer had prior noncompliance or a substantial understatement of tax.

Questions we hear often:

Most likely penalty relief solutions

First time penalty abatement for failure to file and/or pay penalties:  first time abatement (FTA) can used for the failure to file and pay penalties.  FTA applies for certain tax returns, including Forms 1040, for taxpayers with a clean compliance history (no penalties in prior three years, all returns filed, and up to date on any payment plans in effect).   This solution can be evaluated through IRS transcripts and received by phone.

Reasonable cause abatement for failure to file and/or pay penalties:  taxpayers can argue that they made a reasonable attempt to comply. That is, they could not comply due to specific unforeseen circumstances that were outside of their control.   Serious illness, lack of records, sincere ignorance of the law, and many other factors can constitute reasonable cause.   It always helps the reasonable cause argument if the taxpayer has a good compliance history (few penalties, file on time, all returns filed, no audit adjustments, etc.) and has corrected the issue that caused the noncompliance.

Request non-assertion of accuracy penalty in an audit or underreporter notice due to reasonable cause:  when a taxpayer I audited or has a CP2000 notice, the taxpayer must contest the penalty during the audit or CP2000 process prior to the assessment.  Taxpayers need to argue that they made a reasonable attempt to properly report their tax liability.  Reliance on a tax pro, ignorance of the law, and other factors can be considered in requesting non-assertion of the penalty.   If the accuracy penalty is already assessed, the taxpayer must request audit or CP2000 reconsideration to have the penalty abated.

Questions we hear often:

Other potential penalty relief solutions

Appeal adverse penalty abatement determinations:  it is common to have to appeal an adverse penalty relief request.  The failure to file or pay penalty can be informally appealed via a Service Center Appeal.   IF the penalty is not paid, the taxpayer can also appeal, in most circumstances, via a Collection Due Process hearing.   In an audit or underreporter notice, the taxpayer can appeal the proposed accuracy penalty after a 30-day letter is sent.  Taxpayers should always request an appeal on any penalty response in an audit or underreporter notice to timely protect their appeal rights.

Collection Due Process hearing request for abatement:  the taxpayer can request penalty relief on an unpaid penalty during a Collection Due Process hearing.

Audit or CP2000 reconsideration:  for assessed accuracy penalties, the taxpayer can request the IRS to reconsider the penalty if the taxpayer missed the original appeal during the audit or CP2000 assessment process.

Steps to resolve a penalty issue

The steps to resolve penalties depend on the penalty (late filing, late payment, return accuracy) and the type of proceeding (electronic assessment, audit or CP2000, etc.).  For each of the major penalties, here are the steps to resolve and get penalty relief:

Accuracy penalties: Taxpayers follow the deficiency procedures during their audit or CP2000 notice when requesting relief (i.e. non-assertion) for accuracy and other return-related penalties.  If the taxpayer misses the appeal during the audit or CP2000 notice, they can request penalty relief by audit or CP2000 reconsideration.

Estimated tax penalties: For estimated tax penalties, taxpayers request a waiver of the penalty (i.e. annualized income method, etc.) when filing their return (suing Form 2210).

Failure to file/pay penalties:  However, for assessed failure to file and failure to pay penalties, here are the steps to follow to request penalty relief:

#1:  Get background information to evaluate if you qualify for penalty relief:  in this step, you need to gather the information need to evaluate if you qualify for penalty relief and which type of relief to request.  Information is needed from both the IRS and the taxpayer to understand options:

  • IRS account information:   there are 3 items to get from the IRS- compliance history (all returns filed, balances paid in a collection agreement that is in good standing), penalty history (penalties assessed and/or abated in prior years), and the specific penalties assessed that require relief.  This information will be needed to evaluate whether you qualify for FTA.  Also, the compliance history and status will be relevant in a reasonable cause argument.
  • Taxpayer information:    the taxpayer needs to create a timeline of events that cause the noncompliance.   The taxpayer will need to provide an explanation of how the event(s) were unforeseen and outside of their control – and how they caused the noncompliance (late filing or payment).  The taxpayer will need to gather third-party evidence to support their argument.   The taxpayer will also need to show how other areas of their life were affected by the unforeseen circumstances.

#2:  Fix any immediate noncompliance issues:   taxpayers should not proceed with abatement if they are not in compliance.   That means filing all required back returns and making sure they are in good standing with any back balances owed.    

#3:  Determine penalty relief method:   the options are usually to request FTA or reasonable cause. The taxpayer can also request automatic relief if the IRS did not identify the taxpayer as being affected by a Presidentially-declared disaster area.  Most taxpayers request FTA or reasonable cause relief. Taxpayers always need to evaluate FTA First. Any request is first evaluated for FTA, even though the taxpayer requested reasonable cause.  However, if the taxpayer does not qualify for FTA, they can request reasonable cause relief.   

#4:  Request relief:    FTA can be done by phone.  Contact the IRS and ask for FTA – show the IRS that you had no penalties in the three prior years and that you are currently compliant. Reasonable cause abatement should be requested via Form 843 or a penalty abatement request letter.  The request should clearly state the years and forms involved, and the penalties that are requested to be abated.  The request should also state the facts that show the unforeseen circumstances outside of your control that caused the noncompliance. The request should also provide specific dates and facts that show the reasonable cause circumstances, with supporting evidence to prove your argument.  All requests require that the taxpayer attest that all facts presented are accurate, under penalties of perjury.

#5:  Obtain abatement or appeal any adverse determination:  the IRS will issue their determination. FTA requests have an immediate phone determination.  Reasonable cause requests take about 2-3 months for an IRS response.  The IRS determination can be a denial, partial denial, or a full allowance.   Any denial can be appealed to the IRS Service Center Penalty Appeals Coordinator.   The taxpayer has 60 days to appeal the adverse determination.  In reality, because most penalty abatement requests are informal, the IRS will accept an appeal that is filed past the 60 days.  Once the appeal is requests, the taxpayer will get an opportunity to provide their complete circumstances and argument as well as more evidence to an IRS appeals officer.  If the denial is sustained, the taxpayer must pay the penalty and file a claim to re-argue the case against the IRS in court.  This is not a practical remedy for most penalty situations.

#6:  Confirm the penalties were abated:  if the agreement reached on penalty abatement, the taxpayer should follow up to make sure the penalties were abated.  Taxpayers should review their specific account transcripts to make sure the penalties were abated.

Questions we hear often:

Can you appeal a penalty relief disagreement?

Adverse penalty relief determinations are subject to appeal. 

Taxpayers in an audit or underreporter (CP2000) inquiry should appeal the accuracy penalty and any other penalties proposed during the audit/CP2000 process before the penalty is assessed.  The appeal should start with a manager conference, and proceed to IRS appeals if there is no resolution with the IRS auditor’s manager.   Ultimately, timely audit and CP2000 penalty protests can be appealed to the US Tax Court prior to assessment.  Taxpayers need to timely request their appeals throughout the audit/CP2000 process in order to argue these penalties before they are assessed.

Once assessed, the taxpayer can request an information audit/CP2000 reconsideration of the penalty assessed or use the claim for refund procedures (pay the penalty, file a claim for refund of the penalty, wait 180 days/receive IRS notice of claim disallowance, sue the IRS in District Court or Court of Claims) to request penalty relief., there are three levels of appeal for collection disagreements:  a manager conference, the Collection Appeals Program, and, if applicable, a Collection Due Process hearing.   For an OIC rejection, the taxpayer is also afforded an appeal with the IRS Independent Office of Appeals.   Each type of appeal works differently and only the Collection Due Process hearing is subject to review by the US Tax Court.

Late filing and late payment penalties that are assessed electronically require the taxpayer to request abatement.  If relief is denied, the taxpayer can request an IR appeal by sending their request to the IRS Service Center Penalty Appeals Coordinator.   These appeals hearings are informal.  The taxpayer may be able to request a more formal appeals hearing called the Collection Due Process hearing.

To obtain a more formal appeals hearing, the taxpayer must not pay the penalty and file for a Collection Due Process hearing to request penalty relief.   A taxpayer can request a CDP hearing after they receive a final notice of intent to levy (usually IRS letter LT11 or L1058).   CDP requests allow the taxpayer to request penalty abatement.  Taxpayers need to be careful when using a CDP hearing to request abatement as they are close to receiving a levy or Notice of Federal Tax Lien.  They will need to timely request the hearing within 30 days of the levy notice or a lien filing – and to monitor their IRS status to make sure that enforced collection does not occur before the IRS registers their CDP request. 

Questions we hear often:

Best practices for penalty relief

  • Use first-time abatement whenever possible.  You should request first-time penalty abatement relief for the failure to file and pay penalty if you qualify under the FTA rules.    You can request FTA every four years as long as you did not have any prior penalties in the previous three years.
  • Always check on the status of your penalty abatement request.   Penalty abatement requests do not show up on IRS transcripts, nor does the taxpayer get periodic updates on the status of their request.  It is common for the taxpayer to experience long periods of inactivity.  Taxpayers should contact the IRS monthly to check on the status of their request.  The IRS often erroneously closes an abatement request – requiring the taxpayer to resubmit the request.  
  • When requesting penalty relief for unpaid penalties, monitor IRS collection activity to avoid enforced collection.  Informal IRS penalty relief requests (Forms 843 or letter to the IRS) do not stop IRS collection activity.  You should monitor your IRS account and collection notices and ask the IRS for a collection hold while the penalty abatement is pending.   The IRS will usually give short extension periods.  Be prepared to ask for a collection hold multiple times as penalty abatement can take some time.  Initial penalty abatement requests take 2-3 months for an IRS determination.   If an appeal is requested, it can add up to a year or more before the IRS makes a decision.
  • Never use “reliance on a tax professional” as reasonable cause for late filing.  The IRS never allows reliance on a tax professional (rarely allows reliance on tax software) as a reason for filing late.  Taxpayers should argue other reasonable cause factors such as illness or inability to access records.
  • Penalty abatement works better for compliant taxpayers.  Even if FTA does not apply, taxpayers with a clean compliance history fare better when requesting relief.  Other positive factors:  voluntary compliance (i.e. not prompted to comply by IRS notices or enforcement activity)and taking future compliance assurance measures (i.e. hiring a tax professional).
  • It’s hard to argue “reasonable cause” if your circumstances only affected your tax compliance.  Unforeseen circumstances outside of your control need to affect more than just filing and paying on time.  Taxpayers with the best reasonable cause arguments can show how other areas of their life were affected by the unforeseen circumstances.  For late payment, this would include not being able to pay for necessary living expenses.
  • For paid penalties, you must request relief within the statute of limitations period.  Taxpayers can request abatement of a penalty three years after the return is timely filed or two years after the penalty has been paid.  If a taxpayer has not paid their penalty, they can request penalty abatement up to two years after the penalty was paid. 
  • If you qualify, at the end of the payment plan, ask for first-time abatement for the first year’s failure to pay penalty.  If you qualify for first time penalty abatement (I.e. no penalties for prior three years) for the first year of penalties, you should request abatement of the failure to pay penalty at the end of the payment agreement.  The IRS will reduce your balance and/or refund you the penalty paid.
  • Be prepared to appeal adverse failure to file/pay determinations. IRS representatives that review failure to file and pay penalty abatement requests use a computer decision tool to make their penalty abatement determinations.   This tool, called the “Reasonable Cause Assistant,” is designed to help the IRS apply the penalty relief rules.  However, in reality, the tool decides to deny many requests because it cannot evaluate the totality of the taxpayer’s circumstances in determining relief.  As a result, most taxpayers obtain a denial of relief and must request an appeal to have an IRS appeals officer look at all of the facts and circumstances.