CHAPTER 11: REDUCING IRS PENALTIES WITH REASONABLE CAUSE PENALTY ABATEMENTS
There are a lot of common misconceptions surrounding the abatement (removal) of IRS penalties and interest that I thought it was worth its own chapter.
Statistically, well over 90% of taxpayers do what they are supposed to do when it comes to filing and paying their taxes. For most people this is not an issue, but for those that do not comply with the tax law, penalties help shape a conversation about voluntary compliance and encourages self-assessment and taxpayer education.
Congress determined a long time ago that the financial consequences for failure to comply should be severe enough to deter noncompliance.
The tax code has been used in the past for things that were not fair, so they have now created a fair system for all and cannot be used as a punishment against a specific group of people. It needs to be fair on a consistent basis. In addition, penalties need to be impartial, accurate, and still respect the right for representation.
The three most common categories of penalties relate to filing or not filing of the return, the tax payment or nonpayment of the tax, and accuracy of the tax.
Most often, penalty assessment is a direct result of an instigated event, such as a 941 liability that goes unpaid and therefore the trust fund recovery penalty is created. It could also be from a lack of an event when something was supposed to happen (i.e. failure to file penalty).
It is important to note that penalties are set in stone and there is a priority order in which penalties are assessed. Internally at the IRS, most penalties are now calculated electronically without a manager having to sign off on those. The computer is assessing the penalties and not a human.
Because of this, I would recommend doing your own calculation to make sure the penalties are accurate.
*Special Note: Given that penalties and interest are created as a percentage of liability, if the liability that you owe is wrong, the penalties and interest will be wrong as well. If you can pull down that liability to what it properly should be, then the penalty and interest calculation will be adjusted as well.
Penalty relief may be granted after tax accounts are deemed correct and currently compliant. This means that if you want to challenge the tax liability, you need to do that before you are trying to get a penalty abatement; hence why this chapter is after the financial analysis and tax resolution chapters. It is the last thing that you do.
You cannot be accumulating tax debt nor missing filings or not paying federal tax deposits to qualify for abatement.
Assuming you are current and compliant, and the resolution has been put into effect, then you can move onto requesting abatement. There are four specific reasons why abatement is offered. Those four reasons are:
- Reasonable cause
- Statutory exceptions
- Administrative waivers (includes first time abate (FTA))
- Correction of IRS errors
An additional way to get penalty abatement is through Appeals. They may ultimately recommend penalty abatement based on litigation potential. Appeals job is to prevent tax litigation, so if they feel your case could go to court, they may negotiate to save some face and costs on the legal side.
Statutory exceptions, administrative waivers, and correction of IRS errors are uncommon at best. The claiming of reasonable cause is the most common, so I will only be working through that reason in this book.
Reasonable Cause Criteria
Most do not qualify for reasonable cause; let me be clear on that. However, for those that do, it can be an immensely powerful reduction technique regarding penalties.
Reasonable cause is based on all the facts and circumstances regarding your particular tax situation. There is no bias allowed based on industry or types of taxpayers. The IRS must apply a consistent ruling with regards to certain situations.
A lot of whether penalty abatement is granted comes down to how you as a Taxpayer have conducted yourself throughout the resolution process. How you conducted yourself before the tax debt, during the time you were accruing the tax debt, and after you started resolving the tax debt are all important factors that the IRS considers.
There are some consistent questions that you will see as part of this process, so make sure you are prepared to field these types of questions:
- What happened and when?
- During non-compliant period, what prevented filing or paying?
- How did the facts/circumstance prevent compliance?
- How did the taxpayer handle other financial affairs during this time period?
- Once facts/circumstances changed again, what did the taxpayer do? What steps did they take to get back into compliance and the timeline?
Types of Reasonable Cause Penalty Abatement
There are few categories, or types, of reasonable cause abatement, namely:
- Death, serious illness, or unavoidable absence from business affairs
- Fire, casualty, natural disaster
- Loss of records beyond the taxpayer’s control
- Erroneous advice despite exercise of ordinary care and prudence
- Ignorance of the last despite good faith efforts to comply
- Bad advice from the IRS or tax professional
- “Undue economic hardship” – advanced penalty abatement strategy for business owners.
Let us talk through each of these.
If you are an owner/operator subcontractor and you die, are seriously ill, or have an unavoidable absence or a death or serious illness in your immediate family, you might qualify.
In a traditional business, the death, serious illness, or unavoidable absence of a keyperson or a member of that keyperson’s family and that person
had sole authority to execute the return, make the deposit, or pay the tax, then you might qualify as well.
Fire, Casualty, Natural Disaster
If the business could not comply timely because they were affected by fire, casualty, or natural disaster, they may get relief. Ideally, there has been a natural disaster area declared by the President.
Reasonable cause may still be on the table if it is because of fire or another casualty.
Your ability to exercise ordinary business care and prudence given the situation will also go a long way. Factors that the IRS will consider are the timing after the event, the effect on the taxpayer’s business, steps taken to attempt to comply, and if the taxpayer complied when it became possible or not.
Unable to Obtain Records
If a hurricane comes through and floods everything, or records are burned completely, these types of events will give you a chance for abatement potentially. The rule though is if there were circumstances beyond the taxpayer’s control.
The IRS will likely ask why the records were needed to comply? Why weren’t the records backed up in the cloud? When did the business become aware of the records not being there? Etc.
Mistake Was Made
You can try to establish reasonable cause by claiming that a mistake was made. Generally, this is not in keeping with the ordinary business care and prudence standard and does not provide a basis for reasonable cause.
However, the reason for the mistake may be a supporting factor if additional facts and circumstances provide evidence that the taxpayer exercised ordinary business care and prudence, but the result was a lack of compliance within IRS parameters.
The issue here is when the taxpayer became aware of the mistake and to what extent the taxpayer corrected the mistake.
So far, we have not mentioned anything about a general economic decline. The IRS has a position that economic factors should not affect penalty abatement. They believe an owner would take ordinary business care and prudence to plan for economic downturns and how to get through those.
However, an acceptable explanation is not limited to those given in IRM 20.1. The IRS specifies that penalty relief may be warranted based on an “other acceptable explanation,” provided the taxpayer exercised ordinary business care and prudence but was nevertheless unable to comply within the prescribed time.
In other words, the IRS will have some leniency if you can provide a reasonable case that ordinary business care and prudence was met but ultimately created a problem.
Undue Economic Hardship
This is the big one, but what does the IRC specifically mention regarding economic hardship? Let us look at a few different parts of the Internal Revenue Code to showcase a few concepts revolving around economic hardship:
o An immediate threat of adverse action
o Incurring significant costs (including for representation)
o Irreparable injury or long-term adverse impact
o If a levy action by the IRS on tangible business property or assets is preventing from carrying on with a trade or business (generate revenue), then the IRS is creating hardship
o The term “undue hardship” means more than an inconvenience to the taxpayer. It must appear that substantial financial loss will result from selling business property or assets.
All of these references create a general feeling that if the IRS’ actions would jeopardize the businesses ability to continue on or cause a substantial financial loss then it may be undue hardship.
Again, it must be more than just an inconvenience to the taxpayer!
Generally, undue hardship does not impact the ability to file, so this reason is not valid for Failure to File (FTF) penalties.
The reverse could be said if you were claiming a fire caused a loss of records. Well, that might impact filing, but not paying the tax.
Writing Your Penalty Abatement Request
Once you believe you have a reasonable cause argument, it is time to request a penalty abatement.
You can use Form 843, Claim for Refund and Request for Abatement to apply for relief from penalties. However, writing your own letter allows you to provide additional details and information that will help create a better case and give you the ability to go above and beyond what Form 843 provides.
I would recommend explaining the business and how the business works, providing some color regarding initial circumstances before the issues started, why the problem continued after you found out about it, the steps you took to resolve the problem and issue, and what you have done to prevent future issues.
Leave nothing unturned. Write a novel here and explain to the IRS as many relevant facets of the business, how everything works, and what went wrong and how you are fixing the issues.
In this letter, you need to include quotes from the code in this order:
26 CFR 1.6161-1, “The payment of federal taxes over other absolutely necessary business expenses would have resulted in business closure. Business closure and resulting loss of livelihood would be considered “substantial financial loss” as used in the definition of “undue hardship”.
Immediately following, quote this section from 26 CFR 1.6161-1(b), “Undue hardship required for extension. An extension of the time for payment shall be granted only upon a satisfactory showing that payment on the due date of the amount with respect to which the extension is desired will result in an undue hardship. The extension will not be granted upon a general statement of hardship. The term “undue hardship” means more than an inconvenience to the taxpayer. It must appear that substantial financial loss, for example, loss due to the sale of property at a sacrifice price, will result to the taxpayer for making payment on the due date of the amount with respect to which the extension is desired. If a market exists, the sale of property at the current market prices is not ordinarily considered as resulting in an undue hardship.”
Then explain why the business revenue loss occurred that you could not recover from.
Then quote this, “application of the reasonable person standard carries that loss of revenue due to events completely outside the taxpayer’s control that directly impact the principal business activity does establish reasonable cause for failure to pay the tax when due because of the presence of an undue hardship”.
Finally, reference the East Winds Industries Inc vs United States, and later codified in 26 CFR 301.6651-1(c). Feel free to quote it in its entirety.
This is one of the best court cases that you can use to help your defense.
The IRS does not want to put people out on the street or push businesses out of business. If penalties and interest are creating a situation where that would occur due to hardship or other events, you have a potential case to get penalties and interest abated.
Remember, you first need to be in a resolution pathway, and then you can request this abatement.