Two IRS Pronouncements on Penalties by Robert S. Horwitz
When it comes to taxes, Congress is penalty happy. There are over 150 separate penalties that can be imposed for various infractions of the Internal Revenue Code. Two recent IRS pronouncements address penalties.
First Time Abatement Relief
Among the myriad of penalties, the Internal Revenue Code provides for the penalties for:
- Failure to file a tax return by the due date;
- Failure to pay tax shown due on a return by the due date;
- Failure to deposit tax;
Failure to file a partnership return by the due date; and
Failure to file a S-corporation return by the due date.
In 2001, the IRS adopted a “first time abatement” policy for these penalties. Under the policy, a taxpayer could receive relief for these penalties if it is shown that (a) the taxpayer was never previously required to file a return or has no prior penalties for the three preceding years; (b) has filed (or filed an extension) for all currently due returns; and (c) has paid or arranged to pay any tax that is due. The taxpayer who meets these requirements can have the penalty abated for a single tax period. The IRS normally abates the earliest tax period that meets the abatement criteria.
Historically, the IRS only granted first time abatement relief where the taxpayer either asserted reasonable cause or specifically requested first time abatement relief. The Treasury Inspector General for Tax Administration (TIGTA) criticized the IRS for not informing taxpayers of the availability of first time abatement relief and for not addressing the negative impact upon taxpayers who also qualify for abatement for reasonable cause.
An internal IRS memorandum was recently published providing that the IRS will automate the first time abatement process so that all taxpayers who meet the criteria for first time abatement will be granted relief. The IRS estimates that automating the process will increase the number of penalties waived from approximately 350,000 per year to approximately 1.7 million a year.
Besides automating the first time abatement process to ensure that all eligible taxpayers get relief, the memorandum is notable for other reasons. First, it clarifies that the three-year look back period means if you obtained relief in the past and you compliant for three straight years, you can qualify for a later failure. Second, it notes that “civil tax penalties exist for the purpose of encouraging voluntary compliance.” Third, it highlights the fact that the Commissioner has broad discretion to “choose not to impose a penalty on a particular class of taxpayers if he believes that doing so will enhance overall tax compliance.”
Adequate Disclosure to Avoid Penalties
On January 29, 2018, the IRS issued Revenue Procedure 2018-11, to identify the circumstances in which a taxpayer’s return will be deemed to have adequately disclosed an item or position to avoid the understatement penalty imposed by Internal Revenue Code sec. 6662(d) and the preparer penalty under Internal Revenue Code sec. 6694(a).
The understatement penalty under 6662(d) applies if there is a “substantial understatement” of income tax. For an individual a “substantial understatement” is the greater of a) 10% of the tax required to be shown on the return or b) $5,000. For a corporation an understatement is substantial if it exceeds the lesser of a) 10% of the tax required to be shown on the return or b) $10 million.
The preparer penalty under 6694(a) is imposed on a return preparer who prepares a return or refund claim reflecting an understatement of a tax liability due to an “unreasonable position” that the return preparer knew or should have known about. A position is unreasonable unless there is or was a) substantial authority for the position or b) the position was properly disclosed and had a reasonable basis.
The minimal information to constitute adequate disclosure is:
- A description of the item and the verifiable dollar amount ;
- If the item is not one described on a line of the return (i.e., rent, wages), the item must be clearly described and the amount – “other expenses” doesn’t cut it;
- If the return does not provide enough space for an adequate description, the description must be continued on an attachment.
The Revenue Procedure discusses in detail what must be provided for purposes of a) Form 1040 itemized deductions and certain trade or business expenses; b) Form 1165; c) Form 1120; d) Form 1120-L; e) Form 1120-PC; f) Form ll20-S; g) foreign tax items; and g) other tax items.
Of course, all bets are off for the sec. 6662(d) penalty no matter how detailed the disclosure if the position taken does not have a reasonable basis as defined in Treas. Reg. sec. 1.6662-3(b)(3), or is attributable to a tax shelter item or is not adequately substantiated by the taxpayer. For purposes of the preparer penalty, no relief is available if the position taken involves a tax shelter or a “reportable transaction.”