IRS penalties are complex, but there are paths to relief

The Internal Revenue Code provides for more than 100 separate penalties. Some of them apply to more than one type of return, resulting in myriad pitfalls for the unsuspecting taxpayer.

Awareness of potential penalties and how to gain relief is vital for well-intended taxpayers to comply with IRS requirements and prevent costly and disruptive surprises. Here we describe six common types of penalties and methods the IRS offers to abate them:

• Annual income tax
• Employment tax
• Information returns
• International information return
• Accuracy-related
• Miscellaneous

Annual income tax

The IRS imposes penalties for various filing and payment infractions related to annual income tax returns. Generally, penalties for failing to file or pay on time may vary for individuals, business entities, tax-exempt organizations, estates and certain trusts.

For certain types of penalties, relief is available through the IRS' first-time abatement policy, which grants administrative relief for taxpayers who have a clean compliance history for the previous three years. Additionally, penalties may be abated for reasonable cause if the taxpayer can demonstrate that the failure was not due to willful neglect.

Estimated tax penalties apply to individuals, estates, trusts and corporations that do not make required quarterly tax payments. These penalties are interest-based. If certain payment thresholds are met, they can be minimized by filling out Forms 2220 or 2210.

Relief from estimated tax penalties is uncommon and generally requires evidence of extraordinary circumstances, such as casualty events, retirement or disability.

Employment tax

Businesses with employees are required to make regular federal payroll tax deposits and report income paid to independent contractors. Failure to file, pay or deposit taxes on time can result in penalties that increase incrementally over time.

If an employment tax liability is assigned to the IRS Collection Division, the IRS may investigate and assert a trust fund recovery penalty against any person it deems was responsible to collect, truthfully account for, or pay over the taxpayer’s employment tax.

There are potential defenses and avenues for relief for these penalties, such as first-time abatement and reasonable cause. However, they are not available for all penalties. 

Information returns

Taxpayers who file late or incorrect information returns and payee statements are subject to penalties. Penalty amounts depend on the length of delay in correcting the error or filing the return; intentional disregard of the requirements results in a higher penalty.

Penalties may not apply if the failure is due to reasonable cause and not willful neglect. Acting responsibly before and after the failure, having significant mitigating factors, or the failure being beyond the taxpayer’s control can constitute reasonable cause.

To try to avoid penalties, taxpayers can request an extension of time to file an information return. This allows additional time to collect data on payees and prevent late filing.

International information returns

The IRS imposes penalties related to international information returns when taxpayers fail to comply with tax laws, rules and regulations concerning financial activity related to foreign sources. Penalties vary based on the type of return and can increase until a complete, accurate return is filed or the maximum penalty is reached.

Interest is charged on these penalties; however, penalties can be reduced or removed for taxpayers who can demonstrate reasonable cause and good faith.

To prevent penalties, ensure timely and accurate filing of returns and consider applying for an extension if needed. If penalties are assessed, verify the notice’s accuracy and correct any issues promptly.

The Delinquent International Information Return Submission Procedures (DIIRSPs) permit eligible taxpayers to submit delinquent returns through normal filing procedures. To qualify, taxpayers must meet the following criteria:

1. They must have failed to file one or more international information returns.
2. Their failure to file must have been due to reasonable cause.
3. They must not be under civil/criminal investigation by the IRS.
4. They must not have been contacted by the IRS regarding delinquent international information returns.

Penalties may still be assessed in accordance with the existing procedures.

Accuracy-related

The IRS imposes accuracy-related penalties for underpayment of tax due to negligence or disregard of tax rules, a substantial understatement of income tax, or a substantial valuation misstatement.

The penalties may be minimized by adequately disclosing certain information and having a reasonable basis for the treatment of the item on the tax return. Also, penalties may not apply if the underpayment can be attributed to reasonable cause.

The IRS requires written approval for penalty assessments, and taxpayers should ensure this requirement has been satisfied. If not, penalty relief should be requested based on the agency’s failure to fulfill the requirements.

Miscellaneous penalties

The IRS also imposes other penalties depending on various types of tax or type of transaction involved:

• Late filing or payment of quarterly federal excise taxes
• Tender of a bad check or dishonored payment
• Failure to qualify as a real estate investment trust (REIT)
• Failure to maintain investment standards of a qualified opportunity fund (QOF)

Tax penalty prevention and relief: Working with an advisor

It can be challenging for taxpayers to navigate IRS penalties. Filing and reporting requirements can be complex, and your compliance resources may be strained by various business issues.

An advisor with experience working through abatement processes may be able to guide you in dealing with the IRS. Penalty relief often depends on facts and circumstances, and an experienced advisor can discern how yours apply to various IRS criteria and standards, especially establishing reasonable cause.