Main Street Practitioner Blog

How you can use this often-overlooked IRS waiver to help your clients

In 2011, the IRS assessed 38.6 million penalties to taxpayers, totaling almost $11 billion. According to the IRS, the purpose of penalties is to deter noncompliance, not to raise revenues. Certain penalties can be waived or abated if your client has a past history of compliant behavior. In effect, the IRS rewards taxpayers with a history of compliant behavior with a one-time penalty amnesty. For individuals, this relief applies to two of the most common penalties: failure to file (delinquency) and failure to pay. For businesses, this relief also applies to the failure to deposit penalty for payroll taxes.

Types of penalty relief
Penalty relief is usually classified according to one of the following categories:

Reasonable cause. This is a facts and circumstances test in which the taxpayer demonstrates that he or she exercised ordinary business care and prudence in determining the tax obligation, but nevertheless failed to comply. Depending on the penalty, the taxpayer must also prove that he or she acted in good faith or that his or her failure to comply with the law was not due to willful neglect. The IRS determines reasonable cause abatement on a case-by-case basis, treating each tax form and year separately.  The IRS often grants penalty abatement based on reasonable cause because of circumstances beyond the taxpayer’s control, such as illness, natural disasters or destruction of taxpayer records.

Statutory exceptions. The IRS waives or abates penalties because of specific exceptions. For example, Section 6654(e) provides exceptions to the estimated tax penalty when the tax is less than $1,000, when there is no tax liability in the preceding year, or when the taxpayer is newly retired or disabled. Another example is Section 7508, which prohibits penalty assertion for taxpayers in combat zones.

Correction of an IRS error. The IRS waives penalties when it makes an error. For example, if the IRS incorrectly posted an extension to file, resulting in a failure to file penalty, the IRS would waive the penalty. This category can also include erroneous written or oral advice from the IRS that the taxpayer relied on using ordinary business care and prudence.

Appeals nonassertion or relief due to hazards of litigation. The IRS Office of Appeals can waive penalties to settle a case based on “hazards of litigation,” which is the probability that the IRS determination will not be upheld in court. For example, an IRS appeals officer may waive penalties in an appeals hearing to reach an agreement with the taxpayer. This is used primarily for accuracy-related penalties in appeals proceedings involving audits.

Administrative waiver. The IRS can waive penalties to provide relief to taxpayers. For example, in 2012, the IRS provided relief for the failure to pay penalty for taxpayers with financial hardship.

The most prominent example of an administrative waiver is often overlooked and misunderstood:  first-time penalty abatement (FTA) for taxpayers with a clean compliance history. This type of penalty relief allows abatement of certain penalties for a single tax period (one tax year for individual and business income taxes, and one quarter for payroll taxes).

The IRS instituted the first-time penalty abatement waiver in 2001 to bolster voluntary compliance and help fairly administer the application of penalties.

According to a 2012 TIGTA report, in 2010, about 1.65 million individual taxpayers qualified for FTA.  However, according to the same TIGTA report, only 8% actually received the abatement. The report indicates that the primary reason for this disparity is that most taxpayers and tax professionals do not know FTA exists. This is largely because the IRS doesn’t indicate FTA as a relief option on its penalty-related notices. This is likely a strategic move. If the IRS publicized FTA, the IRS would be inundated with requests.

The TIGTA report also highlights that the IRS often incorrectly applies its rules in determining whether taxpayers qualify for FTA, due in part to the IRS’ unreliable Reasonable Cause Assistant, an internal system tool used to make penalty abatement decisions. This inconsistency often necessitates that practitioners send a written request for abatement using one of the other four categories of penalty relief. With sufficient knowledge of the FTA process and a phone call to the IRS, tax professionals can often save their individual and business clients from penalty assessments.

Requesting FTA

The most complex part of requesting FTA is determining whether your client qualifies. FTA applies only to certain penalties and certain returns filed. Your client must also satisfy the clean compliance criteria.

• For individuals, FTA applies to the failure to file and failure to pay penalties. Estate and gift tax returns do not qualify for FTA waivers.
• For businesses and payroll clients, FTA applies to the failure to file, failure to pay and/or the failure to deposit penalties. S corporation and partnership late-filing penalties also qualify under FTA. 

For individual and business clients, FTA does not apply to the estimated tax and accuracy-related penalties. The assertion of an accuracy-related penalty is based on the facts and circumstances of each taxpayer and each tax year.  However, similar to the spirit of the FTA qualifications, accuracy-related penalty responses often carry more weight with the IRS when your client has a proven track record of filing accurate returns on time.

To qualify for FTA, your client must meet the clean compliance criteria rules:

Clean three-year penalty history.  Your client cannot have penalties of a “significant” amount assessed in the prior three years on the same type of tax return. IRS procedures do not publicly define significant amount, but in practice, the IRS has used any penalty amount as significant in its application of the FTA qualification. Practitioners should remind the IRS of the “significant amount” qualification if the IRS rejects the request because of a small penalty amount assessed in the past three years. The estimated tax penalty is an exception and would not disqualify your client from receiving FTA.

Required returns filed.  Your client must have filed all tax returns for the past three years, as required.

The remaining steps are easy.  FTA requests do not have to be in writing. If your client meets the criteria, you can request FTA by phone.  If your client’s case is not in an IRS compliance function, such as Examination, Collection, or the Underreporter unit, you can request FTA with the IRS Practitioner Priority Service.

Keep in mind that there is an unpublished ceiling on the penalty amount that the IRS will abate under FTA by phone. If your client’s penalties are substantial, you can request FTA in writing. If you request abatement in writing, provide other relevant penalty relief arguments, including any reasonable cause arguments. This will increase your client’s chances of penalty abatement.

FTA has been traditionally used by tax professionals who know internal IRS procedures. Now, you have all of the information you need to request FTA for your clients with a clean compliance history and save them from IRS penalties.

 
Reprinted with permission of the AICPA CPA Insider™ E-Newsletter, printed in Main Street Practitioner: July/August 2013

Related Resources
Due Diligence in the Real World (checklist)
Summary of Preparer Penalties under Title 26

Author

Jim Buttonow, CPA/CITP, is the cofounder of New River Innovation, creator of Beyond415 (Beyond415.com). He has more than 25 years of experience in IRS practice and procedure. Reach Jim at jbuttonow@beyond415.com.