Category Archives: Penalties & Interest

What You Need to Know About Penalties & Interest

More often than not, clients come through the door and want to know one thing: how much can be removed from their total tax bill. While penalty abatements are available, I always caution my clients to focus on the more important matter first, which is obtaining a formal resolution to the tax debt. Although penalty abatement can grant some penalty relief if reasonable cause can be established, it is not always wise to request it until the client has paid the tax in full or established a resolution such as in Installment Agreement. In fact, if neither has been done, the taxing authorities will rarely grant penalty abatement.

A lesser known fact when it comes to interest is that Congress, not the IRS, sets the rates (currently 3%). And under the Internal Revenue Code, the rate of interest is determined on a quarterly basis. Interest is probably not going to be waived, but there is an exception if penalties are abated. In such cases, interest on the penalty will be adjusted so that the interest on the penalty amount is removed. However, the interest on the tax itself is a necessary evil and typically cannot be removed.

When it comes to penalties assessed by the IRS, the most common are failure to file, failure to pay, federal tax deposit penalty, estimated tax penalty, and the Trust Fund Recovery Penalty (TFRP). To call the TFRP a penalty is a bit of a misnomer, since it is actually the principal tax amount that a business withheld from employees’ paychecks, and then failed to pay over to the IRS. It is a portion of the related business liability, so if a business is paying its liability through an Installment Agreement, those payments are applied to the TFRP as well. But, remember that establishing a resolution for the business collection case does not automatically resolve the TFRP case against the individual(s). The individual cases must be addressed and resolved separately. 

The IRS will abate or remove penalties if you establish reasonable cause. This is generally granted when the taxpayer proves that he or she exercised ordinary business care and prudence in determining his or her tax obligations but nevertheless failed to comply with those obligations. A showing of reasonable cause typically requires evidence that the taxpayer acted in good faith, and that the failure to comply was not due to willful neglect. Absent first-hand knowledge of what led to the tax accrual, a good starting point for a penalty abatement, is asking the taxpayer to describe in his or her own words what happened. This should provide enough insight for the tax professional to further investigate and eventually expound upon key relevant points. It’s always best to focus on the facts and timelines that overlap with the time of the accrual, thereby providing the best chance of success. 

Some of the specific reasons listed in the IRS penalty handbook that may establish reasonable cause are as follows:

  • Death, serious illness, or unavoidable absence of the taxpayer or in the taxpayer’s immediate family
  • Fire, casualty, disaster or other disturbance
  • Unable to obtain records
  • Erroneous advice or reliance

*The above list is not exhaustive, and other reasons may qualify for penalty relief. It is important to provide as much detail as possible, and any written documentation available, to have the best chance to obtain relief.

If penalties have been assessed against you or your business, you can minimize the damage by remaining current on all tax obligations moving forward, establishing a formal resolution to the back tax liabilities, and formally requesting abatement of all assessed penalties. In the meantime, if you are unsure about your liability, we encourage you to utilize our online calculator tool (click here) that will allow you to calculate the penalty and interest on your tax liability, today.

Appeals on Penalty Abatement Requests

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If at first you don’t succeed… A taxpayer that is seeking an abatement on penalties will initially have to make the request through the Collections Division or other functions within the IRS.  When unsuccessful at this level, it would be wise to escalate the request to the IRS Appeals Division. Appeals is independent from the Collections Division and is tasked with resolving disputes on a fair and impartial basis without litigation.

The Treasury Inspector General for Tax Administration (TIGTA) recently conducted an audit to evaluate whether penalties assessed against taxpayers were fully or partially abated in accordance with Appeals criteria.  On July 30, 2015 TIGTA issued a statement on its findings, noting that Appeals has the authority to abate certain penalties when the abatement request has been denied by another function within the IRS.  Furthermore, the statement pointed out that in Fiscal Year 2013, Appeals abated approximately $127 million in penalties.

Generally, the audit found that in most cases, Appeals properly accepted cases in which the IRS operating division had previously denied the taxpayer’s request for abatement.  There were, however, a number of penalty appeals cases that were not abated in accordance with Appeals criteria.  TIGTA noted that in some cases, they could not determine the justification that Appeals personnel used in granting the penalty abatement. Additionally, the Treasury also determined that a small number of processing errors and control weaknesses might have affected the outcome of penalty abatement decisions at the Appeals level.

While the audit went on to conclude that additional training was necessary for Appeals Technical Employees on the requirements for justifying, documenting and granting abatement on penalties, it nonetheless illustrated the point that Appeals is an effective venue for a second chance at abatement of penalties.

We understand that appeals can play an important role in obtaining a desirable resolution. Click here to learn more about how we assist you with your unique situation.

How Do Tax Penalties Work?

 

Cowardly or not, the Internal Revenue Service and state Taxing Authorities assess penalties against taxpayers who do not meet their tax obligations. Penalties are very costly, and are meant to be that way to discourage citizens from failing to timely file and/or pay the balances due on tax returns. If at all possible, it is always wise to avoid incurring tax penalties by filing and paying all returns when due, making timely and sufficient quarterly estimated tax payments where required, and making proper federal tax deposits if you have a business with employees.

However, if you are reading this, it may be too late to avoid penalties. You may be more concerned with how and why these penalties were assessed against you, and what you can do about it.

The major types of penalties assessed by the Internal Revenue Service against taxpayers are as follows:

  • Failure to File: The Internal Revenue Code imposes a penalty for failure to file a tax return by the due date of 5% of the amount due on the return, for each month or part of a month that the return is late, up to a maximum of 25% of the amount due.
  • Failure to Pay: The penalty for failure to pay is .5% of the unpaid amount, for each month or part of a month that the tax remains unpaid, up to a maximum of 25%. Ten days after notice and demand for payment, this amount is increased to 1%, and if an individual taxpayer enters into an Installment Agreement, this amount is reduced to .25% during the Installment Agreement.
  • Federal Tax Deposit Penalty: The penalty for failure to make a timely federal tax deposit of employer withholding tax begins at 2% of the tax due, and increases up to 15% depending on how late the deposit is made. To ensure compliance, employers should make a deposit in full for each payroll period no later than three business days after each payroll date.
  • Estimated Tax Penalty: Self employed individuals must make quarterly estimated tax payments. The penalty for failure to make these quarterly payments is the federal short-term rate plus 3%.
  • Trust Fund Recovery Penalty: This penalty may be assessed against any person who is responsible for collecting or paying withheld income and employment taxes, or for paying collected excise taxes, and willfully fails to collect or pay them. A responsible person for this purpose can be an officer of a corporation, a partner, a sole proprietor, or an employee of any form of business. A trustee or agent with authority over the funds of the business can also be held responsible for the penalty.

Taxpayers have the right to request removal of penalties, known as penalty abatement. Generally, a taxpayer should have the tax fully paid or be on a formal resolution such as an Installment Agreement before it is wise to request penalty abatement. The standard used by the Internal Revenue Service in deciding whether to abate penalties is “reasonable cause.” If a taxpayer can show that the failure to file and/or pay was due to reasonable cause and not willful neglect, the Internal Revenue Service will abate the penalties and the interest on those penalties. Penalty relief is also available for one period based on a clean compliance history for prior periods. If you were assessed the Trust Fund Recovery Penalty or have a proposed assessment pending, you may be able to remove or prevent this assessment if you were not willful and responsible.

Most states have similar penalty and abatement structures to the Internal Revenue Service rules listed above. Penalties are difficult to stomach. However, if penalties have been assessed against you, you can minimize the damage by remaining current on all tax obligations moving forward, establishing a formal resolution to the back tax liabilities, and requesting abatement of all assessed penalties. At 20/20 Tax Resolution, we specialize in guiding and representing you through this often-complicated process, while working to keep you protected from enforced collection by the Taxing Authorities.

“A penalty is a cowardly way to score.” –Pele

What is a Penalty Abatement and What Can be Abated?

What is a penalty?

For starters, it’s important to understand what a penalty is. A penalty is essentially a fee assessed to a taxpayer to punish the taxpayer for failing to meet certain requirements in its tax obligations. The most common penalties relate to not filing a tax return on time or within the extended time, and not paying the tax due on time. There is generally not an extension to pay, only to file.   Taxing Authorities will also add interest to a tax liability. This interest will accrue on the total liability; including the principal, penalties and previous interest.

What is a penalty abatement?

A penalty abatement is the release of penalties filed for what the IRS calls “reasonable cause,” which is essentially a good excuse for failing to meet a given obligation. A penalty abatement request can be submitted after a penalty has been assessed, and is generally most successful when using the proper forms and supporting documentation in addition to a well-researched brief containing case-law and statute interpretations supporting the argument that the taxpayer has “reasonable cause.” If a penalty abatement request is filed after the penalties have already been paid, this effectively becomes a penalty refund request, and follows the same rules but the IRS will generally not issue refunds more than three years after the penalty has been paid.

What can be abated using this process?

If the Taxing Authority agrees that the taxpayer had reasonable cause for not meeting its obligations, a penalty abatement will be authorized, and the tax liability will be adjusted, or a refund check will be issued if there is no liability. In addition to the penalties that can be abated, any interest that accrues on the penalties (but none that accrues on the principal) will be abated as well. This can often result in drastic reductions in the liability owed. While the IRS does not typically abate interest (except interest on abated penalties), a taxpayer can submit Form 843 and request an abatement of interest in instances of unreasonable error or delay in performing a managerial or ministerial act by the IRS.

What if I have paid some or all of the penalties already?

If you have been in an installment agreement or otherwise been paying towards your liability, you have probably noticed that a sizeable portion of your payments have been applied to penalties and interest instead of the principal, and you may be worried that only the remaining penalties are eligible to be abated. This is actually not the case. If a penalty is abated, the whole value of that penalty is waived from the liability, and the amounts previously applied to the penalty are re-applied to either interest or principal. Even more, if a penalty has been fully paid off before being abated, those payments will go fully towards the principal on that period first, then to any other periods of liability, or refunded if no other periods of liability exist.

Don’t Be Penalized for Foreign Bank Accounts

Did you know that you could find yourself with an unexpected tax penalty for not informing the IRS that you have a bank account abroad? Although this rule only applies if your total amount on all foreign accounts at any time of the calendar year exceeds $10,000, it has to be obeyed even if these accounts don’t produce any taxable income for you. All you have to do to stay out of trouble is to file IRS form 114, Report of Foreign Bank and Financial Accounts, also known as FBAR, along with the completed schedule B of your Income Tax Return (form 1040). Failure to do so results in the highest tax penalty the IRS can assess.

There are already numerous cases when taxpayers have paid millions of dollars to the IRS to satisfy FBAR penalties. A similar thing happened to Carl Zwerner, a director at First State Bank in Florida. This 87 year old taxpayer now owes the IRS over two million dollars in penalties for not reporting the annual value of his Swiss bank account. This amount was calculated as 50% of the annual value of this account in 2004, 2005 and 2006. Although Mr. Zwerner’s case is more complicated than just a failure to file form 114, it is still a good example of the consequences of non compliance with IRS rules.

The IRS form 114 can be filed online through the Bank Secrecy Act (BSA) E-Filing System at http://bsaefiling.fincen.treas.gov/main.html. It is an easy to follow program that allows you to submit all BSA forms and to track the status of your returns online. The IRS also provides help with filing FBAR forms over the phone at 866-270-0733.

In addition, in January 2012 the IRS started a new offshore voluntary disclosure program for those taxpayers who failed to report their offshore income and foreign bank accounts in previous years. Although participating in this program will not eliminate all penalties, it is still a way to minimize the chance of criminal prosecution for failure to disclose foreign accounts and assets.

Obamacare – The New Tax Penalty

The IRS has plenty of penalties it can impose for late filing, late payment, interest, and much more. Starting on the 2014 tax returns there’s a new penalty the IRS can impose based on the Patient Protection and Affordable Care Act, commonly known as Obamacare.

With a few exceptions, everybody is expected to have minimal qualifying health insurance in place by April 1st 2014. It doesn’t matter how you obtain the insurance; you may already have it through your work, Medicare, or Medicaid. For some people, subsidies are available through their state’s health insurance marketplace (also called the exchange).

If you don’t have health insurance in place, you will have to pay a fee on your Federal income taxes for every month you’re without coverage. For 2014, this fee is $95 per adult (half for a child) up to a maximum of $285 per family, or 1% of your taxable income, whichever is greater. This penalty goes up in subsequent years, being 2% of income or $325 per person in 2015, and 2.5% of income or $695 per person in 2016. After that the amount will continue to be adjusted for inflation.

Of course, you may be exempt from these penalties. For example, you’re allowed a “gap” of up to three months without coverage during the year. Or, perhaps you fall under the hardship conditions of being homeless, evicted, the victim of domestic violence, etc. Or, maybe your religion objects to insurance. This is a complex law, spanning over 1,000 pages, but it will apply to most people. This is where it gets interesting.

When you’re completing your 2014 tax return (in 2015) you’re expected to state whether, or not, you have qualifying health insurance. However, there does not appear to be anything in place that will enable to IRS to check this information. It’s difficult enough for the IRS to confirm all the standard income and expense tax form information, but the IRS does have procedures in place and “red flags” suspicious returns.

Even if everybody is completely honest and states when they do not have insurance and owe the new penalty, the IRS still has the problem of collecting the money. Unlike other debts that we discuss on 20/20 Tax Debt Help, for the Obamacare penalty, the IRS cannot issue any liens or levies. In fact, the only way they can collect the money (if somebody chooses not to pay it) is by subtracting it from any tax refund.

Now, we’re not suggesting for a moment that you should try to not get health insurance or try to avoid paying the penalty. However, it is clear that there are serious issues with Obamacare collection procedures and the burden it will place on an already overtaxed (pun intended) IRS.

First Time Penalty Abatement Changes

On the April 5th, 2013, the IRS modified its First Time Abate procedure. This change affected section 20.1.1.3.6.1. of the Internal Revenue Manual. According to the recent update, a taxpayer seeking First Time Penalty Abatement has to be current with all filing and payment requirements, which means that all tax returns have to be filed and all current payments, including federal tax deposits, have to be paid on time and in the full amount.

First Time Abate (FTA) is a policy of the IRS that allows removal of  the Failure-to-File, Failure-to-Pay, or Failure-to-Deposit penalty due to the history of taxpayer’s compliance, and not to any sensible reasons that can be provided by a taxpayer to explain what caused the debt to accrue.

Although it sounds like a great deal, FTA cannot be granted for more than one tax period for a given Master File Tax. If you have multiple periods of the liability, the IRS will grant FTA for the earliest period. You will still have an option to remove all other penalties, but in order to do that you will have to submit a Penalty Abatement request and prove that your failure to comply with your tax obligations was a result of events beyond your control.

Another requirement for FTA to be granted is that the taxpayer cannot have any penalties for 3 consecutive years before the period that is a subject for FTA on the same Master File Tax. In simple words, if you would like to abate a penalty for your 2009 940 – Unemployment Tax return, you cannot have any penalties on your 2006, 2007 and 2008 940 accounts.

However, in some cases the IRS will review other Master File Tax accounts as well  If, for example, your filing requirements were changed.  Let’s say that in 2006, 2007 and 2008 you filed form 944 – Employer’s Annual Federal Tax return (also known as the IRS Master File Tax 14). In 2009 your filing requirements were changed to 941 – Withholding Tax return (which is IRS Master File Tax 01). Looking into the previous 3 years to see whether you had any penalties, the IRS will review your 944 accounts.

IRS First Time Penalty Abatement (FTA)

An IRS penalty is an additional amount that can be assessed on top of your tax liability for various reasons, such as failure to make deposits, failure to file a tax return, failure to pay taxes, etc. There are also Accuracy-Related penalties, penalties for filing a frivolous return, and many more. The reason for penalty assessment is to ensure compliance by taxpayers, which is a very harsh method, considering that the amount of penalty can be anything from 0.5% to 100% of the tax due, or even higher.

The usual way to deal with penalties is to get in compliance with the IRS, which means start filing your returns and paying taxes, and submit a penalty abatement request – assuming you have a reasonable (and acceptable) explanation of why you fell behind. However, the IRS has strict rules when analyzing requests to abate penalties received from the taxpayers, and many of these demands are denied because taxpayers fail to show that they exercised ordinary business care and prudence in determining tax obligations – one of the necessary conditions for the penalty abatement.

Fortunately, there is another option for those who just made a mistake once, and would like to correct it. This waiver is called a First Time Abate (FTA).  If you or the business you are operating accrued a Failure-to-File, Failure-to-Pay, or Failure-to-Deposit penalty, you might be qualified for FTA. Just remember that you can only use FTA to waive penalties for one particular period of the liability, and only if you had a compliant history for the prior three years.

Not all penalties are subject for FTA. For instance, estate and gift tax returns are not included in this list. There are also other restrictions, so the best way to approach this problem is to contact your tax resolution representative and discuss the best way to move forward.

If your FTA is approved by the IRS, you will receive a letter informing you that the penalty was waived due to your history of compliance.

IRS Penalties and Interest

Do you owe taxes to the IRS? If so, you need to take care of it immediately. Ignoring the problem, in the hope that it might disappear, will simply land you in more trouble. The longer you wait, the more the penalties and interest will accumulate. Believe it, or not, it can often be beneficial to borrow money, perhaps even from high-interest credit cards, than to incur the penalties and interest from the IRS.

The interest and penalties can soon add up. You start of with what appears to be a manageable debt and, before you know it, you can owe two or three times what you started with. Typically, the interest portion, which starts accruing from the day the tax return was due, cannot be abated.

This might seem harsh, but the IRS believes that the penalties and interest should be excessive in order to encourage businesses and individuals to comply with the tax obligations. And, don’t imagine that it’s just based on the amount of debt. For example, one penalty that the IRS can apply is for submitting a frivolous return. The IRS has a list of what is considers “frivolous”, and they keep adding to the list. The list includes trying to avoid paying taxes because you’re object to military spending, deliberately using the wrong tax tables, providing inconsistent information, and so on.

One common penalty is for “failure to file” – something that can be imposed if you did not file your tax return on time, but owed tax on that return. The penalty might be small, but can go as high as 25% of the tax owed, especially if the unfiled return was due a long time ago. So, even if you cannot pay your taxes in full, you should still make sure that you file your return, and then negotiate with the IRS to resolve your debt. In many cases, taxpayers may be able to set up, for example, a streamline installment agreement.

There are multiple resolution options that you can assess to pay off your tax debt, including offers in compromise, installment agreements, partial payment plans, etc. However, don’t be surprised if you continue to accumulate penalties and interest.

Of course, if you haven’t paid your tax debt, even if you did file on time, you might still incur a “failure to pay” penalty. One common misconception is that filing for an extension gives you more time to pay your taxes – wrong. The extension is purely for the date of filing. You are still make your best estimate on the amount of tax owed and pay it on time; do not wait until your extension deadline.

There are many other types of penalties and interest that the IRS can apply. These include underestimating the tax due, late payment of estimated tax, accuracy-related penalties, a penalty on unpaid withholding taxes, and many more.

There is no escape from the IRS – you can run, but they will find you. Firstly, always file all paperwork on time and as accurately as possible. Be proactive in trying to settle any debt. Your best weapon is knowledge – knowledge of the inner workings of the IRS and the penalties and interest that they can impose, which is fully explained on their website. Any taxpayer can negotiate with the IRS. If you owe a large amount, or your situation is complex, a 20/20 tax expert can help to ensure that you get the best possible resolution allowed by the law.