With the tax filing season upon us, many small business owners take responsibility for the timely filing and payment of their business and personal tax obligations. Income tax return filings for state and local governments are not to be ignored but specifically concerning the IRS. Many of us dread receiving that official letter in the mail notifying us that something may be amiss. And as much as we plan, it is sometimes impossible to not overlook a tax filing or payment deadline, even with the best of intentions.
The IRS’s first-time abatement penalty waiver (FTA), although introduced 12 years ago, is a tool all too infrequently used by taxpayers who would otherwise qualify. An FTA, however, can only be obtained for three types of penalties: failure-to-file, failure-to-pay, or failure-to-deposit. The first two of these penalties are self-explanatory while failure-to-deposit penalties can occur when a business taxpayer fails to make their payroll tax deposit timely.
To qualify for the FTA, taxpayers must not have been assessed any other penalties of a “significant amount” on the same type of tax return within the past three years and must be in compliance with all filing and payment requirements. As previously mentioned, the FTA is not available for all types of penalties. The most commonly assessed penalties that are not eligible are known as accuracy-related penalties, also referred to as “substantial understatement” and “negligence” penalties. In most situations, taxpayers can request that these penalties be abated based on a reasonable cause standard.
For example, the IRS considers you to have understated your tax if the tax shown on your return is less than the correct tax, after adjustments. The understatement is substantial if it is more than the larger of 10 percent of the correct tax or $5,000 for individuals. For corporations, the understatement is considered substantial if the tax shown on your return exceeds the lesser of 10 percent (or if greater, $10,000) or $10,000,000.
Substantial understatement penalties are calculated as a flat 20 percent of the net understatement of tax. You will not have to pay an accuracy-related penalty if there was a reasonable cause for a position you took and you acted in good faith.
Estimated tax penalties occur in situations where taxpayers have income that is not subject to withholding and would be required to make estimated tax payments during the year. Unlike with other types of penalties, there is no reasonable cause exception for the estimated tax penalty nor is there a first-time-abatement waiver available. Therefore, it is often harder to get this penalty removed, but it is not impossible.
Consult with your CPA or tax professional to determine whether an IRS penalty you have been assessed is best suited for the FTA or a reasonable cause abatement request. Also, penalties and interest are usually assessed together. There is no first-time abatement of IRS interest nor can it be abated for reasonable cause.
Every year, people in the United States who don’t file a return, underpay their taxes and underreport their income cost the government almost $500 billion, according to IRS estimates. This difference between the amount of taxes that taxpayers owe and the amount of taxes that the IRS collects is called the tax gap. To put this number in perspective, last year’s budget deficit was $587 billion. Based on the most recent IRS study, taxpayers comply with their filing and payment responsibilities about 82% of the time. This is known as the voluntary compliance rate. Encouraging compliance is one of the IRS’s major goals as it focuses on closing the annual tax gap. The proper use of penalties helps deter noncompliance, and it is clear that the IRS has been using penalties to that end. In a recent 11-year period, the number of penalties assessed increased by 34%, from 28.3 million to 37.9 million.
Lastly, in almost no situation should a taxpayer not attempt to use the first-time abatement penalty waiver or an explanation based on reasonable cause to avoid the assessment of an IRS penalty. Think of the FTA as your “get out of jail free” card. But, only in a figurative sense, not literally.