IRS Penalty Abatement: Two Methods to Get IRS Penalties Waived
IRS penalties can be onerous, adding thousands of dollars to a taxpayer’s balance with the IRS.
That is, of course, the bad news.
The good news is that it is actually possible to get IRS penalties abated using one of two methods:
- First-time penalty abatement
- Reasonable cause abatement
First-time penalty abatement is mechanical, limited in use, and applicable to only three penalty types; reasonable cause abatement can apply to any IRS penalty but requires more work and in most cases documentation.
Here’s what you need to know about both of these ways of getting IRS penalties erased.
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The IRS Gets It Wrong Sometimes
Now, the first thing you need to understand about penalty abatement requests — at least the ones that are not automatic — is that the IRS gets it wrong sometimes.
The individual on the other side of the letters we send to the IRS requesting penalty abatement for our clients sometimes get it wrong.
Sometimes, even though a client’s situation clearly qualifies for penalty relief according to the IRS’s own Penalty Handbook, which can be found in Internal Revenue Manual Section 20.1, the person at the IRS reviewing our request will deny it.
When this happens, we don’t sweat it — we have to go to Appeals. And I will talk more about that later in this article.
But for now, I just want you to know that by the time you finish this article, you just might know more than many folks at the IRS.
And don’t take this from me. Take it from the IRS’s own Penalty Handbook, which anticipates that its employees will make mistakes when it comes to penalty abatements when it says:
“Strive to make a correct decision in the first instance. A wrong decision, even though eventually corrected, has a negative impact on voluntary compliance. Provide adequate opportunity for incorrect decisions to be corrected.”
So before we get into the nitty-gritty here, just know that.
The Purpose of IRS Penalties
Another thing to keep in mind when we talk about penalty relief is the purpose of IRS penalties.
The stated purpose of IRS penalties according to Internal Revenue Manual Section 220.127.116.11(1) is not to make more money for the government — although that is obviously a side benefit to Uncle Sam — but rather “to encourage voluntary compliance,” which for most taxpayer consists of simply preparing an accurate tax return, filing it on time, and paying any related tax due.
This is important when we talk about penalty relief for reasonable cause later in this article, which is a fairly subjective thing.
And I’ll talk about this more later in this article, but one thing you want to communicate to the IRS when requesting penalty relief for reasonable cause is that there was a very good reason why you were not compliant with your tax obligations in the past, but now you are “back to normal” and going forward you will be a good little taxpayer and file your tax returns on time and pay your taxes timely as well.
First-Time Penalty Abatement
But before we get into the reasonable cause penalty abatement, which is a bit more subjective, let’s talk about the more straightforward kind of IRS penalty abatement you can get, and that is the first-time penalty abatement.
In 2001, the IRS introduced the first-time penalty abatement. And despite its usefulness and having been around for over two decades, many taxpayers still don’t know about it.
Now, contrary to what its name implies, taxpayers can actually use first-time penalty abatement multiple times — and I’ll talk about how later.
But first, let’s discuss the basics.
What Is First-Time Penalty Abatement?
First-time penalty abatement is the complete abatement of a taxpayer’s failure-to-file, failure-to-pay, or failure-to-deposit penalty due to the taxpayer’s previous compliance.
So there are over 100 IRS penalties out there, but the first-time penalty abatement can only be used on these three:
- Failure-to-File Penalty: This is the penalty that the IRS assesses if you file your tax return late. This penalty is equal to 5% of the amount of tax you owe on the return per month or part of the month that your tax return goes unfiled past the due date or the extended due date if you extended your return. It maxes out at 25% of the amount of tax you owe.
- Failure-to-Pay Penalty: This is the penalty that the IRS assesses if you pay your taxes late after April 15 when taxes are due for the previous year. This penalty is equal to 0.5% of the amount of tax you owe on the return per month or part of the month that you have not paid your taxes. It also maxes out at 25% of the amount of tax you owe. If you owe both the failure-to-file penalty and the failure-to-pay penalty, the failure-to-pay penalty is subtracted from the failure-to-file penalty each month so that you never accumulate more than 5% of your balance in penalties every month. And combined, these penalties max out at 47.5% of the tax you owe after a little over four years.
- Failure-to-Deposit Penalty: This is the penalty that the IRS assesses on employers who don’t make their employment tax deposits on time, in the right amount, and in the right way. So if you’re an employee, you know that you get a lot of money taken out of your paycheck every pay period for taxes — as far as the IRS is concerned, you’re looking at federal income taxes, Social Security taxes, Medicare taxes, and the Federal Unemployment Tax. Your employer is responsible for depositing these payments to the United States Treasury. If they do not do so or if they do so late, the IRS charges a penalty between 2% and 15% of the unpaid deposit.
The first-time abatement is not penalty specific, meaning that there is not a first-time abatement for the failure-to-file penalty and a separate first-time abatement for the failure-to-pay penalty; if you are granted first-time penalty abatement for a given tax year, all of the three penalties indicated above are wiped away for that tax year.
Although the Internal Revenue Manual generally speaks with respect to individuals getting their failure-to-file penalty and failure-to-pay penalty abated using first-time penalty abatement, I have had no problem obtaining an abatement for partnership and S corporation failure-to-file penalties as well.
Note, however, that the Internal Revenue Manual explicitly states that first-time penalty abatement cannot be obtained for penalties associated with estate tax returns, gift tax returns, or returns that are attached to another return (such as a Form 5471 or Form 5472); the only way to abate these kinds of penalties is for reasonable cause.
How to Qualify For First-Time Penalty Abatement
In order to qualify for first-time penalty abatement, you must meet these criteria:
- In Filing Compliance Under IRS Policy Statement 5-133: You must have filed all required tax returns currently due, which under IRS Policy Statement 5-133 generally means that you must have filed at least the last six years of returns insofar as you had a filing requirement. And it’s OK if it’s currently between April 15 and October 15 and you extended your tax return for last year. Note that IRS-created substitutes for return do not count toward this requirement.
- In Filing Compliance For the Three Years Before the Tax Year in Question: You must have filed all required tax returns for the three years prior to the tax year you are seeking first-time penalty abatement for.
- In Payment Compliance: You must have paid or arranged to pay all taxes currently due. Note that if you are in a short-term payment plan or an installment agreement with the IRS, and you are current on your required payments, you meet this requirement.
- Clean Penalty History: You do not have any unreversed IRS penalties — other than estimated tax penalties — for the three years prior to the tax year you are seeking first-time penalty abatement for. Also, you cannot have any penalties that were reversed for first-time abatement or tolerance.
Based on the second and fourth criteria above, a taxpayer may only qualify for first-time penalty abatement for every three tax years.
How to Get First-Time Penalty Abatement
When it comes to requesting first-time penalty abatement with the IRS, you have two options:
- Making the request over the phone by calling the toll-free number on your penalty notice
- Making the request via a letter sent to the address on your penalty notice
Personally, I prefer making the request over the phone because 1) it’s easier and 2) you can make multiple attempts if the first IRS representative you speak to denies your request.
Why would an IRS representative deny your request? This is because the IRS representative is using a computer program called the Reasonable Cause Assistant (RCA) to determine if a taxpayer qualifies for penalty abatement — and in my experience some IRS representatives don’t know how to use it correctly!
Note that if your penalty is significant, the IRS representative may inform you that you will need to write the IRS a letter to request first-time penalty abatement.
If this is the case — or if you simply prefer to write a letter rather than calling — you would write a letter to the IRS explaining why you qualify for first-time penalty abatement for a particular tax year and mail this letter to the address on your penalty notice.
If You Are Approved For First-Time Penalty Abatement
If the IRS approves your request for first-time penalty abatement over the phone, they will let you know on the call.
And in all cases where the IRS grants first-time penalty abatement, it will send you Letter 3503C that says something to the effect of:
We are pleased to inform you that your request to remove the failure to file and failure to ay penalties has been granted. However, this action has been taken based solely on the fact that you have a good history of timely filing and timely paying.
This letter also clarifies that if you still have a balance for the tax year in question, the failure-to-pay penalty will continue to run until the tax is paid in full but that after the tax is paid in full, the taxpayer can request abatement of that additional failure-to-pay penalty.
And the Internal Revenue Manual clarifies that this abatement of the additional failure-to-pay penalty that continue to run after this initial first-time abatement was granted can be abated under first-time abatement as well.
If You Are Not Approved For First-Time Penalty Abatement
If you are not approved for first-time penalty abatement, the IRS will send you a rejection letter informing you of the rejection.
In this rejection letter there will be information about how to appeal the IRS’ decision with the IRS Office of Appeals.
If you miss the appeals deadline or if the IRS Office of Appeals denies your abatement as well, your only option is to pay the penalty and sue the government for refund, either in District Court or the Court of Federal Claims.
Appeals will send you Letter 1277 informing you how to file such a suit:
- Pay the penalty.
- File a claim for refund of the penalty on Form 843 with the IRS Service Center that processed the relevant tax return and include a statement requesting your claim be immediately disallowed.
- Wait to receive a formal notice of claim disallowance in the mail.
- File your suit in District Court or the Court of Federal Claims within two years of the date of this notice.
Dealing with the IRS Office of Appeals and appealing penalty rejections really deserves an entire article to it, so I will cover that in a separate article at a later time.
Reasonable Cause Penalty Abatement
If the tax year for which you are seeking penalty abatement does not qualify for first-time penalty abatement, you will need to make an argument to the IRS that the reason you did not comply with your tax obligations was for reasonable cause, meaning that despite you exercising “ordinary business care and prudence” in determining your tax obligations, you were not able to comply with them.
In choosing to grant penalty relief based on reasonable cause, the IRS instructs its employees to look at “all facts and circumstances” relevant to the taxpayer’s situation.
1. Death or Serious Illness
The IRS may grant reasonable cause penalty relief if you or a member of your immediate family — spouse, sibling, parent, grandparent, or child — pass away or sustain a serious illness.
Keep in mind that a death or serious illness in the family does not automatically guarantee that the IRS will grant your penalty abatement; rather, there has to be a logical connection between the unfortunate event and your inability to meet your tax obligations.
In considering this connection, ask yourself the following questions:
- What was your relationship to the individual who became seriously ill or died? The death of a grandparent with whom you had no discernible relationship would likely not be the basis for reasonable cause.
- When did the individual pass away? If your sibling, say, passed away unexpectedly in April 2013, and as a result you entered a severe, medically-documented depression lasting the better part of a year, the IRS may view this as reasonable cause for you to not have filed your 2012 and possibly your 2013 tax returns. However, unless there are other circumstances at play, the IRS would likely not view your sibling’s death as reason for you to not have filed your 2014 and later tax returns.
- How severe was the illness? Millions of people file their tax returns every year while under the weather with the cold or even the flu; unless you were hospitalized, the IRS will likely not consider common illnesses like these as “severe” enough to be grounds for reasonable cause. On the other hand, dealing with a disease that was life-threatening or impeded your ability to function in your typical manner could be grounds for reasonable cause penalty abatement.
- How long did the illness last? Being hospitalized for a week or two and then making a full recovery shortly thereafter would likely not give you grounds for reasonable cause except perhaps if the hospitalization occurred during the tax return deadline.
- How the death / illness prevent tax compliance? That someone died, or that you or someone became ill, is not reason enough for the IRS to abate a penalty on the basis of reasonable cause. There must be some direct connection between the event and the inability to comply with one’s tax obligations.
- Were other business obligations impaired by the death / illness? If you were able to, say, continue to meet other business obligations — such as adequately maintain a full-time job, for example — during the time you were sick or after a loved one passed away, the IRS may question why you weren’t able to fulfill your tax obligations as well.
- When did you become compliant again? It generally makes for a stronger reasonable cause case if you can show that you became compliant again shortly after the event happened.
2. Unavoidable Absence
If you were unavoidably absent from your home for a long period of time — for example, if you were part of a sequestered jury — this could constitute reasonable cause for not meeting your tax obligations.
However, as with all reasonable cause cases, you would still have to show that you exercised “ordinary business care and prudence” to meet your tax obligations while you were away but were still unable to meet your tax obligations.
3. Inability to Obtain Records
If you were not able to obtain your tax records, you may qualify for reasonable cause relief.
IRS Penalty Abatement FAQs
Can I get IRS interest abated?
Yes, you can get IRS interest abated in some circumstances.
For example, if you successfully get an IRS penalty abated, the interest on that penalty will be abated as well.
You may also be able to get IRS interest abated if you can show that the IRS made a mistake pertaining to the assessment of a tax on which interest was calculated.