The IRS imposes civil penalties in many situations. Penalties are meant to act as a stick to motivate the public to comply voluntarily with the tax laws. Tax penalties may be either civil or criminal.
- Civil penalties are financial
- Criminal penalties may involve jail time
This article will focus what you need to know about common civil penalties. We will also discuss civil penalty defenses and methods to argue penalties before the IRS.
Late Filing Penalty for Tax Returns – Section 6651(a)(1)
If a tax return is filed late, the IRS imposes a failure to file penalty. This is one of the most common penalties that we see in our CPA practice. This civil penalty is equal to 5% of the unpaid tax, per month, up to a maximum of 25% of the tax due. This is one of the harsher penalties.
The late filing penalty applies to tax returns for individuals, corporations, and estates and trusts. It also applies to gift tax returns.
The late filing penalty is more expensive than the failure to pay penalty (discussed below). For this reason, we advise clients to file their tax returns on time, even if they cannot afford to pay the tax. The tax can always be paid later, and the penalties for late payment are less severe than for unfiled tax returns.
Defense Against Late Filing Penalties for Tax Returns
Taxpayers may attempt to argue a reasonable cause defense to avoid this penalty. This is based on facts and circumstances.
Late Filing Penalty for Information Returns – Section 6721(a)(1)
What is an Information Return?
Information returns include:
- Form 1099 (to report miscellaneous compensation, such as gambling, interest, dividends, nonemployee compensation or retirement plan distributions)
- Form W-2 (to report employee annual wages and the taxes withheld)
- Form W-3 (to summarize and transmit Forms W-2 to the IRS)
Information return penalties relating for Form W-2 are typically triggered by discrepancies between the W-2 and Form 941. Form 941, Employer’s Quarterly Tax Return, is used to report federal income tax withheld, social security tax, and Medicare tax (FICA taxes) from each employee’s salary. It is also used to calculate the employer’s share of Social Security and Medicare tax.
IRS Civil Penalties for Information Returns
If an information return is filed late, the IRS imposes a civil penalty of $250 per return. The amount of the penalty is adjusted annually for inflation. The total amount of the penalty may not exceed $3 million, also adjusted for inflation.
The penalty for 2023 is $290 per return, with a maximum penalty of $3,532,500.
The penalty for 2024 is $310 per return, with a maximum penalty of $3,783,000.
This penalty also incorporates the penalty for not fling information returns electronically.
Intentional Disregard – Section 6721(E)
The IRS may increase the civil penalty for failure to file an information return, such as Form 1099, if the failure was due to an intentional disregard of the filing requirement. The penalty may go as high as 10% of the aggregate amount of items that should have been reported.
This requires the IRS to demonstrate that the taxpayer knowingly or willfully failed to submit Forms 1099 or other required information returns.
Defenses Against Late Filing Penalties for Information Returns
Taxpayers may attempt to argue a reasonable cause defense to avoid this penalty. This is based on facts and circumstances.
In addition, the IRS will reduce the late filing penalty for information returns if the return is filed within 30 days from the required filing date. The reduced penalties are $110 for 2023 and $120 for 2024.
The IRS will also reduce the penalty, under a de minimis provision, for businesses with average gross receipts under $5 million over a three year period.
Failure to Pay Penalty – Section 6651(a)(2)
Even if a tax return is filed on time, the IRS will impose a failure to pay penalty for unpaid taxes. This penalty is equal to 0.5% of the unpaid paid tax, per month, up to a maximum of 25%.
When both the failure to file penalty and the failure to pay penalties apply simultaneously (a common situation), the failure to file penalty (5% per month) is reduced by the failure to pay penalty (0.5%). Therefore, the maximum penalty for unfiled returns with an amount due is 47.5% of the taxes owed (25%+25%-2.5%). In cases of fraud, the maximum penalty is increased to 75% of the tax due.
Penalty for Underpayment of Estimated Taxes
Taxpayers are required to pay their taxes quarterly if they do not have sufficient taxes withheld through payroll. This is frequently the case for business owners and independent contractors. The IRS will impose a penalty if quarterly taxes are not paid as required.
The amount of the penalty is based on:
- The amount of the underpayment
- The period when the underpayment was due and underpaid
- The interest rate for underpayments that is published quarterly by the IRS
How Do I Avoid a Penalty for Underpayment of Estimated Taxes?
You may avoid this penalty if:
- Your filed tax return shows you owe less than $1,000 or
- You paid at least 90% of the tax shown on the return for the taxable year or 100% of the tax shown on the return for the prior year, whichever amount is less
- If Adjusted Gross Income is over $150,000 ($75,000 for marred filing separately), the percentage increase to 110% of the tax shown on the return for the prior year
In our CPA firm, we call this “penalty protection.”
IRS Civil Penalties for Payroll Tax – Section 6672
This civil penalty is called the Trust Fund Recovery Penalty. It applies when a business fails to submit Trust Fund Taxes.
The amounts withheld by an employer from the employees of the business (income tax, plus the employee’s share of FICA) are held by the employer in trust for the government. Hence, these are known as “Trust Funds Taxes.”
The penalty for failure to submit Trust Fund Taxes is very severe: 100% of the tax.
The Trust Fund Recovery Penalty is imposed on anyone who is deemed to be a “responsible person.” This may include owners and officers of a business, as well as employees with responsibility for financial decisions.
Check out our article on the Trust Fund Recovery Penalty for additional detail.
What is Tax Fraud? What is Tax Evasion?
Tax fraud and tax evasion are intentional violations of the tax rules. To qualify as tax fraud or tax evasion, the taxpayer must have known that he or she had a duty to file a return and pay taxes. Fraud is not the same as negligence. Rather, fraud is an action motivated by a desire to evade a tax. It is an intentional wrongdoing.
Evidence of tax fraud or tax evasion includes:
- substantial understatement of income, especially over several years.
- Inadequate books and records.
- Lying, deceit or concealment, especially during an IRS audit. (Do not ever lie to an IRS agent!)
Burden of Proof in Cases of Civil Fraud
In contrast to other civil penalties, the burden of proof is on the IRS in cases of civil fraud.
In cases of civil fraud, the IRS must be able to prove, by clear and convincing evidence, that the facts of a case justify the imposition of a civil fraud penalty.
Here is a summary of the levels of proof in tax matters:
- Preponderance of the evidence – this is the level of proof required in standard tax cases
- Clear and convincing evidence – this is the standard of proof for civil fraud cases. It is stricter than the preponderance of the evidence standard.
- Beyond a reasonable doubt – this is the standard of proof required for criminal prosecution. It is strictest of the three standards of proof.
Fraud Penalty Combined with a Failure to File Return – Section 6651(f)
If the IRS believes that the taxpayer had no intention to file a tax return, then the IRS may impose a civil fraud penalty equal to 15% per month that the tax return is not filed, with a maximum penalty of 75%.
The normal three-year statute of limitations for assessments does not apply in cases of fraud in combination with an unfiled return. That means that the IRS can assess the tax at any time in the future.
Defense Against Fraud Penalties
Taxpayers may attempt to argue a reasonable cause defense to avoid this penalty. This is based on facts and circumstances.
Fraud on a Filed Tax Return – Section 6663
If the IRS believes that the taxpayer filed a fraudulent tax return, then the IRS may impose a civil fraud penalty equal to 75% of the understated tax.
Filing a subsequent amended return after the due date to correct the fraud will not eliminate the imposition of penalties.
Here too, the normal three-year statute of limitations for assessments does not apply in cases of fraud on a filed return. This means that the IRS can audit the taxpayer at any time in the future if there is fraud.
Defense Against Fraud Penalties
Taxpayers may attempt to argue a reasonable cause defense to avoid this penalty. This is based on facts and circumstances.
Accuracy-Related Penalty – Section 6662
The accuracy-related penalty does not relate to whether or not the return was filed late. Rather, the IRS imposes a 20% accuracy-related penalty for any of the following:
- Negligence or disregard of rules or regulations (most common)
- Substantial understatement of income tax (most common)
- Substantial valuation misstatement
- Substantial overstatement of pension liabilities
- Substantial estate or gift tax valuation understatement
- Disallowance of claimed tax benefits by reason of a transaction lacking economic substance or failing to meet the requirements of any similar rule of law
- Undisclosed foreign financial asset understatement
- Inconsistent estate basis
Accuracy-related penalties are often imposed as a result of an IRS audit.
The way to protect oneself from an accuracy-related penalty is to prove that the you had a reasonable basis for a position taken on a tax return. Reasonable basis means that the position taken on a return is based on statutes, regulations, revenue rulings or case law.
Defenses Against Accuracy-Related Penalties
Taxpayers may attempt to argue a reasonable cause defense to avoid this penalty. This is based on facts and circumstances. The most common defense against the accuracy-related penalty is reliance on a tax professional.
In addition, reasonable basis or substantial authority may be used as defenses against the accuracy-related penalties. The difference between the two standards generally relates to the the likelihood of success if challenged upon audit.
Reasonable Basis: This requires disclosure on the tax return, normally using Form 8275, Disclosure Statement. Filing Form 8275 generally provides penalty protection in case a position is challenged by the IRS upon audit.
Substantial Authority: This is a higher standard of reporting than reasonable basis. Substantial authority requires a filing position where the weight of the authorities (such as case law) supporting the treatment of the tax return is substantial in relation to the weight of authorities supporting a contrary treatment. Substantial authority does not require disclosure.
International Penalties Relating to Form 5471
Form 5471 relates to officers, directors and greater than 50% shareholders of foreign corporations.
The IRS may impose a penalty of $10,000, per Form 5471 that was omitted from a tax return. Continuation penalties may be imposed if the taxpayer fails to file Form 5471 despite a specific request from the IRS to do so. Continuation penalties go as high as $50,000 per Form 5471.
In addition to these penalties, the IRS may impose the following on taxpayers who do not file Form 5471:
- Loss of foreign tax credits
- The accuracy-related penalty for negligence or disregard for rules and regulations is increased from 20% to 40%
- The statute of limitations is extended indefinitely
These penalties are automatically assessed when Form 5471 is filed past the deadline.
Defense Against International Penalties Relating to Form 5471
Taxpayers may attempt to argue a reasonable cause defense to avoid this penalty. This is based on facts and circumstances.
International Penalties Relating to Form 5472
Form 5472 relates to US companies owned by greater than 25% foreign shareholders.
The IRS may impose a penalty of $25,000, per Form 5472 that was omitted from a tax return. Continuation penalties may be imposed if the taxpayer fails to file Form 5472 despite a specific request from the IRS to do so. Continuation penalties are $25,000 for each 30-day period during which the continuation occurs.
In addition to these penalties, the IRS may impose the following on taxpayers who do not file Form 5472:
- Deductions on the tax return may be disallowed
- The statute of limitations is extended indefinitely
These penalties are automatically assessed when Form 5472 is filed past the deadline.
Defense Against International Penalties Relating to Form 5472
Taxpayers may attempt to argue a reasonable cause defense to avoid this penalty. This is based on facts and circumstances.
Note also that the Regulations require that the IRS should apply the reasonable cause standard in a liberal fashion when dealing with Form 5472 for corporations with $20 million or less in gross receipts.
International Penalties Relating to Form 3520
Form 3520 relates to transactions with foreign trusts. It also relates to situations where a U.S. person receives a gift from a foreign person of more than $100,000 (including inheritance from a foreign estate).
For trusts, the penalty is $10,000 or 35% of the amount contributed to or distributed by a foreign trust. The IRS may impose an additional 5% civil penalty in the case of a grantor foreign trust. The IRS may also assert a 40% accuracy-related penalty for undisclosed foreign financial assets.
For foreign gifts, the penalty is 5% of the amount of the gift, per month, that Form 3520 is not filed, up to 25% of the gift.
These penalties are automatically assessed when Form 3520 is filed past the deadline.
Defense Against International Penalties Relating to Form 3520
Taxpayers may attempt to argue a reasonable cause defense to avoid this penalty. This is based on facts and circumstances.
International Penalties Relating to Form 8938
Form 8938 relates to US persons with interests in certain foreign accounts.
Penalties are $10,000 per tax year. Continuation penalties may be imposed if the taxpayer fails to file Form 8938 despite a specific request from the IRS to do so. Continuation penalties are $10,000 for each 30-day period during which the continuation occurs, with a maximum penalty of $50,000.
In addition to these penalties, the IRS may indefinitely extend the statute of limitations for failure to file Form 8938.
Defense Against International Penalties Relating to Form 8938
Taxpayers may attempt to argue a reasonable cause defense to avoid this penalty. This is based on facts and circumstances.
First-Time Penalty Abatement
You may qualify for a first time penalty abatement if you meet the following two requirements:
- No tax penalties have been assessed by the IRS in the past three years
- All returns have been filed and all taxes paid
First-time abatement applies to:
- late-filing of income tax returns
- late payment of taxes
- failure to deposit tax in a timely manner
First-time abatement does not apply to:
- Form 3520
- Form 3520-A (for foreign grantor trusts)
- Form 5471 and Form 5472 (however, exceptions apply)
Penalty Abatement for Reasonable Cause
The IRS may abate a civil tax penalty if the taxpayer can show “reasonable cause.” Reasonable cause generally means the taxpayer exercised “ordinary business care and prudence” with respect to their tax obligations.
Reasonable cause is determined on a case by case basis, based on an evaluation of the facts and circumstances. The IRS will look to determine if the taxpayer acted in a responsible manner, both before and after the failure occurred. Significant mitigating factors include a first-time filer and a clean tax history.
Examples of reasonable cause include cases where the taxpayer:
- Is dead, seriously ill, or dealing with an immediate family member’s death, serious illness, or unavoidable absence
- Was affected by a fire, casualty, natural disaster (for example, COVID 19), or other disturbance
- Was unable to obtain necessary records to comply with a tax obligation
- Made a mistake
- Relied on erroneous advice from a professional
- Was not aware of the requirement and could not reasonably be expected to know of the requirement
The IRS will look at the taxpayer’s tax compliance history over the past three years or more when evaluating reasonable cause.
CPA Pointer: In addition to reducing or eliminating penalties, your CPA may be able to to negotiate the removal of IRS tax liens as well. Be sure to ask your CPA about this strategy.
Are Tax Penalties Deductible?
Tax penalties are never deductible.
Businesses should maintain a separate account for tax penalties in their general ledger. This avoids the problem of deducting penalties in error.
Interest
Interest is generally imposed in combination with civil tax penalties. However, while penalties may be abated for a variety of reasons, the IRS never abates interest. There is nothing you can do about that.
You are welcome to contact our CPA firm if you have an issue with tax penalties. We are able to represent you in this matter before the IRS.
Feel free to call us in Atlanta at 678-235-5460 or in Chicago at 773-828-0551. We will be happy to work with you to resolve your tax matter. We deal with the IRS so you do not have to.
Massey and Company CPA is a boutique tax and accounting firm serving individuals and small businesses in Atlanta, Chicago and throughout the country. Our services include tax return preparation, tax planning for businesses and individuals, IRS tax problem resolution, IRS audit defense, sales tax, and small business accounting and bookkeeping.
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