Taxpayers practically always claim penalties are not warranted. What actually works?
One of the biggest tools is the defense that a tax position was based on reasonable cause. The Internal Revenue Code (IRC) says no penalty can be imposed with respect to any portion of an underpayment if it is shown that there was a reasonable cause for such portion and that the taxpayer acted in good faith with respect it.
How the IRS evaluates this depends on which penalty was assessed. On top of reasonable cause, certain penalty defenses involve other concepts, like an absence of willful neglect.
Who wins in a tax penalty stalemate? The IRS does. Taxpayers bear the burden of proving their reasonable cause. We must exercise ordinary business care in reporting our tax liability. All tax returns are signed under penalties of perjury.
The IRS applies a facts-and-circumstances test on a case-by-case basis to decide whether a taxpayer meets the reasonable-cause exception. That can lead to inconsistent, subjective results. The reasonable-cause exception applies to accuracy-related penalties which are usually 20 percent of the amount at stake. It even applies to penalties for civil fraud which are 75 percent.
The reasonable-cause exception for penalty relief also applies to other penalties the IRS can impose, including penalties for: (1) failure to file a tax return and failure to pay, (2) making an erroneous claim for refund or tax credit; (3) failure to file Form 1099 or other information reporting returns; and (4) the understatement of a taxpayer’s liability by a tax return preparer.
The IRC is full of penalty provisions. A reasonable shortcut is to argue you always behaved reasonably. You also need to be able to say you always claimed every item listed on your tax return in good faith.
The IRS says the most significant factor in determining whether you have reasonable cause and have acted in good faith is your effort to report the proper tax liability. Doing your best to report the right amount sounds simple. Unlike the defense of reasonable basis, reasonable cause does not depend on the legal authority you have. It depends on your actions. For example, suppose you report the amount from an erroneous Form 1099, but you didn’t actually know that the Form 1099 was wrong. You think the Form 1099 has the total you were paid, but under audit it turns out that the Form 1099 reported less than you actually received. Reasonable cause may apply if you simply pick up a reported number and reasonably assume it is correct.
What if you were paid $300,000, but the Form 1099 said $300? It will be harder to say you picked up that number unintentionally and reported it because of the size of the discrepancy. Still, your behavior may be reasonable, even with a big error.
How about an isolated computation or transposition error you make on your return? That may be consistent with reasonable cause and a good-faith effort. It is easy enough to transpose numbers or to make other errors. If you have a dozen of these on your return, it is not as likely the IRS will understand and let you off the penalty hook.
Other factors the IRS considers include your experience, knowledge, education, and reliance on the advice of a tax advisor. When considering the facts and circumstances, your experience, education, and sophistication concerning the tax laws are relevant. Reliance on advice from a tax professional is obviously a point that many taxpayers use to try to avoid penalties.
The IRS requires your reliance to be objectively reasonable. That means you must provide your tax advisor with all the necessary information to evaluate your matter. Cherry picking what you tell your tax adviser to get the answer you want is not reasonable. That kind of behavior would preclude you being viewed as reasonable.
Your tax advisor must be competent in the subject. If you have a complex corporate tax problem and you consult an individual income tax advisor, it might not be reasonable for you to rely on that advisor, no matter how faithfully you follow the advice.
The IRS tells its auditors they should determine whether the taxpayer acted with reasonable cause and in good faith based on all the facts and circumstances on a case-by-case basis. The taxpayer must have exercised the care a reasonably prudent person would have used under the circumstances. The meaning of reasonable cause can also depend on the penalty.
Some penalty sections also require evidence that the taxpayer acted in good faith, or that the taxpayer’s failure to comply was not due to willful neglect. Not every penalty provision has the same penalty relief standard. If you are trying to get out of a penalty, it pays to look at the specific penalty in question. You want to show how your facts and your conduct meet all the required tests.
You almost always should lay out your defense in writing. In many cases, the regulations actually require your request for waiver of the penalty to be in writing and signed under penalties of perjury. Whether the elements that constitute reasonable cause, willful neglect, or good faith are present is based on the facts and circumstances.
Your effort to report the proper tax liability is the most important factor in determining reasonable cause. In assessing your effort, the IRS tells its agents to look at all the relevant factors, including the nature of the tax, the complexity of the issue, the competence of the tax advisor, etc.
In determining whether you exercised ordinary business care and prudence, the IRS tells its agents to consider all the facts and circumstances, and to review all available information, like your reason, compliance history, length of time, and circumstances beyond your control. You might assume that review would extend back one year. However, the IRS tells its agents to look at the three previous tax years. They will look at your payment patterns and compliance history. A taxpayer repeatedly assessed the same penalty may not be exercising ordinary business care.
If this is your first incidence of noncompliance, the IRS will consider that, along with the other reasons and circumstances you provide. The IRS will consider all the facts and circumstances, including the length of time between the occurrence of the tax problem and when you fixed it. The reason for your error should coincide with the timeframe of dates and events that relate to the penalty.
The IRS is even willing to say some mistakes and circumstances are beyond your control. However, the IRS also asks whether you could have foreseen or anticipated the event that caused the problem in the first place.
Oral advice from the IRS itself usually isn’t worth much. If you point to something the IRS told you in writing, it evaluates the information and determines whether the advice was in response to a specific request and related to the facts contained in that request. The IRS also wants to know if you actually relied on its advice.
The IRS says you generally do not have a basis for reasonable cause if the penalty relates to the late filing of a tax return or payment of a tax obligation. Arguing that you or your accountant forgot to file also is not likely so demonstrate reasonable cause. The IRS says everyone is responsible for timely filing and paying taxes, and those duties cannot be delegated. Things like the unavailability of records or a law change that you could not reasonably have been expected to know might be forgiven.