Civil Tax Penalties

Civil penalties assessed by the IRS can add up. If there is a filing, paying, or reporting requirement, it is likely that there is a penalty provision for the failure to satisfy any such requirement.

Section 6663 imposes a civil fraud penalty of 75% of the portion of underpayment that is due to fraud. The IRS cannot impose an accuracy-related penalty and a civil fraud penalty; it must choose to impose one or the other. It is important to note that taxpayers do not have to prove a lack of fraud. The burden of proof is on the IRS to prove fraud by clear and convincing evidence.

The clear and convincing standard is onerous, as illustrated in Matthews v. Commissioner, T.C. Memo. 2018-212, a U.S. Tax Court case. Prior to the Tax Court case, Matthews, the taxpayer, had lied to the IRS Revenue Agent conducting a civil examination of his 2004 through 2006 tax returns and to an IRS Special Agent conducting a criminal investigation into his 2004 through 2008 tax returns. As a result of the criminal investigation, Matthews was convicted of tax perjury and was sentenced to a 27-month prison term. Subsequently, the IRS audited his 2007 and 2008 tax returns and determined that Matthews had fraudulently underreported his income. This opened the statute of limitations for assessments, and the IRS assessed a civil fraud penalty. Matthews, who represented himself pro se (without a lawyer), contested the fraud determination and testified that he was clueless and unsophisticated regarding tax matters. The Court found his testimony to be credible and held that the IRS did not prove civil fraud by clear and convincing evidence. The Court explained that it believed that the lengthy prison sentence “impressed upon [Matthews] the importance of telling the truth[]” and that “he was genuinely confused about the taxability of [his business’s] income when he filed his 2007 and 2008 returns.” Id. at *25, *30.

Pursuant to Section 6662, a 20% penalty applies to each of the following:

1. Negligence or disregard of rules or regulations;
2. Substantial understatement of income tax;
3. Substantial valuation misstatement;
4. Substantial overstatement of pension liabilities;
5. Substantial estate or gift tax valuation understatement;
6. 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;
7. Undisclosed foreign financial asset understatement; and
8. Inconsistent estate basis.

To request an abatement for accuracy-related penalties, taxpayers can argue that they acted in good faith and have reasonable cause.

Treasury Regulations provide several exceptions to the accuracy-related penalty.

1. No negligence penalty is imposed if the portion of the underpayment is due to a position that has a reasonable basis. Treas. Reg. Section 1.6662-3(b).
2. No negligence penalty is imposed on an underpayment attributable to a position contrary to a rule or regulation if the position is disclosed and the position represents a good faith challenge to the validity of the regulation. The position, however, must have a reasonable basis. Treas. Reg. Section 1.6662-3(c).
3. Items for which there is adequate disclosure are treated as if they were shown properly on the return for the taxable year. Therefore, tax attributable to such items is not included in the understatement for that tax year. The items, however, must have a reasonable basis. Treas. Reg. Section 1.6662-4(e).
4. There may be no penalties for disregarding rules and regulations and for a substantial underpayment of income tax if there is adequate disclosure of the position on a return, but only if the position has a reasonable basis. Treas. Reg. Section 1.6662-7(c).

According to Treas. Reg. Section 1.6662-3(b)(2), “[r]easonable basis is a relatively high standard of tax reporting, . . . . [and] is not satisfied by a return position that is merely arguable or that is merely a colorable claim.” Generally, a position will satisfy the standard if it is reasonably based on at least one of the authorities in Treas. Reg. Section 1.6662-4(d)(3)(iii), such as statutes, regulations, revenue rulings, and court cases. With respect to adequate disclosures, in most cases, disclosure is adequate if made on a properly completed Form 8275, Disclosure Statement, or 8275-R, Regulation Disclosure Statement, attached to the tax return. Treas. Reg. 1.6662-4(f).

Section 6651(a)(1) imposes a 5% penalty for each month that a tax return is filed late. This failure to file penalty can be up to 25% of the taxes due. Section 6651(a)(2) imposes a separate penalty of up to 25% of the taxes owed for late payments. The failure to pay penalty is 0.5% of the taxes owed for each month that the payment is late. When both these penalties apply, the failure to file penalty (5% per month) is reduced by the failure to pay penalty (0.5%). This means that a taxpayer who non-fraudulently fails to file a tax return or pay his or her taxes may be subject to a maximum penalty of 47.5% of the taxes owed. A taxpayer who fraudulently fails to file a tax return is subject to a maximum penalty of 75% of the taxes due. Keep in mind that the IRS has the burden of proving fraud.

Reasonable cause and absence of willful neglect may be argued to abate the failure to file and failure to pay penalties.

First Time Abatement

Taxpayers may request a First Time Abatement from the IRS if they have not previously been required to file a return or if no prior penalties have been assessed in the prior three years and have filed returns and paid any tax due. For taxpayers who are not eligible for First Time Abatement, they may still be able to argue for an abatement due to reasonable cause.

Reasonable Cause

The IRS may provide relief from a penalty if the taxpayer has reasonable cause. Reasonable cause generally means the taxpayer exercised ordinary business care and prudence, but still did not satisfy his or her tax obligation. Taxpayers may be able to establish reasonable cause in a variety of situations including when the taxpayer:

1. Is dead, seriously ill, or dealing with an immediate family member’s death, serious illness, or unavoidable absence;
2. Is/was affected by a fire, casualty, natural disaster, or other disturbance;
3. Was unable to obtain necessary records to comply with a tax obligation;
4. Made a mistake;
5. Relied on erroneous advice from a professional; and
6. Was not aware of the requirement and could not reasonably be expected to know of the requirement.

In United States v. Boyle (“Boyle”), 469 U.S. 241 (1985), the Supreme Court of the United States (“Supreme Court”) held that the failure to timely file a tax return is not excused by the taxpayer’s reliance on a professional. In Boyle, the executor of his late-mother’s estate retained an attorney to prepare and file the estate’s tax return. The attorney did not mention a deadline, however, the executor contacted the attorney multiple times to ask if the return had been filed. Unfortunately, the due date was not on the attorney’s calendar and the return was filed three months late. The IRS assessed the estate a $17,124.25 late filing penalty with $1,326.56 in interest. The estate paid the penalty and filed a refund claim in the U.S. district court, which held that the estate had reasonable cause. The Seventh Circuit Court of Appeals affirmed, but the Supreme Court reversed. The Supreme Court held the taxpayer is not entitled to any reasonable cause relief because “one does not have to be a tax expert to know that tax returns have fixed filing dates and that taxes must be paid when they are due.” Id. at 251. The Supreme Court, however, stated that if a taxpayer hires a tax professional to determine whether there is a filing requirement and the tax professional erroneously determines that the taxpayer does not have a filing requirement, then reasonable cause may exist. See id. at 250.

Whether you have reasonable cause is a fact intensive inquiry and we can go over your unique facts during a consultation. Contact us at (310) 272-7600 or complete our online form to set up an appointment.

If you have received a penalty notice from the IRS or FTB, the tax attorneys at the Ben-Cohen Law Firm can help. In addition to being an attorney, Pedram Ben-Cohen is a CPA and a Board Certified Taxation Law Specialist, who has handled countless of tax disputes with the IRS and FTB. Please give us a call at (310) 272-7600 to meet with our tax attorneys.