Understanding IRS Reasonable Cause Criteria

Often times, when someone owes taxes that they haven’t paid for a few years, they are surprised when they find out how much the IRS says they owe.   This is because the IRS inevitably tacks on several of the dozens of penalties they are allowed to charge.   However it’s the late filing, the late payment and the penalty for not making Federal Tax Deposits (when combined) that can add a whopping 65% to your total IRS bill.  The good news is that if your tax debt is more than two years old, you’ve maxed out all these penalties!

The IRS does actually have a compassionate side, and it’s typically found in the penalty abatement process. The thing to keep in mind is that the IRS has very strict guidelines for granting penalty abatements, and these guidelines are referred to as “reasonable cause criteria.” 

The primary IRS penalty abatement reasonable cause criteria center on natural disasters, loss or destruction of vital business records, bad advice from the IRS or an accounting professional, criminal activity, medical issues, substance abuse problems, and other serious circumstances.  Thus, you are more likely to have your penalties abated if the circumstances cause you to answer “yes” to any of the following questions:

  • Were any business records lost or destroyed?
  • Were there any circumstances that led to a substantial drop in collecting on accounts receivable?
  • Was there any transition in the business that lead to the failure to pay taxes?
  • Was there a death or serious illness that directly affected the business or personal wages?
  • Was there any embezzlement of funds, theft of valuable property, or identity theft?
  • Were there any alcohol or drug abuse issues that affected the business or wage earning capability?
  • Was there a natural disaster that impacted you or your business?
  • Did you rely on the advice of a CPA or IRS employee in making tax decisions?
  • Were there any circumstances that created substantial financial hardship, to the point where your business was close to going bankrupt?

Specific Internal Revenue Manual (IRM) References

The sections of the IRM outlined below will help you see what the IRS will consider and how they evaluate each circumstances. Please note that this list is not exhaustive and that the IRS will consider the facts and circumstances on a case by case basis. The other thing to note is that if your initial request is denied, it might be approved via submitting an appeal.

In our next post, we’ll talk about how you can create your reasonable cause letter to the IRS and what it should contain.

How Late Can You File A Tax Return?

April 15th is the annual deadline for most people to file their federal income tax return and pay any taxes they owe. But what happens if you can’t file on time? What happens if you file your return after the due date? If you were owed a refund, can you still receive it? This post will answer all of the above questions and then some.

Annual Due Date For Filing Return. Everyone is pretty familiar with the date of April 15th here in the US. This is “Tax Day” or the date that most people are required to file their Form 1040 U.S. Individual Income Tax Return. While this date may move slightly from year to year (due to local holidays) note that it is actually mandated by law. 26 U.S. Code § 6072 actually stipulates the due dates for individual and corporate tax returns.

Can’t File By Due Date? By law, the IRS may assess penalties to taxpayers for both failing to file a tax return and for failing to pay taxes they owe by the deadline. Now, one way to avoid the late filing penalties is to file an extension. Filing Form 4868 Application for Automatic Extension of Time To File U.S. Individual Income Tax Return, will give you an extra 6 months for you to file your return and have it be considered on time. Now, if you owe money, that is still due on April 15th. If you fail to make a payment by then, you will still be subject to the late payment penalties noted above.

Filing After Extension Due Date? If you file after the extended due date, then one of two scenarios occurs:

  • You had a balance due and are now subject to the late filing and late payment penalties
  • You have a refund and are NOT subject to any penalties, but the clock is now ticking for you to claim your refund or lose it.

3 Year Deadline To Claim Refund 26 U.S. Code § 6511 outlines that a taxpayer basically has 3 years from the time the return was filed or 2 years from the time the tax was paid, whichever of such periods expires the later, to claim their refund. So while you won’t pay any penalties for late filing a return in which you were owed a refund, know that you generally only have 3 years to claim it. What happens if you don’t file by then? Well, that refund becomes the property of the US Government and you lose it forever!

What If You Don’t File Voluntarily If you fail to file file a tax return, the IRS may file a substitute return for you. This return might not give you credit for deductions and exemptions you may be entitled to receive. The return the IRS prepares for you will lead to a tax bill, which if unpaid, will trigger the collection process. This can include such actions as a levy on your wages or bank account or the filing of a notice of federal tax lien.

Need Help Filing Your Past Due Return? For filing help, you can call the IRS at 1-800-829-1040 They can help you obtain wage and income information to help prepare a past due return. If you don’t want to speak to anyone at the IRS, you can obtain your transcripts electronically by using the IRS’ Get Transcript tool to request a return or account transcript. You can also get tax forms and instructions to file your past due return by calling 1-800-Tax-Form (1-800-829-3676).

Now, if you would rather avoid all of the above and have a service file your tax returns for you, we’d be more than happy to help. Just go to this page to get started and you can be filed in as little as 24 hours!

Understanding IRS Penalties

Some of our “current Year” clients come in to see us on April 15th. When they do we often ask “why did you wait so long?” Their response usually has something to do with the fact that they knew they owed and didn’t want to pay the IRS before they had to. To this we usually respond with “you can file your return at any time before the April 15th deadline, EVEN if you have a balance due. The payment isn’t due until April 15th and interest and penalties don’t start running until AFTER that date.”

With that said, here are some key things every taxpayer should know about interest and penalties.

No Penalty Situations.

  • There is no penalty if you’re getting a tax refund, provided that you file within 3 years of the April 15 deadline (or October 15 deadline if you filed an extension).
  • After 3 years, your unclaimed tax refund is forfeited and becomes the property of the U.S. Treasury.
  • There is no penalty if you filed an extension AND paid the taxes owed by April 15, as long as you file your return by the October 15 deadline.

Possible Penalties.  If you file your federal tax return late and owe tax with the return, two penalties may apply. The first is the failure-to-file penalty for filing late. The second is the failure-to-pay penalty for paying late.

Failure To File Penalty (Late Filing).  This penalty applies if you owe taxes and didn’t file your return or extension by April 15.  It will also apply if you owe taxes, filed an extension, but didn’t file your return by the extended October 15th deadline.

  • The late filing penalty applies to the net amount due, which is the tax shown on your return and any additional tax found to be due (as reduced for any credits and estimated payments).
  • The combined penalty is 5% (4.5% late filing and 0.5% late payment) for each month or fraction of a month that your return was late, up to a maximum amount of 25%.
  • If your return was over 60 days late, the minimum failure-to-file penalty is the smaller of $135 or 100% of the tax shown on the return.
  • If after five months you still have not paid, the failure-to-file penalty will max out.

Failure To Pay Penalty (Late Payment).  This penalty applies if you didn’t pay the taxes owed by April 15, whether you filed an extension or not.

  • The late-payment penalty is 0.5% (1/2 of 1%) of the tax owed for each month or fraction of a month that the tax remains unpaid after the due date, up to a maximum of 25%.
  • The 0.5% rate increases to 1% per month if the tax remains unpaid after several notices and 10 days after the IRS issues a final notice of intent to levy or seize property.
  • For any month(s) in which both the late-payment and late-filing penalties apply, the 0.5% late-payment penalty is waived.
  • You will not have to pay the penalty if you can show reasonable cause for the failure to pay on time.
  • If your return was filed timely and you are paying your tax via an installment agreement, the penalty is 0.25% for each month or part of a month that the installment agreement is in effect.

Accuracy Related Penalties.  These penalties are not really related to filing your return on time, but we include them here because one can find them subject to them by not filing all of the income documents associated with their return (e.g.  forget to include a sizable 1099-MISC).  The two most common accuracy related penalties are the “substantial understatement” penalty and the “negligence or disregard of the rules or regulations” penalty. These penalties are calculated as a flat 20 percent of the net understatement of tax.

  1. Penalty for substantial understatement.  You understate your tax if the tax shown on your return is less than the correct tax. The understatement is substantial if it is more than the larger of 10 percent of the correct tax or $5,000 for individuals.
  2. Penalty for negligence and disregard of the rules and regulations.  This penalty may be assessed if you carelessly, recklessly or intentionally disregard IRS rules and regulations, take a position on your return with little or no effort to determine whether the position is correct or knowingly taking a position that is incorrect.

Interest.  In addition to the penalties, you will have to pay interest on any balance that remains unpaid post April 15th.  This interest compounds daily from the due date of the return (regardless of whether an extension was filed or not) until the date of payment.

  • The interest rate is the federal short-term rate plus 3%.
  • The federal short-term rate is determined every three months.  To find the current rate search “quarterly interest rates” on IRS.gov; the relevant interest rate is the rate for underpayments.

Helpful Tips.

  • The late filing penalty can be 10 times higher than the late payment penalty. If you can’t pay your tax bill and didn’t file an extension, at least file your return as soon as possible! You can always amend it later.
  • Always file for an extension if you can.  Secondarily, always file your return before your extension runs out or your be subject to the late filing penalty.
  • Think you owe?  File early!  This way you will know what the balance due is and can either 1) pay it by April 15th, 2) save your money to do number 1 or 3) prepare to make an alternative arrangement (e.g. borrow, charge it, apply for an installment agreement).

How To Pay Taxes Owed

If you find yourself in the undesirable predicament of owing the IRS, here are some things for you to keep in mind so that the situation doesn’t go from bad to worse:

Payment Methods & Tips

  • You can pay taxes electronically 24/7 on www.IRS.gov. Just click on the “Payments” tab near the top left of the home page for details.
  • Check out IRS Direct Pay to pay directly from your bank account. It’s secure and free and you’ll get instant confirmation that you have submitted your payment.
  • Pay in a single step by using your tax software when you e-file. If you use a tax preparer, ask them if they can make your payment electronically.
  • Whether you e-file your tax return or file on paper, you can choose to pay with a credit or debit card. One service that our clients often use is www.1040paytax.com.
  • If you enroll in the Electronic Federal Tax Payment System (EFTPS) you can pay your federal taxes electronically and directly to the government. You have a choice to pay using the Internet, or by phone using the EFTPS Voice Response System.
  • If you can’t pay electronically, you can still pay by a personal or cashier’s check or money order. Just make you check payable to the “U.S. Treasury” and be sure to write your name, address and daytime phone number on the front of your payment. Also, write the tax year, form number you are filing and your Social Security number. Use the SSN shown first if it’s a joint return.
  • If you pay by paper check, complete Form 1040-V, Payment Voucher. Mail it to the address listed in the instructions based on where you live.

Balance Owed On Prior Year Taxes

  • If you filed your return late, just know that the amount owed reflected on the return is incorrect. This is due to interest and penalties. Thus, once you file your return, the IRS will send you a notice indicating the correct amount to satisfy your liability.
  • If you have moved since you last filed a return with the IRS, make sure that you submit Form 8822 so that you can receive all future communications. The last thing you want is for the IRS to think you are ignoring you and then begin aggressive collection actions (e.g. liens, levies, wage garnishments, etc).

Inability To Pay Balance Off With One Payment

  • If you can’t pay off the balance with a single payment, it’s in your best interest to send in as much as you can to minimize the penalties and interest that will be assessed.
  • The IRS has many options for you to pay your balance off, including payment plans. This post on our sister site talks about setting up a guaranteed installment agreement and is well worth the read. 

Need assistance with your tax balance? Give us a call at 844-TAXES88 (844-829-3788) and we’d be happy to discuss you situation and tell you how we can be of service.