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.

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).