Relief From Taxpayer Penalties

When it comes to penalties, it is often times helpful to know why they exist in the first place. Knowing what the purpose of penalties is will be invaluable when it comes to disputing them. According to the Consolidated Penalty Handbook, the purpose of penalties is to aid voluntary compliance if they support a belief in the fairness and effectiveness of the tax system.
The key for the practitioner is to remind the IRS official that penalties are not imposed for punishment. With that in mind, it goes without saying that first time offenders should be given the benefit of the doubt when it comes to the assessment of a penalty. The Internal Revenue Manual requires IRS officials to consider the following factors:

(a) What happened and when it happened;

(b) During the period of time of noncompliance, what were the facts and circumstances that prevented the taxpayer from complying with the tax laws;

(c) How did the facts and circumstances result in noncompliance;

(d) How did the taxpayer handle the remainder of his or her affairs during this period; and

(e) Once the facts and circumstances changed, what attempts did the taxpayer make to come into compliance.

Any one of following reasons can be used to establish reasonable cause:

(a) Death, serious illness or unavoidable absence;

(b) Fire, casualty, natural disaster or other disturbance;

(c) Inability to obtain records,

(d) Lack of funds, and

(e) Mistake or forgetfulness.

 Other factors considered by the Service when determining reasonable cause include: (1) the taxpayer’s experience, (2) the taxpayer’s knowledge, (3) the taxpayer’s sophistication and education, and (4) the taxpayer’s reliance on the advice of a tax advisor. If a taxpayer was misguided or is unsophisticated in tax law but acts in good faith, there is no justification for imposing penalties. However, reliance on the professional advice of another must be reasonable.

1. Erroneous Advice of IRS Officer Or Employee

Any penalty attributable to the erroneous written advice of an officer or employee of the Service – acting in his or her official capacity – must be abated. On the other hand, the Service may abate penalties if a taxpayer relied on the oral advice of an officer or employee of the Service. Note the subtle distinction between written advice of an employee of the Service and oral advice of an employee of the Service.
Factors that the Service considers when deciding whether or not to abate a penalty that is the result of erroneous oral advice include:

(a) Whether the taxpayer exercised ordinary business care and prudence in relying on advice;

(b) Whether there is a clear relationship between the taxpayer’s situation, the advice provided, and the penalty asserted;

(c) The taxpayer’s prior tax history;

(d) Whether the correct information was provided by the Service through another means; and

(e) Whether supporting documentation is available.

Taxpayer must be sure to keep notes of all communications with Service employees, including the date of the communication, the name and badge or employee number of the employee with whom the taxpayer spoke, and the substance of the information provided. These notes may prove useful later on supporting documentation.

2. Reliance on Professional Advice

A taxpayer’s reliance on the advice of a tax advisor or tax professional is often the foundation for a taxpayer’s position that he acted with reasonable cause and in good faith. However, such reliance is not an automatic bar to the imposition of penalties.
The taxpayer’s reliance must be objectively reasonable. A taxpayer who knew or should have known that his tax professional suffered from a conflict of interest or lack of expertise will not be deemed to have acted reasonably. Similarly, a taxpayer who knew that his professional lacked knowledge or expertise in the area in question will not be deemed to have acted reasonably.
Reliance on information found on website written by unidentified individuals or organizations alone is not a basis for a reasonable cause defense. In Woodsum v. Commissioner, 136 T.C. No. 29 (2011), the Tax Court held that the taxpayer’s reliance on his return preparer’s unexplained or erroneous omission was an inadequate reasonable cause defense.
At the same time, the Tax Court suggested that the taxpayer might have another arrow in his quiver – specifically, Treas. Reg. § 1.6664-4(b)(1), which states that an isolated computation or transcriptional error is not inconsistent with reasonable cause and good faith. Unfortunately for Mr. Woodsum, the facts of his case did not support this characterization. As noted by the Tax Court, Mr. Woodsum knew that the omitted item had to be included in the return.
In a case that defies conventional wisdom, the Supreme Court of the United States held that it was not reasonable for a taxpayer to assume that his attorney would meet the statutory deadline to file a federal estate tax return. As a result, his reasonable cause defense went down in flames.
Taxpayers who successfully make an initial showing of reasonable cause must be careful to avoid a common pitfall: reasonable cause once established does not necessarily continue ad infinitum. Consider the following example. Assume that the IRS has asserted penalties for the failure to file a return. While you may be able to establish a claim of reasonable cause at the very outset, to the extent that you knew that your return was due at an earlier time and you blew the deadline, you may not be able to rely upon your initial reasonable cause defense to excuse your late filing. Very simply, your previously established “meritorious” reasonable cause defense does not necessarily continue until the return is filed. Therefore, it may not excuse your late filing.
Reliance on the advice of a tax advisor generally pertaining to the reasonable cause exception in IRC § 6664(c) for accuracy-related penalties. Generally, reliance on the advice of a tax practitioner is limited to those situations where the law is complex and technical. Thus, it should come as no surprise that in cases where there are readily available answers – such as those involving the due date of returns and the payment of taxes – the defense is unsuccessful.
According to the Internal Revenue Manual, the agent should consider the following factors:

(a) Whether the taxpayer reasonably relied upon the advice of the tax advisor;

(b) Whether the taxpayer provided the tax advisor with adequate and accurate information;

(c) Whether the advice was in response to a specific request; and

(d) Whether there was supporting documentation, such as a copy of the advice requested, a copy of the advice provided, and a statement from the tax advisor explaining the circumstances.

II. Request for Penalty Abatement
If a taxpayer believes that he is entitled to penalty relief, he may file a Claim for Refund and Request for Abatement (Form 843). In addition to the reasons for penalty relief discussed above, the following factors may also be helpful in penalty abatement, to the extent that they are relevant to the taxpayer’s circumstances:

(a) Death, serious illness, or unavoidable absence by the taxpayer or immediate family member of the taxpayer,

(b) Fire, casualty, natural disaster, or other disturbance;

(c) Whether the taxpayer was unable to obtain necessary records even though he exercised ordinary business care and prudence; and

(d) Whether the taxpayer made a mistake even though he exercised ordinary business care and prudence.

Finally, there is First Time Abatement (“FTA”). FTA provides relief from failure to file, failure to pay, and failure to deposit penalties for two classes of taxpayers: (1) those who have not previously been required to file a return or (2) those who have not been assessed prior penalties on the same type of federal return for the previous three years. FTA applies only to a single tax period. To the extent that penalty relief is being considered for multiple years, FTA is only available for the earliest tax year in issue. Note that FTA relief does not apply to returns with an event-based filing requirement, such as Form 706.
III. Administrative Waivers
The Service may formally interpret or clarify a provision to provide administrative relief from a penalty that would otherwise be assessed. For example, the Service waived failure to deposit penalties under IRC § 6656 for taxpayers who were first required to make Federal tax deposits by electronic funds transfer beginning on or after July 1, 1987.
IV. When Reasonable Cause is Not a Valid Excuse
While the reasonable cause defense may aid a taxpayer in abating accuracy-related penalties, it is not always available. For example, the reasonable cause defense is not available to a taxpayer who fails to pay a deficiency. In addition, accuracy-related penalties imposed under IRC § 7701(b) for transactions lacking economic substance cannot be abated based on a reasonable cause defense.
Nor can reasonable cause be raised as a defense to substantial overvaluation statements relating to charitable contributions, unless the taxpayer has made a good faith investigation by engaging a qualified appraiser. Finally, reasonable cause does not apply to gross misstatements relating to returns filed after August 17, 2006.
Before a taxpayer can rely on the reasonable cause defense, any reportable transaction that is required to be disclosed must be disclosed. While reasonable cause can be raised as a defense to virtually every penalty that the IRS can assert, there is one penalty for which it can’t. And that is IRC § 6707 penalty, for tax shelters. Indeed, IRC § 6707 enjoys absolute immunity from the reasonable cause exception.
However, all hope is not lost. Unlike most other penalties, the Commissioner may withdraw the IRC § 6707 penalty for reportable non-listed transactions if it would promote compliance with the tax laws and effective tax administration.
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