The Internal Revenue Manual (IRM) contains a Penalty Handbook intended to serve as the foundation for addressing the administration of penalties by the IRS. It is the “one source of authority for the administration of penalties. . .”( Internal Revenue Manual (IRM) 188.8.131.52.1 (02-22-2008). Refer to IRM 9.1.3, Criminal Investigation – Criminal Statutory Provisions and Common Law, for Criminal Penalty provisions.) and provides a “fair, consistent, and comprehensive approach to penalty administration.” As such, the IRM is often the first stop for IRS examiners attempting to determine whether conduct should be subjected to further review and, potentially, civil penalties.
IRM Approach to Penalty Administration. The IRM’s approach to penalty administration provides:
Consistency: The IRS should apply penalties equally in similar situations. Taxpayers base their perceptions about the fairness of the system on their own experience and the information they receive from the media and others. If the IRS does not administer penalties uniformly (guided by the applicable statutes, regulations, and procedures), overall confidence in the tax system is jeopardized.
Accuracy: The IRS must arrive at the correct penalty decision. Accuracy is essential. Erroneous penalty assessments and incorrect calculations confuse taxpayers and misrepresent the overall competency of the IRS.
Impartiality: IRS employees are responsible for administering the penalty statutes and regulations in an even-handed manner that is fair and impartial to both the government and the taxpayer.
Representation: Taxpayers must be given the opportunity to have their interests heard and considered. Employees need to take an active and objective role in case resolution so that all factors are considered.
Relief Due to Reasonable Cause. Many penalties may be avoided based upon a determination that reasonable cause existed for the positions maintained within a return. Reasonable cause is based on a review of all relevant facts and circumstances in each situation and allows the IRS to provide relief from a penalty that would otherwise be assessed. Reasonable cause relief is generally granted when the taxpayer exercises ordinary business care and prudence in determining their tax obligations but nevertheless failed to comply with those obligations. Ordinary business care and prudence includes making provisions for business obligations to be met when reasonably foreseeable events occur. A taxpayer may establish reasonable cause by providing facts and circumstances showing that they exercised ordinary business care and prudence (taking that degree of care that a reasonably prudent person would exercise), but nevertheless were unable to comply with the law.
Taxpayers have reasonable cause when their conduct justifies the non-assertion or abatement of a penalty. Each case must be judged individually based on the relevant facts and circumstances. Examiners are to consider various factors in determining penalty relief based on reasonable cause. What happened and when did it happen? During the period of time the taxpayer was non-compliant, what facts and circumstances prevented the taxpayer from filing a return, paying a tax, and/or otherwise complying with the law? How did the facts and circumstances result in the taxpayer not complying? How did the taxpayer handle the remainder of their affairs during this time? Once the facts and circumstances changed, what attempt did the taxpayer make to comply?
Death, serious illness, or unavoidable absence of the taxpayer may establish reasonable cause for filing, paying, or delinquent deposits. Information examiners consider when evaluating a request for penalty relief based on reasonable cause due to death, serious illness, or unavoidable absence includes, but is not limited to, the relationship of the taxpayer to the other parties involved, the date of death, the dates, duration, and severity of illness, the dates and reasons for absence, how the event prevented compliance, if other business obligations were impaired, and if tax duties were attended to promptly when the illness passed, or within a reasonable period of time after a death or return from an unavoidable absence.
Explanations relating to the inability to obtain the necessary records may constitute reasonable cause in some instances, but may not in others. Reasonable cause may be established if the taxpayer exercised ordinary business care and prudence, but due to circumstances beyond the taxpayer’s control, they were unable to comply. Relevant information includes, but is not limited to, an explanation as to why the records were needed to comply, why the records were unavailable and what steps were taken to secure the records, when and how the taxpayer became aware that they did not have the necessary records, if other means were explored to secure needed information, why the taxpayer did not estimate the information, if the taxpayer contacted the IRS for instructions on what to do about missing information, if the taxpayer promptly complied once the missing information was received, and supporting documentation such as copies of letters written and responses received in an effort to get the needed information.
In Henry v. Commissioner, 170 F.2d 1217 (9th Cir. 1999), the Internal Revenue Service asserted a negligence penalty on the theory that it was unreasonable for the taxpayer to rely on their tax accountant based on the taxpayer’s perceived sophistication and the taxpayer’s failure to fully disclose relevant information to their accountant. In reversing the Tax Court on the issue of negligence penalties, the Ninth Circuit succinctly stated: “. . . the Petitioners consulted their long-time accountant and we find they were reasonable in relying on his preparation of their tax returns.” Id. at 1221.
Still further, “. . . Knowing there is a risk in filing a tax return such that there may be an audit which could result in an income tax deficiency determination, however, does not provide evidence that the taxpayer knew or should have known of the Tax Regulation and unreasonably disregarded it. Similarly, we could say that all of life is a risk, but certainly one is not negligent for going ahead and living it.” Id. at 1222.
Finally, “. . . In conclusion, we find that Petitioners’ reliance on their experienced and long-time accountants’ tax treatment . . . was reasonable. Id. at 1223.
First Time Penalty Abatement. The IRS Reasonable Cause Assistant (RCA) is a decision-support interactive software program developed to reach a reasonable cause determination [IRM 184.108.40.206.6.1 (12-11-2009)]. The RCA will be used when considering penalty relief due to reasonable cause. RCA is to be used after normal case research has been performed, (i.e., applying missing deposits/payments, adjusting tax, or researching for missing extensions of time to file, etc.) for the Failure to File (FTF), Failure to Pay (FTP), and Failure to Deposit (FTD) penalties.
RCA provides an option for penalty relief for the FTF, FTP, and/or FTD penalties if the taxpayer has not previously been required to file a return or if no prior penalties (except the Estimated Tax Penalty) have been assessed on the same account in the prior 3 years. If RCA determines a “First -Time Abate” is applicable, the taxpayer will be advised that the penalty(s) was removed based solely on their history of compliance, that this type of penalty removal is a one-time consideration available only for a first-time penalty charge, and that any future (FTF, FTP, FTD) penalties will only be removed based on information that meets reasonable cause criteria.
Summary. Obtaining relief from civil tax penalties during an IRS examination is anything but certain. It is typically preferrable to have a representative objectively summarize the taxpayer’s position for purposes of seeking penalty relief. The Internal Revenue Manual (available at irs.gov by searching “IRM”) provides helpful guidance on seeking an abatement of penalties. Ultimately, penalty relief is often determined by what the taxpayer (and their advisor) did or did not do with respect to the tax-related issues involved.