Late with filing a tax return with the IRS? Didn’t correctly figure and pay what you owe? Did something you weren’t supposed to do? Don’t worry. While the tax law has multiple penalties in place to discourage and punish mistakes, there are many ways in which you can get them lifted. In tax parlance, this is called penalty abatement. Generally, penalty relief falls into 4 categories: reasonable cause, penalty exceptions created in the Tax Code, administrative waivers from the IRS, and correction of IRS errors.
The following is excerpted from my book J.K. Lasser’s Small Business Taxes 2022, which will be released in December 2021.
Reasonable cause is based on the 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 if you exercised ordinary business care and prudence in determining your tax obligations but nevertheless failed to comply with those obligations. Ordinary business care and prudence requires you to make reasonable effort to determine your tax obligations. In assessing whether you exercised reasonable care, the IRS looks at the reason given, your past compliance history, the time between the event that triggered the noncompliance and subsequent compliance, and whether there were circumstances beyond your control (e.g., serious illness, fire, or storm). Ignorance of the law is no excuse.
For small partnerships and S corporations (those with 10 or fewer owners), reasonable cause is met automatically if all owners are natural persons (and not nonresident aliens), all owners receive equal allocations of each entity item, and all owners have reported these items on their personal returns.
Whether your reliance on erroneous advice from a CPA or other tax professional constitutes reasonable cause depends on the penalty.
Waivers in the Tax Code
The law may provide you with an out. Examples:
- Using postponements of deadlines by reason of a federally declared natural disaster or for other reasons.
- Relying on the written advice of the IRS, which turns out to be incorrect.
- Using specific penalty relief for employment taxes when workers you’ve been treating as independent contractors are reclassified as employees. Section 530 of the Revenue Act of 1978 created this relief.
The IRS has a number of programs that taxpayers can use to avoid penalties.
- Employee Plans Compliance Resolution Program (EPCRS) can be utilized to self-correct errors in qualified retirement plans.
- The penalty relief program for Form 5500-EZ can be used to obtain penalty relief for an overdue return.
- Underpayments of employment taxes can be self-corrected without interest (although penalties may apply). The amount of the underpayment must be paid by the time an adjusted return (e.g., Form 941-X, Adjusted Employer’s QUARTERLY Federal Tax Return or Claim for Return) is filed.
- Undue hardship relief for failing to pay taxes on time can be granted by filing Form 1127, Application of Extension of Time for Payment of Tax Due to Undue Hardship.
- Voluntary Classification Settlement Program (VCSP) may be used for reclassifying independent contractors as employees.
The Small Business/Self-Employed Division of the IRS is working on a new program to enable taxpayers to self-correct errors on their tax returns, which will help to minimize or possibly avoid penalties. The program is not yet up and running but will be covered when details become available.
First-Time Abatement Program
You may be able to escape a penalty under the IRS’s first-time abatement (FTA) penalty waiver program. To qualify, you must have done things right in the past 3 years and be otherwise in compliance with all filings and payment requirements.
With the ever-growing complexity of tax rules for small business owners, incurring a penalty, at least once, is almost inevitable. Just remember, as famous football player and coach Paul Bear Bryant said: “When you make a mistake, there are only three things you should ever do about it: admit it, learn from it, and don’t repeat it.” Good luck.