When the IRS hits you or your business with a tax bill, it usually adds penalties and interest charges. These extra charges can be shocking—an old $7,000 tax bill could have $15,000 in penalties and interest tacked on to it. Some penalties, such as for late payments, are added automatically by IRS computers. Or, IRS personnel may impose penalties if you violated a tax code provision, such as filing a return late. The IRS doesn’t just dream up penalties—each one has been authorized by the elected representatives in Washington. Once penalties are decreed, if you don’t complain, the IRS assumes you accept them. Happily, the IRS can remove a penalty just as easily as it added one. The key to the kingdom of tax penalty relief is showing a reasonable cause for your failure to comply with tax law. This post provides basic knowledge and light tips to get your tax penalties or interest reduced [or even removed at all]. Before the main topics, we are going to discuss some basic knowledge about tax penalties and interest: Common Reasons for Penalties, Underpaying Estimated Taxes, Interest on Tax Bills, Understanding Penalty and Interest Notices. Right after those basic sections, you can find the main “how to” topics: How to Get Penalties Reduced or Eliminated, How to Request a Penalty Abatement [with abatement request letter example], what to do “If Your Abatement Request Is Rejected”? and; How to Get Interest Charges Removed.
Common Reasons for Penalties
The number of different tax code penalties is staggering. This section covers only the penalties most likely to be imposed on a small business [or and its owner]. Here are common reasons for penalties:
Inaccuracies – The IRS can hit you with a 20% penalty if you were negligent (unreasonably careless) or substantially understated your taxes. This accuracy related penalty is applied when you can’t prove a deduction in an audit, or you didn’t report all of your income and the IRS discovers it.
Civil Fraud – If the IRS finds that you underreported your income with a fraudulent intent (it doesn’t look like an honest mistake to the IRS), a fine of 75% can be added. Breathe easy—this civil (non-criminal) tax fraud penalty is imposed in fewer than 2% of all audits. (You may also be charged with the crime of tax fraud, which is even rarer)
Late Payment – The IRS usually adds a penalty from 1/4% to 1% per month to an income tax bill that’s not paid on time. This late payment penalty is automatically tacked on by the IRS computer whenever you file a return without paying the balance owed, or when you pay it late. Penalties for failing to make payroll tax deposits on time are much higher.
Late Filing – If you’re late in filing required forms, the IRS can penalize you an additional 5% per month on any balance due. However, this penalty can be applied only for the first five months following the return’s due date, up to a 25% maximum charge. If there is no balance due, the IRS can still tack on lesser penalties.
Note: An extension to file your tax return does not extend your time to pay any taxes due.
Filing and Paying Late A special rule applies if you both file late and underpay. Tax penalties are not tax deductible for individuals.
The IRS can (and probably will) impose a combined penalty of 25% of the amount owed if not paid in the first five months after the return and tax are due. After five months, the failure to pay penalty continues at 1/2% per month until the two penalties reach a combined maximum of 471/2%. This is a slightly lower (21/2% less overall) penalty than if the two penalties were applied separately. Wow, those IRS folks sure can be generous.
Example: Lie Dharma Putra, lets April 15 pass without filing his tax return or making any payment. He finally gets around to filing on September 16 and owes $4,000. The IRS will tack on a 25% penalty ($1,000), bringing the bill up to $5,000. Interest will be charged as well. In recent years, the IRS has charged 6%–8% interest annually.
Caution: IRS penalties are stackable. Late filing and paying penalties can be imposed by the IRS in addition to any other penalties, such as for fraud or filing an inaccurate return. Congress and the IRS believe the more the merrier when it comes to penalizing delinquent or erring taxpayers.
Underpaying Estimated Taxes
Self-employed folks occasionally get dinged for the estimated tax penalty. All self-employed individuals must estimate their income tax for the year ahead and pay it in quarterly installments. Quarterly estimated tax payments are due on April 15, June 15, September 15, and January 15 of each year. Quarterly payments should be equal—generally you can’t play catch-up with larger payments later in the year and still avoid this penalty.
You must come pretty close to paying everything you will owe, although you don’t have to guess the total amount precisely. Here are the rules for avoiding the penalty:
- If you earn less than $150,000, your quarterly tax payments must equal at least 90% of your final income tax bill, or at least 100% of your last year’s tax bill.
- If you earn more than $150,000, you must pay at least 110% of your last year’s tax bill in estimated payments or risk the underpayment penalty on whatever amount you come up short.
Interest on Tax Bills
Congress requires the IRS to charge interest on delinquent tax bills and has given the IRS very limited discretion in canceling interest charges. The interest rate is adjusted every quarter by a formula and compounded daily—recently ranging from 6%–8% per year. It is charged on a monthly basis. If you are audited and end up owing more tax, interest is charged starting on the original date the tax return was due.
Understanding Penalty and Interest Notices
If you receive a tax bill with penalty and interest charges, it may not show how these charges were computed. For an explanation, call the IRS taxpayer assistance line (800-829-1040) and/or request that a penalty and interest explanation notice (PIN EX) be sent to you.
A PIN EX is a multi-paged computer printout that includes:
- a listing of your business (or personal) tax accounts for the specific years or tax periods you request, showing all tax penalty and interest computations.
- dates, interest rates, penalties assessed, and any credits to your account, such as your quarterly payments, abatements (reductions) by the IRS, or any refunds applied.
- explanations of why particular penalties were charged, with tax code citations authorizing each penalty.
- a summary of your account with balance due, including up-to-date penalty and interest amounts.
How to Get Penalties Reduced or Eliminated
Once you understand why and how the IRS hit you with penalties, you may request that they be reduced or eliminated. The IRS term for this process is abatement. About one-third of all penalties are eventually abated. I suspect that even more penalties would be canceled if people knew how to contest them.
Just telling the IRS that you don’t like a penalty, or can’t afford to pay it, won’t work. You must show reasonable cause, meaning a good excuse. The IRS instruction book for its agents, called The Internal Revenue Manual (IRM), says;
Any sound reason advanced by a taxpayer as the cause for delay in filing a return, making deposits … or paying tax when due will be carefully analyzed.
The IRM lists seven categories of excuses for abating any tax penalty except fraud:
- Death or serious illness of the taxpayer or immediate family
- Unavoidable absence
- Destruction by fire or other casualty of the business or records
- Inability to determine the tax because of reasons beyond the taxpayer’s control
- Civil disturbances
- Lack of funds, but only when the taxpayer can demonstrate the exercise of ordinary business care and prudence
- Other reasons establishing that the taxpayer exercised ordinary business care but couldn’t comply within the time limits.
TIPS: When requesting an abatement, try to fit your excuse into categories 1 to 6 first. If you honestly can’t, try the catch-all number 7. This category covers just about any excuse you can come up with.
How to Request a Penalty Abatement
As soon as you receive a tax notice with penalties, request an abatement in writing, following the form letter below. Be brief and straightforward:
To: Penalty Abatement Coordinator
IRS Service Center
P.O. Box 9941
Ogden, UT 84409
Re: Request for Penalty Abatement
From: Sanford Majors
43 Valley Road
Salt Lake City, UT 84000
February 14, 20xx
To Whom It May Concern:
I am requesting an abatement of penalties asserted in the IRS notice enclosed dated 1/15/xx of $2,312.10.
The reason I [select one or more] : filed late, paid late, didn’t report some income was that [fill in your reason, such as] :
- I was suffering from a nervous breakdown.
- My wife had just passed away.
- My house burned down on April 14 with all of my tax records.
- [any other excuse].
Enclosed is a [describe your documents, such as] :
- Letter from Dr. Freud explaining my condition, which prevented me from filing my tax return on time
- Death certificate confirming my wife’s passing
- Report from the fire department
- [any other documentation].
I have also enclosed payment that covers the amount of the underlying taxes I owe. [optional, but a good idea if you can afford to make the payment] Please abate these penalties for reasonable cause. I can be reached at 801-554-4344 during daytime hours.
Lie Dharma Putra
Enclosed: IRS Tax Notice; doctor’s letter, death certificate, fire report, letter from State Department [or whatever]
State that you are requesting an abatement of penalties, identify the tax bill, and tell the IRS what your reasonable cause is. Attach a photocopy of the IRS notice showing the penalty, along with any documentation supporting your request. Keep several copies of your letters and attachments.
Most penalties are imposed by the IRS Service Center that sent the tax bill, so mail your abatement request there—not to the local IRS office. The IRS is notorious for ignoring, losing, or taking forever to answer correspondence, so you may need to send additional copies later.
Wait at least 45 days before sending your follow-up request. Photocopies of your first request and documents should be sufficient—just change the date of the request.
Tips: Stress your clean IRS record. If true, emphasize that you have never before had a penalty, been behind in paying taxes, or asked for an abatement. Even if your record is not squeaky clean, the IRS penalty examiner may let it go, so let your conscience be your guide.
If Your Abatement Request Is Rejected
If the IRS Service Center officially rejects your request, it will send you a written notice. To go further, take one or more of these actions:
- Write back asking for IRS appeals consideration. There is no IRS form for this—just write a clear letter headed “Penalty Appeal” and explain your reasonable cause. Attach the tax bill in question and any documentation supporting your case, like a doctor’s letter or accident report.
- Call or visit your local IRS office and speak with a customer service representative or a collection employee. They are authorized to consider reasonable cause applications and cancel penalties. Don’t mention that a Service Center turned you down. If you’re turned down again, ask orally and follow up in writing requesting that they forward your case for appeals consideration.
- File an Offer in Compromise based on doubt as to your liability for the penalty. This is a formal procedure for negotiating any unpaid IRS bill, including penalties. Don’t offer any money when contesting a penalty, because you are claiming that you don’t owe it. Follow the directions accompanying Form 656 precisely. Attach your explanation and documents supporting your position, if any.
- Pay the penalty and then file IRS Form 843, Claim for Refund and Request of Abatement. Attach a letter and substantiating documents (as you did to your abatement request letter), or write your explanation in the space provided on the form. If your claim is refused, theoretically you can sue in U.S. District Court or the Court of Federal Claims for a refund. Seldom are tax penalties large enough to justify the expense of a lawsuit, however.
How to Get Interest Charges Removed
It is never easy to get interest removed from a tax bill, unless it resulted from an IRS error. In four instances, however, you might win:
- Logically enough, if a tax or penalty is abated, interest on that amount should be canceled, too. The IRS computer should do this automatically, but always check a tax bill to verify that the excess interest was removed. If you suspect a mistake, call the IRS at the number on the notice or at 800-829-1040. Ask them to explain on the phone or send you a PINEX. If you continue to get incorrect bills, write and call the IRS office that sent the bill.
- Did the interest charges result from delays by the IRS? For instance, say you settled an audit agreeing to pay more tax, and the IRS didn’t send a bill until a year later. The year’s interest should be canceled. However, you can’t get interest abated if it accumulated while you were (unsuccessfully) challenging an IRS bill in an audit appeal or in court.
- If the IRS concludes that you will never be able to pay the tax and interest charges, it may accept less in an Offer in Compromise.
- Interest, along with the tax and penalties, may be reduced or eliminated through bankruptcy.
Whenever you are late in filing a tax return or paying a bill, the IRS adds on penalties and interest. Penalties are discretionary with the IRS and may be canceled (abated) for showing of a “reasonable cause” excuse. The IRS must give you a full explanation of any penalty or interest charge. Interest charges are mandated by Congress and so are rarely excused by the IRS. [Resources: IRS Notice 746, Information About Your Notice, Penalty and Interest. This notice is usually sent with your first tax bill that contains a penalty or interest charge. Download it from the IRS’s website at www.irs.gov, call 800-829-1040, or go to your local IRS office].