Penalties and Interest: Sorting Our IRS Tax Bills
IRS-imposed penalties and interest charges are discussed throughout the book. These fines can be very expensive. I once saw a $7,000 tax bill with $15,000 added in interest and penalties. Tax penalties, from the IRS’s perspective, are explained in Notice 433, Interest and Penalty Information. (A copy is available on the IRS’s website at www.irs.gov.)
Frequently Asked Questions
Is it possible to get the IRS to drop a penalty?
What can I do about the interest on my audit bill?
How many different ways can the IRS penalize me?
Can I negotiate a penalty down?
Does the IRS ever have to pay me interest?
Penalties Added to Tax Bills
When the IRS hits you with an additional tax bill (from an audit, for example), it usually adds penalties and interest. Penalties are added automatically by IRS computers or by IRS personnel at their discretion. Interest charges are required by law (and are discussed below).
Penalties are authorized whenever you file or pay your taxes late, have been found to owe additional taxes, or have failed to file all required tax forms.
Although penalties were originally meant to punish errant taxpayers—that’s why they are called penalties—they are now considered a regular and dependable source of revenue in our national budget. Reflecting this, in the past decade, the total dollar amount of penalties imposed on taxpayers increased by 1,000%. In a recent year, 25 million penalties were assessed for over $6,000,000,000. Yes, that’s six billion dollars. In short, penalties have become a tax—on a tax.
Take heart—you may be able to beat the IRS at the penalty game. The IRS can remove a penalty if you can show that your failure to comply with the tax law was due to “reasonable cause.”
IRS penalties fall into five basic categories—accuracy, fraud, failure to pay taxes, late filings, and a combined late-filing and -paying penalty.
The IRS can add a 20% accuracy-related penalty to your tax bill if IRS auditors find your tax return understated your tax liability. This is a commonly imposed penalty by the IRS.
If the IRS concludes that you fraudulently omitted or underreported income, it can add a heavy fraud penalty. This penalty is 75% of the amount you underreported. For example, if you fraudulently underreported $10,000, the fraud penalty is $7,500.
Or, if the IRS finds that you fraudulently failed to file a return, it can penalize you—15% for every month you didn’t file for up to five months—a total of 75% based on the taxes owed. This penalty is rarely, if ever, imposed. The IRS usually just hits you with a late-filing penalty of 5% per month for a maximum of five months, a total of 25%.
In addition to the accuracy and fraud penalties, the IRS may stack on penalties for late paying and late filing.
Failure to Pay Penalties
The IRS can add to your bill a penalty of ¼% to 1% per month of the amount you failed to pay on time. The penalty starts off at ½% per month. If you enter into an installment agreement to pay the taxes, the IRS drops the penalty to ¼% per month. If you don’t pay and the IRS later issues a Notice of Intent to Levy (see Chapter 7), it can raise the penalty to 1% per month on the balance due.
This penalty starts on the day after the original due date, April 16 for individual tax returns. It is imposed on the unpaid balance and added to your bill on the 16th day of each month thereafter. This penalty is imposed monthly and is not prorated daily.
Late Filing Penalties
Did you file your individual tax return late? The IRS can impose a penalty of 5% per month on the tax balance due, up to 25% of the total. You max out on this penalty if, on September 16—five months and one day after April 15—you still haven’t filed your tax return. If you file late but don’t owe any taxes, there is no penalty. For some information-type forms (other than tax returns) filed late, the IRS can impose a penalty in varying amounts according to specific tax code provisions.
Did you both file late and pay late? The IRS can impose a combined penalty of 5% per month (½% per month less than the separate penalties for each). The combined penalty is based on the unpaid tax balance for each month your return is late. When you reach 25%—five months—for filing late, the penalty for late filing stops. The failure-to-pay portion of the combined penalty continues at ½% per month until it reaches a total of 22½%. Thus, the maximum combined penalty is 47½%. Note that tax penalties do not include charges for interest, which never stops running.
Late-filing penalties, late-payment penalties, or the combined penalty can be stacked—imposed in addition to other penalties such as accuracy or fraud penalties resulting from an audit of your tax return.
Taxpayer Protection From Penalties?
You can provide the IRS with a “reasonable cause” explanation before the penalty is imposed. IRS employees must obtain written approval from a supervisor before assessing an accuracy or fraud penalty. This rule does not apply to late-filing or late-paying penalties, however, which are automatic. (See IRS Form 4751.)
Interest on Tax Bills
The second unwelcome addition to every overdue tax bill is IRS-charged interest. By not paying your taxes on time, you are considered to be borrowing from Uncle Sam. Congress does not like to lend money interest free (except to various dictators and deadbeat foreign countries), so it requires the IRS to charge interest.
The interest rate is also set by Congress and is adjusted by formula four times a year and compounded daily. So interest is charged on interest. For older tax bills, interest calculations cannot be easily verified without a computer that emulates the IRS’s program. In recent years, the interest rate has ranged between 4% and 8% per year. Interest is computed on both the tax and penalties due.
Understanding Penalty and Interest Notices
When you receive a tax bill from the IRS, it usually states penalty and interest charges separately. If you don’t understand the IRS computation—it’s unlikely you will—call the taxpayer assistance number (800-829-1040) or write or ask your local IRS office to mail you a detailed penalty and interest explanation, called a PINEX (Form CP-569).
The PINEX is a multipage computer printout showing:
- your tax account (by Social Security number or employer identification number) showing all tax penalty and interest computations
- dates, interest rates, penalties assessed, and any credits—payments or refunds
- principal tax amounts on which interest and penalties were charged
- explanations of which penalties were applied, and
- a summary of your account with balance due, including up-to-date penalty and interest amounts.
Check the figures on the printout to see that you agree with the amount of the taxes shown, and that you have been credited for all payments you made.
Reducing or Eliminating Penalties and Interest
The IRS can eliminate or reduce a penalty for a reasonable cause if you request it. The term the IRS uses for wiping out a penalty is abatement. About one-third of IRS-imposed penalties are later canceled (abated).
Interest, however, is rarely abated. By law, interest can be canceled only if it was erroneously applied or if it was due to lengthy IRS delays. Additionally, if you qualify for an Offer in Compromise, the IRS may reduce an interest charge or penalty along with the tax due. (See Chapter 6.)
Abatement requests can be granted at any IRS level—IRS campus, automated collection system, or personnel at local IRS offices.
Approximately 20%–25% of all IRS penalties are subsequently abated on request.
Reasonable Cause for a Penalty Abatement
The key to having a penalty removed is to show the IRS some reasonable cause for your failure to follow the tax law. Reasonable cause is any excuse that an IRS officer will buy. The Internal Revenue Manual (IRS Policy Statement P-2-7) 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 …. Examples of … reasonable cause:
- Death or serious illness of the taxpayer or … immediate family. In the case of a corporation, estate, [or] trust … death or serious illness must have been of an individual having sole authority to execute the return or make the deposit or payment.
- Unavoidable absence of the taxpayer ….
- Destruction by fire or other casualty of the taxpayer’s place of business or records.
- Taxpayer was unable to determine amount of deposit of tax due for reasons beyond taxpayer’s control….
- Taxpayer’s ability to make deposits or payments has been materially impaired by civil disturbances.
- Lack of funds is an acceptable reasonable cause for failure to pay any tax or make a deposit … only when a taxpayer can demonstrate the lack of funds occurred despite the exercise of ordinary business care and prudence.
- Other explanations may be acceptable …. Acceptable explanations of delinquency are not limited …. Any reason … established that the taxpayer exercised ordinary business care and prudence but was nevertheless unable to comply within the prescribed time will be accepted as reasonable cause.
Practical suggestions. If possible, choose one of the first six items when requesting a penalty abatement. Also mention Number 7, that you acted with “ordinary business care and prudence” but still couldn’t file or pay your taxes on time.
Here are some explanations the IRS has accepted:
- Reliance on a tax professional who steered you wrong. For example, if your accountant or bookkeeper caused the tax problem by giving you bum advice or filing the wrong form, say so. Bear in mind that the IRS might counter that because you picked the tax professional, you are responsible for his action.
- The IRS wouldn’t help you earlier. If you called, wrote, or visited the IRS and got the wrong information or no response when you tried to clear things up, make the point. Be sure to provide copies of letters you sent, the names and IRS identification numbers of all IRS personnel you spoke with, and the dates and summaries of your conversations.
- Someone else caused your problem. For example, if your employer submitted an incorrect 1099 or W-2 form, be sure to tell it to the IRS.
- If your penalty is from a late payment, plead that you would have suffered an undue hardship if you had paid on time. Be warned that this is a tough sell to the IRS. You will need to show that had you paid your taxes on time, you would not have been able to put food on the table. The IRS is often sympathetic if the hardship is medical related, including alcohol or drug abuse. Again, supply documentation, such as letters from doctors explaining your condition.
If it’s true, stress your clean past IRS record: You’ve never before requested an abatement, had a penalty, or been behind in paying your taxes.
How to Request a Penalty Abatement
For penalties imposed by IRS mailed notices, start the abatement process by mail. As soon as you receive a tax bill with penalties, write back and ask for an abatement. Use a letter like the sample, below. Alternatively, use IRS Form 843, Claim for Refund and Request for Abatement. (A copy is available on the IRS’s website.) Attach to your letter a copy of the IRS notice showing the penalty.
Also attach copies of substantiating documents—such as a doctor’s statement, fire department report, insurance claim, or death certificate of a family member. Without supporting papers, your abatement request may not get serious consideration.
If possible, enclose payment for the underlying tax, and write on your check that the payment is for the tax portion only. Paying the tax stops the accrual of interest on that balance. Send the letter with enclosures to the IRS address in the notice, and use the IRS enclosed bar-coded envelope.
Keep copies of any letters or documents sent to the IRS. The IRS is notorious for ignoring or losing taxpayer correspondence. Send the additional copies if you get another IRS billing before getting a reply to your initial abatement request.
For penalties imposed in an audit, ask the auditor or a manager to drop them before you sign the report. If that doesn’t work, you can protest the penalty to the appeals office. (See Chapter 4.)
If Your Abatement Request Is Rejected
If the IRS officially rejects your abatement request, you will get a written notice. You then have four options besides accepting your fate:
Appeal. File a protest—a letter requesting an appeal. See the sample letter, below.
Send your appeal letter to the IRS. Unlike an appeal of an audit, the IRS does not grant you an in-person appeal hearing after an abatement request is rejected. The appeal is handled by mail or telephone.
Request a transfer of your file. Write the IRS requesting that your file be transferred to your local IRS office. Then request a meeting with a revenue officer to try and convince the officer that your penalty should be removed.
Pay and claim a refund. Pay the penalty and then file for a refund. Despite what you may think, paying first does not hurt your chance of getting a refund granted. Your refund request should be submitted to your IRS campus on Form 843, Claim for Refund and Request for Abatement. You can either attach a letter of explanation similar to the one you tried in your original abatement request or give your reasonable cause explanation in the small space provided on Form 843.
If your Form 843 claim is refused, you can sue in a U.S. District Court or the court of claims. (See Chapter 5.) Rarely, however, are tax penalties large enough to justify the costs of going to court.
Make an Offer in Compromise. An Offer in Compromise is a formal procedure for contesting or negotiating any IRS bill, including a penalty. (See Chapter 6.)
Congress makes the IRS charge interest on a tax bill. Of course, if a tax or penalty is canceled for any reason, interest on it is wiped out as well. Usually the IRS computer does this automatically, but check your bill to make sure.
The tax code authorizes the abatement of interest only in the following circumstances:
(a) The IRS was wrong in charging interest —meaning that either you paid the tax when it was due or didn’t owe any taxes on which interest could be charged. If this happens to you, write to the IRS, explain what is wrong, and ask for an interest abatement. If that doesn’t work, call the Taxpayer Advocate Service at your local IRS office. (See Chapter 8.) You also can sue in U.S. District Court or the Federal Court of Claims to recover interest already paid, but this is too costly to be a practical alternative.
(b) The IRS incorrectly sent you a refund, wants its money back, and is charging you interest all the way back to the time the check was issued. This is not so unusual. Computer-generated tax refunds sometimes come out of the blue. You are entitled to an interest abatement as long as your actions did not cause the refund. Once the IRS asks for its money back, it can, however, charge you interest, but only from the date of the request, until you repay it. (Internal Revenue Code § 6404.)
(c) The interest resulted from delays of the IRS in performing ministerial acts. For example, the IRS delays sending a tax bill after you agree to an audit report. You are entitled to an interest abatement of all but the first 30 days of the delay. (Revenue Procedure 87-42; IRS Regulation 301.6404-2T.) So if, following an audit, a bill with interest arrives 90 days after you agree to the result, you can have the last 60 days of interest abated.
The exception for ministerial acts does not cover interest while you challenge a bill or while the IRS audits you, or while you appeal or go to tax court. This interest cannot be abated, unless you win your case.
(d) The interest accrued more than 18 months after the original due date of a tax return or the date the return was filed, and the IRS did not notify you that additional tax was due during that period. (Internal Revenue Code § 6404.)
(e) The interest accrued on a return you filed late because you were living in a federally declared disaster area when the return was due.
As with taxes and penalties, interest also may be reduced or eliminated by an Offer in Compromise or through bankruptcy. (See Chapter 6.)
Sample Letter Requesting Abatement of Penalties
To: Penalty Abatement Coordinator
P.O. Box 9941
Ogden, UT 84409
Re: Request for Penalty Abatement
From: Sanford Majors
43 Valley Road
Salt Lake City, UT 84000
November 3, 20xx
To Whom It May Concern:
I am requesting an abatement of penalties in the IRS notice enclosed dated 5/5/xx in the amount of $2,312.10.
The reason I [select one] 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
- I was a hostage in Lebanon
- 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
- Letter from the U.S. State Department confirming my status as a hostage
- 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 801-555-3444 during daytime hours.
Enclosed: IRS Tax Notice; doctor’s letter, death certificate, fire report, letter from State Department [or whatever]
Sample Letter Appealing Denial of Abatement of Penalties
P.O. Box 9941
Ogden, UT 84409
Re: Appeal of Penalty Abatement
43 Valley Road
Salt Lake City, UT 84000
Telephone: (801) 555-1212
January 15, 20xx
To Whom It May Concern:
I wish to appeal the denial of my penalty abatement request, which I received on January 10, 20xx. A copy of the denial is attached.
The grounds for my appeal are that I had a reasonable cause for [state type of penalty] filing late, paying late, not reporting some income because [state reasons]:
- I was in a coma
- My tax preparer had just died
- any other excuse.
I can prove my condition with [state type of proof]:
- Letter from Dr. Stein proving my condition
- Death certificate confirming my tax preparer’s death
- any other documentation.
Enclosed: IRS Tax Notice; Dr. Stein’s letter; death certificate [or whatever]
How to Request an Interest Abatement
To request an interest abatement for an IRS error in billing (a) or (b) above, follow the sample form letter. Instead of alleging reasonable cause, as the form letter does, state something like, “The IRS wrongfully sent me a refund and is charging interest. I should not have to pay interest because my actions did not cause the refund to be sent.” Although interest is seldom abated except when the IRS has made the mistake, it never hurts to ask and you are only out the cost of a first-class stamp.
If you are requesting an abatement because of IRS delays ((c) or (d)), use Form 843. If you are in a disaster area, call the IRS for instructions at 800-829-1040.
Designating Late Tax Payments
Always tell the IRS how a late payment should be applied to your tax account. If you don’t, the IRS allocates it first to taxes, then to penalties, and last to interest. Payments are automatically applied to the oldest tax period for which you owe. For example, you owe $10,000 in taxes, penalties, and interest for several of the past eight years. You make a $1,500 payment. Tell the IRS in writing that it is to be applied to the most recent year.
Advantages of Designating Your Payments
On the date income taxes are assessed, the IRS has ten years to collect these taxes, penalties, and interest. If part of your tax bill is for a year for which the ten-year limit is about to expire, then be sure to designate in writing that your payments are to be applied to your most recent tax debts. For example, suppose in 2008 you want to make a payment to a tax debt for years 1999 and 2000. Designate the payment to 2000, because the 1999 tax debt expires on April 16, 2010, assuming you filed your 1999 tax return by April 15, 2000. (See Chapter 6.)
Another reason to designate payments to the most recent years is your right to reduce some tax bills in bankruptcy. Generally, older tax bills are more easily reduced or eliminated in bankruptcy than newer ones. (See Chapter 6.)
How to Designate a Payment
When making an income tax payment by check or money order, write in the lower left-hand corner your Social Security number and the tax period or year you are paying. For a business tax, use your taxpayer identification number instead of your Social Security number.
Unless the payment is for the current tax bill, enclose a letter with the payment clearly stating that payment is to be applied to the tax period or year noted on your check or money order. Otherwise, the IRS will apply the payment to the oldest tax period. If you’re concerned that the IRS has misapplied the funds, you can request an account statement, called a Record of Account for individuals with Social Security numbers or businesses with separate identification numbers. (See Chapter 1.)
If the account statement shows that the IRS ignored your designation request, send photocopies of your letter and the checks to show that payments were not misapplied. With proof of your designation of payment, the IRS will correct its records.
If the IRS refuses or ignores your request, complain to the taxpayer advocate. (See Chapter 8.)
Only voluntary payments can be designated to particular tax periods. If the IRS levies your wages or bank account or withholds a refund, you have no right to designate how it’s applied.
Acknowledgment. R. R. Bobby Covic, EA of Incline Village, Nevada, assisted in the updating of this chapter. Mr. Covic is an IRS procedures expert who can be contacted at email@example.com or 775-831-7694.
- The IRS can add penalties to your bill for a variety of tax misdeeds.
- Interest is always added to a tax bill if the bill isn’t paid on time.
- You may get the IRS to remove a penalty for “reasonable cause.”