John is self-employed and did not file a return for his 2005 tax year. Eventuall
ID: 2547541 • Letter: J
Question
John is self-employed and did not file a return for his 2005 tax year. Eventually, the IRS prepares a substitute for return and alleges that John owes now only income tax for that year, but the penalties for failure to timely file (IRC 6651(a)(1)), failure to timely pay income taxes (IRC 6651(a)(2)), and failure to timely pay estimated taxes (IRC 6654). The IRC permits all of these penalties to be assessed at the same time, and then lets the IRS charge interest on not only the unpaid tax but all the penalties as well. Does that seem fair to you?
Explanation / Answer
Failure to File Penalty Under IRC § 6651(a)(1), Failure to Pay an
Amount Shown as Tax on Return Under IRC § 6651(a)(2), and
Failure to Pay Estimated Tax Penalty Under IRC § 6654
Present law
Under IRC § 6651(a)(1), a taxpayer who fails to file a return on or before its due date (including exten-
sions) will be subject to a penalty of five percent of the tax due (minus any credit the taxpayer is entitled
to receive and payments made by the due date) for each month or partial month the return is late, up to a
maximum of 25 percent, unless the failure is due to reasonable cause and not willful neglect.4
To establish
reasonable cause, the taxpayer must show that he or she exercised ordinary business care and prudence but
was still unable to file by the due date.5
The failure to file penalty applies to income, estate, gift, employ-
ment and self-employment, and certain excise tax returns.
The failure to pay penalty applies to a taxpayer who fails to pay an amount shown as tax on his or her
return. The penalty accrues at a rate of 0.5 percent per month on the unpaid balance for as long as the
balance due remains unpaid, up to a maximum of 25 percent of the amount due.7
When both the failure
to file and failure to pay penalties are imposed for the same month, the amount of the failure to pay
penalty reduces the amount of the failure to file penalty by 0.5 percent for each month.8
The failure to pay penalty applies to income, estate, gift, employment and self-employment, and certain
excise tax returns.9
The taxpayer will not be held liable if he or she can establish reasonable cause, i.e.,
the taxpayer must show that he or she exercised ordinary business care and prudence but still could not
pay by the due date, or that payment on the due date would have caused undue hardship.10 Courts will
consider “all the facts and circumstances of the taxpayer’s financial situation” to determine whether the
taxpayer exercised ordinary business care and prudence.11 In addition, “consideration will be given to the
nature of the tax which the taxpayer has failed to pay.”12
IRC § 6654 imposes a penalty on any underpayment of estimated tax by an individual or by certain
estates or trusts.13 The law requires four installments per taxable year, each generally 25 percent of the
annual payment.14 The required annual payment is generally the lesser of of 90 percent of the tax shown
on the return for the current taxable year or 100 percent of the tax shown on the return for the previous
year.15 The IRS will determine the amount of the penalty by applying the underpayment rate according
to IRC § 6621 to the amount of the underpayment for the applicable period.16
To avoid the penalty, the taxpayer has the burden of proving that one of the following exceptions applies:
The tax due (after taking into account any federal income tax withheld) is less than $1,000;17
The preceding taxable year was a full 12 months, the taxpayer had no liability for the preceding
taxable year, and the taxpayer was a U.S. citizen or resident throughout that year;18
The IRS determines that because of casualty, disaster, or other unusual circumstances, the imposi-
tion of the penalty would be against equity and good conscience.
The taxpayer retired after reaching age 62 or became disabled in the taxable year for which esti-
mated payments were required or in the taxable year preceding that year, and the underpayment
was due to reasonable cause and not willful neglect.20
In any court proceeding, the IRS has the burden of producing sufficient evidence that it appropriately
imposed the failure to file, failure to pay, or estimated tax penalties.
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