Civil Tax Penalties (Portfolio 634)

Tax Management Portfolio, Civil Tax Penalties, No. 634-3rd, analyzes the many civil tax penalties that can be imposed for various tax offenses. To view this Portfolio, visit Bloomberg Tax for a free trial.

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Description

Tax Management Portfolio, Civil Tax Penalties, No. 634-3rd, analyzes the many civil tax penalties that can be imposed for various tax offenses. These penalties are designed to regulate the conduct of preparers, payors and tax-exempt entities, in addition to that of taxpayers. The Internal Revenue Service Penalty Handbook (Chapter 20.1 of the Internal Revenue Manual) is intended to ensure that the penalties are applied uniformly.

The civil tax penalties can be divided into seven major categories:

  • The failure to file and failure to pay penalties (which are primarily set forth in §6651 relating to the general penalty and §6721–§6724 relating to certain information returns and payee statements);
  • The accuracy-related penalties of §6662 and §6662A;
  • The fraud penalty of §6663;
  • The tax return preparer penalties under §6694–§6696;
  • The promoter, protester and tax shelter penalties under §6700–§6703, §6707–§6708, and §6111–§6112;
  • Penalties relating to compensation statements and exempt organizations; and
  • Penalties relating to certain foreign persons.

The estimated tax penalties, trust fund recovery penalty, and criminal penalties are covered in other Tax Management Portfolios.

The Portfolio also describes the exception to many of the penalties for reasonable cause, including an analysis of the most common reasons advanced as constituting reasonable cause. In addition, the Portfolio summarizes how the various penalties can be assessed and collected by the IRS.

This Portfolio can be cited as Tarr and Drucker, 634-3rd T.M., Civil Tax Penalties.

Authors

Alan J. Tarr, Esq.

Alan J. Tarr, B.S., Brown University (1975); J.D., Vanderbilt University School of Law (1979); M.B.A., Vanderbilt University Graduate School of Management (1979); LL.M. (Taxation), New York University School of Law (1982); member, New York Bar, New York City Bar Association (Chair, Committee on Taxation of Business Entities (2008– )), New York State Bar Association (Executive Committee (1995–2003), Tax Section and Committee on Partnership Taxation) and American Bar Association (Tax Section; Vice-Chair, Federal Income Taxation of Real Property, Real Property, Probate and Trust Law Section (2004–2007)); member, Tax Management Advisory Board; author, 581 T.M., Estimated Tax; author, various chapters for Tax Practice Series; co-author, 59 T.M., Corporate Liquidations: Planning; contributor, various tax publications.

Pamela Jensen Drucker, Esq.

Pamela Jensen Drucker, B.S., M.S. (Tax) Arizona State University (1986, 1994); J.D., Arizona State University College of Law (1997); LL.M. (Taxation), New York University (1998); member, California Bar, American Bar Association (Tax Section), Los Angeles County Bar Association (Tax Section officer (2004–2009); Chair Foreign Tax Committee (2003–2004)); contributor, various tax publications.


Table of Contents

Detailed Analysis
I. Introduction
A. The Growth of Penalties
B. Policy
C. Criticisms of Penalty Policies
D. Basic Structure
II. Failure to File Penalties
A. Introduction
B. General Penalty
1. In General
2. Timeliness of Filing
3. Sufficiency of a Return
a. Proper Form
b. Signature Requirement
c. Data Sufficient to Calculate Tax Liability
4. Computation of the Penalty
a. Rate
b. Penalty Period
c. Net Tax Amount
5. Reasonable Cause Exception
C. Certain Information Returns and Payee Statements
D. Partnership Returns
1. Required Returns
2. Penalty
3. Reasonable Cause Exception
E. REMIC Return
1. Income Tax Return
2. Information Return
F. Certain Corporate Transactions
G. Low Income Housing Bonds
H. S Corporation Returns
I. Corporation Returns
III. Failure to Pay Penalties
A. Tax Shown on Return
1. In General
2. Computation of the Penalty
a. Rate
b. Penalty Period
c. Delinquent Amount
3. Exceptions
a. Reasonable Cause
b. Bankruptcy
c. Postponement of Deadline
d. IRS Extensions of Time to Pay
B. Tax Not Shown on Return
1. In General
2. Computation of the Penalty
a. Rate
b. Penalty Period
c. Net Amount Due
3. Exceptions
C. Stamp Tax
D. Federal Tax Deposits
1. Deposit Requirement
2. Methods for Making Deposits
a. Federal Tax Deposit Coupon Method
b. EFT Deposit Method (“EFTPS”)
3. How the IRS Applies Deposits
4. Penalty
5. Reasonable Cause Exception
6. Special Exception for First-Time Depositors
7. One Time Refund of Penalty
E. Bad Checks
IV. Accuracy-Related Penalties
A. Background
B. General Rules
1. Scope of Penalty
2. Amount of Penalty
a. In General
b. Qualified Amended Return
c. Rebate
d. Underpayments to Which 40% Penalty Applies
e. Suspension of Accrual
3. Tiered Partnerships
C. Reasonable Cause Exception
1. In General
2. Reasonable Cause for Tax Shelter Items of a Corporation
3. Waiver of Attorney-Client Privilege
D. Negligence and Disregard
1. Definition of Negligence and Disregard
a. Statute and Regulations
b. Case Law
2. Exception for Reasonable Basis
3. Exception for Adequate Disclosure
4. Carrybacks and Carryovers
5. Prior Law
E. Substantial Understatement of Income Tax
1. In General
2. Definition of Substantial Understatement
a. In General
b. Carrybacks and Carryovers
3. Exception for Substantial Authority
a. What Constitutes “Substantial Authority”
b. IRS List of Unsupported Positions
4. Exception for Adequate Disclosure
5. Special Rules for Tax Shelter Items
a. Noncorporate Taxpayers
b. Corporate Taxpayers
c. Tax Shelter Defined
d. 2002 Tax Shelter Disclosure Initiative
6. Prior Law
F. Reportable Transaction Understatements
1. In General
2. Amount of Penalty
3. Definition of Reportable Transaction Understatement
4. Reasonable Cause Exception
a. In General
b. Disqualified Tax Advisor
(1) Participating Material Advisor
(2) Disqualified Compensation Arrangement with a Material Advisor
(3) Disqualified Contingent Compensation
(4) Disqualified Financial Interest
c. Disqualified Tax Opinion
5. Coordination with Other Penalties
G. Substantial Valuation Misstatement Penalty
1. In General
2. Gross Valuation Misstatement
3. Penalty Thresholds
4. Pass-Through Entities
5. Carrybacks and Carryovers
6. Attributable to a Valuation Misstatement
7. Reasonable Cause Exception
a. General
b. Special Rule for Charitable Deduction Property
8. Section 482 Transfer Pricing Penalty
9. Prior Law
H. Penalty for Substantial Overstatement of Pension Liabilities
1. Statutory Provisions
2. Prior Law
I. Substantial Estate or Gift Tax Valuation Understatement
J. Understatement Due to Lack of Economic Substance
K. Understatement Due to Undisclosed Foreign Financial Assets
L. Inconsistent Estate Basis Penalty
M. Penalty for Erroneous Claim for Refund or Credit
N. Appraiser Penalties
V. Fraud Penalty
A. Statutory Provisions
B. Burden of Proof
C. Underpayment Plus Intent
D. Relevant Factors
1. In General
2. Failure to Report Income
3. Lack of Cooperation with IRS
4. Awareness of Tax Laws
5. Criminal Prosecution
6. Failure to File Tax Returns — Prior Law
E. Possible Defenses
1. Reasonable Cause
a. In General
b. Reliance on Third Parties
2. Innocent Spouse Relief
VI. Certain Information Returns and Payee Statements
A. In General
B. Information Returns Subject to Penalty
1. Reporting Requirements
2. Penalty for Failure to Timely File or Include Information
a. Reduced Penalties for Prompt Correction
b. Exception for De Minimis Failures
c. Increased Penalties for Intentional Disregard
d. Reasonable Cause Defense
3. Penalty for Failure to Furnish Correct Payee Statements
a. Reporting Requirements
b. Penalty Amounts
c. Reduced Penalties for Prompt Correction
d. Exception for De Minimis Failures
e. Increased Penalties for Intentional Disregard
4. Penalty for Failure to Comply with Other Reporting Requirements
C. Reasonable Cause Exception
1. In General
2. Significant Mitigating Factors
3. Events Beyond Filer's Control
4. Acted in a Responsible Manner
D. Broker Notification Requirements
E. OID Information Requirements
F. Attorney Fee Reporting
G. Foreign Bank and Financial Accounts
H. Foreign Financial Assets
VII. Tax Return Preparer Penalties
A. Background
B. Definition of Tax Return Preparer
1. Who Is Considered a Tax Return Preparer?
a. General
b. Person
c. Prepares or Employs Another to Prepare
d. All or a Substantial Portion
e. Return or Claim for Refund
f. For Compensation
2. Signing Tax Return Preparer
3. Nonsigning Tax Return Preparer
4. Exceptions
C. Understatement of Taxpayer's Liability by Tax Return Preparer
1. Tax Return Preparers Subject to the Penalty
a. Individual Within a Firm
b. Firm
2. Returns and Claims for Refund
3. Understatement Due to Unreasonable Position
a. Penalty
b. Knew (or Reasonably Should Have Known)
c. Reasonable Belief More Likely than Not Position Will Be Sustained on the Merits
d. Exception for Substantial Authority
e. Exception for Reasonable Basis and Adequate Disclosure
f. Special Rule for Tax Shelter Transactions
g. Exception for Reasonable Cause and Good Faith
4. Understatement Due to Willful or Reckless Conduct
a. Penalty
b. Willful Attempt to Understate Liability
c. Reckless or Intentional Disregard of Rules or Regulations
d. Applicable Returns or Claims for Refund
5. Understatement of Tax Liability
6. Income Derived (or to be Derived)
7. Verification of Information
8. Assessment of Penalty
9. Coordination with Other Penalties
10. Assessment, Collection and Refund of Penalty
D. Section 6694 Penalty for Periods Before May 26, 2007
1. General
a. Income Tax Return Preparer
b. Verification of Information
c. Understatement of Liability
d. Preparers Subject to the Understatement Penalties
2. Unrealistic Positions
a. Penalty
b. Exceptions
(1) Adequate Disclosure of Nonfrivolous Position
(2) Reasonable Cause and Good Faith
(3) Coordination with Aiding and Abetting Penalty
(4) Burden of Proof
3. Willful or Reckless Conduct
a. Penalty
b. Exceptions
(1) Realistic Possibility of Being Sustained
(2) Adequate Disclosure of Nonfrivolous Position
(3) Special Rule for Employers and Partnerships
(4) Coordination with Aiding and Abetting Penalty
(5) Burden of Proof
E. Other Duties of a Tax Return Preparer and Related Penalties
1. Signing Return or Claim for Relief
2. Furnishing Preparer's Tax Identification Number
3. Providing Copy of Return to Taxpayer
4. Retaining Copy or List
5. Record of Tax Return Preparers Employed
6. Due Diligence in Determining Eligibility for Certain Tax Benefits
7. No Negotiating Refund Check
8. Fiduciary Duty
F. Assessment of Tax Return Preparer Penalties
1. Assessment Procedure
2. Claim for Refund of a Preparer Penalty
3. Suit for Refund
4. Abatement of Penalty
5. Special Procedures Regarding Understatement Penalties
6. Application of Overpaid Penalty
7. Interest
G. Other Preparer Penalties
1. Aiding and Abetting
2. Disclosure or Use of Information
3. Action to Enjoin Preparer
4. Coordination of Preparer Penalties
VIII. Promoter and Protester Penalties
A. Tax Shelters
1. Promoting Abusive Tax Shelters
a. In General
b. Who Is a Promoter?
(1) In General
(2) Organization of a Tax Shelter
(3) Participation in the Sale
c. Conduct to Which the Penalty Applies
(1) False Statements
(2) Gross Valuation Overstatement
2. Action to Enjoin Promoter
3. Failure to Furnish Information
a. Tax Shelter Disclosure Statement by Participant
(1) Transactions on or After February 28, 2003
(a) In General
(b) Reportable Transactions
(c) Participation
(d) Reporting
(2) Transactions Before March 1, 2003
(a) Who Must Submit
(b) Indirect Participation
(c) Reportable Transactions
(i) Transactions On or After January 1, 2003
(ii) Transactions Before January 1, 2003
(d) Manner of Disclosure
(3) Penalty
b. Tax Shelter Disclosure Statement by Material Advisor
(1) Requirements
(a) In General
(b) Reportable Transaction
(c) Material Advisor
(d) Multiple Material Advisors
(e) Filing of Return
(2) Penalty
(3) Action to Enjoin Material Advisor
c. Registration with IRS — Prior Law
(1) Requirements — Prior Law
(a) In General
(b) Tax Shelter Organizer
(c) Tax Shelter
(d) Confidential Corporate Tax Shelters
(2) Penalty — Prior Law
d. Furnish Registration Numbers — Prior Law
e. Include Registration Numbers on Return — Prior Law
f. List of Advisees
(1) Requirements
(2) Preparation and Maintenance of Lists
(3) Multiple Material Advisors
(4) Penalty
(5) Action to Enjoin Material Advisor
g. List of Investors — Prior Law
(1) Transactions On or After February 28, 2003 — Prior Law
(a) In General
(b) Potentially Abusive Tax Shelter
(c) Organizer and Seller
(d) Preparation and Maintenance of Lists
(2) Transactions Before February 28, 2003
(3) Penalty — Prior Law
B. Aiding and Abetting an Understatement of Tax
1. In General
2. Prohibited Conduct
a. Activities Subject to Penalty
b. Knowledge Required
c. False or Fraudulent Return Standard
3. Amount of Penalty
4. Action to Enjoin Advisor
5. Disciplinary Action
C. Frivolous Positions
1. Frivolous Income Tax Returns
a. Penalty
b. Frivolous Returns
c. Desire to Delay or Impede Administration of Federal Tax Laws
2. Frivolous Positions in Court
a. Penalty
b. Primarily for Delay
c. Frivolous or Groundless Position
d. Failure to Exhaust Administrative Remedies
e. Unreasonably and Vexatiously Multiplied the Proceedings
D. Procedural Rules
1. Coordination of Penalties
2. Burden of Proof
3. Statute of Limitations
4. Deficiency Procedures Do Not Apply
5. Special Procedures to Contest Penalty
IX. Compensation Statements, Pension Plans, Exempt Organizations, Education Programs and Other Reporting
A. Compensation
1. Employee Statements
2. False Information with Respect to Withholding
3. Tips
B. Reports Relating to Plan Participants
1. In General
2. Annual Registration
3. Notification of Change
4. Statement to Plan Participants
5. Reasonable Cause Exception
C. Notices to Recipients of ERISA Qualified Plan Distributions
1. Notices Regarding Withholding
2. Notices Regarding Rollovers
D. Exempt Organizations and Certain Trusts
1. In General
2. Failure to File Exempt Organization Annual Return
3. Public Inspection and Copies of Annual Returns
4. Willful Failure to Allow Public Inspection
5. Return Reporting Liquidation of Exempt Organization
6. Failure to File Trust Return
7. Reasonable Cause Exception
8. Chapter 42 Tax
9. Charitable Contributions
a. Quid Pro Quo Contributions
b. Donations of Motor Vehicles, Boats and Airplanes
10. Fundraising Solicitations
a. Nondeductible Contributions
b. Premium Available from Federal Government
11. Failure to File Notice Required Under Section 506
E. ERISA Qualified Plan Trusts and ESOPs
1. Owner-Employees
2. Designated Distributions
3. Employee Stock Ownership Plans
4. Certain Fringe Benefit Plans
5. Penalty
F. Deductible Employee Contributions
G. IRA, SEP, and SIMPLE Reports
1. Annual Reports
2. Nondeductible Contributions to or Distributions from IRAs
3. Notices Relating to SIMPLE Retirement Accounts
H. Actuarial Reports
1. Periodic Reports
2. Merger or Consolidation
I. Savings Accounts
1. Archer Medical Savings Accounts
2. Health Savings Accounts
3. Coverdell Educational Savings Accounts
4. Qualified ABLE Programs
J. Qualified Tuition Programs
K. Mortgage Credit Certificates
L. Transfers at Death and by Gift
M. Penalty for Failing to Maintain Minimum Essential Health Coverage
N. Penalty For Failure to Provide Notice Regarding Small Employer Health Reimbursement Arrangements
O. Penalty for Failure to Provide Notice Regarding Qualified Equity Grants
X. Certain Foreign Persons
A. Foreign Persons Investing in U.S. Real Property
B. Information with Respect to Foreign Trusts
1. In General
2. Penalty
C. Gifts from Foreign Persons
D. Expatriate Returns
E. Returns with Respect to Foreign Corporations, Foreign Partnerships and Foreign Disregarded Entities
1. Organization, Reorganization or Acquisition of Stock in Foreign Corporation
2. Interests in Controlled Foreign Corporations
3. Interests in Foreign Partnerships
4. Outbound Transfers to Foreign Corporation
5. Returns of Officers, Directors, and Shareholders of Foreign Personal Holding Companies — Prior Law
6. Foreign Disregarded Entities
7. Penalties
F. Foreign-Owned Corporations
G. Foreign Corporations Engaged in a U.S. Trade or Business
H. Foreign Corporation Personal Holding Company Return
I. FSC and DISC Returns
J. Notice of Redetermination of Foreign Tax
K. Residents of U.S. Possessions
L. Treaty-Based Return Positions
XI. Reasonable Cause Exception
A. In General
B. Time and Manner of Claiming the Exception
1. General Rule
2. Special Rule for Partnership Items
C. Requirements for the Exception
1. Reasonable Cause
2. Good Faith or Absence of Willful Neglect
3. Causation and Duration
D. Common Reasons Given as Reasonable Cause
1. Reliance on Tax Advisor
a. IRS Guidance
b. Filing Return vs. Substantive Law
c. Reasonable Reliance
d. Tax Preparation Software
2. Death, Serious Illness, or Unavoidable Absence
3. Records Unavailable
4. Inability to Pay
5. Ignorance of the Law
6. Mistake or Forgetfulness
7. Misfeasance by Employee or Agent
8. Erroneous Advice from the IRS
a. Written Advice
b. Oral Advice
9. Time and Business Pressures
10. Invalid Extension
11. Constitutional Objections and Religious Beliefs
12. Service in Combat Zone or Contingency Operation
13. Failure Arising from Fifth Amendment Concerns
14. Fire, Casualty, Natural Disaster or Other Disturbance
15. Prohibition Against Communicating with Accountant
16. IRS's First-Time Penalty Abatement Policy
XII. Assessment and Collection
A. In General
1. General Rule
2. Special Rule for Partnerships
B. Appeals of Penalties
1. Deficiency Procedures
2. Post-Assessment Appeal
3. Collection Due Process Hearing
4. Equivalent Hearing
5. Taxpayer Assistance Order
6. Collection Appeals Program
7. Refund Claim
C. Persons Responsible for Penalty
1. In General
2. General Partners
D. Transferee Liability
XIII. Seriously Delinquent Tax Debt

Working Papers

Table of Worksheets
Worksheet 1 Guide to Most Common Information Returns: Names; What to Report; Amounts to Report; Due Dates — Excerpt from General Instructions for Certain Information Returns
Worksheet 2 Guide to Commonly Used Frivolous Arguments
Worksheet 3 Penalty Relief — Application Chart (Reasonable Cause and Other Relief)
Worksheet 4 Annual Figures for Penalty for Failure to File Return
Worksheet 4A Annual Figures for Penalty for Failure to File Certain Information Returns, Registration Statements, Etc.
Worksheet 4B Annual Figures for Other Assessable Penalties With Respect to the Preparation of Tax Returns for Other Persons
Worksheet 4C Annual Figures for Penalty for Failure to File Partnership Return
Worksheet 4D Annual Figures for Penalty for Failure to File S Corporation Return
Worksheet 4E Annual Figures for Penalty for Failure to File Correct Information Returns
Worksheet 4F Annual Figures for Penalty for Failure to Furnish Correct Payee Statements
Worksheet 5 Excerpts from Conference Report to Accompany H.R. 3299, The Omnibus Budget Reconciliation Act of 1989 (Dealing with Revision of Civil Penalties)
Worksheet 6 Excerpts from Conference Report to Accompany H.R. 4520, American Jobs Creation Act of 2004 (Dealing with Additions and Revision of Tax Shelter Disclosure and List Maintenance Penalties, Accuracy, and Advisor, Promoter, and Advisee Penalties)
Worksheet 7 Sample IRS Reasonable Cause Letter — Late Filed Partnership Return
Worksheet 8 Sample IRS Reasonable Cause Letter — Late Filed Exempt Organization Return
Worksheet 9 Sample IRS Reasonable Cause Letter — Late Employment Tax Deposit
Worksheet 10 Sample IRS First-Time Penalty Abatement Request