Florida Tax Attorney Blog

A taxpayer who underpays their tax liability may be subject to an accuracy-related penalty under Section 6662 of the Internal Revenue Code. That statute provides for a penalty equal to 20% of the underpayment of tax. So this is something that can definitely add up.

There are three types of accuracy-related penalties under Section 6662:

(1) Negligence;
(2) Disregard of Rules and Regulations; or
(3) Substantial Understatement.

Negligence

In the tax context, the term negligence essentially means a failure to make a reasonable attempt to comply with the provisions of the Internal Revenue Code or a failure to exercise ordinary and reasonable care in the preparation of a tax return. I.R.C. § 6662(c); Treas. Reg. § 1.6662-3(b)(1). Thus, the relevant question is essentially whether a reasonable taxpayer would have made similar compliance efforts under similar circumstances. If the answer is yes, than the taxpayer's underpayment cannot be said to be the result of negligence. But if a reasonable taxpayer would have made more of an effort to comply with the tax law, then the taxpayer might be subject to a negligence penalty.

Disregard of Rules and Regulations

When the Internal Revenue Code refers to a disregard of tax rules and regulations, it contemplates taxpayer conduct that is in disregard of the Internal Revenue Code, Treasury regulations, or IRS authority. I.R.C. § 6662(c); Treas. Reg. § 1.6662-3(b)(2). But in order for a taxpayer to be considered to have "disregarded" the rules or regulations, the taxpayer's non-compliance must be careless, reckless, or intentional. In this respect, a taxpayer's disregard of tax rules is "careless" if the taxpayer fails to exercise reasonable diligence to determine the correctness of a tax return position. Treas. Reg. § 1.6662-3(b)(2). A taxpayer's disregard of tax rules is "reckless" if the taxpayer makes little or no effort to determine whether a rule or regulation exists under circumstances which demonstrate a substantial deviation from the standard of conduct that a reasonable person would observe. Id. Finally, a taxpayer's disregard of tax rules is "intentional" if the taxpayer knows that a rule exists, but nevertheless disregards it. Id. Thus, whether a taxpayer has disregarded rules and regulations within the contemplated meaning of this statute is a subjective analysis which will necessarily turn on the facts and circumstances of the particular case.

Substantial Understatement

In determining whether there has been a "substantial understatement" within the meaning of the statute, the question is whether the taxpayer understated the gross tax on the return by the greater of $5,000 or 10% of the gross tax required to be shown. Thus, unlike the previous two grounds for assessing an accuracy-related penalty, this ground is clear and objective.

It is important to note that only one 20% accuracy penalty can apply under I.R.C. § 6662. See Treas. Reg. § 1.6662-2(c) (providing that there can be no stacking of accuracy-related penalties). That is, the IRS cannot assess multiple accuracy penalties, even if the taxpayer's understatement satisfies more than one of the three grounds discussed above. Note, however, that the IRS may permissibly assess both an accuracy penalty and a delinquency penalty. For a summary of IRS delinquency penalties, see IRS Delinquency Penalties in a Nutshell.

As a final matter, keep in mind that there are defenses that can be asserted to avoid IRS penalties. For an overview of IRS penalty defense, see IRS Penalty Defense 101.

Is the IRS asserting that you owe an accuracy-related penalty? Contact me today. I may be able to obtain a waiver of the penalties, and consultation is always free.

There are several ways to defend against IRS penalties. Sometimes the asserted defense will depend on the type of penalty at issue, but the most common defense is "reasonable cause." The primary authority for this defense is found in I.R.C. § 6664(c), which provides that, "[n]o penalty shall be imposed . . . if it is shown that there was a reasonable cause . . . and that the taxpayer acted in good faith." See also Treas. Reg. § 1.6664-4(a).

Sounds simple enough, but "reasonable cause" is a legal term of art, and the tax law defines it in abstract terms. The Treasury Regulations tell us that "reasonable cause" entails the exercise of ordinary business care and prudence to comply with the tax law. Treas. Reg. § 301.6651-1. But that begs the question: what constitutes ordinary business care and prudence? That depends.

One thing that I have learned as a lawyer is that people hate it when lawyers answer questions with, "it depends." But before you kill the messenger, let me explain. The standard of reasonable cause "depends" because the determination is made on a case-by-case basis taking into account all pertinent facts and circumstances. See Treas. Reg. § 1.6664-4(b). In this respect, the most important factor is the extent of the taxpayer's effort to properly comply with tax obligations. Id. In other words, what we need to establish to prevail in petitioning the IRS to waive civil tax penalties is that the taxpayer's non-compliance was not only unintentional but that the taxpayer in fact tried to comply with the relevant tax obligation.

Is the IRS trying to assess penalties against you? Contact me today! I may be able to obtain an abatement of the penalties, and consultation is always free!

If you're reading this, your attempted negotiations with the IRS have likely been unsuccessful, and you are considering bringing your case to court. At this stage of the tax controversy, a taxpayer has two options in terms of where to file the lawsuit. One option is to file a petition with the United States Tax Court. The other option is to file a petition with the United States District Court in your jurisdiction. While the decision between tax court and district court may seem inconsequential, this is actually a critical strategic decision that can affect the ultimate outcome of the litigation in some cases.

Pay to Play

In Tax Court, a taxpayer is not required to "pay to play." That is, a taxpayer can dispute the matter in Tax Court without first paying the disputed tax. By contrast, a taxpayer is required to pay the disputed tax, including penalties and interest, prior to filing a lawsuit in district court. This single factor is the determining factor for many taxpayers because paying the tax upfront can be difficult. However, for taxpayers who have the ability to pay, there are several additional considerations that should be taken into account before deciding on where to file the lawsuit.

Scope of Jurisdiction

Once a taxpayer is in Tax Court, the Tax Court acquires exclusive jurisdiction over the entire tax year at issue, regardless of whether the issue was raised in the IRS' pre-trial correspondence. By contrast, the district court's jurisdiction is limited to the specific claim pleaded and filed with the court. As a result, if there are potential additional tax issues that the IRS has not raised, a taxpayer may want to consider filing the lawsuit in district court in order to limit jurisdiction.

Jury

The right to a jury trial and other protections typically associated with litigation are only available in courts which are established under Article 3 of the U.S. Constitution (i.e. "Article 3 courts"). The federal district courts are all Article 3 courts. Consequently, a taxpayer who files in district court is entitled to all of the protections typically afforded to litigants, including the right to a jury of peers. By contrast, the U.S. Tax Court was created under the authority of Article 1 of the U.S Constitution. As a result, there is no right to a jury in Tax Court. Instead, Tax Court cases are decided by the judge in what is commonly referred to as a "bench trial." Thus, if a taxpayer thinks that a jury may be advantageous, he or she should consider filing the lawsuit in district court. For instance, a taxpayer accused of civil tax fraud may want to consider filing the lawsuit in district court given the subjective analysis involved in fraud cases. Similarly, taxpayers with sympathetic cases that a jury would likely be able to relate to may want to consider filing the lawsuit in district court.

Tax Expertise

All of the judges in Tax Court are tax experts. Most of them worked as tax lawyers at prestigious law firms and public accounting firms, and many of them possess accounting degrees, CPAs, and LL.M degrees in taxation. By contrast, district court judges are typically not tax experts, and while some of them may have general business backgrounds, most of them lack prior accounting or tax experience. In cases involving complex tax issues or interpretation and application of technical tax rules, the taxpayer may therefore want to consider filing the lawsuit in Tax Court. However, if the application of technical tax rules is likely to result in an adverse result, the taxpayer may want to consider filing the lawsuit in district court where that technical rule may be given less weight.

Opposing Counsel

The government sends lawyers from the IRS Office of Chief Counsel to prosecute cases in Tax Court. By contrast, the government sends lawyers from the U.S. Department of Justice ("DOJ") to prosecute cases in district court. Many of the lawyers from the DOJ work primarily in the criminal division (rather than civil tax controversies) and consequently have a reputation for being aggressive. As a result, the case may be prosecuted more vigorously in district court. At the same time, Tax Court is like the IRS' home court, so in that respect, the government as a home court advantage of sorts in Tax Court. A taxpayer should consider both of these aspects in determining where to file the lawsuit.

Procedure

Litigation in Tax Court is governed by special procedures that are different from those that govern other federal courts. In this respect, there are different discovery rules, different requirements for parties' briefs, etc. As compared to the Federal Rules of Civil Procedure which govern in other federal courts, the Tax Court rules are less formal. For instance, the parties are required to stipulate as many facts as possible. In practice, this often means that the parties have agreed to the relevant facts prior to trial so that the court is only evaluating the legal merits of the case and not considering any factual disputes. For taxpayers who elect to represent themselves against the IRS (which I would not recommend), the informal practice and procedure of the U.S. Tax Court may be less intimidating and more conducive to pro se representation.

A taxpayer must go to IRS Appeals prior to going to Tax Court. In this respect, a taxpayer has two options:

(1) the taxpayer can pursue what is referred to as a "non-docketed appeal" following receipt of the 30-day letter*; or

(2) the taxpayer can pursue a "docketed appeal" following receipt of the statutory notice of deficiency.**

So which route should you take? In matters of tax law, the answer is usually a resounding "it depends," and the answer is no different here. There are potential advantages to both courses of appeal, so a taxpayer should consider the advantages of each and make his or her decision accordingly.

Docketed Appeal. Waiting to go to IRS Appeals is mostly a strategic trial decision and probably the more aggressive course of action. Most significantly, by waiting until after receipt of the 90-day letter, the taxpayer is able to learn more about the government's case against him or her. Additionally, some practitioners believe that waiting for appeal sends a signal to the IRS that you're tough and not willing to immediately settle. Similarly, waiting creates a little bit of time pressure since the case is docketed on the Tax Court's calendar at this point. Thus, the IRS may be more willing to settle as the trial date approaches.

Non-Docketed Appeal. Notwithstanding the foregoing, there are two very good reasons to consider a non-docketed appeal earlier on. First, all information relating to the tax controversy is protected by privacy laws at this stage of the controversy. See I.R.C. § 6103 (providing that all tax returns and return information shall be confidential). However, once the petition is filed with the Tax Court, it becomes a matter of public record. Second, in cases where it is determined that the IRS was not justified in taking the taxpayer to court, then the court can compel the IRS to pay the taxpayer's legal costs. See I.R.C. § 7430. Significantly, however, a taxpayer must "exhaust all administrative remedies," including pursuit of a non-docketed appeal, in order to be eligible to receive legal costs under this statute. See .R.C. § 7430(b). Thus, if the taxpayer's case is sufficiently strong so that the IRS could potentially be viewed as unjustified in going to court, then the taxpayer would be well-advised to pursue a non-docketed appeal in order to preserve the right to relief under Section 7403.

* The 30-day letter is a form letter which states the determination proposed by the IRS. It is accompanied by a copy of the IRS report explaining the basis for the proposed IRS determination. If the taxpayer agrees with the IRS, he or she can indicate agreement by executing and returning a waiver or acceptance. Alternatively, if the taxpayer disagrees with the IRS, he or she can appeal within 30 days.Treas. Reg. §601.105(d).

**If the taxpayer does not respond to the 30-day letter within the 30-day period, then a statutory notice of deficiency will be issued. The taxpayer has 90 days from the mailing of this letter to petition he Tax Court. I.R.C. § 6213(a).

There are two types of IRS delinquency penalties, one for failure to timely file a return and another for failure to timely pay tax owed. The failure to file penalty applies if a taxpayer files a tax return after the due date (including extensions). I.R.C. § 6651(a)(1). The failure to pay penalty applies if a taxpayer pays the tax owed after the due date (excluding extensions). I.R.C. § 6651(a)(2).

Amount of Penalty

The amount of the penalty depends on which delinquency penalty we are talking about. With respect to the failure to file penalty, the penalty is equal to 5% of the net tax required to be shown for each month, or fraction thereof, that the return is late. With respect to the failure to pay penalty, the penalty is equal to 0.5% of the net tax shown for each month, or fraction thereof, that the return is late.

In order to understand the practical application of these penalties, three things must be noted:

(1) The method for calculating the failure to file penalty is different than the method for calculating the failure to pay penalty.

If you look at the statutory language of I.R.C. § 6651(a), the failure to timely file penalty is calculated by reference to the tax required to be shown whereas the failure to timely pay penalty is calculated by reference to the tax shown. In other words, the failure to timely file penalty is applied to the tax that should have been reported on the return whereas the failure to timely pay penalty is applied to the tax that was actually reported on the return.

This is best illustrated by an example. Assume that an individual taxpayer's total federal income tax owed is $100,000. [This is the amount of tax required to be shown]. The return is due on April 15. The taxpayer files his return on July 16 at which time he reports and pays $75,000 of federal income tax. [This is the amount of tax actually shown]. Both a failure to timely file penalty and a failure to timely pay penalty would apply here.

The failure to timely file penalty would be equal to 20% of the $100,000 of tax required to be shown, or $20,000. Right now, you're probably wondering why I just applied a 20% penalty when the statute provides for a 5% penalty. The answer is because the penalty is not 5% in the aggregate but rather 5% for every month (or fraction of a month) that the return is late. Here, the return was due on April 15, but filed on July 16. Thus, the return was 3 months and 1 day late, or 4 units. 5% for each of these 4 units is equal to 20%. So you can see here that just 1 day can make a big difference when you're talking about tax penalties.

The failure to pay penalty would be equal to 2% (0.5% penalty * 4 units late) of the $75,000 tax actually reported (not the $100,000 tax that should have been reported) on the return, or $1,500.

(2) Total Delinquency Penalties Capped at Failure to File Penalty

In cases where both the failure to file penalty and the failure to pay penalty apply, the failure to file penalty is reduced by the failure to pay penalty with the practical effect being that the aggregate delinquency penalty is limited to the amount of the failure to file penalty.

Once again, this is best illustrated by an example. In the above example, it was determined that a failure to file penalty of $20,000 and a failure to pay penalty of $1,500 would apply. However, the $20,000 failure to file penalty would be reduced by the $1,500 failure to pay penalty resulting in failure to file penalty of $18,500 and a failure to pay penalty of $1,500 for an aggregate delinquency penalty of $20,000. See I.R.C. § 6651(c).

(3) Maximum Penalty of 25% of Tax Required to be Shown

Both the failure to file penalty and the failure to pay penalty are subject to a cap of 25% of the tax required to be shown. That is, the maximum penalty that can be imposed for late filing or late payment is 25% of the tax that should have been reported on the return. In our example above, the maximum penalty allowed would be $25,000 (25% * $100,000 tax required to be shown). In our example, however, the $20,000 penalty calculated is less than the $25,000 maximum penalty allowed, so the 25% cap is not triggered.

Behind on your taxes? Contact me. I may be able to help you obtain some relief from IRS penalties and interest, and consultation is always free.

If you're reading this article, you probably received a letter from the IRS asserting that you owe additional income tax. So what should you do?

First things first ... relax! Absent tax fraud or tax evasion, an IRS notice does not mean that you're "in trouble" with the law in a criminal sense. In other words, you're not going to jail, so you can stop thinking about how awful prison is going to be. Still, an IRS notice is something that needs to be taken seriously and handled promptly. In this respect, one important thing to think about is interest.

Interest on Underpaid Tax. In addition to having liability for the underpaid tax, a taxpayer will also be required to pay interest on the amount of the underpaid tax. It should also be noted that the taxpayer may also be required to pay interest on any penalties that apply. As a general rule, interest starts to accrue on the underpaid tax liability from the due date for paying the tax (excluding extensions). In this respect, when the statute uses the word "from," it actually means that interest accrual begins the day after the due date. So if the due date for the return is April 15th, as is the case with individual income tax returns, interest begins to accrue as of April 16th. But don't worry! There are steps that a taxpayer can take to stop the accrual of interest.

Stop Accrual of Interest. A taxpayer can stop interest accrual during the pendency of the tax controversy by making a "remittance" to the IRS. In this respect, a "remittance" can come in one of two forms. First, the taxpayer can remit payment of the tax (i.e. pay the tax). Alternatively, the taxpayer can remit a deposit of the tax.

Payment vs. Deposit. So what's the difference between a payment and a deposit? While either a payment or a deposit is sufficient to stop interest accrual, the primary difference between the two options is the taxpayer's ability to proceed to Tax Court. If the tax is paid, there is no longer a tax controversy and, as a result, the U.S. Tax Court lacks jurisdiction to hear the matter. By contrast, if a deposit is made, the controversy remains active, and the Tax Court's jurisdiction is preserved. To be clear, a taxpayer does not lose the right to challenge the IRS by paying the tax in full. There is always the option of filing a refund suit in Federal district court, but it is the right to go to Tax Court that is lost by remitting payment in full. Tax Court is often preferred over Federal district court for tax matters for various reasons, so the loss of Tax Court jurisdiction is not something that should be dismissed lightly for taxpayers who want to stop interest accrual but think that they may want to challenge the IRS assessment. Note, however, that a taxpayer must affirmatively designate a remittance as a deposit; otherwise the IRS will automatically treat any amount receives as a payment. In this respect, the IRS has provided specific procedures that must be followed to designate a remittance as a deposit.