Avoid Irs Penalties—reasonable Cause Is Surprisingly Reasonable

• Publication year: 2020
• Author: Robert W. Wood

Avoid IRS Penalties—Reasonable Cause Is Surprisingly Reasonable

Robert W. Wood practices law with Wood LLP (www.WoodLLP.com) and is the author of Taxation of Damage Awards and Settlement Payments and other books available at www.TaxInstitute.com. This discussion is not intended as legal advice.

Robert W. Wood

Dear IRS, no penalties please! Taxpayers claim that penalties are not warranted for many reasons, but what works? One of the biggest yet most misunderstood protections for taxpayers is the defense that a tax position was based on reasonable cause, and the taxpayer acted in good faith. Those seem like pretty friendly, easy-to-under-stand words, but they are terms of art. Even if you think you comply with them as a matter of common sense, the IRS may not agree.

Among other things, how the IRS evaluates a defense depends on which penalty has been assessed, so you need to know that to see if you are, well, reasonable. In addition, on top of reasonable cause, certain penalty defenses involve other concepts, such as an absence of willful neglect. Isn't that proving a negative? You bet.

Who wins in a tax penalty stalemate? This one should not surprise you. The IRS does, of course. Put differently, taxpayers bear the burden of substantiating their reasonable cause. We all must exercise ordinary business care and prudence in reporting our proper tax liability. And remember, all tax returns are signed under penalties of perjury, so keep that in mind too.

The IRS applies a facts and circumstances test on a case-by-case basis to determine whether a taxpayer meets the reasonable cause and good faith exception. As you might expect, that can lead to inconsistent results, and ones that are subjective. The stakes can be big too. The reasonable cause exception under section 6664(c) of the tax code applies to accuracy, related penalties under Internal Revenue Code ("IRC") section 6662, which are usually 20% of the amount at stake.

The reasonable cause exception even applies to penalties for civil fraud under section 6663. How much is the civil fraud penalty? A whopping 75%. So, if your flaky tax deduction amounts to $10,000 in tax, you can add another $7,500 on top if the IRS says it was fraud. Fraud penalties are not asserted frequently, but still, it is not an exaggeration to say that penalties can be big. That makes your ability to sidestep them big too, even if you end up having to pay all the tax and the interest.

But wait, there is more. Reasonable cause exceptions for penalty relief also apply to other penalties the IRS can impose, including penalties: (1) for failure to file a tax return, and failure to pay, imposed by section 6651 of the tax code, (2) for making an erroneous claim for refund or tax credit, under section 6676; (3) for failure to file Form 1099 or other information reporting returns under section 6721; and (4) for the understatement of a taxpayer's liability by a tax return preparer under section 6694.

In fact, the tax...