Penalties and Interest

• Author: W. Patrick Cantrell
• Pages: 215-266

215

CHAPTER 5

Penalties and Interest

Federal Penalty Structure

I. Introduction

A. Scope of Presentation

The intent of this presentation is to provide the reader with a bird’s-eye

view of the civil penalty structure of the Internal Revenue Code to see

how it all fits together. The process of securing a reduction or abatement

of any asserted penalty is discusse d later in this chapter under “Penalty

Abatement.” Additionally, the following specific penalties, because of

their relative importance, are discussed elsewhere in some depth:

1. Underestimate penalties (later in this chapter),

2. Civil fraud (chapter 8),

3. Trust fund liability (later in this chapter), and

4. Preparer penalty (chapter 9).

B. Background

There are over 150 penalties in the Internal Revenue Code. As it is pres-

ently configured, the existing system is a patchwork maze of incon-

sistent, overlapping, and often draconian levies. This subchapter will

attempt to explain and make some sense of this system and highlight

some of the more common penalties that the average practitioner is

likely to encounter.

C. IRS Policy and Procedure

The IRS’s stated policy is that a penalty i s to be imposed only to ensure

voluntary compliance with the tax law.1 However, the result of pen-

alty imposition is also to raise revenue, punish the taxpayer, and reim-

burse the IRS for the cost of enforcement. According to existing policy,

IRS agents may not use penalties as a bargaining ploy to extract an

216 PENALTIES AND INTEREST

agreement on other issues.2 In any “notice” that gives a taxpayer a

right of appeal, the IRS is required to provide an explanation for any

proposed penalty. However, failure to do so will not invalidate such a

notice.3

D. Civil and Criminal Penalties Distinguished

Penalties couched in terms of a percentage of the tax owed are called

“ad valorem” civil penalties and are designed to encourage or coerce

compliance with the law. Nearly all civil penalties are ad valorem,

whereas criminal penalties, imposed on ly after conviction in court, do

not depend on the amount of the tax involved. Thus, there are two prin-

cipal penalty classifications: (1) specific penalties, consisting principally

of fines with maximum lim its and imprisonment; and (2) ad valorem

penalties, measured by a percentage of the tax liability. Note that

acquittal on a criminal c harge does not prevent the later imposition of

a civil fraud penalty.4 The ad valorem provisions of the I.R.C. are often

referred to in the statute as “additions” to tax, but the generic term is

“penalty.” Ad valorem penalties may be determined and assessed by

the IRS, but specific criminal penalties cannot be so assessed and are

enforceable only by a suit and prosecution.

E. Assessable versus Nonassessable

Chapter 68 of the I.R.C. refers to “assessable penalties” and “additions to

the tax,” as if there were some important distinction between the two cat-

egories. “Additions to the tax” are found in I.R.C. §§6651 through 6665.

“Assessable penalties” are found in I.R.C. §§6671 through 6751. But, as

a practical matter, there are no distinctions between the two categories.

F. Constitutional Objections

Civil tax penalties have survived a number of constitutional chal-

lenges, most notably the double jeopardy clause, which forbids a sec-

ond “punishment” for the same offense.5

G. Penalty “Stacking”

There are some judicially imposed limits on the IRS’s attempts to

impose multiple penalties on the same deficiency. For example, the

IRS cannot stack penalty on top of penalty just because of an under-

statement of tax attributable to investment in a tax shelter, particularly

where the taxpayer is inexperienced and uneducated.6

II. Failure to File or Pay

A. Failure to File

1. General rule: In the case of a failure to file a return, or late filing of

a return, the I.R.C. imposes a penalty equal to 5 percent of the tax

Failure to File or Pay 217

due, per month of delinquency or fraction thereof, up to 25 percent

in the aggregate. As can be seen, this is a significant deterrent to

filing late. This penalty can be avoided or abated upon a showing

of reasonable cause.7 This penalty is also commonly referred to as

the “delinquency” penalty.

2. Extended returns: Merely paying the tax within an approved

extension period will not avoid the § 6651(a)(1) penalty if the

return is filed after the extension period expired, absent a showing

of reasonable cause. Thus, in the event of late filing, the penalty

is based on the total correct tax, unreduced by the payment made

after the due date.8

3. Accrual starting point: For purposes of the “per month” calculation,

the date of accrual is the first day after the final extension period

has expired.9

4. De minimis rule: The failure-to-file penalty will never be lower

than the lesser of (1) $135 or (2) 100 percent of the tax liability.

Thus, if the late-filed return reflects a refund or zero liability, the

delinquency penalty will likewise be zero.10

5. Mailbox rule: When there is a dispute as to when (or whether)

an extension was filed, a taxpayer’s own sworn statement when

coupled with other circumstantial evidence will be sufficient to

establish timely filing under the “mailbox” rule.11

6. Fraud: If a failure to file is fraudulent, the penalty rate is tripled.

Five percent per month becomes 15 percent per month, and the

25percent maximum becomes 75 percent.12

7. Exempt organization returns: In the case of failure to file an exempt

organization return (see Form 990), the penalty is $20 for each

day during which the failure continues. The maximum penalty

is the lesser of $10,000 or 5 percent of the gross receipts of the

tax-exempt organization.13 This penalty can also be abated upon a

showing of reasonable cause.14

8. Pension or profit-sharing returns: In the case of failure to file a return

(Form 5500 series) for a deferred compensation plan, the penalty is

$25 per day, not to exceed $15,000.15

B. Failure to Pay

1. General rule: Regardless of whether a return is filed in a timely

manner, or within an approved extension period, a failure-to-

pay penalty is imposed if 100 percent of the tax due is not paid

on or before the original due date of the return. This penalty is

calculated at a rate of 0.5 percent (of the unpaid tax), per month (or

fraction thereof), up to 25 percent in the aggregate. This penalty

may also be avoided by a showing of reasonable cause.16

2. Deficiency cases: The failure-to-pay penalty can also be imposed

with respect to a tax deficiency, but only after twenty-one days