A Proposal for First-time Abatement of Timeliness Penalties,

• Publication year: 2020
• Author: By Kathy Freeman & Ovsep Akopchikyan,

A Proposal for First-Time Abatement of Timeliness Penalties1,2

By Kathy Freeman³ & Ovsep Akopchikyan⁴,⁵

EXECUTIVE SUMMARY

This paper calls for a change in California law to automatically abate penalties imposed on a taxpayer for the failure to timely file a tax return or timely pay tax if the taxpayer has a demonstrated history of filing and paying on time. Federal law already contains an automatic penalty abatement program and our proposal is that California adopt an abatement program that is substantially similar to existing federal law.

The purpose of our proposal is to reduce the cost and distress to taxpayers who have an established history of filing and paying on time, and to reduce the amount of resources the California Franchise Tax Board (FTB) dedicates to reviewing penalty abatement requests, which are largely dependent on the facts and circumstances of each case. One of the policies underlying civil tax penalties is that they encourage voluntary compliance with tax laws. Imposing a timeliness penalty on a taxpayer that has a long history of filing and paying on time for an isolated incident probably does not do much to encourage voluntary compliance—at least that is one of the reasons supporting the federal program and the proposal here.

Existing California law imposes timeliness penalties on taxpayers who are late in filing tax returns or making tax payments. While such taxpayers may request penalty abatement by showing that the failure was due to reasonable cause and not willful neglect, the large body of existing case law demonstrates that this is a difficult burden to meet. The large body of case law also demonstrates that these penalty abatement determinations generally require taxpayers to present substantial amounts of factual evidence, and also require the FTB to evaluate this evidence and then compare and contrast the taxpayer's facts with case law to make a determination. We think it is safe to say that the amount of FTB resources expended on reviewing penalty abatement requests is not insignificant due to the complexities involved in making those determinations. Our proposal should reduce the amount of FTB resources that are devoted to penalty abatement requests without negatively impacting the FTB's enforcement mission.

DISCUSSION

I. THE NEED FOR FIRST-TIME PENALTY RELIEF IN CALIFORNIA A. California and Federal Timeliness Penalties

California law imposes penalties when a taxpayer does not timely file an income tax return or pay tax by the required due date, unless the taxpayer shows that the failure was due to reasonable cause and not willful neglect.⁶,⁷ California's penalty regime largely mirrors federal law, which also imposes penalties for late filings of tax returns and late payments of tax, unless the failure was due to reasonable cause and not willful neglect.⁸

The penalty amounts imposed under California law are similar to the penalty amounts imposed under federal law. Under both regimes, the failure to file penalty is generally five percent of the tax due every month that the return is late up to a maximum of 25 percent.⁹ The failure to pay penalty is generally five percent of the unpaid tax plus 0.5 percent each month up to 25 percent of the total unpaid tax under California law, and 0.5 percent each month up to 25 percent of the total unpaid tax under federal law.¹⁰,¹¹

B. Under Both California And Federal Law, Taxpayers Have The Burden Of Proving That The Failure To File Or Pay On Time Was Due To Reasonable Cause

1. Federal Law And Internal Revenue Policy Recognize The Need For Relief From Strict Enforcement of Civil Tax Penalties

The Internal Revenue Manual, the official compendium of internal guidelines for Internal Revenue Service (IRS) personnel, indicates that tax penalties "advance the mission of the IRS when they encourage voluntary compliance."¹²,¹³ The IRS further notes that "penalties best aid voluntary compliance if they support belief in the fairness and effectiveness of the tax system."¹⁴ To that end, federal penalties will not apply to taxpayers able to demonstrate "reasonable cause," which is a case-by-case determination based on all the facts and circumstances.¹⁵

The case-by-case determination requires the IRS and the courts to spend considerable resources when evaluating claims of reasonable cause to such a degree that the U.S. Supreme Court sought in 1985 to create "a rule with as 'bright' a line as can be drawn consistent with the statute and implementing regulations" in United States v. Boyle.¹⁶ The Supreme Court in Boyle established as close to a "bright-line" test as possible in the context of a taxpayer's reliance on a tax professional to timely f i le a tax return, which is only one of many reasons why taxpayers fail to timely file a tax return or pay tax. Notwithstanding Boyle's bright-line test, taxpayers continue to make requests for penalty abatement based on reliance on a tax professional, which demonstrates that the existence of a rule that was intended to be as bright as a line as possible fails to halt requests for penalty abatement. The FTB and the courts must continue deciding whether certain sets of facts constitute reasonable cause for penalty relief.

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It is with this understanding that the IRS developed its "First-Time Abate" administrative waiver in 2001, which provides relief to qualified taxpayers without the need to show reasonable cause. To qualify for penalty relief under this program, a taxpayer must be compliant with all tax filing and payment obligations and must not have had a similar penalty assessed (or waived) in the prior three years. While the program is referred to as "first-time abate," qualified taxpayers may seek penalty relief once...