Reasonable Cause to Abate IRS Penalties (Case Study Example)

Reasonable Cause to Abate IRS Penalties (Case Study Example)

Reasonable Cause to Abate IRS Penalties

When a Taxpayer has been penalized by the Internal Revenue Service, they have the opportunity to try to seek removal of those penalties by showing that they acted with reasonable cause in their non-compliance. Generally, the phraseology is that a taxpayer must be able to show that they acted with reasonable cause and not willful neglect. In order to fight an IRS penalty using reasonable cause, a taxpayer is not required to submit a reasonable cause form per se. Rather the Taxpayer prepares and submits a presentation of their facts and various laws/regulations and other materials to support their position in letter form. During the life of a penalty dispute with the IRS, Taxpayers may have multiple chances to prove reasonable cause. The process is usually initiated by protesting the penalty (CP15 Notice) — and then following it up later with an Appeal or Collection Due Process Hearing Request. Let’s take a look at five important facts about reasonable cause by using an example:

Maggie Did Not Report a Foreign Gift or Business

Maggie is a Lawful Permanent Resident who relocated to the United States a few years ago. At the time she relocated to the United States, she did not have any interest in a foreign business – and did not have any ownership or signature authority over any foreign accounts. Therefore, she was not required to report any information about foreign assets to the IRS. Fast forward a few years later, and Maggie’s father who is getting on in age decided he wanted to gift her a 25% value of the foreign family business, which is worth about $900,000. Maggie was unaware that she was required to report this information because her current CPA told her that since the gift was not income and that the foreign business was not distributing any money — so that nothing was required. Later, after speaking with a different CPA, she learned she had missed reporting requirements in the prior year. The CPA sends off the late-filed Form 5471 and Form 3520 — and about 18 months later, Maggie gets hit with assessable penalties for failure to file Form 5471 and Form 3520.

Protest Letter to Prove Reasonable Cause

Maggie receives a CP15 Notice which gives her 30 days to protest the penalty. In order to protest the penalty, Maggie should put together a reasonable cause statement package. Maggie’s goal is to apply a ‘totality of the circumstance’ approach to explain that the failure to report the foreign information was due to reasonable cause and not willful neglect.  Unfortunately, in the current IRS landscape of agents being overworked and underpaid, oftentimes these protest letters are automatically rejected, even if the taxpayer has reasonable cause. But it is very important for the taxpayer to submit a persuasive and concise protest letter to begin the journey of proving reasonable cause.

What Goes into a Reasonable Cause Letter?

The reasonable cause letter is not a one-size-fits-all submission. In fact, it is not even reported on a specific IRS form. Instead, it is submitted as a persuasive and concise correspondence, explaining why the person should have their penalty abated. In order to draft a reasonable cause letter, taxpayers should review the different resources available online to assist them. Taxpayers may want to begin with the Internal Revenue Manual in order to have an idea of what the IRS looks for when evaluating a reasonable cause submission. The taxpayer should also refer to the specific code section that forms the basics of their penalty, along with any applicable regulations.  For example, if a person receives an assessable penalty for Form 8938 (failing to report their foreign accounts and assets on their tax return), but one reason they did so was that it would violate the foreign country’s law – by reading the code section, they would learn that:
      • (g) Reasonable cause exception:
          • No penalty shall be imposed by this section on any failure which is shown to be due to reasonable cause and not due to willful neglect. The fact that a foreign jurisdiction would impose a civil or criminal penalty on the taxpayer (or any other person) for disclosing the required information is not reasonable cause.

If Reasonable Cause Protest is Rejected, Should You Appeal?

If a taxpayer attempts to abate the penalties with the protest letter and it is not successful, the taxpayer must decide whether or not they want to appeal the rejection — or do they want to try and hold out for the opportunity to pursue a Collection Due Process Hearing (CDP). Both types of hearings provide the taxpayer with an opportunity to present their reasonable cause submission to a person with more authority –– but there are some pros and cons to each approach.

Appeal or CDP Hearing

Generally, the opportunity to appeal comes faster, but it is harder to go to Tax Court if the taxpayer loses the appeal. Taxpayers who want an opportunity to go to tax court will typically pursue the Collection Due Process Hearing because he gives a more direct route to tax court if the collection due process does not bear fruit. While there is no absolute rule that Taxpayers who had an appeal cannot then pursue a CDP hearing on the same issue, that is a position the IRS can (and does take). The problem with the CDP is that is it it is an endgame opportunity. In other words, absent some intervening action such as the IRS making claim to a state refund — which is a shortcut opportunity to pursue the CDP — the taxpayer may have to wait several months (or even years) to have the opportunity for a CDP. All the while, they will continue to accrue interest, receive collection notices such as CP 503/504 notices —  and even become subject to a notice of federal tax lien.

With the appeal, the taxpayer can pay the amount first in order to cut off interest in case they lose, whereas if the taxpayer submits payment, they generally lose the right to a CDP. Presumably, they will not receive a CDP opportunity — since there is no collection pending as the amount was paid.

*Some taxpayers may try to offset interest and pursue a CDP by only submitting estimated interest payments — but as you may imagine that may come with a whole host of other headaches in trying to deal with the IRS on that issue.

You Had Reasonable Cause But Rejected

If you sincerely believe that you had a reasonable cause the entire time and that the IRS is simply not playing fair, the typical route would be to protest the CP 15 notice and then wait for the CDP so that you can go to tax court after if you lose. You may want to consider speaking with a Board-Certified Tax Law Specialist in order to understand the different options and identify the best strategy for your situation, before making your submission.

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