Reasonable Cause & IRS Tax Penalties

Reasonable Cause & IRS Tax Penalties

Reasonable Cause & IRS Penalties

Reasonable Cause & IRS Tax Penalties: When a non-willful taxpayer faces potential penalties for failing to comply with the Internal Revenue Code, they may be penalized by the IRS. The taxpayer may be able to avoid, minimize, or abate the penalties if the taxpayer can establish reasonable cause. Ideally, it is better for the taxpayer to avoid the penalty than it is to abate the penalty — but that is not always an option — especially if they received an automatic assessed penalty for 3520, 3520-A, 5471, or 8938.

When a taxpayer seeks to avoid the penalty, they should submit a detailed Reasonable Cause statement package before the penalties are issued.

If instead the taxpayer has already been charged with a penalty, they have a much steeper uphill battle to try to get those penalties removed by proving Reasonable Cause — and negating willful disregard.

In recent years, the most severe Internal Revenue Service penalties involve international information reporting noncompliance penalties. The IRS knows that a lot of international taxpayers have not been keeping up to speed with their international reporting requirements, such as international gifts, trusts, foreign bank accounts, assets, and investments. 

Let’s walk through an example of a Foreign Trust issued penalty and a play for Reasonable Cause:

Keith’s Foreign Trust Reporting Penalty

Keith is a Legal Permanent Resident who resides in the United States. Recently, Keith learned that he might have had to report his ownership interest in a foreign trust that took effect five (5) years ago. Sure, the ownership interest in the foreign trust was transferred to Keith by his sweet grandmother in Peru, but a rule is rule — and Keith wants to play by the rules.

Therefore, Keith jumps online and begins his research quest on Google — in and out of various rabbit holes.

Keith Reviews the Statute

Keith looks at the statute and sees that if he can show Reasonable Cause, he may be able to avoid the penalty (IRC (Internal Revenue Code) section 6048).

Specifically, the language of IRC 6048 provides the following:

  • “Reasonable cause exception Paragraph (1) shall not apply to any failure to report a foreign gift if the United States person shows that the failure is due to reasonable cause and not due to willful neglect.”

What is Willful Neglect?

The next step for Keith in his quest to avoid penalties is to research willful neglect. Keith takes time to evaluate all the different resources available, which may include revenue rulings, regulations, revenue procedures, case rulings, regulations, etc.

Keith starts with the IRM to see if he can better understand what is referred to as willful neglect.

What is the IRM?

The IRM is the Internal Revenue Manual.

It is designed for IRS personnel to understand and implement the procedures the IRS has in place for handling certain cases.

The manual is published online, so taxpayers and their representatives have a general idea of how the IRS may handle a certain tax situation.

It is important to remember that the IRM is not the law and it has no force of law.

What does the IRM Provide about Willful Neglect?

At the bottom of Section 20.1, Keith finds the following small blurb:

  • Willful Neglect: Conscious, intentional failure to comply with the provisions of the IRC, or reckless indifference to such provisions.”

Okay…so not much help.

In Keith’s mind, all he did was receive a gift from his grandma. There was no unreported income or other offshore assets to report. Keith continues researching to learn more about Reasonable Cause and Willful Neglect.

He researches various other IRS publications and PLR (Private Letter Rulings), before landing on regulation 26 CFR § 301.6724-1.

26 CFR § 301.6724-1 – Reasonable Cause

The Code of Federal Regulations provides further insight as to how a taxpayer can prove Reasonable Cause.

As provided by the CFR:

“(a) Waiver of the Penalty –

(1) General rule.

The penalty for a failure relating to an information reporting requirement (as defined in paragraph (j) of this section) is waived if the failure is due to reasonable cause and is not due to willful neglect. 

(2) Reasonable cause defined.

The penalty is waived for reasonable cause only if the filer establishes that either

(i) There are significant mitigating factors with respect to the failure, as described in paragraph (b) of this section; or

(ii) The failure arose from events beyond the filer’s control (“impediment”), as described in paragraph (c) of this section.

Moreover, the filer must establish that the filer acted in a responsible manner, as described in paragraph (d) of this section, both before and after the failure occurred. Thus, if the filer establishes that there are significant mitigating factors for a failure but is unable to establish that the filer acted in a responsible manner, the mitigating factors will not be sufficient to obtain a waiver of the penalty. Similarly, if the filer establishes that a failure arose from an impediment but is unable to establish that the filer acted in a responsible manner, the impediment will not be sufficient to obtain a waiver of the penalty.

See paragraph (g) of this section for the reasonable cause safe harbor for persons who exercise due diligence.”

What Does This Mean?

Okay, so there is some hope for Keith after all. Essentially he must show reasonable cause and lack of willful neglect by showing either:

    • There were significant mitigating factors and responsible behavior; or
    • It was beyond the taxpayer’s control and responsible behavior.

Unless Keith was truly impeded from filing, his best bet will be proving significant mitigating factors and/or meeting the safe harbor provision.

Significant Mitigating Factors

“In order to establish reasonable cause under this paragraph (b), the filer must satisfy paragraph (d) of this section and must show that there are significant mitigating factors for the failure.

The mitigating factors include, but are not limited to –

(1) The fact that prior to the failure the filer was never required to file the particular type of return or furnish the particular type of statement with respect to which the failure occurred, or

(2) The fact that the filer has an established history of complying with the information reporting requirement with respect to which the failure occurred. In determining whether the filer has such an established history, significant consideration is given to –

(i) Whether the filer has incurred any penalty under §§ 301.6721-1, 301.6722-1, or 301.6723-1 in prior years for the failure (or under parallel provisions of prior law), and

(ii) If the filer has incurred any such penalty in prior years, the extent of the filer’s success in lessening its error rate from year to year. A filer may treat as a penalty not incurred any penalty under sections 6721 through 6723 that was self-assessed under section 6724(c)(3) and any penalty under section 6676(b) that was self-assessed under section 6676(d), prior to amendment or repeal by the Omnibus Budget Reconciliation Act of 1989. See paragraph (c)(5) of this section for the application of this paragraph (b) to failures attributable to the actions of a filer’s agent.

Responsible Manner 

(1) In general.

Acting in a responsible manner means –

(i) That the filer exercised reasonable care, which is that standard of care that a reasonably prudent person would use under the circumstances in the course of its business in determining its filing obligations and in handling account information such as account numbers and balances, and (ii) That the filer undertook significant steps to avoid or mitigate the failure, including, where applicable –

(A) Requesting appropriate extensions of time to file, when practicable, in order to avoid the failure,

(B) Attempting to prevent an impediment or a failure, if it was foreseeable,

(C) Acting to remove an impediment or the cause of a failure, once it occurred, and

(D) Rectifying the failure as promptly as possible once the impediment was removed or the failure was discovered. Ordinarily, a rectification is considered prompt if it is made within 30 days after the date the impediment is removed or the failure is discovered or on the earliest date thereafter on which a regular submission of corrections is made.

DIIRSP is No Longer an Option

Prior to November 2020, taxpayers with no unreported income and only delinquent international reporting forms were almost always certain to avoid penalties by using DIIRSP (Delinquent International Information Return Submission Procedures).

Unfortunately, that program has ended — or rather “mutated” back into a reasonable cause submission. DFSP for delinquent FBAR submission still appears to be valid at least at the time of publication of this article.

Writing a Strong Reasonable Cause Statement

Keith rolls up his sleeves and gets to work.

Reasonable cause statements are very complicated. If you are submitting to the IRS, you may consider hiring an experienced tax specialist to represent you — and while that will not guarantee success, it can help preserve your rights throughout the process.

Keith should outline and assess the facts and circumstances in detail. Then, Keith should review and evaluate the code, regulations, and other supporting information and use all of the information to draft a specific, concise but persuasive statement. The letter should include both facts and law to effectively support his position that he acted reasonably.

Even if the Reasonable Cause statement is not successful at the outset, it sets up the taxpayer to fight the good fight at different levels of the IRS. With a good reasonable cause statement, the taxpayer will have a strong filing history record reflecting that they showed reasonable cause from the outset.

*If you or your Tax Representative prepared a reasonable cause letter and it amounts to about a half-page or so in total, then chances are it probably lacks the necessary facts and legal arguments sufficient to establish reasonable cause.

What Happens if an Initial Reasonable Cause Statement is Rejected?

This is no time to give up.

It’s not always as simple as writing a letter and that’s the end of it.  In addition, it is crucial to note that just submitting a protest/appeal (for example in response to a CP 15 notice) does not automatically stay the enforcement. If collections sent you a Notice of Lien or Levy (such as CP504) — you have an opportunity to file with the IRS Office of Appeals — so an early implemented strategy is crucial.

An Effective Reasonable Cause Package is Crucial

Reasonable Cause can be a great opportunity for taxpayers to minimize, avoid, or abate penalties. Depending on whether the penalties are reporting-related or tax-related will impact the avenues you have available for Reasonable Cause. In addition, Reasonable Cause statements will vary depending on what stage of the process you are in.

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