Avoiding Accuracy-Related Penalties with Reasonable Cause

Avoiding Accuracy-Related Penalties with Reasonable Cause

While there are many different types of IRS penalties that a US Taxpayer can be hit with, one of the most common types are accuracy-related penalties. The different types of accuracy-related penalties can be found under Internal Revenue Code Section 6662 (26 U.S.C. 6662) — with Sections 6662(b)(1), (2), and (7) as the three most common types. Even if a taxpayer finds themselves on the receiving end of a 6662 accuracy-related penalty, they may be able to avoid these penalties by showing that they have reasonable cause. Unfortunately, there is no bright-line test to determine how a taxpayer qualifies for the reasonable cause exception — although in general, the Taxpayer must show by the totality of the circumstance that they acted with reasonable cause sufficient to avoid or eliminate penalties. Let’s take a look at how Taxpayers may be able to avoid accuracy-related penalties by showing they acted with reasonable cause by referencing the Statute, Regulations, and Internal Revenue Manual (IRM).

26 U.S. Code § 6662 – Imposition of accuracy-related penalty on underpayments U.S. Code

• • • (a) Imposition of penalty

      • If this section applies to any portion of an underpayment of tax required to be shown on a return, there shall be added to the tax an amount equal to 20 percent of the portion of the underpayment to which this section applies.

    • (b)Portion of underpayment to which section applies

      • This section shall apply to the portion of any underpayment which is attributable to 1 or more of the following:

        • (b)(1) Negligence or disregard of rules or regulations.

        • (b)(2) Any substantial understatement of income tax.

        • (b)(7) Any undisclosed foreign financial asset understatement.

26 CFR 16662-1 (Reasonable Cause)

• • • No accuracy-related penalty may be imposed on any portion of an underpayment if there was reasonable cause for, and the taxpayer acted in good faith with respect to, such portion.

      • The reasonable cause and good faith exception to the accuracy-related penalty is set forth in § 1.6664-4.

1.6664-4 Reasonable cause and good faith exception to section 6662 penalties.

• • • In general.

      • No penalty may be imposed under section 6662 with respect to any portion of an underpayment upon a showing by the taxpayer that there was reasonable cause for, and the taxpayer acted in good faith with respect to, such portion. Rules for determining whether the reasonable cause and good faith exception applies are set forth in paragraphs (b) through (h) of this section.

    • (b) Facts and circumstances taken into account –

      • (1) In general.

• • • • • • The determination of whether a taxpayer acted with reasonable cause and in good faith is made on a case-by-case basis, taking into account all pertinent facts and circumstances. (See paragraph (e) of this section for certain rules relating to a substantial understatement penalty attributable to tax shelter items of corporations.) Generally, the most important factor is the extent of the taxpayer’s effort to assess the taxpayer’s proper tax liability. Circumstances that may indicate reasonable cause and good faith include an honest misunderstanding of fact or law that is reasonable in light of all of the facts and circumstances, including the experience, knowledge, and education of the taxpayer. An isolated computational or transcriptional error generally is not inconsistent with reasonable cause and good faith. Reliance on an information return or on the advice of a professional tax advisor or an appraiser does not necessarily demonstrate reasonable cause and good faith.

          • Similarly, reasonable cause and good faith is not necessarily indicated by reliance on facts that, unknown to the taxpayer, are incorrect. Reliance on an information return, professional advice, or other facts, however, constitutes reasonable cause and good faith if, under all the circumstances, such reliance was reasonable and the taxpayer acted in good faith. (See paragraph (c) of this section for certain rules relating to reliance on the advice of others.)

          • For example, reliance on erroneous information (such as an error relating to the cost or adjusted basis of property, the date property was placed in service, or the amount of opening or closing inventory) inadvertently included in data compiled by the various divisions of a multidivisional corporation or in financial books and records prepared by those divisions generally indicates reasonable cause and good faith, provided the corporation employed internal controls and procedures, reasonable under the circumstances, that were designed to identify such factual errors. Reasonable cause and good faith ordinarily is not indicated by the mere fact that there is an appraisal of the value of property. Other factors to consider include the methodology and assumptions underlying the appraisal, the appraised value, the relationship between appraised value and purchase price, the circumstances under which the appraisal was obtained, and the appraiser’s relationship to the taxpayer or to the activity in which the property is used. (See paragraph (g) of this section for certain rules relating to appraisals for charitable deduction property.)

          • A taxpayer’s reliance on erroneous information reported on a Form W-2, Form 1099, or other information return indicates reasonable cause and good faith, provided the taxpayer did not know or have reason to know that the information was incorrect. Generally, a taxpayer knows, or has reason to know, that the information on an information return is incorrect if such information is inconsistent with other information reported or otherwise furnished to the taxpayer, or with the taxpayer’s knowledge of the transaction. This knowledge includes, for example, the taxpayer’s knowledge of the terms of his employment relationship or of the rate of return on a payor’s obligation.

IRM 20.1.1.3.2 (Reasonable Cause)

1. 1. 1. Reasonable cause is based on all the facts and circumstances in each situation and allows the IRS to provide relief from a penalty that would otherwise apply. Reasonable cause relief is generally granted when the taxpayer exercised ordinary business care and prudence in determining their tax obligations but was nevertheless unable to comply with those obligations.

      2. In the interest of equitable treatment of the taxpayer and effective tax administration, the non-assertion or abatement of certain civil penalties based on reasonable cause or other relief provisions provided in this IRM must be made in a consistent manner and should conform with the considerations specified in the IRC, Treasury Regulations (Treas. Regs.), policy statements, and IRM Part 20.1, Penalty Handbook.

      3. Reasonable cause relief is not available for all penalties; however, other exceptions may apply.

         • For those penalties where reasonable cause can be considered, any reason which establishes that the taxpayer exercised ordinary business care and prudence, but nevertheless was unable to comply with a prescribed duty within the prescribed time, will be considered.

         • If a reasonable cause provision applies only to a specific IRC section, that reasonable cause provision will be discussed in the IRM 20.1, Penalty Handbook, section relating to that specific IRC section. See IRM 20.1.1.1.2, Authority, and Exhibit 20.1.1-1, Penalty Relief Application Chart.

         • When considering the information provided in the following subsections, remember that an acceptable explanation is not limited to those given in IRM 20.1. Penalty relief may be warranted based on an “other acceptable explanation,” provided the taxpayer exercised ordinary business care and prudence but was nevertheless unable to comply within the prescribed time. See IRM 20.1.1.3.2.2, Ordinary Business Care and Prudence.

      4. The wording used to describe reasonable cause provisions varies. Some IRC penalty sections also require evidence that the taxpayer acted in good faith or that the taxpayer’s failure to comply with the law was not due to willful neglect. See specific IRM 20.1, Penalty Handbook, sections for the rules that apply to a specific IRC penalty section. See IRM 20.1.1.1.2, Authority.

      5. Taxpayers have reasonable cause when their conduct justifies the non-assertion or abatement of a penalty. Each case must be judged individually based on the facts and circumstances at hand. Consider the following in conjunction with specific criteria identified in the remainder of this subsection:

         • What happened and when did it happen?

         • During the period of time the taxpayer was non-compliant, what facts and circumstances prevented the taxpayer from filing a return, paying a tax, and/or otherwise complying with the law?

         • How did the facts and circumstances result in the taxpayer not complying?

         • How did the taxpayer handle the remainder of their affairs during this time?

         • Once the facts and circumstances changed, what attempt did the taxpayer make to comply?

           • Reasonable cause does not exist if after the facts and circumstances that explain the taxpayer’s noncompliant behavior cease to exist, the taxpayer fails to comply with the tax obligation within a reasonable period of time.

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