The IRS does abate penalties provided you can prove reasonable cause. Establishing reasonable cause is very much a hit-or-miss proposition. However, there is a more effortless penalty abatement procedure if you can qualify.
First Time Abate or FTA will automatically remove the Failure to File, Failure to Deposit, and Failure to Pay penalties for those who have a good record of compliance. A good record of compliance has the following requirements:
- All current-year tax returns have been filed or are on extension.
- Have paid all past year’s taxes or are on a payment plan.
- Have filed the same type of tax return, if required, for the past 3 tax years before the year to be abated.
- Did not receive any penalties for the past 3 tax years before the year to be abated.
Now comes the hard part, how to apply:
- Just call them up and get abated over the phone.
- Mail a Form 843 Claim for Refund and Request for Abatement.
I have found that most IRS people will wipe out the penalties without an argument over the phone. The problem is that it takes hours to get one of them on the phone. It’s far easier to file Form 843, which takes less than 10 minutes than to deal with the IRS phone system. The downside to the mailing is that they are also very inefficient in processing paper returns. So, expect six months minimum of waiting for an answer.
The Inflation Reduction Act (which apparently has nothing to do with inflation) included $79.6 billion more dollars for the IRS over the next 10 years. This has created a lot of commotion along the lines that IRS auditors are going to be everywhere.
Let me point out a few things that should reduce anybody’s anxiety over this concern:
- The spending increase is over the next 10 years during which the baby boomers in the IRS are retiring in record numbers.
- Currently, the IRS has some 8,000 revenue agents. The headcount 10 years ago was 13,000 and in the mid-1990s it was over 15,000. The expected new hirers will bring the levels of revenue agents up to about 17,000 at the end of the 10 years.
- Training new agents will take close to one year and will require the IRS to remove some of their better agents from the field. This means everyday people are not going to see any expansion of IRS audits for the next several years.
- The federal government has rarely demonstrated the ability to be effective at anything it does. The IRS is no exception and can’t even answer their own phones.
The idea that IRS auditors are going to be banging on everybody’s door is very much overblown.
Here is the scenario. You filed your 1040 on February 1 in the hopes of getting your refund fast. Three weeks later you receive a 1099 in the mail that was not included on your return. Worse, it was for a sizable amount of money that you had assumed was non-taxable since the 1099 was not received in January. Without a doubt, the IRS is going to hit you with a balance due. What’s more, the 20% accuracy penalty is going to be assessed on top of that. Are you up the creek without a paddle?
Not necessarily. The Internal Revenue Manual 18.104.22.168.10 (03-18-2022) refers to “Superseding Returns” and defines these as either an amended return (1040-X) or a corrected (duplicate) return filed after the first return but before the April 15th due date. This IRM requires IRS employees to adjust their databases to reflect the corrected return information. (Hint: It would be a great idea to write “Superseding Return” at the top of the new tax return). The fact that you have correctly filed your return by the due date removes the potential for any penalties other than failure to pay and estimated tax penalties.
This procedure does have an important limitation. While you can correct income and deductions, you cannot modify any irrevocable elections that were made on the first return. Elections such as filing jointly are irrevocable and cannot be reversed with a superseding return.
Rumors are leaking out in the tax representation community that the IRS is finally going to do something about answering their phone. They have a pilot program running with the Practitioner Priority Service phone number that requires the caller to repeat a phrase before being placed on hold. The idea here is to ensure that it is an actual person calling rather than some auto-dialer.
I am not holding my breath on this, but this is the first action step they have taken that I have heard. It is certainly a significant economic waste to have thousands of people on hold for hours at a time.
In other news, the IRS has issued the Inflation Adjusted Numbers for 2023 in Rev.Proc. 2022-38. Running a few of the numbers on Excel shows a change of 6.9% from 2022.
Finally, there is a potentially big issue coming down the highway. PPP Loans that were improperly forgiven cannot be excluded from income according to the IRS Chief Counsel. How this will work in practice is a question. If the debt is no longer forgiven and must be paid back, it would still not be income. Presumably, the SBA would make that repayment demand as part of their determination process. The only way this would produce taxable income is that they left the loan forgiven in spite of their determination that the forgiveness was improper. That seems unlikely. Perhaps the plan is to have IRS agents make the determination of improperness as part of their audit process and not bother with foregiveness.
It’s a natural tendency to want to avoid dealing with an unpleasant task such as an IRS debt problem. After all, the IRS is not particularly speedy in most of the things they do, so ignoring them, in the beginning, is easy. But this is probably going to cost you. Waiting for that levy notice to come in the mail is going to reduce the time available for you to arrange your finances so that your payments to the government are minimized.
Why is this? Unless you qualify for a streamlined payment plan, the IRS is going to perform a financial analysis of your situation to determine how much money they should be able to collect. Basically, they are going to relate your income to what they consider to be the “reasonable” costs of living. If that cash flow projection is positive, they are going to want a deal that gives them that amount as a minimum.
Here is where the time problem comes in. Given enough time in advance of that levy notice, you can use the IRS financial analysis approach in advance to figure out what changes you can make to minimize the amount that the IRS might think of as collectible. For example, say you do not have life insurance. The IRS allowable expenses include term life insurance premiums. But, you need at least 3 months of payments to the insurance company before the IRS will include this money in their calculations. So, signing up for life insurance tomorrow is not going to work. Given enough time in advance of negotiating with the IRS could result in you having life insurance with zero difference to your cash flow.
Performing the financial analysis early allows you to develop a strategy to minimize the IRS’s impact on your life. Waiting for the levy notice is a mistake
Economic Hardship is a kind of get-out-of-jail-free card when it comes to dealing with IRS Collections Division. It can be used to get a levy released or an Offer-in-Compromise accepted if the financial analysis showed the result would place the taxpayer in an economic hardship
So, just what is an Economic Hardship? Economic hardship occurs when a taxpayer is unable to pay reasonable basic living expenses. The IRS considers the taxpayer’s equity in assets and expected cash flow to determine how much money should be available to pay their tax debts. This information is brought together with a formula that is called the Reasonable Collection Potential or RCP. Much of the “reasonableness” in the formula comes from various tables of allowed or allowable living costs.
Plug all the numbers into the RCP and if the result is positive, the IRS figures you can make payments. If the number comes out negative, then you are in an Economic Hardship situation.
This leads us to one of the major reasons for Offers-in-Compromise to fail. Nobody did the RCP analysis and instead made an offer that was unacceptable on the face of it.
A retired couple decides to liquidate some of their stock investments because they are no longer able to handle the ups and downs of the market. This action puts them into a strong and safe cash position but also produces a large tax bill. Paying that bill significantly reduces the savings they have built and depend upon for their retirement years.
They decide to make an Offer-in-Compromise with the IRS instead. The offer is rejected by the IRS because the analysis of their financial position shows that they could full-pay the debt. Is it a lost cause for this couple?
Not necessarily. The IRS can accept the Offer under Special Circumstances where the collection of the debt in full would create an “Economic Hardship”. This would be the case for the retired couple depending upon their savings for the rest of their lives.
The big factor for taxpayers hoping to have an Offer with Special Circumstances accepted is a history of compliance. Investing in dubious tax shelter schemes, repeated non-filing penalties, or failure to pay on a regular basis are all factors that will work against the offer. Most of these offers are in fact initially rejected by the IRS, so you can expect that a trip to Appeals is going to be part of the process.
I will discuss the meaning of “Economic Hardship” in more detail in my next post.
The IRS does have the power to have the State Department revoke your passport for owing back taxes is YES. Recently the Fifth Circuit upheld the constitutionality of the government restricting international travel for James Franklin due to back tax debts of $55,000. Mr. Franklin had claimed that revoking his passport had violated his 5th Amendment rights to due process. Luckily, the US is a big country, so you can still have some places to go while all those IRS notices are building up in your mailbox.
Revoking your passport is not the only tool in the IRS toolkit that goes beyond liens and levies. In 2014 Congress passed the Consolidated and Further Continuing Appropriations Act that prohibited federal agencies from awarding contracts or grants to contractors with any amount of delinquency in federal taxes. This law does not get used consistently, but it is another good reason to avoid getting in the hole with the IRS.
Cash flow is in the toilet, and you are past due on prior quarters’ payroll tax liabilities. You can barely cover the next payroll check run. What to do? My number one rule for having a better life is “Don’t go broke while owing the IRS for payroll taxes”. The reason is simple. They will make your life even more miserable by assessing the Trust Fund portion of the taxes on you personally. You will not be able to discharge this penalty in bankruptcy which means that the IRS will be after you for the next 10 years.
Must Do Steps
Step Number One is you need a new business plan, and you need it fast. Moreover, it must be a real plan that shows a clear path to cash flow and profitability. If you can’t produce this plan, it’s time to shut the business down. Either go back to being a sole proprietor without employees or move on to something better. Digging the hole deeper is a bad bet.
Step Number Two is to reduce the liability for the Trust Funds portion of the payroll tax liabilities. Assuming the business is being taxed as a corporation, transfer whatever cash is available to the owner and let them make a voluntary payment to the IRS for the payroll taxes. The owner needs to pay the IRS by check along with a letter that designates that the payment is to be applied to the “Trust Funds Only” for each outstanding liability period under Rev. Proc. 2002-26. Eliminating the trust fund portion of the tax debt eliminates the possibility of the Trust Fund Recovery Penalty being assessed on the owner individually.
Staying in Business
Here are a couple of ideas if the business is going to continue:
- The business should immediately set up a payment plan to cover the balance of the payroll taxes owed. Do not wait for the IRS to contact you. Things will not get better with a Revenue Officer assigned to your case.
- Make future payroll tax deposits on the same day that you pay the employees. Your payment plan will automatically be in default if you do not make all tax deposits timely. It is critical that you don’t let this get away from you.
The great thing about the American Economic System is that you are allowed to fail and go on to other things. However, a payroll tax liability that is perhaps in the hundreds of thousands is going to make that recovery ever so much harder.
Companies that fail to make their payroll tax deposits will eventually be faced with dealing with IRS Collections. One of the tools that the IRS has in its arsenal is the Trust Fund Recovery Penalty which is assessed on the people responsible for not making the payments. Defending against this assessment starts with understanding who the IRS will consider to be a responsible person.
The IRS considers a responsible person to be anybody who is accountable for collecting OR paying the payroll taxes and who then willfully fails to do so. “Willful” sounds like a possible out if your cash flow is in the toilet, but it’s not. Paying other bills before the IRS is considered evidence of willfulness.
Typically, the IRS will assess people in the following positions:
- The owner/operator – There is no out for anybody in this position. Even if you did not know the taxes were not being paid, the courts have held that you should have.
- Other officers of the corporation if they had signature authority on bank accounts and knew that the payroll taxes were not being paid.
- Accountants that had signature authority on bank accounts and signed the payroll tax returns.
- Lenders who have funded payrolls in the amount that only covers the employees’ net paycheck. The theory here is that they knew the company owed the funds and could have required them to borrow enough to pay the taxes.
The best defense for anybody in these positions, other than the owner, is to not have signature authority on any business bank accounts. The ultimate responsible person is always the top guy or gal. Business owners and CEOs cannot delegate this responsibility away.
My next post will cover some strategies for dealing with a potential Trust Fund Recovery Penalty.