IRS Penalty Defense
- Freeman’s tax controversy and litigation practice and attorneys have been nationally and regionally recognized, including in U.S. News and World Report’s Best Lawyers in America, Chambers & Partners, and “Leading Tax Controversy Litigation Attorney of the Year” in the State of Texas.
- Freeman’s tax controversy and litigation attorneys are highly credentialed and experienced. They include a former Internal Revenue Service (IRS) trial attorney, a former clerk to the Chief Judge of the United States Tax Court, multiple tax law professors at highly-ranked and respected law schools, dual-credentialed Certified Public Accountants (CPAs), and multiple attorneys with advanced LL.M. tax degrees from the most prestigious advanced tax law programs in the United States. One-third of our attorneys are law professors at tier one law schools, effectively teaching the next generation of tax lawyers.
- Freeman regularly takes on the nation’s biggest tax litigation firms: The Department of Justice Tax Division and IRS Chief Counsel. We bring a systematic approach to tax litigation, and we are rewriting the odds in complex tax disputes, one case at a time.
IRS Civil Penalties Tax Litigation
The Internal Revenue Code (the “Code”) houses more than 150 civil penalties. And additional civil penalties exist outside of the Code. For example, Title 31 of the United States Code imposes draconian civil penalties related to FBAR filings.
IRS guidance specifically advises IRS examiners to look for and propose all appropriate civil penalties during the course of their examinations. Therefore, the IRS routinely—and sometimes even systemically—imposes civil penalties against taxpayers.
Taxpayers are not left without options. Rather, they can contest the civil penalties by properly and strategically invoking various penalty defenses. Freeman’s tax controversy and litigation attorneys are well-versed in raising these penalty defenses, including successfully having such penalties waived or abated at various stages, including IRS examination, IRS Appeals, or through Tax Court and federal court litigation, if necessary.
Failure-to-File and Failure-to-Pay Penalties
Taxpayers who file tax returns late or make late payments of tax to the IRS may be liable for late-filing and late-payment penalties. Generally, these penalties apply to a host of various tax return and tax payment obligations, including those related to individual income tax returns, corporate income tax returns, estate and gift tax returns, and employment tax returns.
The late-filing penalty is 5 percent of the amount of tax required to be shown on the return if the failure is not more than one month, increasing to additional 5 percent penalties for each subsequent month. The penalty may not exceed 25 percent in the aggregate and may be reduced to the extent that the late-payment penalty is also imposed for the same month.
The late-payment penalty is 0.5% of the amount of tax shown on the return if the failure is not more than one month, increasing to additional 0.5% penalties for each subsequent month. Similar to the late-filing penalty, the late-payment penalty may not exceed 25 percent in the aggregate.
Accuracy-Related Penalties
The Code contains a litany of civil penalties designed to ensure that taxpayers file accurate and complete tax returns with the IRS. One of the more common civil penalty provisions—section 6662—imposes an accuracy-related penalty on the portion of any underpayment of tax attributable to, among other things: (1) negligence or disregard of rules or regulations; (2) any substantial understatement of income tax; (3) any substantial valuation misstatement for income tax purposes; and (4) any inconsistent estate basis. In these cases, the civil penalty is 20% of the amount of the underpayment of tax unless any portion of the underpayment is attributable to a gross valuation misstatement, which increases the civil penalty to 40% of that same amount.
Fraud Penalties
The IRS commonly seeks to find taxpayers who are purposely filing false tax returns or fraudulently not filing tax returns at all. In these instances, the IRS may impose increased civil penalties against such taxpayers under section 6663 or section 6651(f) of the Code.
Section 6663 governs fraudulent filings. Under that provision, the IRS may impose a fraud penalty of 75% of the underpayment of tax attributable to fraud if any part of the underpayment of tax required to be shown on a tax return is due to fraud. Federal courts have held that taxpayers who file a fraudulent return may not generally cure the fraud through a later filing of a corrected amended tax return. Moreover, if the IRS can prove fraud, the statute of limitations for the IRS to make adjustments to any part of the fraudulent tax return remains open indefinitely.
Section 6651(f) governs the fraudulent failure to file a tax return. Under that provision, the IRS may impose a fraud penalty of 75% of the tax required to be shown on a tax return if the tax return is not filed with the specific intent to evade tax.
The potential for civil fraud penalties raises complex issues that require careful advice of tax counsel. In many instances, an IRS examination related to civil tax fraud may escalate to a referral for criminal prosecution.
Tax Shelter Penalties
The Code imposes certain reporting obligations on so-called “tax shelters.” For example, taxpayers who participate in a “reportable transaction” must generally file IRS Form 8886, Reportable Transaction Disclosure Statement. In addition, the taxpayer is required to send the same form to the Office of Tax Shelter Analysis (the “OTSA”) when the taxpayer first files the form for the reportable transaction. If the taxpayer fails to properly report the transaction, the taxpayer may be subject to a penalty under section 6707A. The section 6707A penalty is generally equal to 75 percent of the decrease in tax reflected on the return as a result of the transaction.
The types of reportable transactions include: (1) listed transactions; (2) confidential transactions; (3) contractual protection transactions; (4) loss transactions; and (5) transactions of interest. As a general matter, these types of reportable transactions are ones that the IRS has determined are subject to potential abuse or tax evasion.
International Tax Penalties
The Code and Title 31 contain civil penalty provisions for a taxpayer’s failure to properly report certain foreign transactions or holdings. In recent years, the IRS has ramped up its enforcement and compliance efforts in this area, subjecting more and more taxpayers to international tax penalties.
International tax penalties apply to the following international tax reporting forms:
- Form 5471, Information Return of U.S. Persons with Respect to Certain Foreign Corporations;
- Form 5472, Information Return of a 25% Foreign-Owned U.S. Corporation or a Foreign Corporation Engaged in a U.S. Trade or Business;
- Form 8865, Return of U.S. Persons with Respect to Certain Foreign Partnerships;
- Form 926, Return by a U.S. Transferor of Property to a Foreign Corporation;
- Form 8938, Statement of Specified Foreign Financial Assets;
- Form 3520, Annual Return to Report Transactions with Foreign Trusts and Receipt of Foreign Gifts;
- Form 3520-A, Annual Information Return of Foreign Trust with a U.S. Owner;
- FinCEN Form 114, Report of Foreign Bank and Financial Accounts.
Employment Tax Penalties
Employers are required to timely file employment tax returns (e.g., Forms 940 and Forms 941) with the IRS. In addition, they must timely remit employment taxes to the IRS. If an employer fails to meet either obligation, the Code permits the IRS to impose various civil penalties against the employer.
Under section 6656, the IRS may impose failure-to-deposit civil penalties, which relate to the deposit requirement for payment of employment taxes. Generally, the amount of the civil penalty depends largely on when the deposit is eventually made. The maximum civil penalty may be 15% of the amount of the underpayment.
The failure-to-file, failure-to-pay, and fraud civil penalties may also be imposed against employers who fail to timely file or timely pay employment taxes to the IRS.
Trust Fund Recovery Penalties
Certain persons have statutory obligations to account for, collect, and remit employment taxes to the IRS on behalf of an employer. If the person willfully fails to do so, the IRS may assess trust fund recovery penalties directly against the individual. Certain important administrative procedures are provided to individuals prior to an assessment of the trust fund recovery penalty and such individuals should ensure that they exercise these important rights. Significantly, the trust fund recovery penalty—once assessed—is not subject to discharge in bankruptcy.
Penalty Defenses
Each individual civil penalty has different penalty defenses. Stated differently, not all penalty defenses apply to all civil penalties. Accordingly, it is important to raise the proper penalty defenses with the IRS at the appropriate time.
In many penalty cases (but not all), taxpayers may raise “reasonable cause” as a defense. This defense looks at the particular facts and circumstances as to why the taxpayer failed to comply with a statutory or regulatory obligation. Because the facts and circumstances drive the analysis—i.e., whether the IRS and federal courts will accept it—taxpayers should be mindful of governing case law and IRS guidance on the issues raised in their reasonable cause defense to increase their likelihood of success in obtaining penalty relief with this defense.
Certain penalties are also subject to procedural defenses. For example, with respect to some penalties, taxpayers may raise the defense of section 6751(b), which requires the IRS to obtain managerial approval of the penalty determination.
Moreover, taxpayers should be mindful of the evidentiary burden of the particular penalty at issue. In fraud cases, the IRS must generally satisfy a higher evidentiary standard—“clear and convincing evidence”—rather than the general preponderance of the evidence standard. In these instances, taxpayers should attempt to rebut indicia of fraud through the introduction of favorable evidence. Taxpayers should also have a careful understanding of the factors that the IRS looks to when determining whether a taxpayer potentially engaged in fraud.
Representative Matters
- Obtained penalty abatement and removal of IRS penalties in excess of $14 million.
- Represented estate before IRS in having over $500,000 in late-filing and late-payment penalties removed.
- Represented client in Tax Court proceedings, resulting in over $400,000 of late-filing, late-payment, and failure to make estimated tax payment penalties waived.
