IRS Tax Penalty Forgiveness: Challenge Of Proving “Reasonable Cause”

Tax penalties can be a harsh reality for many taxpayers, especially those dealing with complex international tax obligations. The IRS imposes penalties to encourage compliance and deter negligence. This article provides a general overview of commonly encountered tax penalties, and then delves into the often-misunderstood penalty relief, “reasonable cause.”

Overview Of Tax Penalties

Tax penalties can arise in various situations, from late filings to underpayments of tax. One common penalty is the “accuracy-related penalty”, which can apply when a tax underpayment is due to negligence or disregard of IRS rules and regulations. This penalty is typically 20% of the underpaid tax, but if the underpayment is related to an undisclosed foreign financial asset (such as stock in a non-US company), the penalty increases to 40%.

For taxpayers with international ties, penalties for failing to file foreign-related information returns (even if no tax understatement is involved) can be especially severe. For instance, failing to timely file Form 5471 (for ownership in a foreign corporation) or Form 8865 (for ownership in a foreign partnership) can result in a $10,000 penalty per return. This penalty increases by an additional $10,000 per month if the failure continues after IRS notification. In some cases, penalties can be based on a percentage of the transaction or asset, such as the 25% penalty on the value of a foreign gift or bequest when a taxpayer fails to file Form 3520 reporting it.

Reasonable Cause Penalty Relief

While the penalties can be severe, taxpayers may be able to argue that the tax noncompliance should not be penalized since the taxpayer has “reasonable cause” for the error or omission. While reasonable cause can be crucial for avoiding penalties, it is not easy to prove. The taxpayer must demonstrate that he exercised ordinary business care and prudence in meeting his tax obligations but nevertheless failed to meet them.

The determination is highly fact-sensitive and depends on the specific circumstances of the case. The taxpayer’s education, knowledge, and experience play a critical role in whether they are considered to have acted prudently. Factors such as serious illness, inability to obtain necessary records, reliance on a tax professional, natural disasters and others, may qualify as reasonable cause. IRS Treasury Regulations, the Internal Revenue Manual and case law all provide guidance.

Preparing a robust reasonable cause statement is not a simple matter. A statement that may win the case requires meticulous care, referencing guidance from relevant IRS materials and Treasury regulations, while specifying and paying attention to all relevant facts.

The International Taxpayer

Reasonable cause takes on particular significance for the U.S. taxpayer with non-U.S. accounts, businesses, or assets. A vast array of international foreign information returns are required of U.S persons who engage in non-U.S. transactions or have ownership interests in non-U.S. entities or other assets. These include IRS Forms 5471, 5472, 3520, 3520-A, 8938, 926, 8865, 8621, 8858 among others. Very high penalties are assessed for failing to file them, but reasonable cause can bring relief.

Demonstrating reasonable cause is not easy considering the IRS’ concerted efforts to educate taxpayers about their filing duties for offshore assets and transactions. It now expects taxpayers to have a certain degree of awareness. Professional assistance in preparing the statement is highly recommended.

Relying On Professional Advice

One of the more common arguments taxpayers make when invoking reasonable cause is that they relied on the advice of a tax professional. While this can be a valid defense, the IRS carefully scrutinizes such claims. Treasury Regulations set forth criteria to evaluate whether reliance on a professional’s advice was reasonable. Key factors include the tax professional’s qualifications and whether the taxpayer provided the professional with complete and accurate information.

In Neonatology Associates, P.A. v. Commissioner, 115 T.C. 43 (2000), aff’d 299 F.3d 221 (3rd Cir. 2002). The court formulated a three-part test to assess whether reliance on professional advice was reasonable:

1. Was the advisor a competent professional with expertise in the relevant area?

2. Did the taxpayer provide the advisor with all necessary and accurate information?

3. Did the taxpayer act in good faith, relying on the professional’s advice?

A later case applied the Neonatology Associates principles to a taxpayer who failed to properly report his ownership of a foreign corporation. IRS assessed penalties for the unfiled information return, but the court found the taxpayer had reasonable cause since he had fully disclosed the existence of this foreign company to the tax return preparers. The penalty was abated.

Avoiding Tax Penalties: Be Proactive

For the taxpayer living and working abroad, or owning non-U.S. assets, extra care must be taken choosing the right tax professional. Ultimately, the best way to avoid penalties is to be proactive and seek the right tax advice from professionals who are well-versed in U.S. international tax law. Many U.S.-based tax advisors may not have the expertise required for handling complex international issues, which can put the taxpayer at risk. Taxpayers should ensure that their advisor has the specialized knowledge necessary to handle their specific tax situation. The takeaway from case law is that taxpayers cannot blindly rely on their tax advisors or tax return preparers.

In a world of fast tax advice, it pays to slow down and seek quality counsel. Even if penalties have already been assessed, with proper representation, it may still be possible to have them abated through reasonable cause.