IRS penalty relief: First Time Abate and reasonable cause

Of Michael's $86,000, about $9,700 was penalty and about $4,000 more was interest on that penalty. Of Anthony's original $57,000, more than $12,000 was failure-to-file penalty computed on tax he did not actually owe. For most people with a debt more than two years old, the penalty layer is the softest part of the balance, and this chapter is about how to remove it.

Expectations first. Penalties are not automatically removable, and the IRS does not remove them because you ask nicely or because paying them is hard. It removes them for two reasons: because you qualify for an administrative waiver that the IRS has decided to give to people with clean histories, or because you can show a reason for the failure that meets a legal standard called reasonable cause. The first is close to automatic if you fit. The second requires facts and documents. Both are worth pursuing, and the order matters.

First Time Abate

The IRS has a policy, not a law, called First Time Abate. If you have a clean compliance history for the three years before the year in question, the IRS will remove the failure-to-file, failure-to-pay, and failure-to-deposit penalties for that one year on request, without asking why you were late.

Clean history means no penalties of those kinds assessed in the prior three years, other than the estimated tax penalty, which does not count against you. If penalties were assessed and later removed for reasonable cause, that still counts as clean. You also need to have filed all required returns, or valid extensions, and to have paid, or arranged to pay, whatever you owe. A current installment agreement satisfies the arrangement requirement.

Nothing else is required. No story. No documentation. You call and ask, or write and ask, and if your account meets the test, the penalty is removed for that period. If the representative does not offer it, ask for it by name.

Three tactical points.

It applies to one period. If you have penalties on three years, First Time Abate removes them on one, and the IRS will apply it to the earliest year unless you specify otherwise. Specify otherwise. Pick the year where the penalty is largest. Michael's oldest year carried $5,040 of failure-to-pay penalty; his newest carried $1,530. He asked for the oldest.

The failure-to-pay penalty keeps running until the tax is paid. If you get First Time Abate on a failure-to-pay penalty while you still owe the tax, the IRS removes what has accrued so far, and then the penalty starts accruing again from that date. For maximum effect on a failure-to-pay penalty, wait until the tax for that year is paid, then request the abatement, and the whole amount comes off at once. For a failure-to-file penalty, which maxes out at five months and then stops, timing does not matter; ask whenever you like. Michael, who was going to be paying his oldest year for several more years, asked immediately and got the $4,100 that had accrued to that point rather than the eventual full amount. That was a reasonable trade for getting his payment plan approved. A taxpayer who can pay the year off first should.

The interest on the penalty comes off too. When a penalty is abated, the interest that accrued on it is reversed automatically. On an older debt this can be a quarter or more of the penalty amount itself.

First Time Abate is the most underused tool in this book. The IRS does not advertise it on notices, representatives do not always volunteer it, and taxpayers do not know to ask. If you have a clean three-year history and penalties on one year, you are leaving money on the table until you make the call.

Reasonable cause

For penalties that First Time Abate does not reach, because you used it on another year, or because your history is not clean, or because the penalty is a type it does not cover, the remaining route is reasonable cause.

The legal standard is that you exercised ordinary business care and prudence but were nonetheless unable to comply. The IRS looks at what happened, when it happened, how it prevented you from filing or paying, and what you did once the obstacle was removed. The question is not whether your situation was hard. It is whether a prudent person in your situation would also have failed to comply.

Something critical about this standard, before the part about how to meet it. "Ordinary business care and prudence" was written with a particular person in mind: someone with a bookkeeper, a preparer, a filing cabinet, and the habit of attending to deadlines. For that person, a missed return is an anomaly that needs explaining, and the standard asks for the explanation. But the people who actually miss returns and payments are disproportionately the ones without any of that: the sole proprietor doing the books at midnight, the widow who never handled the finances, the person whose life came apart in the exact month the form was due. The standard measures them against a kind of person they were never in a position to be, and then the IRS runs the request through an automated tool that the Taxpayer Advocate has criticized for denying claims a human would have granted. If a reasonable cause denial feels unjust, it may be. That is why the appeal exists, and why I will tell you below to use it.

The circumstances the IRS's manual recognizes most readily:

Death, serious illness, or unavoidable absence of the taxpayer or a member of the immediate family, during the period when the return was due or the payment was required. Linda's husband's final illness and death fall squarely here. The illness has to actually overlap the compliance failure; a hospitalization in March does not explain a return that was due the previous April.

Fire, casualty, natural disaster, or other disturbance that destroyed records or made compliance impossible. Federally declared disasters often come with automatic relief, but even outside that, a house fire that took your records is reasonable cause for the delay in reconstructing them.

Inability to obtain records despite diligent effort, where the records were necessary to file. This has to be documented: letters to the former employer, requests to the bank, and so on.

Erroneous written advice from the IRS, where you relied on it and it was wrong. Oral advice is harder to prove and the IRS gives it less weight, but a documented conversation with a date and an employee ID can help.

Reliance on a tax professional for advice about a substantive tax question, where the professional was competent, you gave them complete information, and you relied on what they told you. This does not extend to relying on a professional to file your return on time; the Supreme Court held in a case called Boyle that the duty to file is yours and you cannot delegate it. But if your preparer told you a retirement distribution was not taxable and it was, that is reliance on advice, and it can be reasonable cause for the accuracy penalty and sometimes the failure-to-pay penalty on the resulting tax.

Ignorance of the law is generally not reasonable cause, with narrow exceptions for a first-time, unusual obligation that a reasonable person could not have been expected to know about. A first-year freelancer who did not know about self-employment tax has a weak argument. A widow who was never told that her husband's retirement account would generate taxable income when she cashed it out to pay for his care has a better one, particularly combined with the death itself.

Financial hardship is complicated. It is not reasonable cause for failing to file; filing costs nothing. For failing to pay, the regulations allow relief where paying on time would have caused undue hardship, meaning more than an inconvenience, and where you made reasonable efforts to conserve assets for the tax. In practice this is granted sparingly and requires showing that the hardship was outside your control and that you paid as soon as you could. A job loss that made the tax unpayable, followed by payment or a payment plan as soon as income resumed, is the kind of fact pattern that sometimes works. Spending the money on something else and then being unable to pay is not.

What does not work

This will save you some effort.

"I did not know I owed it" is not reasonable cause. "I was busy" is not. "My business was struggling" is not, by itself. "I forgot" is not. "The preparer was supposed to file it" is not, under Boyle. "I was going through a divorce" is not, by itself, although the specific effects of a divorce on records and residence sometimes are. Anthony tried the divorce argument on two of his three years and was denied on both. First Time Abate got him the third, and the other two failure-to-file penalties stayed, recomputed on the corrected tax, which was still a large improvement over where he started.

The common thread in what does not work is that the explanation describes a difficulty without showing that the difficulty actually prevented compliance by a prudent person. The common thread in what does is a specific event, documented, that overlapped the due date and ended, after which you complied.

How to ask

For First Time Abate, call. It can be done on the phone, often in a few minutes once you reach someone.

For reasonable cause, write. A letter, or Form 843 with a letter attached. Send it to the address on the penalty notice, or if there is no notice, to the campus that handles your account.

The letter should do five things, in order. Identify the taxpayer, the tax period, and the specific penalty by name and amount. State the facts: what happened, with dates. Explain how those facts prevented you from filing or paying on time. Explain what you did to comply once you could, with dates. List the documents enclosed: the death certificate, the hospital records, the insurance claim, the letters requesting records, the professional's written advice. Keep it to two pages. Do not editorialize about the fairness of the tax system. The person reading it has forty more in the pile.

If the request is denied, you will get a letter explaining why, and you have the right to appeal to the Independent Office of Appeals. Many denials are form letters generated by the IRS's automated penalty reasonable-cause tool, which has been criticized by the Taxpayer Advocate for rejecting requests that should have been granted. An appeal puts your letter in front of a person with authority to weigh the facts. Use it.

The other penalties

The two late penalties account for most of what ordinary taxpayers pay, but a few others deserve a word.

The accuracy-related penalty can be 20 percent of an underpayment attributable to negligence or a substantial understatement, subject to the applicable rules. A CP2000 may propose a penalty; it does not itself assess the penalty or make the proposed tax a bill. Follow the notice response process while changes remain proposed. Reasonable cause and good faith may support relief, but reliance on advice is evaluated on its facts. Substantial authority and adequate disclosure have different requirements and do not defeat every type of accuracy-related penalty. Explain the applicable grounds and provide evidence rather than assuming any reasonable position guarantees relief.

The estimated tax penalty is really interest by another name and is not removable for reasonable cause in the ordinary way. It can be waived if you retired after age 62 or became disabled during the year and the underpayment was due to reasonable cause, or if a casualty or disaster made the payments impossible. Form 2210 has the waiver request. It can also be reduced by annualizing income if your income was uneven across the year.

The failure-to-deposit penalty for employment taxes is covered by First Time Abate and reasonable cause, and there is also relief for a first-time depositor who deposits late in the first quarter they were required to deposit. David's chapter.

Information return penalties, for late or missing 1099s and W-2s, have their own reasonable cause rules and a separate correction process.

Linda's penalties, and why it did not matter

Linda's two years of failure-to-pay penalties and interest came to about $6,400 of her $31,000. Her daughter prepared a reasonable cause letter around the death of her husband and the fact that no one had told her the distributions were taxable, with the death certificate and the hospital bills. It was a strong letter.

They never sent it. The effective tax administration offer was accepted first, for $6,000, which took the penalties and everything else with it. There was no point reducing a debt that was about to be compromised.

I mention this because sequencing matters. If you are going to make an offer, penalty relief first is wasted effort unless the penalty is so large that removing it changes whether the offer formula works. If you are going into a payment plan or a partial payment agreement, penalty relief first is exactly right, because it lowers the balance the plan has to cover. If you are in CNC status waiting for the clocks to run, penalty relief does not matter at all, because the whole balance expires regardless. Think about which exit you are headed for before you spend time on the penalties.

Michael's penalties

First Time Abate on the oldest year, $4,100 of penalty and about $1,100 of interest on it, obtained by phone in one call, used to make his payment plan fit within the collection deadlines. Reasonable cause on the other two years was not available; his history was no longer clean, and "the business was slow" is not a reason the IRS accepts. He paid those. They were, by then, accruing at the reduced quarter-percent rate because he was in an agreement, which was the other half of the penalty strategy, and the half most people miss.

That is the end of the ordinary options. Payment plans for people who can pay, offers for people whose numbers say they cannot, hardship status for people with nothing, penalty relief for people with a clean year or a real reason. Most readers will find their answer in one of those four.

Some will not, because the problem is not the size of the debt or the ability to pay. It is whose debt it is, or whether a court can discharge it, or whether the person on the other side of the table is about to become a federal prosecutor. Those are different problems with different rules, and they are the last chapter of Part III.

Official notice sources

IRS CP2000 series instructions and Publication 5181: tax return reviews by mail. Follow current instructions and the deadline on your actual notice.