Supreme Court Justice Oliver Wendell Holmes famously wrote, “Taxes are what we pay for a civilized society.” That may be true, but I can say with confidence that nobody likes paying penalties associated with those taxes. In 2017 alone, the IRS assessed 38.8 million civil penalties to the tune of $26.5 billion, according to the IRS Data Book.
Fortunately for the penalized, the IRS also abated just under $9 billion in penalties the same year — nearly a third of all penalties assessed. Today I want to walk you through one of the best ways to help get your clients’ penalties abated — First Time Abatement — and how to apply FTA strategically to save your clients the most money possible.
A quick First Time Abatement refresher
The IRS established First Time Abatement in 2001 as administrative relief for specific penalties assessed on a single return. The goal was to provide relief to people who were typically good taxpayers but had fallen behind, as well as to encourage them to return to their good tax-paying habits.
The three types of penalties that can be abated using FTA are:
• Failure to File penalty under IRC 6651(a)(1), IRC 6698(a)(1), or IRC 6699(A)(1),
• Failure to Pay penalty under IRC 6651(A)(2), and/or IRC 6651(A)(3),
• Failure to Deposit penalty under IRC 6656
Recently, the IRS has updated its stance on FTA and clarified some of the qualifications.
First, the period seeking abatement must not have had a penalty assessed in the three preceding years. Until November of 2017, the language had stated “no penalties of significance,” but it has been changed to reflect “no penalties” within the three years prior to the period seeking abatement. This eliminates the de minimis argument regarding what constitutes a significant penalty.
In conjunction, the taxpayer must be in filing compliance through submission of all required returns (or extension for all required returns) and have paid, or arranged to pay, the tax currently due.
Choosing the right year for FTA
Take our imaginary taxpayer John for example. He’s a self-employed (Schedule C filer) home remodeler. John has seen several booms and busts during his time in business — one downturn from 2008-2010 due to the recession, and one from 2014-2015 due to a personal tragedy. As a result, he neglected to pay estimated taxes and file his tax returns on time and started racking up back taxes, penalties and interest.
Recently, John realized he has to get his business in order to provide for his family and future. He has engaged a firm to represent him before the IRS in an effort to put the issues behind him. Based upon his financial standing, John doesn’t qualify for an offer in compromise or "currently not collectible" status with the IRS. His tax practitioner has negotiated an installment agreement for all periods and wants to use FTA to reduce the balance owed. In order to make sure John gets the best abatement possible, the practitioner needs to look over the penalties associated with various years and employ a bit of strategy.
As you can see, John has two years eligible for FTA but can only claim one of them. So which one?
While the penalties for 2014 as shown above are higher than the penalties for 2008, the overall amount points to 2008 as the best period to abate. That’s because when a penalty is abated, the associated interest is also removed. Therefore John and his tax professional should choose 2008, with a total abatement of $1,196.29 ($1,015.82 in penalties and $180.47 in interest) instead of the 2014 total of $1,172.72 ($1,105.25 in penalties and $67.47 in interest).
One of the most important things a tax practitioner can do for a client is to maximize the opportunities to save their client’s money. That is where the strategic approach of penalty relief comes into play. Since FTA was designed as a one-time break for otherwise compliant taxpayers, the tax professional should make it a standard operating procedure to look for an FTA opportunity and which year provides the biggest bang for the buck.