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Failure to File Penalties for Partnerships and S-Corporations; Tips to Avoid Assessed Penalties
The IRS assesses penalties for taxpayers who fail to file their tax returns in order to motivate compliance with IRS tax deadlines. In 2015, the IRS collected over $24 billion in penalties. For most taxpayers, the failure to file penalty is based on the total taxes due. However, pass-through entities such as partnerships and S-corporations may not be aware that the penalties assessed by the IRS when a business fails to file are based on the number of partners or shareholders rather than the total tax liability. For example, a partnership with 20 partners that fails to file is subject to failure to file penalties of $3,900 per month (or partial month) up to $46,800. Even if the total tax liability of the taxpayer is zero, the penalties would still apply.
In 1978, when the original legislation on failure to file penalties was passed, the maximum penalty for failure to file a partnership 1065 or S-corp 1120S return was set at $50 per partner up to 5 months or a total of $250 per partner. For many small partnerships, the cost of preparing tax returns was simply greater than the penalties that would be assessed, consequently some companies simply did not file business tax returns and reported income on their personal returns.
By 2009, the IRS began to increase the maximum penalty to $89 per partner up to 12 months for a maximum of $1,068 per partner, and finally to the current level of $195 per partner up to 12 months for a maximum per partner of $2,340. This amount was determined to be sufficient to deter the management of partnerships, joint ventures and other pass-through entities from making the cost/benefit decision to “willfully neglect” to file their partnership returns.
Should your business find itself facing failure to file penalties, there are several ways to avoid the significant penalties assessed. The penalty notice should be addressed immediately and a timely response made to all notices. Failure to respond in a timely manner could result in a loss of taxpayer rights to contest the penalties. The following are the primary methods by which a business can receive abatement or relief from these penalties.
- If the taxpayer has filed in a timely manner for the preceding three years or has not been required to file, the IRS will allow for a first time abatement. The abatement must be requested, it will not be automatically provided.
- The IRS allows for “reasonable cause” to abate the penalties. While generally successful less than 10% of the time when submitted, reasonable cause can be allowed in circumstances such as erroneous written or verbal advice from the IRS or tax experts, medical illness, act of God or financial hardship, to name a few. The initial request under reasonable cause is made to an IRS agent who uses an automated tool called the Reasonable Cause Assistant (RCA) to make initial penalty abatement determinations. This tool provides a series of reasonable cause factors that the agent will check against and ignores the full picture of the taxpayer’s circumstances. For the 90%+ of taxpayers who are denied the reasonable cause abatement, a secondary request to the appeals division for a more extended evaluation of the taxpayer circumstances is necessary.
- If the taxpayer fails on a first time abatement and reasonable cause abatement, there is a carve-out for small partnerships under Revenue Procedure 84-35. In 2001, the Pacific-Northwest Citizen Advocacy Panel argued that small partnerships are assessed the penalty unfairly and contrary to the Congressional intent to treat small partnerships more leniently than large partnerships. 84-35 was revised to include six criteria that when met, will establish reasonable cause:
-The partnership has to be a domestic partnership,
-Must have 10 or fewer partners (husband and wife and their estate are treated as one partner),
-all partners have to be natural persons (other than a nonresident alien) or an estate of a deceased partner,
-each partner’s share of each partnership item has to be the same as their share of every other item,
-all partners need to have filed their income tax returns timely, and
-all the partners need to have fully reported their share of the income, deductions, and credits of the partnership on their timely filed income tax returns.
Knowing the basics of what abatement or relief is available will assist taxpayers in developing the most appropriate request for abatement to the IRS when failure to file penalties are assessed. Being patient, maintaining good records and documentation is essential to have a favorable outcome.