The IRS offers a First Time Abatement (FTA) program that is intended to be, and often is, taxpayer-favorable. Nevertheless, as currently implemented, the FTA sometimes overrides the reasonable cause abatement and disadvantages taxpayers. The scope of this problem will increase dramatically if the IRS follows through with its current proposal to automatically apply the FTA. In this week’s blog, I will focus on how this systemic FTA would be implemented, how it would essentially write the reasonable cause abatement out of the law, and how a revised approach would allow taxpayers to enjoy the intended benefits of both abatements.

The First Time Abatement Provides an Important Mechanism for Penalty Relief

Occasionally, otherwise-compliant taxpayers make good faith mistakes regarding the filing of their tax return or payment of their tax obligations. Further, not all of these errors are eligible for the reasonable cause abatement provided by Internal Revenue Code (IRC) §§ 6651(a) and 6656(a). In my 2001 Annual Report to Congress, I provided the following example of this problem:

A taxpayer mailed his 2000 return on April 15 with a check for $200,000, which was in full payment of the balance due on his return. On April 20 the return was sent back to him for insufficient postage – the required postage was $1.50, but he mistakenly put $1.40 on the envelope. Subsequently he mailed the return with the required postage on April 21 but the tax return was deemed late. The taxpayer was assessed the failure to file penalty in the amount of $10,000, as well as the failure to pay penalty.

I proposed that Congress enact a “one-time-stupid-act” penalty abatement provision to address just such situations where the error in question does not qualify for a reasonable cause abatement. Shortly thereafter, the IRS adopted the FTA.

As currently administered, the IRS offers taxpayers who are subject to failure to file, failure to pay, or failure to deposit penalties an FTA of those penalties, provided that taxpayers are in compliance and have not utilized the FTA within the last three years (Internal Revenue Manual (IRM) 20.1.1.3.3.2.1). This abatement proceeds from an individual review that is triggered by a request from the taxpayer. The IRS, however, has implemented FTA so that it supplants, rather than complements, reasonable cause.

The First Time Abatement, As Currently Applied, Can Yield Inequitable Treatment of Taxpayers

If an FTA is requested (or, more likely, if the taxpayer requests reasonable cause abatement and the IRS offers FTA in response), and if the taxpayer qualifies, the FTA will be automatically granted. The FTA is applied by the IRS, however, without first looking to see if the taxpayer might be eligible for a reasonable cause abatement (IRM 20.1.1.3). This rule of precedence, also known as “stacking,” is problematic because once the IRS grants an FTA, a taxpayer does not again become potentially eligible for another three years. The IRM generally sets out the specific priority of consideration of the different reasons for abating a penalty in the following order:

1. Correction of IRS error;
2. Statutory and Regulatory exceptions;
3. Administrative waivers [including the FTA];
4. Reasonable cause.

In some situations, this stacking rule can result in disparate treatment of taxpayers. For example, assume that a taxpayer files a late return in year one for reasons that would qualify for a reasonable cause abatement, as well as for the FTA. Assume further that in year three, the taxpayer is subject to a late payment penalty for reasons that do not meet the reasonable cause standards. In this scenario, under the IRS stacking rules, the taxpayer would receive the FTA in year one but would be afforded no relief in year three.

By contrast, if the IRS considered reasonable cause, which is a statutory remedy, prior to application of FTA, the taxpayer would have received the reasonable cause abatement in year one. This approach would have preserved eligibility for the FTA over the next three years, thus enabling its use in year three against the failure to pay penalty. Moreover, this approach adheres to the right to a fair and just tax system, which means that taxpayers should have their tax liability determined based on the specific facts and circumstances of their particular case.

Automating Application of the FTA Is a Commendable Policy, If Done Correctly

The IRS Office of Servicewide Penalties is proposing to automate application of the FTA. This step would have some tangible benefits to both taxpayers and the IRS. According to the IRS, it would likely result in the provision of an additional 1.35 million FTAs, yielding an extra $261 million in annual abatements. This computation is baffling to me. Is it that the IRS currently doesn’t have the resources to answer phone calls from taxpayers who are asking for abatements?  Or is it that many taxpayers are eligible for FTA abatements but they don’t call in to obtain them?  In either case, the automated FTA would result in more abatements. However, it begs the question of why the IRS would set up and assess penalties in the first place if they would be abated automatically later. Why not use the algorithm before issuing the penalty and save everyone a lot of angst?  Never mind.

At any rate, the IRS further estimates that it would free up approximately 99-167 personnel who could be reallocated elsewhere. In fact, I first proposed use of the systemic FTA back in 2010. As a long-time proponent of this practice, I applaud the IRS for exploring potential automation of this policy, but it must be careful to adopt the proper stacking rule so as to ensure that the automated FTA fully benefits taxpayers and does not eliminate the application of reasonable cause abatement.

First Time Abatement Automation Should Not Be Implemented in a Way That Overrides Reasonable Cause Relief

As currently conceived, the IRS’s proposal for automating the FTA would continue to mandate the application of FTA over reasonable cause, even if a taxpayer had a clear-cut case in favor of reasonable cause relief. In effect, the proposed policy would write reasonable cause out of the law for the year in which the FTA was applied. It would violate taxpayers’ right to pay no more than the correct amount of tax, right to challenge the IRS’s position and be heard, and right to a fair and just tax system. Additionally, the IRS would be elevating its own internally created remedy (i.e., the FTA) over a statutory remedy created by Congress (i.e., the reasonable cause abatement).

The IRS should develop systems that first consider eligibility for reasonable cause prior to automatic application of the FTA. While these systems are being put into place, or if they prove impracticable, the IRS could apply other policies that would continue to preserve primacy of the reasonable cause abatement. For example, the systemic FTA could be automatically applied, accompanied with the sending of a “soft letter” explaining the reasons for the abatement. Thereafter, those taxpayers believing they qualified for reasonable cause could present their cases to the IRS and, where eligible, could have reasonable cause applied in lieu of the FTA, thus preserving FTA as a future remedy. In addition, if in a later year, a taxpayer would have been eligible for FTA but for its earlier application, the taxpayer could show that he was eligible for reasonable cause abatement in the earlier year and the IRS could then grant FTA in the later year without reversing the prior year abatement. This would entail the IRS creating a systemic override for “prior year reasonable cause.”

Year 1:  Taxpayer A is eligible for reasonable cause abatement. The IRS systemically abates the penalty under First Time Abatement policy.

Year 3:  Taxpayer A is not eligible for reasonable cause abatement but would qualify for FTA if it had not been used for Year 1 penalty abatement. Taxpayer successfully demonstrates eligibility for reasonable cause abatement for Year 1, and IRS grants FTA for Year 3.

I acknowledge that this approach is a Rube Goldberg contraption – but I am only proposing it in response to the IRS implementing a policy that all but ensures do-overs and complicated maneuverings in order to get the correct legal answer. The IRS has opposed our proposal, however, arguing that it would require additional resources and would nullify some of the desired savings from adoption of the systemic FTA. Resource maximization, however, is not an acceptable justification for overriding taxpayer rights – particularly those, like reasonable cause, which are explicitly provided for in the Internal Revenue Code.

The IRS should implement the program in a way that is fair for all taxpayers and that allows the consideration of reasonable cause before the FTA is irrevocably applied. Such an adjustment would have an incremental cost to the IRS, but would result in a redesigned program of which the IRS can be proud, and that demonstrates to taxpayers that the IRS genuinely has their best interests at heart. Programs such as these develop trust in the tax system and reinforce the IRS’s legitimacy, which is crucial for the successful function of the voluntary tax system. FTA can be systemically applied in a way that respects the law and taxpayer rights, while minimizing resources. As it stands now, the IRS is not doing this.