- Written by Sidney Kess, CPA, J.D., LL.M.
Actions, or inactions, can trigger tax penalties; these penalties can be substantial. Some penalties can be abated under certain circumstances; other penalties can be avoided entirely if proper action is taken.
Joint and Several Liability
Husbands and wives who file joint returns are jointly and severally liable for the tax, interest and penalties related to the returns. However, one spouse can avoid this liability by claiming innocent spouse relief (Code Sec. 6015).
There are three types of innocent spouse relief:
- Basic innocent spouse relief, whether married or now divorced (Code Sec. 6015(b)). The innocent spouse must show that the understatement is due to the other spouse, that he/she had no knowledge of or reason to know of the understatement and did not benefit from it (i.e., it would be inequitable to hold such spouse liable).
- Separate liability for former spouses where one spouse can avoid or limit liability to his/her allocable share (Code Sec. 6015(c)).
- Equitable relief where it is inequitable to hold one spouse liable, given the facts and circumstances (Code Sec. 6015(f)).
To claim innocent spouse relief, an election must be filed no later than two years from the date that the IRS first began collection activities. This is done by filing Form 8857, Innocent Spouse Relief.
The Tax Court had concluded that regulations enforcing the two-year rule in the case of equitable relief were invalid (Lantz, 132 TC No. 8 (2009); the Seventh Circuit, however, recently reversed this holding (CA-7, USTC ¶50,446). Thus, a claim for equitable relief from liability on a joint return can be considered only if the request is timely filed (i.e., within the two-year period).
Innocent spouse relief is discretionary with the IRS; the IRS can even reverse an initial grant of relief (Chief Counsel Advice Memorandum 200802030). The U.S. Tax Court has jurisdiction to review a denial of innocent spouse relief.
Individual income tax returns that are not filed by the due date (or extended due date if applicable) are subject to a penalty of 5% of the amount of tax shown on the return, up to a maximum of 25% (Code Sec. 6651(a)). If the return is more than 60 days late, the penalty is not less than the lesser of $135 or 100% of the tax due on the return (prior to 2009, it was $100 or 100% of the tax due; Heroes Earnings Assistance and Relief Tax Act of 2008; P.L. 110-245).
The penalty can be waived if it can be shown that the failure was due to reasonable cause and not to willful neglect. The law and regulations do not define reasonable cause, but the Internal Revenue Manual (Handbook) provides some guidance (I.R.M. 18.104.22.168.1.2, February 2008). For example, the Manual recognizes that a taxpayer has an obligation to make reasonable efforts to determine tax rules (including filing returns); in effect, ignorance of the law usually is not an excuse for nonfiling or late filing. However, depending on the circumstances, valid excuses may include health problems of the taxpayer or family member, a death in the family or reliance on the advice of a tax advisor or IRS employee.
Excuses that will not result in a penalty waiver include:
- Illness or death of the taxpayer’s accountant (see e.g., Gale, TC Memo 2002-54; Frank, TC Memo 1982-214).
- Failure to obtain advice (see e.g., Sparkman, TC Memo 2005-136, aff’d on other issues, CA-9, 2008-1 USTC ¶50,102).
Individual income taxes operate on a “pay as you go” system. This requires individuals to pay their taxes through withholding on wages and certain other income and/or quarterly estimated taxes. If there is an underpayment because estimated taxes are not paid at all when they should be or are paid but in insufficient amounts (below “safe harbors”), a penalty results (Code Sec. 6654).
The IRS has discretion to waive the penalty if:
- The failure to make estimated payments is caused by a casualty, disaster or other unusual circumstance, and it would be inequitable to impose the penalty, or
- The taxpayer has retired (after reaching age 62) or becomes disabled during the tax year for which estimated payments were required to be made or in the preceding tax year (Code Sec. 6654(e)(3)). In this instance, the underpayment must be due to reasonable cause and not to willful neglect.
Sometimes, special waivers are granted by the IRS or through legislation because of new tax rules or for other reasons. For example, the IRS said it would not impose underpayment penalties on 2009 income tax returns resulting from the making work pay credit (www.irs.gov/newsroom/article/0,,id=218941,00.html).
Early Withdrawals from Qualified Plans and IRAs
Those who take money from these retirement accounts before age 59½ usually are subject to a 10% early distribution penalty (Code Sec. 72(t)). Thus, in addition to regular taxes on the distributions, there is also a penalty. The penalty can be avoided in a number of circumstances.
Some penalty exceptions apply to both qualified retirement plans and IRAs, some apply only to qualified plans or to IRAs.
Penalty exceptions applicable to both qualified plans and IRAs: distributions on account of death, disability, part of a series of substantially equal periodic payments, medical costs exceeding 7.5% of adjusted gross income qualified reservist distributions or levy by the IRS. From time to time, there may be an exception created for qualified disaster distributions, as was the case with Hurricanes Katrina, Rita and Wilma in 2005 and the Midwestern storms and flooding in 2008.
Penalty exceptions applicable only to qualified plans: distributions following separation from service at age 55 or older and payments to alternate payees (such as former spouses) under qualified domestic relations orders (QDROs). Distributions from a state or local pension plan to a public safety officer after reaching age 50 are also exempt from penalty.
Penalty exceptions applicable only to IRAs: distributions for first-time home-buy costs up to $10,000, higher education costs, payments of health insurance premiums by certain unemployed individuals and transfers incident to divorce.
There is no exception to the penalty from qualified plans or IRAs for financial hardships (see e.g., Dollander, TC Memo 2009-187; Venet, TC Memo 2009-268). Thus, while a 401(k) plan may permit a withdrawal on account of financial hardship prior to age 59½, such distribution is taxable and subject to the 10% early distribution penalty.
Those who are at least age 70½, as well as beneficiaries, of qualified plans and IRAs who do not take sufficient distributions from these accounts to meet required minimum distribution (RMD) rules are subject to a 50% penalty (Code Sec. 4974). The penalty is 50% of the amount that should have been distributed compared with what, if any, has been distributed.
The RMD rules were suspended for 2009 to give taxpayers an opportunity to have their accounts recover from the stock market collapse (Worker, Retiree, and Employer Recovery Act of 2008, P.L. 110-458); the RMD rules have not been suspended for 2010. There is a special rule for individuals who turned age 70½ in 2009. Normally, their first RMD would be April 1, 2010. However, because of the 2009 suspension, their first RMD deadline is December 31, 2010.
The penalty can be waived by requesting IRS relief, which will be granted if there is reasonable cause for the insufficient withdrawal and steps are being taken by the taxpayer to remedy the situation. The IRS instructs taxpayers to request relief by filing Form 5329, Additional Taxes on Qualified Plans (Including IRAs) and other Tax-Favored Accounts. Enter “RC” on the line next to the penalty, along with the amount to be waived; this reduces the amount of the penalty owed. A letter of explanation should accompany the form. If the IRS does not approve of the excuse, it will send a bill for the additional penalty.
Sidney Kess, CPA, J.D., LL.M., has authored hundreds of books on tax-related topics. He probably is best-known for lecturing to more than 700,000 practitioners on tax and estate planning.
A penalty exception for early withdrawal available to both IRAs and qualified plans is financial hardship: True or False
There is no exception to the penalty, according to TC Memo 2009-268. Disaster relief is the penalty exemption for both IRAs and qualified plans.