CPA REG: IRS Penalties and Procedures

IRS Penalties and Procedures for the CPA REG Exam

Tax penalties and IRS procedures are a significant portion of the REG exam. Candidates must understand the various civil penalties imposed on taxpayers and tax return preparers, the procedural framework for audits and appeals, and the criminal penalties for tax fraud and evasion.

Failure-to-File Penalty (IRC Section 6651(a)(1))

The failure-to-file penalty is 5% of the net tax due per month (or partial month), up to a maximum of 25%. If the return is more than 60 days late, the minimum penalty is the lesser of $485 (adjusted for inflation) or 100% of the tax due. The penalty is reduced by any failure-to-pay penalty for the same month. The penalty does not apply if the failure is due to reasonable cause and not willful neglect. Filing an extension avoids the failure-to-file penalty but does not extend the time to pay.

Failure-to-Pay Penalty (IRC Section 6651(a)(2))

The failure-to-pay penalty is 0.5% of the unpaid tax per month, up to a maximum of 25%. The rate increases to 1% per month if the IRS issues a notice of intent to levy and the taxpayer does not pay within 10 days. The rate decreases to 0.25% per month if the taxpayer has filed a timely return and entered into an installment agreement. When both the failure-to-file and failure-to-pay penalties apply for the same month, the failure-to-file penalty is reduced by the failure-to-pay amount, resulting in a combined 5% per month.

Accuracy-Related Penalties (IRC Section 6662)

A 20% penalty applies to the portion of an underpayment attributable to negligence or disregard of rules, substantial understatement of income tax, substantial valuation misstatement, overstatement of pension liabilities, or substantial estate or gift tax valuation understatement. Negligence means any failure to make a reasonable attempt to comply with the tax law. A substantial understatement exists when the understatement exceeds the greater of 10% of the correct tax or $5,000 ($10,000 for corporations).

The substantial understatement penalty can be avoided by disclosing the position on the return (if there is a reasonable basis for the position) or by demonstrating substantial authority for the position (a standard above reasonable basis but below more likely than not). The penalty may also be waived if the taxpayer acted in good faith and there was reasonable cause.

A 40% penalty applies for gross valuation misstatements (where the claimed value is 200% or more of the correct value for overstatements, or 40% or less of the correct value for understatements).

Fraud Penalty (IRC Section 6663)

The civil fraud penalty is 75% of the portion of the underpayment attributable to fraud. The IRS bears the burden of proving fraud by clear and convincing evidence. Once the IRS establishes fraud for any portion of the underpayment, the entire underpayment is presumed fraudulent, and the burden shifts to the taxpayer to prove otherwise. The fraud penalty and the accuracy-related penalty cannot both apply to the same portion of an underpayment.

Estimated Tax Penalty (IRC Section 6654)

Individual taxpayers must make estimated tax payments if they expect to owe $1,000 or more. The penalty for underpayment of estimated tax is calculated at the federal short-term interest rate plus 3 percentage points. The penalty does not apply if the taxpayer pays through withholding and estimated payments at least 90% of the current year's tax or 100% of the prior year's tax (110% if AGI exceeds $150,000). Corporations must pay at least 100% of the current year's tax in estimated payments.

Tax Return Preparer Penalties

IRC Section 6694 imposes penalties on tax return preparers. A penalty of the greater of $1,000 or 50% of the income derived from the return applies for understatements due to unreasonable positions. An unreasonable position is one without substantial authority (or without adequate disclosure and a reasonable basis for disclosed positions, or without a more-likely-than-not standard for tax shelters). A penalty of the greater of $5,000 or 75% of the income derived applies for understatements due to willful or reckless conduct.

Additional preparer penalties under IRC Section 6695 include penalties for failure to furnish a copy of the return to the taxpayer, failure to sign the return, failure to include the preparer's identification number, failure to retain copies, and failure to file correct information returns.

IRS Audit and Appeals Process

The IRS selects returns for audit through various methods, including the Discriminant Index Function (DIF) score. There are three types of audits: correspondence (conducted by mail), office (conducted at an IRS office), and field (conducted at the taxpayer's place of business). After an audit, the taxpayer receives a report with proposed changes. If the taxpayer disagrees, they may request a conference with the IRS Appeals Office, which has authority to settle cases based on litigation hazards.

If the taxpayer cannot resolve the dispute through appeals, they may petition the U.S. Tax Court (before paying the tax), pay the tax and sue for a refund in the U.S. District Court or the U.S. Court of Federal Claims, or in certain cases use the Tax Court's small case procedure for disputes under $50,000.

Exam Tips

• Know the rates and caps for failure-to-file (5%, max 25%) and failure-to-pay (0.5%, max 25%)
• The accuracy-related penalty (20%) and fraud penalty (75%) cannot both apply to the same underpayment
• Substantial understatement is the greater of 10% of correct tax or $5,000
• Preparer penalties have different thresholds for unreasonable positions versus willful conduct
• Tax Court does not require prepayment; District Court and Court of Federal Claims do