Why Companies Should Always Contest IRS Tax Reporting Penalties

Michael Chittenden and Michael Lloyd, or Mike & Mike, specialize in helping companies deal with all sorts of tax issues, including tax reporting. They will speak at GCS Intelligent Reporting in San Antonio about seeking abatement of IRS penalties. Sovos sat down with both to discuss why companies should generally challenge IRS tax reporting penalties.   

Michael Chittenden specializes in tax and employee benefits, the Foreign Account Tax Compliance Act (FATCA), information reporting (e.g., Forms 1095, 1096, 1098, 1099, W-2, 1042, and 1042-S) and withholding, payroll taxes, and fringe benefits. 

Michael Lloyd practices in the areas of tax and employee benefits with a focus on information reporting and withholding on cross-border payments (e.g., Forms 1042 and 1042-S) and Foreign Account Tax Compliance Act (FATCA), backup withholding, employment taxation, the treatment of fringe benefits, cross-border compensation, domestic information reporting (e.g., Forms W-2, 1099, 1095 series returns), penalty abatement, and general tax planning and controversy matters.

Sovos: Why is the process of abating penalties so difficult? 

Michael Lloyd: We do a lot of penalty work in a variety of areas. Taxpayers frequently are denied penalty relief at early stages before relief is ultimately granted. Penalties arise in different contexts. For information return penalties, a Notice 972CG is often issued and proposes–rather than assesses–an information return penalty. Assessment is the act of recording a liability on a taxpayer account. The Notice 972CG prompts the filer to send a response to the IRS to explain why the proposed penalties should not be assessed. Taxpayers may be initially denied after they send their first submission, but they should then often protest such a denial. 

Sovos: What are some best practices for responding to penalty notices? 

Michael Lloyd: The government often shoots first and asks questions later, so to speak. When responding to a notice proposing penalties or a notice that assesses penalties, you should view every stage of the process as a full opportunity to fully make your case to the IRS. Your first submission should not be a one-page request that includes little detail or substance. It should be a detailed, introspective submission that demonstrates the taxpayer’s focus on compliance.

The document should include a full discussion of the taxpayer’s history of compliance and a robust review of the taxpayer’s compliance activities. This goes not only for federal information returns but all aspects of federal, state, and local compliance. The taxpayer should demonstrate ordinary business care and prudence, and that, as an organization, the taxpayer conducts itself properly not just with respect to tax filings but with all compliance requirements. That way, the taxpayer better demonstrates that the event that resulted in the proposal or assessment of penalties was aberrational and that the taxpayer’s compliance levels are very high in all aspects of the business. 

Michael Chittenden: One of the things you want to do is review your transcript. When we’re preparing submissions for our clients, we get a power of attorney and look at their transcripts to see if there is a history of penalties. Smaller penalties are often seen as a nuisance, so companies pay them because they’re not much money. But when you do that, the taxpayer’s transcript may appear as though the taxpayer does not care about compliance. Then, if a large penalty is subsequently assessed, it can appear to the IRS that the penalty is justified, so the likelihood of abatement is diminished. The IRS assesses penalties to improve voluntary compliance based upon its penalty policy. When a taxpayer incurs frequent penalties, it is more difficult to challenge the penalty assessments on policy grounds. 

Sovos: What’s wrong with just paying penalties rather than taking the time to try and fight them? 

Michael Chittenden: Failing to act to refute penalties may make it seem like a taxpayer is noncompliant more often than they actually are. This can be problematic for larger penalties.  One example of penalties that should almost always be challenged are penalties for intentional disregard. There is generally no maximum for such penalties. Intentional disregard penalties can arise when a taxpayer’s Forms W-2 data does not agree with its Form 941 data. The penalty is computed based upon a 10 percent rate multiplied by the difference in wage data.  We have seen taxpayers decide to simply pay these penalties because it seemed too difficult to challenge them. The problem with that approach is that the taxpayer now has a history of intentional disregard penalties on its transcripts. 

Then imagine that in the next period, the taxpayer suffered some sort of systemic failure that prompted the maximum penalty under section 6721 of $3.3 million. The taxpayer will not only need to contest the system failure but also explain why it should not have admitted to intentional disregard in the prior period. The payment of the prior penalty makes it look like you don’t care. It’s the cost of compliance versus the cost of a penalty. You’ve determined it’s cheaper to pay the penalty. When you get hit for real, you might not be able to get out of it. 

Further, Congress has increased maximum and per-return penalties for standard penalties, so it takes fewer returns with errors to generate the maximum penalty than it did in the past. It now takes 12,131 returns filed late or with errors in order to hit the maximum in 2018. For a large organization, if there is a significant systemic problem, the taxpayer could be starting off with the maximum. 

Michael Lloyd: It’s prudent for taxpayers to really review their notices. Often, where there’s smoke, there’s fire. If you’re getting a lot of penalty notices, there may be something wrong that you need to pay attention to. As companies grow, they have more personnel to deal with issues. Ignoring penalties is just postponing a bigger problem. 

Sovos: What’s your feeling on hiring an outside vendor handle tax reporting? 

Michael Chittenden: The use of outside companies has a very positive effect on tax compliance. The IRS has recognized this for a long time. Having providers that know their stuff and have systems that are designed to provide the information the government is requesting is a net positive. When a taxpayer requests relief for reasonable cause, the IRS is not looking at your service provider. It’s looking at you as a taxpayer. The IRS would view a taxpayer with frequent failures with more of a jaundiced view than a taxpayer that uses a service provider and has a clean compliance history. 

Sovos: Does the service provider ultimately serve as a fall guy for penalties? 

Michael Lloyd: No, it should not.  Blaming a service provider for noncompliance is generally not the best approach. Most large taxpayers are careful when selecting their service providers, and they focus on the quality of those providers. This should be the focus when contesting penalties, even if the failure arose due to a failure by the provider. We tend to believe that throwing the service provider under the bus is not a good tactic because it undermines the theme of the abatement request, which is that the taxpayer conducts itself with ordinary business care and prudence. It the service provider was so awful, what did they hire them for? We tend to think that explaining the provider’s attributes demonstrates that the selection of the provider was a good decision. The vendor’s level of trust, sophistication, and compliance for all of its clients shows that the vendor and the taxpayer take compliance seriously.