Taxing Definitions

Definition — Estimating the Penalty

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When you think of getting a penalty abated, you probably immediately think of “reasonable cause.” That’s the term for requesting relief from tax code penalties when you exercise ordinary care in complying with tax law, and your actions were not due to willful negligence.

However, reasonable cause is not a pass for escaping all penalties in the tax code. For example, the penalty for failing to pay estimated tax (section 6654) has only one exception for reasonable cause or lack of willful neglect. To benefit, you must also be either be newly retired or disabled.

There are other statutory exceptions for the estimated tax penalty, such as when the tax you owe is less than $1,000 or when you owed no tax the year before. In addition, casualties and disasters will get you a waiver.

There’s also a “safe harbor” provision based on your prior year tax, and you may avoid penalties for relying on erroneous written IRS advice or other unusual circumstances based on “equity and good conscience.”

Here are two situations where questions arose about abating estimated tax penalties.

1.

In T.C. Memo. 2012-131 (Farhoumand), the taxpayer argued that he qualified for a waiver from the underpayment of estimated tax penalty on his 2000 federal income tax return.

The taxpayer claimed he had negative cash flow every quarter and had no money to pay estimated tax. He believed “the bursting of the Dot-Com bubble in 2000”, which was one of the “most momentous” collapses in stock market history, qualified as an unusual circumstance.

Though he had taxable income, “[o]n a profit and loss basis * * * losses exceeded income by $2,000,000.” Because of the continuous losses, he assumed he had no income and would not owe any income tax for 2000. However, during the return preparation process, the taxpayer found out he was permitted to deduct only $3,000 of the capital loss.

His argument: Imposition of the addition to tax would be against equity and good conscience. Although section 6654(a) contains no reasonable cause exception, an honest mistake as to tax liability qualifies as reasonable cause for other penalties. Therefore the imposition of the estimated tax penalty would be against equity and good conscience.

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The case: T.C. Memo. 2012-131 (Farhoumand)

2.

Back in 1999, Roth IRAs were still new. They’d just been created in the Taxpayer Relief Act of 1997, 1998 was the first year the accounts were available, and the IRS issued final regulations in February 1999. Taxpayers were confused by the new rules, and many failed to include in estimated tax calculations the additional income generated by conversions from traditional IRAs to Roths.

The Brookhaven IRS campus received a significant number of requests for abatement of the estimated tax penalty. The associate counsel asked for advice from the office of chief counsel: Could the IRS abate the estimated tax penalties when the penalties were based upon the additional income reported for the taxable year pursuant to a roll-over from a traditional IRA to a Roth IRA?

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The memo: Number 200105062

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Right answer!
For the IRS.

Even if the taxpayer did not know about the limitations on deductibility of capital losses, as of the time when each payment of estimated tax was due he did not know whether he would have income or a loss for the full year. He had no way of predicting whether he would be able to recoup losses by year-end, and he continued his investment activity, presumably with the hope of a market turnaround.

We also reject the taxpayer’s argument that he had no money to pay estimated tax because he used money to pay for stock losses. He did not pay for stock losses, as he claims. He incurred losses upon selling shares he owned. Yet he continued to purchase other stocks, instead of using the sale proceeds to pay estimated tax.

In addition, the taxpayer’s estimate that he owed no tax for the taxable year is irrelevant because the code does not provide for the reasonable cause defense for the section 6654(a) addition to tax, nor would the imposition of the addition to tax be against equity and good conscience under the circumstances of this case.

Lastly, we disagree that the stock market volatility is an unusual circumstance. Accordingly, we conclude that the taxpayer does not qualify for a waiver under section 6654(e)(3).

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No, the waiver provisions do not apply.

The regulations expressly provide that any amount that is converted to a Roth IRA is includible in gross income. Therefore, the conversion from a traditional IRA to a Roth IRA constitutes a taxable distribution of income to the taxpayer seeking such conversion.

Absent a waiver, a taxpayer who converts from a traditional IRA to a Roth IRA must include the income realized as a result of the conversion in his or her estimated tax calculations. The circumstances under which the estimated tax penalty may be waived are found at § 6654(e)(3) of the code. Section 6654(e)(3) limits the waiver of the estimated tax penalty to those situations in which the underpayment is the result of “casualty, disaster, or other unusual circumstances.”

The waiver provisions do not apply to the present situation. Therefore, because the conversion from a traditional IRA to a Roth IRA constitutes a taxable distribution of income which must be included in a taxpayer’s estimated tax payments, the IRS may not abate the estimated tax penalty if the underpayment is the result of the conversion from a traditional IRA to a Roth IRA.

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