The failure-to-file penalty: nuances every tax practitioner should know.

Under Sec. 6651 (a)(1), late-filed (or unfiled) Federal tax returns are subject to a penalty of 5% per month (4 1/2% during any month that both the failure-to-file and failure-to-pay penalties apply), or fraction thereof, up to a maximum of 25%. The failure-to-file penalty is imposed on the "net amount due," which is computed by reducing the taxpayer's correct tax liability for the tax period at issue by the amount of tax paid on or before the date prescribed for payment of the tax (and by the amount of any credit against the tax that may be claimed on the return). Sec. 6151(a) provides that, as a general ride, the payment due date is the same as the due date for filing the return, determined without regard to any extension of time for filing the return.

Accordingly, as most practitioners know, returns that are filed late, but which show no tax due in excess of the taxpayer's withholding and/or estimated tax payments (and applicable credits), are not subject to the Sec. 6651(a)(1) late-filing penalty, since there is no net amount due on which such penalty can be imposed.

* Pitfall # 1: The late-filing penalty, however, will be asserted by the IRS if the correction of a mathematical or clerical error on a delinquent return results in net tax due or, more importantly, if on examination the Service proposes adjustments that create a deficiency in tax exceeding the overpayment shown on the return. (It should also be noted that late-filed returns can result in "blown" elections, requiring the taxpayer to seek an extension of time for making the election under Temp. Regs. Secs. 301.9100-1T through -3T.)

* Pitfall #2: Because there is a common misunderstanding of what "net amount due" means for purposes of the late-filing penalty, some taxpayers and tax practitioners attempt to minimize or cut off the penalty by making one or more payments of tax, rather than expeditiously filing the delinquent return. Their intention, of course, is to reduce or eliminate the amount on which the delinquency penalty will be imposed in the second and subsequent months. However, while such payments do reduce the amount of unpaid tax on which the failure-to-pay penalty (Sec. 6651(a)(2)) is computed, they have no effect on the failure-to-file penalty. Because these payments were made after the date prescribed for payment of the tax, they do not reduce the "net amount due" on which the late-filing penalty is imposed (see Crocker, 92 TC 899 (1989)). Simply put, the failure to file a tax return can only be cured by filing it.

The situation described in pitfall #2 usually occurs when an application for an automatic extension of time to file the return (for individuals, Form 4868, Application for Automatic Extension of Time To File U.S. Individual Income Tax Return; for corporations, Form 7004, Application for Automatic Extension of Time to File Corporation Income Tax Return) is not timely filed. Note that a timely filed extension request generally provides the taxpayer with complete protection from the late-filing penalty (assuming, of course, that the return is filed on or before the extended due date). On the application for extension, the taxpayer must properly estimate its tax liability for the tax year and, in the case of a corporation, remit any unpaid amount on or before the date prescribed for payment. When the IRS processes a tax return filed pursuant to an extension, it will not automatically invalidate the extension if the return as filed reports a tax liability greater than the estimated liability shown on the request for extension, even if the discrepancy between the two amounts is substantial.

On examination, however, the Service could invalidate the extension if it determines that the taxpayer failed to make a "bona fide and reasonable" estimate of its liability based on the information available at the time the request for extension was made (Crocker, supra). Regs. Sec. 301.6651-1(c)(4)(ii) -- which provides that for purposes of the failure-to-pay penalty, reasonable cause is presumed if the amount of tax shown on Form 7004 is at least 90% of the amount of tax shown on the taxpayer's Form 1120, U.S. Corporation Income Tax Return -- is not relevant to the issue of whether ail extension of time to file is valid.