Dishonored check and payment penalty (IRC 6657): amounts, electronic payments and relief

How much the penalty is

IRC 6657 imposes a penalty, payable on notice and demand in the same manner as tax, equal to 2 percent of the dishonored instrument, “except that if the amount of such instrument is less than $1,250, the penalty under this section shall be $25 or the amount of such instrument, whichever is the lesser.” IRM 20.1.10.7.1 states the amounts as a schedule:

Earlier periods used different numbers (for example, $750 and $15 for payments between November 10, 1988 and May 25, 2007), which matters only for old modules. The current figures apply to transactions after May 25, 2007, and to electronic payments for transactions after July 1, 2010.

The penalty is separate from, and in addition to, everything that follows from the payment not counting. The statute says it applies “in addition to any other penalties provided by law”. Interest on the penalty itself runs from notice and demand only if it is not paid within 21 calendar days, under the general rule in IRC 6601(e)(2)(A).

Which payments are covered

Before July 2, 2010, the penalty applied only to checks and money orders. The Homebuyer Assistance and Improvement Act of 2010 amended IRC 6657 to cover any “instrument in payment, by any commercially acceptable means, of any amount.” IRM 20.1.10.7 lists what that includes:

• paper checks and money orders;
• EFTPS payments and deposits, and other electronic funds transfer payments and deposits;
• direct debit installment agreement (DDIA) payments;
• electronic bill payments;
• federal payment levy program payments;
• same day wire payments;
• credit card and debit card payments.

A paper check that the IRS converts to an electronic item under its remittance strategy for paper check conversion is still treated as a paper check for this purpose, and is penalized if returned unpaid (IRM 20.1.10.7.5). Generally, the IRM notes, bad check penalties are not assessed on items with a stop payment, although stop payment situations have their own relief rules discussed below.

How the penalty posts and what it does to the account

When a payment is dishonored, the IRS reverses it with a dishonored payment transaction code (TC 611, 621, 641, 651, 661, 671, 681, 691 or 721), and the original credit is marked as reversed. The posting of that reversal generates the penalty systemically as TC 286; a manually computed penalty posts as TC 280. On an account transcript, a payment followed by its reversal and a TC 286 tells the story. The transcript code decoder lists the codes.

The reversal is the bigger problem. The liability the payment was supposed to satisfy is open again, so depending on what the payment was for:

• a balance due payment that bounces leaves the tax unpaid, and the failure-to-pay penalty and interest continue to accrue;
• a federal tax deposit that bounces is a deposit that was not made, which exposes the employer to the failure-to-deposit penalty on top of the 6657 penalty;
• a direct debit installment agreement payment that bounces is a missed installment payment; see installment agreements for what the IRS does with missed payments.

IRM 20.1.10.7.2 says the taxpayer receives a notice of the dishonored payment and any penalty and interest, and describes the notice as one that “acts to educate the taxpayer and encourage future compliance.” If a payment was only partly dishonored because of an encoding error, the IRM says a dishonored payment code should not have been used at all, and any penalty that resulted is abated as IRS error.

Relief and what the IRS accepts

The statute has its own exception: the penalty does not apply “if the person tendered such instrument in good faith and with reasonable cause to believe that it would be duly paid.” The IRM adds procedural limits that make this a paper exercise:

The IRM recognizes these grounds, with the documentation each needs:

On that last row, IRM 20.1.10.7.3 lets employees abate without any written communication when research shows the penalty should not have been assessed in the first place, citing IRC 6404(a)(3), and gives as examples errors from misunderstanding website instructions, a data entry error on an online form, and duplicate transactions. Representatives can point the employee to the facts on a call, but should be ready to follow up in writing if the employee cannot confirm them from the account.

General reasonable cause under IRM 20.1.1.3 is also available, but because of the written-documentation rule, it has to be supported on paper. See the reasonable cause guide.

If relief is granted, the penalty is abated with TC 281 and the taxpayer is told by notice, Letter 608-C or phone. If the information is incomplete, the IRS uses Letter 608-C to ask for more. If relief is denied, the IRS sends Letter 854-C or an equivalent with appeal rights; see appealing a denial.

Responding to a dishonored payment notice

1. Find out why the payment was returned: insufficient funds, closed account, a bank or EFTPS processing error, a stop payment, or an IRS posting error. Get the bank's return reason in writing.
2. Make the payment again by a method that will clear, for the amount that was dishonored. The IRS page on this penalty tells taxpayers disputing a bank error to send a letter with payment for only the amount of the payment owed.
3. If the bank or the payment processor erred, get a letter from them stating the funds were available and explaining the error.
4. Send a signed written statement explaining why the penalty should be removed, with the bank letter, bank statements or incident report, to the address on the notice. The IRS page asks for documents showing there was enough money in the account.
5. Then deal with the knock-on effects: request relief separately for any failure-to-pay or failure-to-deposit penalty that resulted, and confirm any installment agreement is still in good standing.
6. If the 6657 penalty is denied, use the appeal rights in the denial letter.

For the related penalties, the reason the payment bounced is usually the reasonable cause argument: a bank error that dishonored a timely deposit supports relief from the failure-to-deposit penalty as well as from the 6657 penalty, if the replacement deposit was made promptly. Address each penalty by name, because the IRS considers only the penalties a request identifies (IRM 20.1.1.3.5). See requesting abatement by phone, in writing or on Form 843.

Avoiding the problem on client payments

The IRS's own advice on this penalty is to keep enough funds in the account to cover the payment. For practitioners who schedule payments for clients, a short checklist covers the mechanics the IRM's relief rules turn on: confirm the debit account is open and is the one the client intends, confirm funds will be there on the settlement date (not just the scheduling date), make sure a payment is not scheduled twice through different channels, and check the account transcript after the settlement date to confirm the payment posted and was not reversed. Because relief requires written proof, keep the bank confirmations.

Questions practitioners ask