Failure-to-pay penalty under IRC 6651(a)(2) and (a)(3): computation and relief

Two penalties, one rate structure

IRC 6651(a)(2) applies to tax shown on a return and not paid by the payment due date, which is the filing due date without regard to extensions. IRC 6651(a)(3) applies to tax required to be shown but not shown (a deficiency, an amended return increase or a math error assessment) that is not paid “within 21 calendar days from the date of notice and demand therefor (10 business days if the amount for which such notice and demand is made equals or exceeds $100,000)”. Both are excused if the failure is due to reasonable cause and not willful neglect.

The (a)(2) penalty applies to income, employment, excise, gift, estate and partnership returns; it does not apply to information returns or to estimated tax payments, which have their own penalties (IRM 20.1.2.3.8.4; IRC 6651(e)). See the estimated tax penalty.

The three rates

The 1 percent rate. IRM 20.1.2.3.8.1.1 lists the notices that count as a notice of intent to levy: CP 504, the Collection Due Process notice, ACS letter LT11 and field Letter 1058. The higher rate applies to all failure-to-pay penalties on the module for months beginning after the trigger. See CP504 and LT11 and Letter 1058.

The 0.25 percent rate. Both conditions must be met: the taxpayer is an individual, and the return was filed on time. The IRM warns that an installment agreement code on the account does not by itself mean the reduced rate applies; check the filing date. The rate can apply to individual income, employment and excise tax and to estate tax returns. It ends after the month the agreement terminates, which happens on default, on an additional assessment not included in the agreement, when the account is reported uncollectible, on a bankruptcy filing, 10 days after a notice of intent to levy, or on a jeopardy demand (IRM 20.1.2.3.8.1.2). See installment agreements.

The 25 percent cap

The penalty for each underlying tax assessment cannot exceed 25 percent in the aggregate. A separate computation applies to tax shown on the return and to each notice of additional tax, so “the 25 percent aggregate maximum may be reached for tax shown on the return while the FTP penalty is still accruing for additional tax billed in a subsequent notice” (IRM 20.1.2.3.8.1). At 0.5 percent a month the cap takes 50 months to reach; the 1 percent rate gets there faster.

For months when both the failure-to-file and failure-to-pay penalties apply, IRC 6651(c)(1) reduces the failure-to-file penalty by the failure-to-pay amount; see the failure-to-file penalty.

Months and the unpaid balance

For (a)(2), the first penalty month begins the day after the latest of the payment due date, an extended payment date under IRC 6161 to 6167, a disaster date or a combat zone date. Months end on the day matching the due date, with the same last-day-of-month and February rules as failure to file (IRM 20.1.2.3.8.4.2). For each month, the amount subject to penalty is the tax shown that was not paid before the month began (IRC 6651(b)(2)); if the tax required to be shown is less than the tax shown, the lower amount is used (IRC 6651(c)(2)).

For (a)(3), the first month begins the day after the date for payment stated in the notice: 21 calendar days after the notice date if under $100,000, otherwise 10 business days (IRM 20.1.2.3.8.5.2). The base is the net additional tax in that notice not paid before the month began.

Payments are applied to failure-to-pay penalty and interest only after all other amounts are paid (IRM 20.1.2.3.8.7.3), which affects the unpaid tax balance used in later computations.

Extensions and the 90 percent rule

“An extension of time to file does not extend the time to pay” (IRM 20.1.2.3.8.4). But Treas. Reg. 301.6651-1(c)(3) and (4) presume reasonable cause for the extension period when enough was paid on time:

• Individuals: the unpaid tax shown on the return is no more than 10 percent of the tax shown, and the balance is paid with the return. IRS computers apply this automatically (IRM 20.1.2.2.3.1).
• Corporations: at least 90 percent of the tax shown on the Form 1120 was shown on Form 7004 or paid by the regular due date, and the balance is paid by the extended due date.

If an individual pays after the extended due date, the IRM says the penalty is computed from the original due date unless reasonable cause is shown for the later period, even if 90 percent was paid on time.

A true extension of time to pay under IRC 6161, requested on Form 1127 for undue hardship, delays the start of the penalty, generally for up to 6 months for tax shown on the return. Installment agreements and other deferrals are different: “The penalty for failure to pay does accrue during any deferral period” (IRM 20.1.2.2.3.2).

A worked example from the IRM

IRM 20.1.2.3.8.7.3 computes an (a)(3) penalty on a $1,000 deficiency. Notice and demand was dated 3/15/2023; the amount was not paid within 21 days; a notice of intent to levy issued 5/17/2023; penalty was computed to 7/26/2023.

The penalty and interest calculator applies the same month counting. Interest on the unpaid tax is a separate charge at the underpayment rate under IRC 6621, which is 7 percent for October to December 2026 (IRS quarterly interest rates, IRB 2026-36); see IRS interest rates.

Bankruptcy

IRC 6658 bars failure-to-pay penalties while a bankruptcy case is pending for tax incurred by the debtor before the order for relief, if the petition was filed before the return due date (including extensions) or for penalty months beginning on or after the petition date. It does not protect withheld or collected taxes (IRM 20.1.2.3.8.6). See bankruptcy and tax debts.

Relief

Reasonable cause. Treas. Reg. 301.6651-1(c)(1) requires a showing that the taxpayer “exercised ordinary business care and prudence in providing for payment of his tax liability” and was nevertheless unable to pay or would suffer undue hardship by paying on the due date. IRM 20.1.2.2.4.1 adds:

• “Insufficient funds generally is not reasonable cause for failure to pay unless the funds were depleted due to unusual or unforeseen circumstances.”
• Significant hardship can qualify: paying for necessary medical expenses instead of the tax, or being able to pay only by selling assets well below fair market value.
• The penalty generally should not be abated until the tax is paid, but “Abatement for reasonable cause may not be denied merely because the underlying tax has not yet been paid.” If the client later willfully continues not to pay, the penalty may be reasserted from the original start date.
• The decision is made separately for each assessment: tax shown, math error, amended return, deficiency.
• When abated for reasonable cause, the abatement covers the whole related penalty, including accruals not yet assessed.

The courts read the regulation the same way, and the one point of disagreement favors taxpayers in some circuits. In East Wind Industries, Inc. v. United States, 196 F.3d 499 (3d Cir. 1999), a clothing contractor stopped paying over withheld employment taxes for six years after corrupt procurement officials, whose bribe demands it refused, withheld payments and rejected its goods; the Third Circuit rejected the Sixth Circuit's rule that “financial difficulties can never constitute reasonable cause to excuse the penalties for nonpayment of withholding taxes by an employer” (Brewery, Inc. v. United States, 33 F.3d 589 (6th Cir. 1994)), adopted the Second Circuit's all-facts-and-circumstances approach from Fran Corp. v. United States, 164 F.3d 814 (2d Cir. 1999), and held that “because the Taxpayers exercised ordinary business care and prudence and would have suffered undue financial hardship if they would have paid their taxes when due, the nonpayment of trust fund taxes was due to reasonable cause and not willful neglect.” The court stressed that the owners borrowed personally, paid only essential creditors, and ultimately paid the tax in full. Outside the Sixth Circuit, then, a financial hardship claim for the IRC 6651(a)(2) penalty is decided on the regulation's factors, and the facts to assemble are the ones East Wind turned on: what caused the shortfall, what the client paid instead and why, what was borrowed or sold, and when the tax was paid. The general reliance standard comes from United States v. Boyle, 469 U.S. 241 (1985), discussed on the reasonable cause page: an agent's failure to pay or file on time is not the taxpayer's reasonable cause.

First Time Abate. Covers (a)(2) and (a)(3). If tax is unpaid, the IRS abates under FTA and the penalty keeps accruing on the balance until paid; see First Time Abate.

Trust fund taxes. The regulation notes that circumstances that might excuse not paying income tax “may not constitute reasonable cause” for failing to pay over withheld taxes (Treas. Reg. 301.6651-1(c)(2)). See the trust fund recovery penalty.

Interest on the failure-to-pay penalty runs from notice and demand for the penalty (IRM 20.1.2.2.4). No supervisory approval is required under IRC 6751(b)(2).

Questions practitioners ask