Ch8. The Internal Revenue Code — Tax Obligation, Penalties, and Dispute Procedures

The Lifecycle of a Federal Tax Obligation

Arising (IRC § 6151 and related provisions):
- Tax obligation arises when the taxable event occurs
- Income tax: When income is recognized (earned)
- Corporate tax: When the taxable year ends
- Sales tax: At the point of sale
- Gift tax: When the gift is completed
- Estate tax: On the date of death

Becoming fixed:
- Self-assessment: Taxpayer files a return and computes liability
  → Individual income tax, corporate tax, estate/gift tax
- Government assessment: Government determines and notifies taxpayer
  (Deficiency notice after audit; math error notice; automated AUR)

Extinguishing:
- Full payment of assessed tax
- Offer in Compromise (settled for less)
- Expiration of collection statute (generally 10 years from assessment)
- Bankruptcy discharge (some taxes dischargeable)

Statutes of Limitations — Assessment and Collection

Assessment Statute of Limitations (how long the IRS has to assess tax):
Standard: 3 years from the later of the return due date or filing date
Extended: 6 years if gross income understated by 25%+
Unlimited: If no return was filed, or return was fraudulent

Collection Statute of Limitations:
10 years from the date of assessment
(Can be extended by installment agreement, offer in compromise,
bankruptcy, or Taxpayer Assistance Order)

Note: These are different time limits:
- Assessment = IRS must propose the tax deficiency within this period
- Collection = IRS must collect (levy, lien, etc.) within this period
  once the tax is assessed and unpaid

Penalties

Failure-to-File Penalty (IRC § 6651(a)(1)):
5% per month (or partial month) of unpaid tax
Maximum: 25%
Fraudulent failure to file: 15%/month; maximum 75%

Failure-to-Pay Penalty (IRC § 6651(a)(2)):
0.5% per month of unpaid tax
Maximum: 25%
(Reduced to 0.25%/month while on an installment agreement)

Combined maximum: 47.5% (FTF 22.5% + FTP 25%)
→ The FTF penalty is reduced by the FTP penalty for each month both apply

Accuracy-Related Penalty (IRC § 6662):
20% of underpayment attributable to:
- Negligence or disregard of rules
- Substantial understatement of income tax
  (understatement > greater of 10% of correct tax or $5,000)
- Transfer pricing misstatement

Civil Fraud Penalty (IRC § 6663):
75% of underpayment attributable to fraud
(IRS bears the burden of proving fraud by clear and convincing evidence)

Underpayment Penalty (IRC § 6654 / 6655):
Charged when estimated taxes are insufficient
Rate: Federal short-term rate + 3 percentage points (compounded daily)
Currently approximately 8%

Amended return penalty relief (equivalent to Korean voluntary correction):
Filing an amended return (Form 1040-X) with additional tax:
Within 30 days of notice: penalty may be 0% (depending on circumstances)
Unprompted amended returns: penalty reduction available;
First-Time Abatement (FTA) can waive FTF/FTP for first offense

IRS Examinations (Audits)

Selection methods:
① DIF (Discriminant Function System): Statistical scoring flags unusual returns
② Automated Underreporter (AUR): Computer matches 1099s/W-2s to returns
③ Information returns mismatch: e.g., 1099 received by IRS not on return
④ Related audit: Examiner finds an issue affecting multiple taxpayers/years
⑤ Compliance campaign: IRS focuses on specific industry or issue

Examination types:
① Correspondence examination: IRS sends letter requesting documentation
② Office examination: Taxpayer meets with examiner at IRS office
③ Field examination: IRS agent visits taxpayer's home or business
   (For complex returns and large corporations)

Audit duration and scope:
- Limited to the tax year(s) identified in the opening document
- May be extended (with taxpayer consent via Form 872) if nearing SOL
- Statute of limitations: 3 years (standard); 6 years; unlimited (fraud/no return)

Taxpayer rights during audit:
- Right to representation (CPA, enrolled agent, attorney)
- Right to receive a copy of the audit report
- Right to appeal the examiner's findings
- Right to contact the Taxpayer Advocate Service if experiencing hardship

Administrative and Judicial Appeals

After an audit — available administrative remedies:

30-Day Letter:
IRS proposes adjustments; taxpayer has 30 days to:
→ Accept the adjustment, OR
→ File a written protest and request IRS Appeals

IRS Office of Appeals (independent within IRS):
- Written protest required if proposed tax > $25,000
- Appeal conference with Appeals Officer
- Appeals Officer has settlement authority
- No requirement to pay tax to use Appeals
- ~85% of appealed cases resolved without going to court

90-Day Letter (Notice of Deficiency — Statutory Notice):
If no protest filed or Appeals unsuccessful:
IRS sends 90-day letter (150 days if taxpayer is outside the US)
Taxpayer must file Tax Court petition within 90 days
→ If no petition filed: deficiency is automatically assessed

Judicial options:
US Tax Court: Petition within 90 days of deficiency notice; no prepayment required
US District Court: Pay first; sue for refund; jury trial available
US Court of Federal Claims: Pay first; sue for refund; no jury
US Courts of Appeals: Appellate review of lower court decisions

Administrative pre-condition:
Tax Court and refund suits require exhaustion of administrative remedies
(must have filed a return; generally must have gone through IRS process)

Constitutional challenge:
If a tax statute is itself unconstitutional: Federal circuit court,
ultimately US Supreme Court

Assessment statute of limitations ★★★★★ : Standard = 3 years from filing/due date. Substantial understatement (>25%) = 6 years. No return or fraud = unlimited. Memory tip: 3-6-unlimited → standard, large omission, fraud/no return

Penalty rates ★★★★★ : FTF = 5%/month (max 25%). FTP = 0.5%/month (max 25%). Accuracy = 20%. Civil fraud = 75%. Memory tip: FTF = 5x worse per month than FTP; Fraud = 75% one-shot penalty

Appeals process order ★★★★☆ : 30-day letter → IRS Appeals (preferred) → 90-day letter → Tax Court OR pay + sue in District Court/Court of Federal Claims. Memory tip: IRS Appeals before Tax Court; Tax Court before paying; District Court after paying

Practice Quiz

Q. A corporation filed its tax return for 2021 (calendar year) on April 15, 2022. The IRS has not audited it yet. As of today (assume it is April 16, 2025), can the IRS still assess additional tax?

Yes. The 3-year standard assessment period runs from the later of the due date (April 15, 2022) or the filing date (April 15, 2022). Three years from April 15, 2022 = April 15, 2025. If today is April 16, 2025, the standard period has technically expired. BUT: if gross income was understated by >25%, the IRS has 6 years (until April 15, 2028). Check for fraud or no-return situations for unlimited period.

Q. A taxpayer disagrees with a tax deficiency proposed by an IRS examiner. They want to litigate but cannot afford to pay the tax first. What is the correct forum?

The US Tax Court. Tax Court is the only judicial forum where the taxpayer can contest a deficiency without first paying the tax. The taxpayer must file a petition within 90 days of the Notice of Deficiency.