COMPUTER SOFTWARE TO CHECK PENALTY AND INTEREST COMPUTATIONS

By Tom Persky, TimeValue Software

With the advent of new software tools, IRS penalty notices now present opportunities for the CPA practitioner to solve current problems for clients and to "audit" IRS penalty and interest assessments for prior years. These opportunities can also be used for practice development purposes.

The Federal Tax Deposit (FTD) penalty is the most often asserted Federal penalty. Similar issues, however, arise with respect to assessments of interest and penalties relating to income tax.

How Accurate Are FTD Penalties?

According to the Commissioner's annual report, the IRS sends out nearly 5 million FTD penalties each year. Assuming that some taxpayers get multiple notices, the overall number of notices suggest that perhaps one in five business taxpayers will get a penalty notice this year.

While the majority of FTD penalties are properly asserted and calculated correctly, several questions arise. How many penalty notices are wrong? How much do incorrect notices cost taxpayers? How many technically correct notices could be abated due to reasonable cause? How can taxpayers determine if a penalty is correct? How can software tools help avoid a penalty or determine whether a penalty can be abated?

In a 1993 report, a GAO investigation gave rise to the following estimates:

* Taxpayers made errors on 20% of all FTD coupons,

* The IRS and taxpayers made errors with respect to 10% of employment tax returns, and

* There are "numerous instances" in which the banking system contributes additional errors.

While the IRS has implemented some automated error correction techniques, it is likely that as many as 10% of FTD penalties are incorrect. As a result, taxpayers are being assessed about half a billion dollars in erroneous penalties.

Most of the problems with the accuracy of penalties come from the basic design of the FTD penalty system. Since the system's design is likely to remain unchanged for the next few years, tax deposit penalty problems are likely to continue. With hundreds of thousands of incorrect penalties and millions of dollars at issue, it pays to be vigilant about the accuracy of asserted penalties.

How Errors Arise

Under the current system, employment tax liability information is reported on the quarterly 941 form, but deposit information is collected from the banking system. Even though the 941 form contains an internal check requiring a balance of liabilities and deposits, this check is quite limited and comes too late to avoid a penalty.

To avoid a penalty, the following intricate series of events must occur. First, every FTD coupon must be completed correctly. Second, the 941 form and Schedule B must be correct. Third, the 941 and Schedule B information must be correctly transcribed by the IRS. Fourth, deposit information must be correctly reported and recorded. If there is a break in any link in the chain, the result can be an IRS penalty notice. Here's a closer look at how errors arise and how they can be detected.

Taxpayer Errors

FTD Coupons. As a general rule, taxpayers have the authority to designate the application of so-called voluntary payments. Since payments made with a FTD coupon usually qualify as voluntary payments, the IRS generally follows the taxpayer's instructions. An incorrect designation on an FTD coupon may generate a refund for one quarter's return and a late deposit for the next quarter's return. In this context, the IRS sometimes refers to returns as tax modules. A tax module is the taxpayer's account for a specific return for a specific period. For example, the 941 for the first quarter of a year is one module; the second quarter return is a different module.

Schedule B. A second troublesome area is Schedule B. Taxpayers who put forms in a typewriter are asking for trouble. It is simply too easy to transpose numbers or put the right amount on the wrong line. For monthly depositors, similar concerns arise with respect to line 17 of the 941 form. In order to avoid penalties, taxpayers should consider using available software solutions for preparing Schedule B.

Other Return-Related Errors. In addition to the errors that arise from improper "correction" of FTD coupons, the GAO also identified other IRS errors. IRS errors included data entry mistakes or failure to input data. The combination of IRS and taxpayers errors has led to the IRS reported rate of 10% for employment tax return containing errors.

Financial Institution Errors

The financial institutions that are Federal tax depositories play a major role in the FTD system. With that major role comes the opportunity for errors. And, the GAO discovered that financial institutions are not perfect. Consider the following quotation from the 1993 GAO report:

Depositories also contributed to FTD processing problems. GAO identified numerous instances where the taxpayer made a timely FTD payment as required, but the depository did not accurately record the payment date. Typically in these cases, the FTC coupon was stamped by the depository with a date later than the date it actually received the payment or contained no date at all. In such cases, the taxpayer, although having paid on time, receives a penalty notice for late payment of taxes.

Reasonable Cause Issues

When a penalty notice comes, certain IRS administrative practices‹particularly the offset and payment allocation rules‹can turn a single problem into a complex maze of underpayments, penalties, refunds, and interest.

A proliferation problem arises in the IRS automated method for handling taxpayer accounts. One single error may cause an underpayment in one module and an overpayment in another. The underpayment is penalized and the overpayment is refunded. Perhaps the taxpayer didn't expect a refund, but instead anticipated that the amount would be available as a credit for the next quarter. Of course, the anticipated credit is not there and the module is charged penalties and interest.

Similar issues arise in the context of the IRS offset program. Under certain circumstances, the IRS will automatically debit an overpayment module to satisfy an underpayment module. While the offset mechanism is an efficient collection device, the potential for incorrect transfers presents high risks. In addition, the complexity of any problem is significantly increased as payments and debits begin to ricochet from one module to another.

The same kind of problem results from the IRS's "first-in-first-out" application rule for penalty computation. In Rev. Proc. 90-58 the IRS took the position that current payments are used to satisfy the oldest deposit obligation within a module. In other words, every payment is used to pay off old obligations before the deposit is applied to a current liability. The potential for problems can be illustrated by the following example:

Assume that the taxpayer incurs a $5,000 deposit obligation every Friday. For the third quarter 1994, the taxpayer failed to make the first deposit. All other deposits were timely.

The single failure to make the first deposit can be shown to result in 14 separate penalties over a six month period, for a total of $3,750. Instead of a one penalty with a maximum of 10%, the allocation method causes 14 penalties with an effective penalty rate of 75%. By pinpointing the specific failures that cause a penalty, the taxpayers can significantly enhance the ability to abate penalties. For example, in the prior case, the taxpayer needs to identify a reasonable cause defense for only one incident, rather than account for a multiplicity of penalties.

Use Your Computer to Avoid IRS Penalty Problems

A particularly user-friendly software package is Tax941 by TimeValue Software. The software is unique in that it will predict deposit due dates, reconcile IRS penalties, and print the most common Federal payroll tax forms.

Using Tax941, the dates and amounts of liabilities and deposits are entered, and the program will determine whether and how much penalty is due. Tax941 can be used to test a 941 form (or 940, 943, or 945) before the return is filed. As a result, taxpayer errors can be identified before they generate IRS penalty correspondence. Because of its simplicity, checking a typical 941 form takes less than five minutes.

Tax941 gives practitioners a simple tool to determine:

* whether an employment tax return will generate a penalty, and

* the specific failure or failures that caused any penalty.

The program requires about two megabytes of hard disk space and is available for DOS or Windows. While printing 941 and other forms requires that all information needed for the forms be input, penalty calculations can be completed by answering only deposit and liability amounts. A sample of the printout for three late payments is shown in the accompanying Exhibit. With this information, practitioners can enhance services to existing clients and can prospect for new work. Because the program requires only a small amount of input, the investment in these activities is equally small.

If a return can be corrected or a penalty abated, the benefit is obvious. If a practitioner can make a penalty disappear, the client is likely to be both appreciative and loyal. And, even if the return or penalty is correct, the client gets the comfort that flows from this due diligence verification. At the same time, the practitioner has the opportunity to display a high level of professional skill.

The retail price of Tax941 is $149 and is a product of TimeValue Software. The program is also available as a $99 add-on to the RIA payroll tax service. *

APOLOGIES TO AUTHOR MICHAEL J. CHAZAN, ESQ.

An article appearing in this column in the August issue of The CPA Journal entitled "Ownership of Life Insurance by a Third Party," was substantially based on an article written by Michael J. Chazan, Esq., also entitled "Ownership of Life Insurance by a Third Party," which was originally published in the May/June 1994 issue of Estate Planning. The editors and Russell J. Rolnick, the person who submitted the article to The CPA Journal, express their apologies to Mr. Chazan and Estate Planning for any use of this material without appropriate attribution and permission.

Subject to permission from the copyright owner, copies of Mr. Chazan's complete article as it appeared in Estate Planning will be made available upon request from The CPA Journal by writing to‹

The Managing Editor

The CPA Journal

530 Fifth Avenue

New York NY 10036-5101

Editor:
Milton Miller, CPA
Consultant

Contributing Editors:
Andrew B. Blackman, CFP, CPA/PFS
Shapiro & Lobel LLP
William Bregman, CPA
David Berdon & Co. LLP

OCTOBER 1995 / THE CPA JOURNAL

Company: Payroll Practitioner Example Period ending: 09-30-94

EIN: XX-XXXX Depositor type: Semiweekly

Form: Federal 941 Status as of: 11-01-94

Days Deposit

Event Date Amount Penalty Base Late Rate Penalty

Liability 07-01-94 Fri $5,000.00

Due date 07-07-94 Thu

Deposit 1 07-13-94 Wed 5,000.00 $5,000.00 6 5% $250.00

Liability 07-08-94 Fri 5,000.00

Due date 07-13-94 Wed

Deposit 2 07-20-94 Wed 5,000.00 5,000.00 7 5% 250.00

Liability 07-15-94 Fri 5,000.00

Due date 07-20-94 Wed

Deposit 3 07-27-94 Wed 5,000.00 5,000.00 7 5% 250.00

Total deposit penalty $750.00

OCTOBER 1995 / THE CPA JOURNAL