What Is the IRS Overpayment Penalty?
The IRS doesn't penalize standard tax refunds. Learn about the specific penalty for erroneous claims and the reasonable basis required to avoid it.
The term “overpayment penalty” can be misleading, as the Internal Revenue Service (IRS) does not penalize a taxpayer for simply paying more tax than they owe. The confusion stems from a specific penalty for improper or erroneous refund claims. This penalty is not for honest calculation mistakes but targets claims for refunds or credits to which a taxpayer is not entitled because the claim lacks a reasonable basis.
The Erroneous Claim for Refund Penalty
The formal name for this penalty is the “Erroneous Claim for Refund or Credit” penalty, codified under Internal Revenue Code Section 6676. It was enacted to deter taxpayers from filing aggressive or unsubstantiated claims that burden the tax administration system. The penalty is triggered by the claim itself, even if the IRS disallows the refund before any money is paid out. It can be applied to claims made on an original tax return, an amended return such as Form 1040-X, or any other written request for a refund or credit.
Common Triggers for the Penalty
A common trigger for the penalty involves claims for fuel tax credits by individuals who are not entitled to them. These credits are intended for off-highway business use of fuel, such as in farming or construction, and taxpayers claiming them without such a business activity may have their claim disallowed and face a penalty. Other triggers include using debunked tax-protester arguments or claiming personal expenses as business costs. The penalty also applies to claims related to transactions lacking economic substance, as defined under Internal Revenue Code Section 6662. For these specific transactions, the law removes the possibility of arguing for a “reasonable cause” exception.
Calculating the Penalty Amount
The penalty is assessed at a flat rate of 20% of the “disallowed portion” of the refund claim. The disallowed portion, also called the “excessive amount,” is the part of your claim that the IRS determines you were not entitled to receive. For example, imagine you filed an amended return claiming an $8,000 refund. Upon review, the IRS determines only $3,000 of your claim is valid, and the remaining $5,000 is erroneous. The penalty would be 20% of the disallowed $5,000 portion, resulting in a $1,000 penalty. This penalty is separate from and in addition to the repayment of the erroneously claimed amount if it was already paid out.
Requesting Penalty Abatement
A taxpayer who has been assessed the erroneous claim penalty may have it removed, or “abated,” if they can demonstrate “reasonable cause” for the error. Reasonable cause is determined based on all the facts and circumstances of a case. It can indicate that the taxpayer exercised ordinary business care, had an honest misunderstanding of fact or law, or relied on erroneous advice from a competent tax professional. To request abatement, a taxpayer can respond to the IRS notice proposing the penalty, such as a CP2000 notice or a 30-day letter, with a written explanation and supporting documents. If the penalty has already been formally assessed, the taxpayer must file Form 843, Claim for Refund and Request for Abatement, with a detailed explanation.