The failure-to-pay penalty under IRC 6651(a)(2) and (a)(3) is the one that keeps growing. It runs monthly until the tax is paid, up to its statutory cap. People who file on time but cannot pay often assume the penalty is just the price of being short on cash.

Sometimes it is. But the regulations recognize a reasonable cause defense specific to paying late, and it is different from the defense for filing late. If you understand the difference, you will know whether you have a case.

The rule for failure to pay

Treas. Reg. 301.6651-1(c)(1) says a failure to pay will be considered due to reasonable cause to the extent the taxpayer has made a satisfactory showing that they exercised ordinary business care and prudence in providing for payment of the tax liability and were nevertheless either unable to pay the tax or would suffer an undue hardship if they paid on the due date.

Two parts again. First, you planned prudently to pay. Second, you were still unable to pay, or paying would have caused undue hardship.

The first part is where most requests fail. The IRS website says plainly that lack of funds, by itself, is not reasonable cause for failing to pay or deposit. The inability has to come despite prudent planning, not instead of it.

What prudent planning looks like

The regulation tells the IRS to consider all the facts of your financial situation, including the amount and nature of your spending in light of the income you could reasonably expect before the payment date. It then gives examples of what is not prudent:

  • Lavish or extravagant living expenses in an amount that leaves your remaining assets and expected income insufficient to pay the tax.
  • Investing funds in speculative or illiquid assets, unless at the time the rest of your assets and income would cover the tax, or the investment could reasonably be expected to be sold or borrowed against to pay it.

And it gives the positive standard: you are considered to have exercised ordinary business care if you made reasonable efforts to conserve sufficient assets in marketable form to satisfy the tax and were nevertheless unable to pay all or part of it when due.

So the story the IRS wants to hear is something like this. I set aside money for the tax. Then something I could not reasonably foresee took it, or took the income I was counting on.

What the IRS will ask

IRM 20.1.1.3.3.3 lists the information the IRS considers for a hardship-based request:

  • When did you know you could not pay?
  • Why were you unable to pay?
  • Did you explore other means to secure the funds?
  • What supporting documentation did you provide, such as bank statements?
  • Did you pay when the funds became available?

The manual also says the taxpayer may claim enough funds were on hand, but because of unanticipated events, the taxpayer was unable to pay. That is the classic successful fact pattern: money was there, then something unforeseeable happened.

And it says that where a taxpayer files bankruptcy, inability to pay may be considered if the insolvency occurred before the payment due date.

What undue hardship means

Undue hardship is a defined term. Treas. Reg. 1.6161-1(b) says it means more than an inconvenience. It must appear that substantial financial loss will result from paying on the due date, and the regulation's example is loss due to selling property at a sacrifice price. It adds that if a market exists, selling property at the current market price is not ordinarily considered undue hardship.

So having to sell stock at market value to pay the tax is not undue hardship. Having to dump an illiquid asset at a fire-sale price to make the deadline may be. The IRM says the IRS should consider an individual's inability to pay as a factor if the taxpayer shows that paying on the due date would have caused undue hardship as defined in that regulation.

The forward-looking option: Form 1127

If you see the problem coming, there is a formal request you can make before the due date. Treas. Reg. 1.6161-1 allows an extension of time to pay for undue hardship, applied for on Form 1127. The application must be filed on or before the payment due date, with evidence of the hardship, a statement of assets and liabilities, and an itemized statement of receipts and disbursements for each of the three months before the due date. For tax shown on a return, the extension generally cannot exceed six months, with a longer period possible for taxpayers abroad.

Interest still runs during the extension; the regulation says so. And IRM 20.1.1.3.3.3 notes that an extension of time to pay does not extend the time to file and does not relieve failure-to-file penalties. File the return on time regardless.

Building the file

A hardship-based request lives or dies on financial documentation. Plan to provide:

  • Bank statements covering the months before and after the due date, showing the money you had set aside and what happened to it.
  • Proof of the unforeseeable event: a customer's bankruptcy notice, a medical bill, an insurance denial, a contract cancellation.
  • Evidence that you looked for other sources of funds, such as loan applications or denials.
  • A record of what you paid and when, especially payments made as soon as funds became available.

Think about how a hypothetical contractor might present it. She set aside enough for her April payment from a large job. In March, the customer filed bankruptcy and the final payment never came. She applied for a line of credit and was turned down, paid part of the tax on April 15, and paid the rest from the next job in July. Each step is documented. That is the regulation's standard told as a story: prudent provision, an event outside her control, effort to find funds, and payment as soon as possible.

Trust fund taxes are different

None of this helps much with withheld payroll taxes. The regulation itself says that facts that may be reasonable cause for not paying income taxes may not be reasonable cause for failing to pay over taxes collected or withheld from others. The IRM is more direct: if payroll was met, taxes were withheld and should be available for deposit, employers must hold withheld money in trust, and undue hardship does not support relief from the trust fund recovery penalty under IRC 6672.

Employers dealing with deposit penalties should read failure-to-deposit penalty relief instead.

Other ways to limit the penalty

If you do not have a reasonable cause case, there are still ways to limit the damage:

  • Check first-time abatement. It covers failure-to-pay penalties regardless of your reason, if your history is clean. For older years, it removes what has been assessed, and the later accruals can be removed after the balance is paid.
  • For individuals who file on time, Treas. Reg. 301.6651-1(a)(4) reduces the monthly failure-to-pay rate from 0.5 percent to 0.25 percent for any month in which an installment agreement under IRC 6159 is in effect.
  • Pay what you can now. The penalty is computed on the unpaid balance, so every payment reduces what it runs on.

The one thing that always makes this penalty worse is waiting. The regulation's standard asks whether you paid when the funds became available. Show that you did, and you have given yourself the best chance at relief.