IRS Automatic Penalty Relief Needs More Transparency
This article first appeared in Law360: IRS Automatic Penalty Relief Needs More Transparency
The IRS has historically provided three categories of penalty relief and abatement to taxpayers who face failure to file, failure to pay or failure to deposit penalties.[1] This included administrative waivers, reasonable cause and statutory exceptions.[2]
While the manual first-time abate, or FTA, waiver was historically the most common administrative relief program, the IRS is phasing it out in favour of the automatic exemption from penalty, or AEP.
However, migrating from manual administrative discretion to algorithmic enforcement creates an opaque black box that strips taxpayers of procedural visibility and complicates due process.
The Transition Already Underway
In July, the IRS began phasing in the AEP for eligible 2025 tax year returns and 2026 quarterly returns. The AEP will replace FTA waivers for eligible original returns due on or after Jan. 1, 2027.[3]
That implementation date is the immediate reason tax lawyers should examine the program now. Returns are already moving through the transition, and a processing date can determine whether the taxpayer receives automatic relief, must request an FTA or must pursue reasonable cause.
The AEP directly addresses genuine inequity. FTA waivers depended on a taxpayer or representative knowing that an administrative waiver existed and asking for it after assessment. The AEP instead instructs the IRS Master File to prevent specified penalties from being assessed when the account reflects the required compliance history.[4]
The IRS Master File serves as the official repository for all taxpayer records, comprehensively archiving transaction histories, tax returns, payments and statutory penalties for both individual and corporate entities. Systemic administrative actions applied by the IRS, such as the AEP, are processed directly through the master file, which automatically issues a corresponding confirmation notice to the taxpayer.
The National Taxpayer Advocate has called automatic relief a long-awaited taxpayer win, because eligible taxpayers should not pay different amounts merely because one knows the correct words to use on an IRS call.[5]
The challenge is determining the procedural protections needed to accompany that improvement. The AEP’s algorithmic framework creates a black-box dilemma, with distinct gaps between the internal account codes driving the determination and the transparent explanations a taxpayer needs to contest it.
Furthermore, while this automation ensures consistent treatment, it simultaneously obscures the detection and analysis of systemic programming errors.
What the AEP Does
The AEP covers specified initial filings and addresses specific penalties.[6] To qualify, the return must be submitted no later than three years after its initial due date.
Qualifying for penalty relief requires passing a compliance history test that is much stricter than most realise. The IRS looks back at the last three years of taxes — or 12 quarters for businesses — to ensure no penalty, except the estimated tax penalty, was assessed.
A prior penalty abated for reasonable cause or IRS error, for example, will still signal a compliant history determination. However, if the taxpayer already used an FTA or AEP waiver during that window, they are disqualified.[7]
When the IRS mechanically approves an AEP waiver, its computers automatically execute a series of behind-the-scenes steps: They cancel the penalty, lock the account and send out a specific notice. For example, with a failure-to-pay penalty, the system generally logs Transaction Code 971 with Action Code 996.[8] This specific combination removes the penalty, but also acts as a digital padlock, blocking the taxpayer from getting another automatic waiver for the next three years.
While these entries create a necessary internal audit trail for the IRS, they are nothing more than a technical shorthand. They do not constitute an adequate explanation for taxpayers, who require a substantive, plain-language breakdown of the resolution and its future compliance implications.
The Most Important Unanswered Question
The intersection of the AEP program and traditional reasonable-cause relief demands immediate clarification. While the AEP functions as an administrative waiver predicated solely on compliance history, reasonable cause operates on distinct legal principles.
Sections 6651 and 6656 of the Internal Revenue Code condition the assessment of penalties on a lack of reasonable cause. Accordingly, the underlying regulations mandate a comprehensive inquiry of the facts and circumstances to determine whether the taxpayer exercised ordinary business care and prudence.
Ultimately, reasonable-cause relief adjudicates the legal merits of a taxpayer’s behaviour, contrasting sharply with the AEP, which is merely a triennial administrative allowance.
Critically, a penalty abated for reasonable cause will not block an AEP application in future years, but an AEP grant blocks another AEP grant during the next three-year or 12-quarter cycle. Thus, automatic relief can be economically favourable today, but less favourable than a reasonable-cause determination over time.
This matters especially to employers, whose quarterly filing and deposit obligations create repeated opportunities for systems or third-party failures.
Published guidance does not clearly explain whether a taxpayer whose penalty was automatically suppressed may decline an AEP, obtain a reasonable-cause determination instead, or reverse Action Code 996 after documenting reasonable cause.
Because no penalty is assessed, there may be no adverse determination from which to take the ordinary penalty appeal. Yet the account has incurred a real future consequence: The administrative waiver has been used because an AEP can only be processed every three years; it will not become available again for another three years.
If a minor penalty occurred because of a legitimate, verifiable disaster or medical emergency — i.e., a reasonable cause — the taxpayer should ideally be able to preserve their administrative pass for a future, potentially much larger accidental mistake.
Under current AEP systemic coding, there is no procedure in place that affords the taxpayer this option.
The Case for Transparent AEP Notices
The Taxpayer Bill of Rights, codified in Section 7803(a)(3) of the IRC, includes the rights to be informed, pay no more than the correct amount, challenge the IRS’ position and be heard, and appeal an IRS decision in an independent forum.[9]
An AEP’s favourable outcome does not itself violate those principles. The concern is that a conclusory approval notice or a penalty notice reflecting an unexplained denial may not disclose enough information for the taxpayer to determine whether the system used accurate inputs.
A taxpayer denied an AEP may be looking at a missing compliance code, a reversal code, a prior waiver, a substitute-for-return marker, the wrong return type, a secondary-spouse module, or an employment tax restriction.
The interim Internal Revenue Manual permits a manual AEP when an IRS error prevented relief, including programming limitations, an original return posted to the wrong taxpayer or period, or a processing error involving a return attachment. But a practitioner cannot identify the right correction path without knowing which condition failed.
The answer is not disclosure of source code or protected system architecture. The IRS should provide an eligibility statement identifying the return and penalty tested, the look-back periods examined, whether each period was treated as compliant, whether prior administrative relief was detected, and the reason relief was granted or denied.
The statement should also distinguish an IRS error correction request from a reasonable-cause request, and state the applicable response and appeal route.
A Penalty Notice Protocol for Taxpayer Representatives
Until that disclosure exists, taxpayer representatives may have to consider how they triage penalty matters.
First, classify the issue by determining whether the penalty was computed or assessed incorrectly, whether the facts support a statutory or regulatory reasonable-cause defence, and — only then — whether an AEP or transitional FTA applies.
Second, obtain account transcripts for the affected period and the complete look-back window.[10] AEP approval should generally appear as Transaction Code 971 and should correspond to the separate notice identified in the interim instructions.[11]
Third, preserve reasonable-cause positions even when automatic relief has produced a zero penalty. If a credible reasonable-cause defence exists, a taxpayer representative should consider submitting a protective written request asking the IRS to apply the reasonable-cause determination in lieu of the taxpayer’s AEP.
Since current guidance lacks an explicit mechanism for this, tax representatives should frame the submission as an issue-preservation request rather than assuming an unannounced procedural right.
Fourth, if the IRS assesses a penalty, reconcile the notice against the account transcript to pinpoint the specific failed AEP condition in writing. Request a manual AEP override only if a documented agency error caused the automated system to fail.
Otherwise, tax representatives can assert a merits-based reasonable-cause defence backed by the specific factual substantiation required under Treasury Regulation, Section 301.6651-1(c), or the governing penalty statute.
If the IRS issues a denial, tax representatives should consider appealing the determination to protect the refund-claim limitations period.
The Reform AEP Still Needs
While the AEP should remain automatic to prevent recreating the systemic access barriers it was designed to solve, the IRS should implement three crucial safeguards: (1) standardised eligibility worksheets enclosed with each AEP notice, (2) a published administrative reconsideration framework requiring written determinations, and (3) a reasonable-cause substitution mechanism to protect a taxpayer’s AEP usage.
Furthermore, the agency must publish aggregate error and correction metrics to provide practitioners and Congress the transparency necessary to evaluate whether the automated system administers relief equitably.
Automation achieves its highest value when it intercepts penalties before assessment and strips away administrative red tape. Yet it strains credibility when taxpayers are presented with an unyielding conclusion, while the decisive data and correction paths remain entirely obscured.
Ultimately, the AEP can fulfil its promise to improve tax administration only if automated relief is balanced by an intelligible record, a meaningful avenue for correction and a mechanism to preserve defences rooted in the penalty statutes themselves.
References
[1] IRC § 6651(a)(1) (Tax returns); IRC § 6698(a)(1) (Partnership returns); and IRC § 6699(a)(1) (S-corporation returns); IRC § 6651(a)(2) (applicable when the tax shown on the return is not paid by the due date); IRC § 6651(a)(3) (applicable when the tax is required to be shown on the return, but was not, and that tax was not paid by the date stated in the notice or demand for payment); IRC § 6655(a)(2) (applicable when the tax was not deposited in the correct amount, by the due date, and/or in the required manner).
[2] The more common statutory exceptions include situations where the (1) taxpayer reliance on incorrect written advice from the IRS, (2) taxpayer was living in a federal disaster area, (3) taxpayer mailed the tax return on time but still received a penalty, or (4) taxpayer was involved in military operations in a combat zone.
[3] IRS, Automatic Exemption from Penalty: What Taxpayers Should Know, FS-2026-12
(July 2026), https://www.irs.gov/newsroom/automatic-exemption-from-penalty-what-taxpayers-should-know; IRS Tax Tip 2026-59 (July 30, 2026),
https://www.irs.gov/newsroom/eligible-taxpayers-may-receive-automatic-penalty-relief.
[4] The IRS Master File is the core, automated system that records and updates all official tax actions for every taxpayer in the United States. The Individual Master File manages all individual tax accounts (Form 1040 series) sorted by Social Security Number and the Business Master File manages corporate, partnership, estate, trust, and employment tax accounts sorted by Employer Identification Number. The IRS also utilises smaller files like the Employee Plans Master File for pensions and the Payer Master File for tracking W-2s and 1099s.
[5] National Taxpayer Advocate, A Long-Awaited Taxpayer Win: The IRS Implements Automatic Penalty Relief (July 8, 2026), https://www.taxpayeradvocate.irs.gov/news/nta-blog/a-long-awaited-taxpayer-win-the-irs-implements-automatic-penalty-relief/2026/07.
[6] Forms 1040, 1065, 1120, 1120-S, 940, 941, 943, 944, 945, and CT-1. Conversely, the program categorically excludes event-driven returns, information-reporting penalties, and other non-designated tax matters. AEP addresses failure-to-file statutory penalties governed by IRC §§ 6651(a)(1), 6698(a)(1), and 6699(a)(1) are systematically abated, alongside failure-to-pay penalties under §§ 6651(a)(2) and (3), and failure-to-deposit penalties under § 6656.
[7] Joint returns require qualifying history under both spouses’ taxpayer identification numbers, and businesses filing payroll taxes face even tougher rules regarding payment and deposit systems.
[8] IRS, Internal Revenue manual, Part 20, Penalty and Interest, (November 25, 2025), https://www.irs.gov/irm/part20/irm_20-001-001r. Transaction Codes record a completed financial or administrative event on a taxpayer’s account (e.g., changes the account balance, records a return filing, or applies a penalty/refund) and are publicly visible on official IRS tax transcripts. Conversely, Action Codes flag a module for internal IRS action or routing and are rarely available to or visible by taxpayers.
[9] See also IRS, The Taxpayer Bill of Rights, Publication 1 (Rev. 9-2017),
https://www.irs.gov/pub/irs-pdf/p1.pdf.
[10] For joint returns, both spouses’ relevant modules require review. For employment taxes, reconcile all quarters, return-type changes, deposits, and waiver codes and confirm the original return’s processing date because AEP and FTA overlap during the 2025 and 2026 transition period.
[11] AC 996 may not be visible on the return transcript.
