The IRS Hit Me With a $10,000 Penalty — and It Could Happen to You, Too!

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I’m not sure I had ever been that scared in my life…

…and it all started with a simple LLC!

Despite being a letter from the government, it was clear as could be: I was being charged a nearly $10,000 penalty from the IRS.

What was I going to do? I didn’t even have $10,000!?

And why was I being charged this?

After several panicked hours of research, I finally realized why I was being hit with this fee:

Because I was stupid.

OK, being stupid isn’t technically the reason why I was being charged $10,000.

Maybe “over zealous” is a better term — and it’s a simple mistake anyone could make.

Including you.

70-percent-rule-example

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It Started With An LLC…

Here’s the deal:

When I first started investing in real estate, I heard a lot about LLCs.

I needed one, right? At least, that’s what I thought.

I had just purchased a triplex with some good friends of mine, so of course, we wanted to be cool “official.”

So I went to my Secretary of State’s website and paid the $300 or so for an LLC. I printed out the documents, made a nice file folder for it, and put it in my file cabinet.

Related: 5 Reasons I Do NOT Invest in Real Estate Using An LLC

Now I was official, right?

(In reality, because I never transferred the property into the LLC, the LLC wasn’t doing anything. I assumed I would get the property transferred in soon, but never had the time. Besides, the “Due on Sale Clause” made it a little sticky if I wanted to transfer the property into an LLC anyway. More on that here.)

So the LLC was formed, and the LLC just sat there.

Maybe a mistake — but definitely not a $10,000 mistake. Sure, I wasted $300 on an LLC that I didn’t use.

But the real problem didn’t start until tax time.

The Fateful Mistake

A year later, I started working on my taxes.

Back then, I did all my own taxes using a popular online tax planning software, which was relatively cheap and easy to use.

Because my LLC had absolutely no activity (due to me never transferring the property into it), it didn’t make a profit. So, total taxes owed on that LLC would be $0, of course.

So I just ignored it.

I mean, the IRS wouldn’t care if I mentioned it on the taxes because it made no money, right?

WRONG.

Here’s the problem: The IRS requires that every non-single member LLC (in other words, any LLC that you have that is not you alone or you with your spouse) must file a business tax return (Form 1065) every year — even if the LLC makes no money.

So, had this LLC been just my wife and I, things would have been fine.

But because it was a partnership with another couple, a business tax return was required, along with K-1s for each partner.

Whoopsies.

About a year after filing those taxes is when I received the letter in the mail. The IRS was fining me almost $10,000.

Why?

Because according to the official 1065 instructions from the IRS, “The penalty is $195 for each month or part of a month (for a maximum of 12 months) the failure continues, multiplied by the total number of persons who were partners in the partnership during any part of the partnership’s tax year for which the return is due.”

So, with four partners on the LLC:

$195 x 12 x 4 = $9,360.

Ouch. And that was just for that one year. I could have been hit with several years, and I’m sure I would have, had I not fought my way out.

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How I Avoided the Penalty

This post could easily turn into a rant against the IRS, but honestly, it was my own stupidity that caused the problem.

Simply put: I didn’t know what I was doing.

So what happened? Did I have to pay the fine?

Nope!

The first thing I did was called a CPA I had heard about on BiggerPockets named Amanda Han (from Keystone CPA). I explained the issue to her, and she helped explain the problem and how to correct it. (Thanks, Amanda!)

A phone call to the IRS, with a promise not to do it again, and the penalty was waived. One hundred percent of it.

Phew!

This is why I still use Amanda Han and Keystone CPA today for my own investing. Not only did she help me out there, but she’s helped me out numerous times since, including preparing my taxes each year.

She even recently helped me create a Solo 401(k) so I can use it to fund my real estate deals! Whoop whoop!

And this is also why I pushed so hard to have Amanda write The Book on Tax Strategies for the Savvy Real Estate Investor, which launched last week here on BiggerPockets and is on sale until Friday, February 26th.

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How YOU Can Avoid Penalties from the IRS

So, what’s the point?

I made a lot of mistakes, but I guess if I could summarize my entire experience it would be this:

You need to understand basic tax stuff. If not, you’ll do stupid things.

Don’t go opening up an LLC because you think it’s the cool thing to do. Learn why an LLC is important and the right way to do it.

How?

The Book on Tax Strategies for the Savvy Real Estate InvestorWell, a good way to start would be to pick up a copy of The Book on Tax Strategies for the Savvy Real Estate Investor today. Inside, you’ll learn about LLCs, deductions, using retirement accounts, and more.

(Also, trust me, it’s not boring, as you would imagine a tax book would be. It’s filled with stories, humor, education, and wisdom that will help make sure you pay less to the IRS so you have more capital to build your business!)

Related: The Ultimate Guide to Real Estate Investment Tax Benefits

As a reminder, or in case you didn’t know, there is an awesome promotion on the book that ends on Friday, February 26th, 2016, at midnight. If you buy the book on BiggerPockets before then, you’ll get the digital book plus a bunch of great bonuses — and one of those bonuses is ONLY available until Friday at midnight, which is called “How to Use a Self-Directed 401(k) To Fund Your Real Estate Deals!”

This video/audio/transcription bonus will explain the ins and outs of using the Solo 401(k) to fund your deals — and if you are looking to borrow money from private lenders in the future, this is one video you CAN’T afford to miss.

To pick up a copy, click here.

Conclusion

Mistakes happen.

While you can always learn from your own mistakes, you can also learn from the mistakes of others — like me.

Mistakes generally happen when you don’t know enough, but don’t let that stop you from moving forward.

The point of this post was not to scare you into inaction but to show you that mistakes can be overcome with knowledge.

About Author

Brandon Turner

Brandon Turner (G+ | Twitter) spends a lot of time on BiggerPockets.com. Like... seriously... a lot. Oh, and he is also an active real estate investor, entrepreneur, traveler, third-person speaker, husband, and author of "The Book on Investing in Real Estate with No (and Low) Money Down", and "The Book on Rental Property Investing" which you should probably read if you want to do more deals.

28 Comments

  1. William Morrison

    I have an LLC as well with no activity. My tax software did tell me to submit.
    There is an additional issue with the K1s.
    There is an annual loss with the annual payments to the state and the registered agent even though no other activity.
    The partners who use a tax preparer are charged by item/page. Each K1 has a charge. The charge far exceeds the loss and not by a little for them.
    You may also think that if you have a small loss, say $7.00, you would not have to file as an individual. It’s true for some losses as long as there is not a gain in the K1 being offset. I can’t remember the type or amount of the gain threshold. Ours did not require it. I did check with an accountant on that to assure those partners that not filing was acceptable. The tax software didn’t help with “not filing”.

    If you are the one receiving the K1, you should know that the 1065 includes a copy of your K1 and your tax number.

  2. Kimberly H.

    IMHO, a real estate buy and hold investor really needs an accountant with experience in RE to handle this stuff. Tax software and run-of-the-mill accountants are not sophisticated enough to know about professional real estate investor status, multi-member LLC treatment, bonus depreciation, etc.

  3. David Dachtera

    … and, of course, you remember that business tax returns are due by MARCH 15th!

    Made that mistake a couple years ago myself!

    David J Dachtera

    “Success is not a destination. Failure is not an event. Success is a process, failure is a choice.”
    – DJ Benedict

    • Patrick Moore CPA on

      Hello:

      An entity taxed as a partnership that has a year end of December 31, 2015 is due on April 18, 2016. (The 18th as Friday, April 15th is the day the District of Columbia observes Emancipation Day.)

      H.R. 3236 and the changes to business tax return due dates apply to tax years beginning after December 31, 2015. For 2016 (the 2017 filing season), partnership returns will be due two and half months after year end (March 15) and C Corporation returns will be due three and half months after year end (April 15). S Corporations remain the same with a March 15 due date.

      That being said, it can’t hurt you to have your 2015 partnership return filed by March 15. Other members or partners and their tax preparers would be happy to have those K-1’s early!

  4. Michael Boyer

    Neat topic and evidence we can often learn more from missteps than triumphs (nice balance of both on BP, maybe leaning a bit towards success stories, which are more fun to share, of course)..

    Also, nice addition as one more cautionary note/reminder on the LLC (along with those in your linked article). The LLC seems to be the perennial newbie question. And for the average person with a duplex it may not be without considerations as you mention (due on sale, financing, formation, representing yourself in court–even for simple default eviction, and as you aptly note tax)…. It is a nice organizational tool for risk management (I especially like it for paid off residential, all commercial, joint ownership, etc) but not always ideal for every situation (See ,for example, the many forums where small scale residential landlords discuss the alternative triumvirate: use safe practices, great landlord policy, and umbrella policy, for example)….

  5. Matt Merkel

    I had the same thing happen to the tune of $3,000.00 because I formed an LLC in 2007, but never applied for an EIN (because it did no business & had no taxable events). Last year, it did some business, and I applied for the EIN, stating a business start date in 2007 (when the LLC was formed).

    About a month later, I got the notice of the fine, because the IRS automated system assumed that I had started in 2007, and not filed until last year. I called up the IRS and spoke to an agent, who completely understood, and waived the fine. Basically, I should have stated the business start date of last year, instead of the LLC filing date.

    In my experience, the IRS isn’t that bad to deal with, as long as you’re doing things ethically, and reasonably well informed. So, to agree with the author… seek help if you’re unsure!

    • Patrick Moore CPA on

      If you are in a non-community property state, the IRS’ position is that a limited liability company is not eligible for “qualified joint venture” treatment and a partnership return should be filed. In a community property state, you would basically have two options: 1) liquidate the LLC and hold the business or property personally, or 2) convert the LLC to an entity eligible to treated as a qualified joint venture, a general partnership. In either case, you will be losing your protection from unlimited liability. Unfortunately, this is just one of those cases of being stuck with how the rules and regulations are written.

  6. Nicholas Burton

    Good Article Brandon! It does depend how you filed your LLC (Corporation, Partnership) to when the Tax Return is due. If the LLC is treated as a corporation for tax purposes, you must file an annual IRS Form 1120 by the due date. The due date of the LLCs corporate tax return is the 15th day of the third month following the end of the tax year (as David Dachtera stated above). You must choose to use either a fiscal or calendar tax year when you file the business’s first income tax return. A calendar year requires you to report all income and expenses for the period of Jan. 1 through Dec. 31. If a Partnership, the LLC must file IRS Form 1065 by the 15th day of the fourth month after the tax year ends. Good information found here: http://info.legalzoom.com/taxes-due-llc-3699.html But as with anything else, talk with an informed RE Accountant.

  7. Mary B.

    Brandon,

    If you would have went on and secured an EIN from the IRS for that multi-member LLC you might’ve known that it had filing requirements. Although Form 1065 is simply an information document, its quite costly if not filed. However, there is a way that you could likely get that penalty abated by writing a letter to them and getting a ”reasonable cause penalty abatement” as a first timer (of the business return 1065 of course) who has a record of otherwise being fully tax compliant. You might even get a refund if the statutes haven’t expired. No accounting or legal advice here…just saying.

    Kudos,
    Mary

  8. Nick E.

    The 1065 instructions also say :

    “Except as provided below, every domestic partnership must file Form 1065, unless it neither receives income nor incurs any expenditures treated as deductions or credits for federal income tax purposes.”

    If your LLC had no income or expense, why were you required to file?

    • Patrick Moore CPA on

      I believe the argument would be that there is little chance that a legal entity formed under state law would have literally zero expenses. It would cost something in the form of state filing fees to form the entity, even if you did not hire the assistance of an attorney to file the paperwork with the Secretary of State. After formation, it would most likely cost something in annual filings with the Secretary of State as well. Even if the entity elects to capitalize the organizational or startup costs and forgo the immediate deduction of up to $5,000 of each, you would still need to file a timely return to make a valid election.

      In my opinion, it is a more prudent course of action to file a zero return and get the statute of limitations running than to worry about a notice from the IRS regarding a missed filing.

  9. Patrick Moore CPA on

    In certain circumstances, the IRS provides automatic abatement of penalties for filing a late partnership return. You do need to request it in writing after you receive your notice with a letter that lists out why you qualify for relief under Rev Proc 84-35. There are some nuances to the requirements, so I would recommend discussing this with a tax professional rather than tackling it on your own. This method of requesting abatement can be used over and over again, however, I would not recommend it. Being a habitual late filer will not get you much sympathy with the IRS when you need relief for something more important, such as an important missed election.

  10. Melissa Richardson

    This is why it always pays to have a good accountant or an agent who is in the know. Excellent information and warning for people who are new to investing. For experienced real estate agents and investors, if you have a website and aren’t using a live chat right now, I highly recommend it. Once you have invested and have property, it’s the best way to find leads.

    http://readychat.com/

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