The IRS Dishonored Check or Other Form of Payment Penalty applies if you don’t have enough money in your bank account to cover the payment you made for the tax you owe. In these cases, your bank dishonors and returns your bad check or electronic payment and declares the amount unpaid. The IRS then sends a Notice CP 165 or Letter 608C stating that you owe the Dishonored Check or Other Form of Payment Penalty.
For dishonored payments under $1,250, the penalty is lesser of $25 or the payment amount. Thus, if the dishonored payment is between $25 and $1,250, the penalty is $25. For dishonored payments over $1,250, the penalty can be quite high as it is based on 2% of the dishonored payment amount. There is no maximum penalty amount, so a large, dishonored payment can result in a very significant penalty.
The IRS will abate (remove) this penalty if you made a payment in good faith and with reasonable cause to believe there was enough money in your bank account to cover the payment.
Reasonable cause is not defined under the statute for this penalty; however, in other statutes, the law provides that a taxpayer may demonstrate reasonable cause by showing the taxpayer exercised ordinary business care and prudence in providing for payment of taxes.
The Internal Revenue Manual, the manual that IRS employees use for guidance in these cases, states that penalty relief may be granted if a taxpayer can furnish evidence that the bank account contained sufficient funds at the time the payment was submitted, but due to a bank or IRS error, the payment was dishonored.
Alternatively, this penalty can be abated if reasonable cause as described in the Internal Revenue Manual is met. According to the IRS, reasonable cause relief is generally granted when the taxpayer exercised ordinary business care and prudence in determining his or her tax obligations but was nevertheless unable to comply with those obligations.
Therefore, this penalty may be abated if either:
(1) the taxpayer’s bank account contained the sufficient funds but was nevertheless dishonored due to either bank or IRS error, or
(2) if the taxpayer had reasonable cause.
Disputing the penalty because your bank dishonored your payment, requires sending the IRS a letter explaining why you believe the IRS shouldn’t charge the penalty. This letter should include the IRS penalty notice and a detailed explanation that it should be abated based on bank error, IRS error or reasonable cause. Also, the letter should include relevant supporting documentation, such as a bank statement showing the funds were available at the time of the payment.
Additionally, a dishonored check penalty isn’t assessed on checks or other payment instruments for which you placed a stop payment order. If the IRS mistakenly assessed this penalty for a stopped payment, the penalty can be abated by providing the IRS a copy of the stop payment order.