Your S Corporation Return Was Filed Late. The IRS Penalty Is Often Waivable. The California One Is Not.
The federal per-shareholder penalty on a late S corporation return is usually removable. The California penalty is not, and most owners find that out after the federal one is already gone.
Han S Kim, CPA
10/6/20265 min read
The extended deadline for Form 1120-S was September 15. If the return went in after that date, the notice that follows is a CP162, and it arrives in October or November. The number on it will not match anything on the return, because the penalty is not computed from tax. The California notice comes later, is smaller, and is harder to get rid of.
Why is the penalty on a late Form 1120-S larger than the tax you owed?
IRC §6699(a) imposes a penalty on any S corporation that files after its due date, including extensions, or files a return missing required information. The amount under §6699(b) is a fixed dollar figure multiplied by the number of shareholders, charged for each month or part of a month the failure continues, capped at twelve months. For returns required to be filed in 2026, which includes the 2025 return due September 15, the figure is $255 per shareholder per month according to the IRS instructions for Form 1120-S. A three-shareholder corporation that files on October 6 owes $765 for one month. The same corporation that lets it run to the cap owes $9,180. None of that depends on whether the entity owed tax, and most S corporations owe none at the entity level, which is why the figure looks disconnected from the return. Under §6699(c) the penalty is assessed against the corporation rather than the shareholders, though in a closely held company that distinction is bookkeeping.
This is a filing penalty. The payment-side penalties and interest that apply when tax is actually owed run on different mechanics, covered in what happens when you cannot pay your full tax bill by April 15. A missed election deadline is a separate failure with its own relief path, covered in whether the IRS will fix a late S corporation election.
Who counts as a shareholder for the penalty calculation?
Section 6699(b)(2) counts every person who was a shareholder during any part of the taxable year. An owner bought out in February counts for all twelve months. A new shareholder admitted in December counts the same. The IRS takes the number from the shareholder count the corporation reported on the return itself, so the first thing to check on a CP162 is whether that count is right. A corporation that had one owner all year and reported two because a spouse was listed on a K-1 in error will pay double until someone corrects it, and the IRS will not catch that on its own.
Can you take the IRS to Tax Court over this penalty?
No. Section 6699(d) provides that the deficiency procedures in subchapter B of chapter 63 do not apply. There is no notice of deficiency and no Tax Court petition right before payment. The IRS assesses the penalty when the late return posts, bills it on the CP162, and the dispute happens administratively: a request for administrative relief, then a written reasonable cause claim on Form 843, then an Appeals conference if that is denied. Judicial review comes only after paying the penalty and suing for a refund. For a penalty in the low thousands, litigation is not a realistic path, which is why the administrative request has to be done correctly the first time.
Will the IRS remove the penalty, and what changed in 2026?
For years the answer for a first offense has been First Time Abate. If the corporation had no penalties on its 1120-S account for the prior three years and is current on its filings, the IRS removes the §6699 penalty on request, often on a phone call. That still works for the 2025 return.
The mechanism is changing under an IRS procedural update issued June 17, 2026. For eligible original returns due on or after January 1, 2027, First Time Abate is discontinued. It is replaced by Automatic Exemption from Penalty, under which the IRS checks the three-year history when the return posts and suppresses the §6699 penalty systemically before it is ever assessed. The transition began in summer 2026 with 2025 returns, and the IRS states that not every 2025 return will get the automatic treatment during the transition year. A corporation that receives a CP162 on its 2025 return can still request First Time Abate. A corporation that instead receives a CP195B has already been granted the exemption and has nothing to request.
Two things do not change. Relief attaches to one tax period. If the corporation was late two years in a row, the earliest year gets the administrative relief and the later year must stand on reasonable cause. The taxpayer does not choose which year, and under the new system the later year cannot qualify at all until three more compliant years have posted. Reasonable cause, in turn, has a floor set by the Supreme Court in United States v. Boyle, 469 U.S. 241 (1985): relying on an accountant to file is not reasonable cause, because filing on time requires no expertise. The first appellate decision on e-filed returns, Lee v. United States (11th Cir. 2023), applied Boyle where the taxpayer had signed Form 8879 and the CPA never transmitted. Signing the authorization form does not transfer the duty.
Why does the California penalty survive after the IRS removes theirs?
California imposes its own per-shareholder penalty on a late Form 100S under R&TC §19172.5: $18 per shareholder for each month or part of a month, up to twelve months, on top of the delinquency penalty under §19131 when tax is owed. The dollar figure is small. Two features make it the more durable problem.
First, California has no equivalent to First Time Abate or the new automatic exemption for entities. The FTB's one-time penalty abatement under R&TC §19132.5 is limited by statute to individuals subject to the Personal Income Tax Law, and the FTB's own guidance says it is not available to business entities. An S corporation's only path is reasonable cause under §19172.5(a), and the Office of Tax Appeals applies the ordinary business care and prudence standard with the burden on the taxpayer. Waiting on a Schedule K-1 from a partnership the corporation holds an interest in did not meet that standard in Appeal of Marketing Holdings, Inc. (2024-OTA-523, nonprecedential), where a single-shareholder corporation filed on October 6 and lost.
Second, the month count runs differently. Federal months run from September 15 because the Form 7004 extension, once granted, stands. California's six-month extension under R&TC §18604 is automatic and conditional, and when the extended date is missed the FTB counts from the original March 15 due date. In Marketing Holdings, October 6 was seven months late, not one. That is why the California penalty on a three-shareholder corporation that files three weeks late is $378 rather than $54, and why it stays on the account after the $765 federal penalty is gone.
For an owner in this position, the California reasonable cause claim is the part that requires judgment. It has to be built from the facts of the specific year, and a weak first submission forecloses a better one. Building it is the substance of an S corporation advisory engagement, and it usually runs alongside whatever caused the late filing in the first place.
What does this cost you after tax?
IRC §162(f)(1) denies a deduction for any amount paid to a government in relation to the violation of a law. Late-filing penalties are punitive rather than compensatory, so neither the federal nor the California penalty is deductible by the corporation, and neither reduces the income that flows through to the owner. A combined $1,143 penalty on a three-shareholder corporation that filed one month late is paid with after-tax dollars. At a 37 percent federal marginal rate alone, producing $1,143 after tax requires $1,814 of pre-tax income, before California's rate is applied.
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