IRS Automatic Exemption from Penalty: What Small Business Owners Should Know Before 2027

A clean driving record can affect how an insurer views your risk. The IRS is applying a similar idea to certain penalties: a record of timely compliance may help you receive automatic relief when a qualifying return is filed late.

1. What AEP changes, and what it doesn’t

The IRS announced the Automatic Exemption from Penalty (AEP) in news release IR-2026-83 on July 8, 2026. AEP replaces the long-standing First Time Abate (FTA) administrative relief for eligible returns with original due dates on or after January 1, 2027. Instead of assessing certain penalties and then removing them after a request, the IRS applies AEP during original return processing when its records show the taxpayer meets the requirements.

No application, form, or separate request is required when AEP applies. The IRS sends a notice explaining that the penalty was not assessed because of the taxpayer’s timely compliance history.

AEP covers certain failure-to-file, failure-to-pay, and failure-to-deposit penalties. It does not eliminate penalties generally. Publication 6171 (7-2026), “AEP Myths vs Facts,” is the IRS’s own myth-correction resource, and it directly corrects the common misread that the IRS is eliminating penalties. The relief is limited, and owners must continue filing returns, paying taxes, and making required deposits on time.

AEP is an administrative IRS program, not a statute, and IRS guidance may change. This article reflects IRS guidance as of October 2026. AEP is in transition, so business owners should pay attention to whether a return was processed before or after the program began.

2. Who may qualify: the lookback and exceptions

For a non-quarterly return, the general standard is a timely filing history for the same return type and payment of any tax due during the three prior years. For quarterly returns, the lookback is 12 consecutive quarters. A return filed on time in one series does not automatically establish a timely record for another return type.

The taxpayer must also meet the penalty-history test: either no penalty other than an estimated tax penalty was assessed, or an assessed penalty was later abated for reasonable cause or IRS error. Business taxpayers have additional requirements. During the relevant prior period, the IRS must not have waived the failure-to-deposit penalty four or more times, and the taxpayer must not have had a failure-to-deposit penalty charged for EFTPS avoidance.

AEP is not available for every return or penalty. It does not apply to accuracy-related penalties, information return penalties, the Daily Delinquency Penalty, information reporting dependent on another filing, or returns filed once or infrequently, such as event-based Forms 706 and 709.

Form CT-1 is listed as an eligible return series, but it is not programmed for systemic automatic application. Taxpayers with Form CT-1 must contact the IRS for manual consideration; they should not assume relief will be applied automatically.

3. Which years, returns, and transition rules matter

The IRS identifies Forms 1040, 1065, 1120, 940, 941, 943, 944, 945, and CT-1 as eligible return series. AEP applies to 2025 tax year returns and 2026 quarterly returns, and subsequent periods. For eligible returns with original due dates on or after January 1, 2027, AEP replaces FTA.

The transition matters. Some taxpayers may receive penalty notices for eligible 2025 tax year returns and 2026 quarterly returns even if they may qualify for relief. FTA remains available by request for eligible 2024 tax year returns, eligible 2025 quarterly returns, and eligible 2025 tax year returns and 2026 quarterly returns processed before AEP began. If you receive a notice during the transition, do not assume the penalty was automatically reviewed under AEP; discuss the notice and possible FTA request with your tax professional.

Keep the lookback years straight. For a 2026 return, the three prior years are 2023, 2024, and 2025. Your 2026 conduct does not affect AEP eligibility on your own 2026 return. Instead, your 2026 track record becomes part of the lookback for future years.

For example, a single late 2026 Form 941 or Form 1120-S may affect whether the same return type meets the timely-filing history for a later return in 2027, 2028, or 2029. It can cost you automatic relief down the road. It does not buy AEP relief on the 2026 return.

4. Penalty exposure still matters: examples and deposits

AEP does not change the underlying penalty mechanics. For individuals and most business returns, the failure-to-file penalty is generally 5% of tax due for each month or partial month late, capped at 25%, and reduced by the failure-to-pay penalty applied in the same month. The minimum failure-to-file penalty of $525 applies only when the return is more than 60 days late, and is the lesser of $525 or 100% of the underpayment. That minimum applies to Forms 1040 and 1120, not to pass-through Forms 1065 and 1120-S.

For Forms 1065 and 1120-S due after December 31, 2025, the base failure-to-file penalty is $255 per partner or shareholder per month, for up to 12 months. It can apply even when the entity owes no tax.

Illustrative calculation, not an IRS figure: A Form 1120-S with four shareholders filed three months late could have a base penalty calculation of $255 × 4 shareholders × 3 months = $3,060. This calculation illustrates the base formula; a specific account’s assessment or potential relief requires individual review.

The failure-to-pay penalty is 0.5% of unpaid tax for each month or partial month, capped at 25%.

Illustrative calculation, not an IRS figure: Suppose $30,000 of tax remains unpaid and the original return is four months late. The failure-to-file penalty is 5% per month for four months, or 20%. For each month where both penalties apply, the failure-to-file rate is reduced by the 0.5% failure-to-pay rate, so the two together total about 5% of the unpaid tax for that month. Four months lands near 22% of the unpaid tax, or roughly $6,600 on a $30,000 balance, before interest. The $525 minimum does not come into play here because the return is not more than 60 days late.

Failure-to-deposit penalties depend on how late a deposit is: 2% for 1–5 calendar days, 5% for 6–15 calendar days, 10% for more than 15 calendar days, and 15% if it remains unpaid more than 10 days after the date of the first notice or the day of an immediate-payment notice. Interest is charged on penalties.

Illustrative calculation, not an IRS figure: A $40,000 payroll tax deposit made seven calendar days late falls in the 5% tier. The illustrative penalty calculation is $40,000 × 5% = $2,000.

Payroll deposits are separate from payroll return filings. Deposit schedules remain monthly or semi-weekly, determined before each calendar year from the lookback period in Publication 15. Monthly depositors generally deposit by the 15th day of the following month. Semi-weekly depositors deposit taxes for wages paid Wednesday through Friday by the following Wednesday, and taxes for wages paid Saturday through Tuesday by the following Friday. The next-day rule applies if $100,000 or more in taxes accumulates on any one day. Federal tax deposits must be made by electronic funds transfer.

5. What business owners should do now

Build a repeatable process. AEP may reduce the need to request relief for a qualifying event, but it does not replace filing, payment, or deposit controls. Use this action plan:

Build a compliance calendar for each required return, tax payment, and payroll deposit. Assign a person responsible for preparing, reviewing, and confirming completion.
Confirm your deposit schedule before the calendar year begins. Check whether you are monthly or semi-weekly, map the applicable due dates, and confirm that your EFT payment method is ready.
Confirm that the same return type was filed timely for each of the prior three years, or for the applicable 12 consecutive quarters. Review IRS account notices with your CPA or tax professional; do not rely only on an internal calendar.
Screen for missed or incomplete filings before year-end. Resolve open bookkeeping items, identify missing records, and flag returns that may still need professional attention.
Document facts that may support a reasonable-cause review, such as a disruption that affected the business’s ability to meet its obligations. Keep records organized and share them with your tax professional.
Work with your CPA or tax professional on any IRS notice. During the transition, a qualifying taxpayer may need to contact the IRS to request FTA rather than assume AEP was applied. FTA is not applied automatically; the taxpayer generally contacts the IRS using the phone number on the notice or submits a written request, and any unpaid tax and interest remain due even when a penalty is removed.

Penalty determinations and penalty abatement requests for a specific account belong to the taxpayer's CPA or tax professional. LunaSi Accounting, LLC does not prepare tax returns, does not file returns, does not request First Time Abate or penalty relief, and does not represent taxpayers before the IRS.

LunaSi Accounting, LLC provides monthly bookkeeping, account reconciliations, month-end close, accounts payable and receivable, payroll support, financial reporting, Controller/CFO-level support, and audit-readiness preparation. These services help owners keep financial records organized and support visibility into business performance; they are not tax representation or penalty-abatement services.

AEP is a federal program only. State penalty rules are separate and may differ, so review state obligations with your tax professional.

6. Getting started

Start by confirming your filing calendar, return history, and payroll deposit schedule with your CPA or tax professional. For bookkeeping and financial reporting support, contact LunaSi Accounting, LLC to discuss your business’s needs.

This content is for general informational purposes and is not legal, tax, or accounting advice. Consult a qualified professional for your specific situation.

09.10.2026