What is the new IRS Automatic Exemption from Penalty (AEP)?

When the Form 1065, U.S. Return of Partnership Income, finally went out the door, six weeks late, I did what I’ve always done. I warned the client about a likely late-filing penalty and mentally filed the case under: “We’ll deal with the notice when it comes.”

For eligible 2025 tax-year returns, 2026 quarterly returns and later periods, that same late partnership return may tell a very different story.

When “wait for the notice” was the default move

Under the familiar playbook, the IRS generally assessed the applicable penalty first. Relief came later, if the taxpayer qualified. The underlying penalty authority may have come from several code sections, including §6651 for failure to file or failure to pay, §6656 for failure to deposit, and §§6698 and 6699 for partnership and S corporation late-filing penalties.

In that world, a late Form 1065 was a two-step process:

1. File the return, knowing the partnership late-filing penalty clock was already running under §6698. 
2. Wait for the notice, then decide whether to use first-time abate (FTA) or other administrative relief from the IRS’s Consolidated Penalty Handbook (IRM 20.1).

FTA lived downstream of the assessment. A compliant history could get the penalty removed, but only after it appeared on the account. The practitioner’s job was to request relief after assessment and confirm whether the IRS abated the penalty.

AEP moves the decision inside the IRS

Beginning in summer 2026, the IRS will begin shifting that sequence with Automatic Exemption from Penalty (AEP) for certain penalties on eligible returns. Under AEP, the key decision happens when the original return completes processing, not after a notice goes out.

Here’s what changes for our late partnership return, and for a lot of other filings:

• AEP applies to eligible 2025 tax-year returns and 2026 quarterly returns and later periods. 
• Covered return series include Forms 1040, 1065, 1120, 940, 941, 943, 944, 945 and CT-1. 
• Covered penalties include failure to file tax returns, partnership returns and S corporation returns under §§6651(a)(1), 6698(a)(1) and 6699(a)(1); failure to pay under §6651(a)(2) and (a)(3); and failure to deposit under §6656.

If the taxpayer qualifies, the IRS uses AEP to avoid assessing the eligible penalty in the first place. Instead of a post-assessment abatement like FTA, the exemption is built into the processing step. The IRS says it will send a notice explaining that AEP relief was applied and that no response is needed.

FTA is not disappearing all at once. Tax professionals may still request FTA for eligible 2024 and earlier returns, as well as certain 2025 tax-year and 2025 or 2026 quarterly returns processed before AEP begins. For eligible original returns with due dates on or after Jan. 1, 2027, AEP replaces FTA.

Reading the notice: Which story are you in?

If a client with a late or underpaid return is in an AEP-covered period and form series, and the notice does not show a failure-to-file, failure-to-pay or failure-to-deposit penalty, AEP may already have operated behind the scenes. No separate FTA request and no follow-up tracking, because the eligible penalty never hit the account.

But AEP does not erase everything:

• It does not remove unpaid tax.
• It does not remove interest on unpaid tax, though interest tied to a penalty should be reduced or removed when that penalty is reduced or removed.
• It does not cover every other penalty, including fraud-related penalties, the Daily Delinquency Penalty, returns filed once or infrequently, or information reporting dependent on another filing.

That means the notice becomes the practitioner’s diagnostic tool. If an eligible penalty is shown for a period and return type that AEP should cover, and the taxpayer appears to meet the criteria, the IRS has instructed taxpayers to contact the IRS using the information on the notice to resolve the discrepancy. 

In our original Form 1065 story, that might mean explaining to the client that the absence of a late-filing penalty line could reflect Automatic Exemption from Penalty, not an error, and that other amounts, like tax and interest, may still be due.

Quick card: old FTA reflex vs. new AEP question

Old FTA reflex

• Wait for the penalty notice showing a failure-to-file or failure-to-pay penalty under §6651, a failure-to-deposit penalty under §6656, a partnership return penalty under §6698(a)(1) or an S corporation return penalty under §6699(a)(1).
• Check whether the client qualifies for FTA, using compliance history and IRM penalty relief guidance (IRM 20.1). 
• Request relief after assessment, documenting first-time abate or reasonable cause.
• Track whether the IRS removes the penalty and updates the account.

New AEP question

• Did the IRS assess the penalty at all? Review the notice for failure-to-file, failure-to-pay or failure-to-deposit line items.
• Is this an AEP-covered period and return type? Confirm that it’s an eligible 2025 tax-year return or 2026 quarterly return (or later) and in the covered series (1040, 1065, 1120, 940, 941, 943, 944, 945, CT-1). 
• Did the IRS apply relief automatically? If an eligible penalty is missing for a late or underpaid return, AEP may have exempted it.
• Does the notice still show tax, interest or other amounts due? Remember, AEP does not remove unpaid tax, interest on unpaid tax or other penalties not subject to AEP.

What to tell the client:

“The IRS may have applied automatic penalty relief because your account showed a timely compliance history. That means the eligible penalty was not assessed, but tax, interest or other amounts may still be due.”

For more details, see the IRS’s Administrative penalty relief page.