I regularly receive phone calls inquiring about IRS penalties; questions like: “I didn’t make my estimated tax payment. What are the penalties?” or “I was audited and now I owe additional tax. What kind of penalties will I incur?”
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The IRS can hand down a variety of penalties for non-compliant taxpayers. Here’s a breakdown of the most common:
Filing late. If you do not file your return by the due date (including extensions), you may have to pay a penalty of 5% for each month or part of a month that a return is late, not to exceed 25%. The penalty is based on the tax not paid by the due date, without regard to extensions. This is why it is prudent to file a tax return even if you can’t afford to pay the tax bill.
Late-payment penalty. You will have to pay a failure-to-pay penalty of 0.50% of your unpaid taxes for each month, or part of a month, after the due date that the tax is not paid. If you filed for an extension, please note that the extension is only for filing, not paying. You will not be penalized during the automatic six-month extension if you paid at least 90% of your actual tax liability on or before the due date of your return, and pay the balance when you file the return.
If you contract with the IRS for an installment agreement, you will still incur late-payment penalties, but the rate will be only 0.25% of the unpaid balance. You only enjoy this reduced rate if you filed your tax return on time.
Filing and paying late. If you experience both late filing and late payment in any given month, the failure-to-file penalty is reduced by the failure-to-pay penalty. If you are more than 60 days late in filing and paying, the minimum penalty is the smaller of $135 or 100% of the remaining tax owed at the time of filing.
Underpayment of estimated taxes. This penalty calculation is not at all straightforward. Depending upon circumstances, you may not incur a penalty--even if you miss an installment. The IRS does not take action when you miss an installment payment: They don’t take note, nor do they care. First of all, it’s an “estimated tax,” which means it’s subject to change. Maybe business nose-dived and you will have a loss for the year; you will have no need to make an estimated tax payment if nothing will be due. The IRS won’t figure it out until you file your income tax return. Almost every tax software tax program can make the calculation. You must complete form 2210 and file it with your tax return in order to determine the amount (if any) of the penalty. The rate can be as small as .00008 or as high as .02383. Be sure to check out the form: At the top of page one is a flow chart to determine if you are subject to a penalty.
You may also get a break by annualizing income. For example, if business was good the first two quarters of the year and you made your estimates on time and then suddenly you experienced business reversals for five consecutive months, which meant you paid no estimate for third quarter. Then during the last month of the year, business rebounded and you were going to owe more than what you had paid in for the first two quarters, so you make your fourth quarter installment then pay the remaining balance on April 15 when you file your tax return. There is a worksheet on Form 2210 where you can show how much taxable income was earned during each quarter and escape penalty for the quarters in which your liability was covered by the estimates that were made. After all, when you suffered the losses during third and part of fourth quarter, you no longer owed that third-quarter installment.
Accuracy-related penalty.You may have to pay an accuracy-related penalty if you underpay your tax because:
1. You showed negligence or disregard of the rules or regulations. Negligence includes not keeping good books and records, as well as intentional disregard for the rules and regulations.
2. You substantially understate your income tax. This means you paid less than the larger of 10% of the correct tax liability or $5,000.
3. You claim tax benefits for a transaction that lacks economic substance. Economic substance is defined in the Internal Revenue Code as (A) the transaction changes in a meaningful way (apart from Federal income tax effects) the taxpayer’s economic position, and (B) the taxpayer has a substantial purpose (apart from Federal income tax effects) for entering into such transaction.
4. You fail to disclose a foreign financial asset.
An accuracy-related penalty is equal to 20% of the underpayment. The penalty is 40% of any portion of the underpayment that is attributable to an undisclosed noneconomic substance transaction or an undisclosed foreign financial asset transaction. The penalty will not be figured on any part of an underpayment on which the fraud penalty is charged.
An accuracy-related penalty can be abated fairly easily for reasons No.1 and No. 2 if you made adequate disclosure of your position on the tax return and you thought you had a reasonable basis for taking that particular position. It’s a fairly subjective area and one in which the complexity of the tax code can prove to your benefit. If your tax preparer made an error resulting in an accuracy-related penalty, you will usually have no trouble having it abated.
In fact, many penalties can be abated for reasonable cause. I prepared 20 years of tax returns for a new client. He escaped failure to file penalties because he had gone through a horrible divorce and was under a doctor’s care for severe depression.
Bonnie Lee is an Enrolled Agent admitted to practice and representing taxpayers in all fifty states at all levels within the Internal Revenue Service. She is the owner of Taxpertise in Sonoma, CA and the author of Entrepreneur Press book, “Taxpertise, The Complete Book of Dirty Little Secrets and Hidden Deductions for Small Business that the IRS Doesn't Want You to Know,” available at all major booksellers. Follow Bonnie Lee on Twitter at BLTaxpertise and at Facebook.