IRS audit penalties can inflate the tax debt of any taxpayer, and knowing more about these penalties can help taxpayers avoid or minimize them.
In this article:
- Who Merits an IRS Tax Audit?
- What Are the Usual IRS Tax Audit Penalties?
- When Do the Tax Audit Penalties Apply?
- Where Can a Taxpayer Go for Help?
- Why Does a Taxpayer Receive These IRS Audit Penalties?
- How Can a Taxpayer Proceed With These IRS Audit Penalties?
Frequently Asked Questions About IRS Audit Penalties
Who Merits an IRS Tax Audit?
In 2017, the IRS did almost a million audits, the lowest number of audits since 2003. The 943,000 tax audits translate to a .6% chance of a taxpayer being audited, but this low percentage does not discount the possibility of getting audited.
Taxpayers should look at the possibility of an IRS audit in two areas. The first area relates to how long ago a taxpayer filed the tax returns and the second lies on whether or not the taxpayer has an IRS trigger.
Technically, the IRS can go after taxes 10 years or newer, since taxes filed over 10 years ago typically fall under the Statute of Limitations. However, the IRS prefers to audit tax returns three years or earlier, so the risk of a tax audit typically lowers the older the tax return.
Regarding red flags, taxpayers should take care of avoiding the following:
- Reporting a sudden increase in income and revenue. If unavoidable, taxpayers should make sure that documents proving legality and reasonableness are available for a fast audit.
- Documenting large charity deductions. Being generous benefits both the giver and receiver, and to be clear, the IRS frowns upon excessive charitable deductions, not donations.
- For self-employed people and business owners, using up all business deductions in the filed IRS schedule C can lead to an audit. The IRS has data to compare if a taxpayer deviates from the norm regarding deductions.
- The IRS receiving conflicting reports from taxpayers, especially from employers and employees or clients and freelancers.
- Reporting high or all travel expenses as a business expense
- Documenting no or very low cash flow or income for a tax year
- Any home office deduction has a high chance of an audit.
- Lifestyle shows a big discrepancy between income and net worth
- Filing rental property expenses outside the norm
What Are the Usual IRS Tax Audit Penalties?
Most of the times an IRS audit penalty focuses on inaccuracies. However, there are also penalties for fraud and illegal actions, like tax evasion and employee misclassification.
Most of the penalties related to inaccuracies attach a 20% penalty of the inaccurate amount. Inaccuracy audit penalties include:
- Substantially understating income. The IRS deems income as substantially understated if the accurate amount is $5,000 or reaches 10% of the correct amount, whichever is lower.
- Understatements of reportable transactions. The IRS applies a 20% fee of inaccurate amounts that undergo a reportable transaction, like money going through a Guam Trust.
- Understated gifts or estates. If the understatement is 65% of the total market value of the gift/estate or the understated amount reaches $5,000, then the IRS attaches an audit penalty.
- Substantially overstating pension liabilities. Some businesses give out pension benefits for retired employees as deductibles and expenses, which can lead them to overstate these pension liabilities for a lower tax bracket.
- Substantially misstating the value of a property. Undervaluing or overvaluing a property by 200% leads to a 20% fee, while a 400% inaccuracy leads to a 40% penalty.
- Disregard for IRS rules and regulations. Some taxpayers make obvious mistakes, like filing an incorrect form when the had IRS already sent appropriate ones.
- Negligence of regulations. Negligence refers to good faith and reasonableness in learning the tax process, like being aware April 15th is generally the tax deadline.
The rest of the penalties refer to bad faith or fraud, which typically carry not only massive fees ranging from 50% to 100% of the total tax debt, but also the possibility of a prison sentence and a criminal record.
When Do the Tax Audit Penalties Apply?
Tax audit penalties apply after the IRS sends out the decision of a tax concern. However, other penalties may apply retroactively and can inflate the tax debt.
For example, if the IRS judged the overstatement of pension started three years ago, then the penalty applies retroactively. If so, then the failure to file and failure to pay the fee of 5% and .5% respectively may also apply retroactively, inflating the tax debt.
Also, it is important to remember tax debt and penalties also accrue interest. The longer the period of retroactive penalty application, the higher the interest in the long-term.
Usually, the IRS gives the taxpayer a chance to pay the tax debt without the accrued interest within 10 to 30 days, depending on how the negotiations and the audit went.
Where Can a Taxpayer Go for Help?
A taxpayer can try to handle the IRS audit by himself or through a taxpayer advocate.
Knowing the Tax Audit Process can help taxpayers properly prepare to avoid possible penalties.
Lastly, if the taxpayer has already paid the penalty, and upon the appeal the penalty was canceled or waived, the taxpayer cannot get the money back right away. He or she should apply for a tax refund or have the money credited for the next tax year.
It is also important to note an audit does not always merit a visit from a Revenue Officer. An IRS audit can come in three forms:
- Audit through correspondence, which is the most common. Here, the taxpayer goes through the audit by sending documents, which gives taxpayers enough time and opportunity to get help from experts.
- An office or field audit, where tax officers and taxpayers meet in the office or residence where tax documents are easily accessible for a review.
- Designated venue audits, like a neutral third-party location, tax court, or other safe spaces for discussions about the audit. Usually, serious cases like employee misclassification and tax fraud use this kind of audit.
Why Does a Taxpayer Receive These IRS Audit Penalties?
- Inaccurate information sent to the IRS. Taxpayers can massively decrease the chances of an audit by ensuring data sent to the IRS is accurate and filed properly.
- Innocent mistake, mainly due to the complexity of the tax process. A taxpayer may find himself or herself under audit for negligence or disregard. Anyone can prevent simple but obvious mistakes by frequenting useful tax websites like Tax Relief Center.
- Unavoidable discrepancies, which are red flags that may trigger an audit. For example, a taxpayer may suddenly get a promotion with a big raise, then get a large inheritance, while donating maximum deductible gifts to charities, which are three red flags for the IRS.
- The rare case wherein a taxpayer did something wrong, like misclassify an employee as a freelancer rather than an employee to save on Social Security and Medicare contributions.
How Can a Taxpayer Proceed With These IRS Audit Penalties?
In an audit, there are three possible judgments.
- The taxpayer accepts the audit results. Any penalties or tax debts applicable become final and executory upon the taxpayer assenting to the decision via written or verbal reply or through lapse of time (no reply within 30 days).
- The IRS accepts the reasons given by the taxpayer.
- Due to the unfavorable decision, the taxpayer sends an appeal to the IRS or tax court.
For the first two situations, the penalties, if there are any, apply retroactively. For the third situation, the IRS suspends the penalties but can backtrack the application of the fees and interest if the appeal fails.
If the judgment does have an attached penalty, the taxpayer can:
- Pay for the whole tax debt directly if possible. Sometimes, it may be better to take a loan from the bank, as bank rates are typically lower than IRS fees.
- Look for a payment plan. If paying a lump sum is difficult, a scheduled payment scheme can help taxpayers and the IRS send and receive the tax debt in a timely manner.
- Send the IRS an Offer in Compromise. If successful, the taxpayer may end up paying a lower tax debt and consequently lower IRS audit penalties.
- Apply for a CNC status, wherein the IRS suspends any penalties from accruing and giving the taxpayer an extension for paying the tax debt.
IRS audit penalties may inflate tax debts, but they serve as a great deterrent towards fraud as well as give the IRS the ability to review suspicious tax cases. As long as the taxpayer does what he or she is required by law properly and responsibly, a tax audit is not something to be feared.
Have you received any IRS audit penalties before? How did you handle it? Let us discuss in the comments section below.
If you owe back taxes, visit taxreliefcenter.org for more information on tax relief options.