Taxpayers lose billions of dollars each year on IRS penalties, and some of these expenses can be easily avoided if taxpayers know what to do.
In this article:
- IRS Penalty for Filing Taxes Late
- IRS Failure to Pay
- Interest Rate on Unpaid Taxes
- Civil Fraud Penalty
- Fraudulent Failure to File Penalty
- Understatement of Taxes
- For Business Owners, Underpayment of Estimated Taxes
- IRS Penalty for Negligence or Intentional Disregard
- Criminal Charges, Commonly for Tax Fraud
The 9 Most Common IRS Penalties and How to Avoid or Minimize Them
1. IRS Penalty for Filing Taxes Late
Generally known as the Failure to File Penalty, this expense totals to a monthly 5% rate for taxpayers who do not file taxes by the tax deadline, which is usually April 15 or the next business day.
This 5% rate applies to unfiled taxes, and the IRS uses the amount in their Letter 2566. The tax amount in the letter is usually higher, as the tax amounts do not necessarily reflect all possible deductions for the taxpayer and may have inaccurate taxable income levels.
The higher tax amount means higher penalties for taxpayers who do not file. To minimize the penalty, the taxpayer should reply to the Letter 2566 with an amended tax return with the correct tax amount.
Additionally, this penalty applies immediately after the tax deadline and then continues every calendar month. To clarify, the day after the tax deadline, a taxpayer gets the 5% penalty, and then on May 1st, another 5% applies, for a total failure to file penalty of 10%.
The IRS sets a minimum amount for the penalty. For Tax Year 2018, the taxpayer pays the higher amount between $205 or 100% of unpaid taxes.
The law does safeguard the taxpayer, as there is a 25% penalty cap to assist taxpayers in paying for the penalty.
In summary, the Failure to File penalty maxes out to 5% of unpaid taxes, which the taxpayer should review, as the amount used by the IRS is usually higher. The penalty applies first after the tax deadline, and then on the 1st of every succeeding calendar month.
A more in-depth discussion is available on the Failure to File penalty resource page.
2. IRS Failure to Pay
Another common penalty, taxpayers pay an additional .5% of the unpaid taxes each month for not sending the taxes. Both the failure to file and failure to pay penalty can exist independent of each other.
The good news for taxpayers is that the law limits the failure to pay penalty to 25%. Additionally, if both failure to file and failure to pay penalties apply, the IRS only applies a 5% monthly rate, rather than 5.5%.
Like the previous failure to file penalty, the taxpayer receives the first .5% the day after the tax deadline. The other 0.5% applies immediately on May 1st and then every first day of the month until the penalty limit of 25% applies.
Another similarity lies in the need to review the tax amount allegedly owed. The IRS uses their own calculations in the same Letter 2566, which means the taxpayer likely needs to negotiate first with the IRS, further prolonging the process.
3. Interest Rate on Unpaid Taxes
While not technically a penalty, but rather a fee, the IRS applies an interest rate on unpaid taxes.
The IRS usually uses the short-term interest rate plus 3%, which the Federal Reserve controls.
This interest rate applies every month and can change as the rates are flexible.
For example, the Federal Short-term rate for August 2018 is 2.42% for annual loans and 2.40% for monthly loans. The IRS can apply an additional 3%, so for taxes unpaid as of August 1, 2018, the monthly interest rate becomes 5.40%, which is very high when compared to bank loans.
4. Civil Fraud Penalty
A more serious allegation, the IRS can file for civil fraud penalty during an IRS audit. Civil fraud arises when 1), there is an underpayment of taxes; and 2), at least part of underpayment comes from fraud.
Rather than file a lengthier criminal case, the IRS can opt to just file for civil liability to the courts. However, the penalty is quite stiff: An additional 75% of the fraudulent underpayment.
The penalty applies immediately after the court decision, which means retroactivity of the penalty.
At this point, taxpayers may want to find a lawyer or tax advocate that fits their needs.
5. Fraudulent Failure to File Penalty
Related to the civil fraud penalty, fraudulent failure to file penalty arises from misrepresenting why a taxpayer did not file on time. Another requirement is that the reason why fraud was committed is due to evasion of taxes, like fraudulently postponing filing to hide extra income in offshore banks.
The failure to file penalty is a whopping 15% per month. The law caps the penalty at 75%.
The fraudulent failure to file penalty can exist independently from the civil fraud penalty.
6. Understatement of Taxes
Also known as underreporting, taxpayers can receive a 20% penalty if they report a lower amount for their taxable amount.
If the IRS finds fraud, the civil fraud penalty or even criminal penalty can proceed. If there is no fraud, the IRS instead applies a 20% penalty.
The IRS considers a taxpayer liable for underreporting if the total tax amount decreased by 10%, or $5,000 (whichever is lower).
7. For Business Owners, Underpayment of Estimated Taxes
The IRS can apply a 4% penalty of the underpaid or unpaid amount to business owners who erroneously sent lower estimated taxes. Since some businesses do not withhold taxes due to difficulty in accurately projecting taxes, as well as collecting income, they opt to go with an estimated tax system.
Estimated Tax Definition: Since businesses may have difficulty paying an accurate amount for a month due to difficulties in projecting income or with revenue coming in late (like a client paying the business after the usual 60 or 90 days), business owners opt to pay in advance by predicting their projected income. Usually, business owners pay 100% or 110% of previous annual tax liabilities staggered in 4 quarterly payments.
Sometimes, businesses may have weak seasons, or the taxpayer was not able to accurately pay the estimated tax amount due to an error. The IRS applies a 4% penalty to these quarterly payments.
8. IRS Penalty for Negligence or Intentional Disregard
Usually, the IRS sides with the taxpayer and believes in good faith when the taxpayer asserts that an error was unintentional.
However, if the disregard of IRS procedures leads to underpayment of taxes, the taxpayer receives a 20% rate penalty applied to the underpaid tax due to the negligence of the taxpayer.
The usual errors include not just the total tax amount, but also overstating deductions and unreported income.
Tip: The main difference between negligence and fraud lies in intent. If the IRS can prove that the underreporting was unintentional, then only the 20% penalty applies.
On the other hand, the 75% civil fraud penalty applies if the IRS can prove that the taxpayer knowingly and intentionally underreported or underpaid their taxes.
9. Criminal Charges, Commonly for Tax Fraud
Last, but definitely NOT least, are criminal charges. Underpaying of taxes does not normally mean jail time, but falsifying records and tax fraud have very steep penalties.
In this case, the IRS files a case against the taxpayer in the court with jurisdiction, usually the state where the taxpayer resides in.
For crimes committed against the IRS, the court can decide damages of $10,000 or jail time. The monetary damages add to the other penalties, like a failure to pay penalty, civil fraud penalty, and interest on taxes by the IRS.
The Top 3 Options on How to Minimize the Tax Amount or Lower Tax Payments
- Asking for a tax penalty abatement will help the taxpayer plan their finances properly. Abatement of penalty means an overall lower amount to pay, which can free up funds for other necessary expenses.
- Applying for a payment plan can give taxpayers some good breathing room. Once the IRS accepts the offer, penalties stop accruing as well, to help taxpayers pay the tax debt.
- Finally, an Offer In Compromise (OIC) can also help taxpayers get not only lower rates, but also preferable terms and schedule. Of course, millions of taxpayers also apply for an OIC, and to have better chances, taxpayers should learn more about what an OIC is all about.
Knowledge of these 9 IRS penalties and the available options can help taxpayers avoid or minimize paying large amounts of taxes. With such knowledge, the tax process becomes easier, cheaper, and less stressful for both taxpayers and the IRS.
Do you have any questions about IRS penalties? Do you have any kind of experience, positive or negative, with the tax process? Let’s discuss in the comments section below!
If you owe back taxes, visit taxreliefcenter.org for more information on tax relief options.