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Penalties

The Internal Revenue Service (IRS) imposes a variety of penalties on taxpayers who fail to comply with tax laws. These penalties can apply to individuals, businesses, and other entities. They serve as both a punitive measure and a deterrent to encourage compliance.

California’s Franchise Tax Board (FTB) and the Employment Development Department (EDD) both assert penalties for non-compliance, as do most all other state tax agencies that administer income, employment, and sales taxes.

Types of IRS Penalties
IRS penalties can be broadly categorized into four main types: failure to file, failure to pay, accuracy-related, and fraud-related penalties.

1. Failure to File Penalty
The failure to file penalty applies when a taxpayer does not submit their tax return by the due date, including extensions.

  • Rate: The penalty is typically 5% of the unpaid tax (balance due with the filing of the return) for each month or part of a month that a tax return is late, up to a maximum of 25%.
  • Minimum Penalty: If the return is more than 60 days late, the minimum penalty is the lesser of $435 or 100% of the unpaid tax.

2. Failure to Pay Penalty
This penalty is assessed when a taxpayer does not pay the taxes owed by the original due date (the granting of an extension is solely for filing after the due date; any tax due with the filing of the return must be paid by the original due date, or the failure to pay penalty may be assessed).

  • Rate: The penalty is 0.5% of the unpaid taxes for each month or part of a month after the due date, up to a maximum of 25% of the unpaid taxes.
  • Reduction: If both failure to file and failure to pay penalties apply in the same month, the failure to file penalty is reduced by the amount of the failure to pay penalty.

3. Accuracy-Related Penalties
Accuracy-related penalties apply to underpayments due to negligence, substantial understatement of income tax, or substantial valuation misstatements.  They generally result from an IRS audit or a failure to include income that is reported on a 1099 that is discovered during the return’s matching process with filed information returns.

  • Negligence or Disregard of Rules: A 20% penalty on the underpayment due to negligence or disregard of IRS rules and regulations.
  • Substantial Understatement of Income Tax: A 20% penalty on the underpayment if the understatement exceeds the greater of 10% of the tax required to be shown on the return or $5,000.
  • Substantial Valuation Misstatement: A 20% penalty on the underpayment if the value claimed for the property is 150% or more of the correct value.

4. Fraud-Related Penalties
Penalties for fraud are severe and are intended to penalize deliberate attempts to evade taxes.

  • Civil Fraud Penalty: A 75% penalty on the portion of the underpayment attributable to fraud.
  • Criminal Penalties: Tax evasion and fraud can also result in criminal charges, which may lead to imprisonment, substantial fines, or both.

Other Common Penalties
In addition to the main categories, there are other penalties that taxpayers may encounter:

  • Failure to Deposit Penalty: For businesses that do not deposit payroll taxes correctly.
  • Estimated Tax Penalty: For individuals and businesses that do not pay enough tax throughout the year.  This penalty has risen dramatically in the last couple of years.  Taxpayers can avoid it by increasing withholding or making estimated tax penalties to cover their projected tax liability with the filing of their return.
  • Information Return Penalties: For businesses that fail to file required information returns or provide incorrect information (e.g., Forms W-2 and 1099).

Avoiding and Mitigating Penalties
There are several strategies to avoid or mitigate IRS penalties:

1. Timely Filing and Payment

  • File on Time: Submit tax returns by the due date to avoid failure to file penalties. Consider filing for an extension if more time is needed.
  • Pay on Time: Ensure that taxes owed are paid by the due date to avoid failure to pay penalties. If unable to pay in full, consider setting up an installment agreement with the IRS, or pursue an offer in compromise if the liability cannot be fully paid before the expiration of the collection statute of expiration (CSED) even with a payment agreement.

2. Accurate Reporting

  • Double-Check Information: Ensure that all information on the tax return is accurate and complete to avoid accuracy-related penalties.  Using tax software can minimize the chance of making errors.
  • Professional Assistance: Consider retaining the services of a tax professional or accountant (such as an enrolled agent or CPA) to prepare and review tax returns, especially if the tax situation is complex.

3. Reasonable Cause Relief
The IRS may waive some types of penalties if the taxpayer can demonstrate reasonable cause for failing to comply with tax obligations.

  • Documentation: Provide documentation and a clear explanation of the circumstances that led to the failure.
  • Events: Common reasons for reasonable cause include natural disasters, serious illness, or death.

4. First-Time Penalty Abatement

  • Eligibility: Taxpayers who have a clean compliance history for the past three years and have filed all required returns and paid or arranged to pay any due tax can request first-time penalty abatement.  There are a limited number of penalties that are eligible for this category of relief.

Conclusion
IRS penalties can be substantial and can significantly impact individuals and businesses. Understanding the types of penalties and the conditions under which they are imposed is crucial for maintaining compliance with tax laws. By filing and paying taxes on time, accurately reporting income and expenses, and seeking professional assistance when needed, taxpayers can avoid or mitigate these penalties. In cases where penalties are assessed, exploring options such as reasonable cause relief and first-time penalty abatement can provide relief. Ultimately, proactive and diligent tax practices are the best defense against IRS penalties.