Understanding Tax Penalties

Tax Day is the date by which you need to submit your individual tax return to the IRS (usually April the 15th each year). If you have all the money to pay your liability, then all is great. But, what happens when you lack the necessary funds? In this case, the IRS may charge tax penalties. The same applies to some other occasions.

All of that will be discussed in depth here, so you know exactly what to expect and what to do if you are called on by the IRS to pay tax penalties. 

What is a Tax Penalty?

The IRS charges both interest and penalties in several different instances. For example, you will be called to pay some additional costs for:

• Failure to file – This means that you did not manage to file your tax return by April 15. Do note, though, that you can request a deadline extension. If it is approved, you won’t be charged any failure-to-file tax penalties. 
• Failure to pay – You don’t have the money to pay the taxes on your return or are unable to make the needed payment before the expiration of the due date (April 15). Beware, in this case, because you will still have to pay your taxes within the given deadline even if your deadline extension (to file your tax return) request has been approved. 
• Failure to pay tax – If you don’t make tax payments as you earn income (quarterly), you are penalized for late estimated tax payments. 
• Dishonored check – You have submitted a preferred payment form (i.e., check), but your bank does not honor it.  Or in other words, your check bounces. 

If you owe money to the IRS, the Internal Revenue Service will send you a Notice of Tax Due and Demand for Payment, which includes not only the owed taxes but also the penalties and interest. 

What is The Penalty for Filing Taxes Late?

There are two different scenarios here, according to the Internal Revenue Code §6651(a)(1). 

If you owe taxes and fail to file your tax return on time, the IRS will start charging 5% of every unpaid tax you have to report on your return for every month you are late to file (0.5% for not paying and 4.5% for not filing). The total penalty you may be asked to pay for not filing taxes on time can add up to nearly 48% of the tax owed, plus interest. 

So, basically, the IRS begins to accumulate charges in your name. If you are more than 60 days late, the minimum penalty you will be called to pay equals to the lesser of two sums – either a specific dollar amount (for 2020, it is set at $435) or 100% of the tax required to be paid on your return (plus interest). 

Now, if you are expecting a tax refund and do not file your tax return within the due date, you won’t be charged any fees. However, you won’t be able to receive your refund until you do file your tax return.

Bear in mind that the late filing penalty is NOT the same as the penalty you get for making late payments. You are charged a late filing penalty when you don’t turn in essential tax documents on time, such as your Form 1040. The late payment penalty is applied when you are late in making your tax payments and is 0.5% of your unpaid taxes for every 30 days you do not pay your outstanding taxes. 

What is the Penalty for Not Filing Taxes?

If you fail to file, the IRS may file a substitute return for you, which will NOT include your standard deductions included in your return. The only exception to the substitute return is married filing separately or single filing. Under IRC § 6651(a)(1), the penalty is 5% of the due balance, plus an extra 5% for every 30 days (or a fraction thereof) during which you continue to fail filing taxes. The maximum penalty is 25%. 

Notes:

• As soon as you pay your balance, both interest and penalties stop accruing. 
• Even if you pay your tax in full before the month ends, the IRS will still apply full monthly charges. 
• If you cannot pay your balance in full, you could apply for an Installment Agreement to help repay the remaining liability. 
• You may be eligible for penalty relief if you have complied with the law requirements but were not able to meet your obligations toward the IRS. 
• If you disagree with your balance, you can call 1-800-829-1040. Make sure you have all the required paperwork ready (i.e., amended return, canceled checks, etc.) when you make that call to the IRS. 

 

Do You Have to File Taxes?

You must file a tax return if you:

• Are self-employed and earned $400 or more during the year.
• Have claimed unemployment income during the year.
• Have made more than the standard deduction for your filing status and age. 
• Have a negative or zero tax bill (unless you want to claim Earned Income Tax Credit or other refundable credits). 
• Have had tax withheld by your employer during the year and wish to receive a refund. 

Note that for individual taxpayers under 65 years of age, the standard deductions are $12,000 (single filers), $24,400 for joint filers, and $18,350 for single parents (2019 IRS rules). For single filers over 65 years old, the amount climbs to $13,850 or $20,000 if you are the head of the household. For joint filers where one or both spouses are over 65, the deduction is $25,700. 

How is the Tax Underpayment Penalty Calculated?

Taxpayers in America pay taxes the moment they make money rather than a lump amount. And, they can pay taxes either by making estimated tax payments or via withholding. The penalty for underpayment of estimated tax is usually applied to individuals that have skipped some tax payments the previous fiscal year. To put it simply, a tax underpayment penalty is a penalty that you owe if you fail to pay enough in estimated tax payments or through withholding during the year. 

Failure to pay proper estimated tax usually comes with a penalty if you owe at least $1,000 when you file the return, per the Internal Revenue Code §6654. You might be able to make unequal payments and annualize your income as a means to lower or even avoid the penalty, though. This typically happens when you receive your income unevenly during the year. 

In some instances, you can waive this penalty:

1. Your tax payments were (1) 90% or more of the tax liability during the year or 
2. Your tax payments were 100% of the tax liability of the previous year. 
3. You did not make a payment due to an out-of-the-blue event, such as a disaster or casualty. 

The IRS may also waive a tax underpayment penalty for retirees over 62 years of age or individuals that became disabled either during the current or the previous tax year. Some exceptions apply for some household employers and fishers. Ask us to give you all the details or read the IRS Publication 505. 

The IRS calculates your penalty for every installment separately, where they first determine the number of days you are late and then multiply that number by the interest rate that is effective for the installment period. However, you may also check whether you owe a tax underpayment penalty by using Form 2210 (Underpayment of Estimated Tax by Individuals, Estates, and Trusts) or Form 2220 (Underpayment of Estimated Tax by Corporations) depending on your case – look for the flowchart. 

If you do owe a penalty, you will need to figure out what you owe in taxes per quarter (and what you have paid in taxes during this time) to calculate the per-quarter penalty sum. Then, you will get your total penalty amount by totaling your quarterly penalties. According to the IRS, the following interest rates on underpayments apply:

• 2.5% for the portion of an overpayment over $10,000 (for corporations).
• 5% for underpayments and overpayments (not for corporations).
• 4% for corporation overpayments.
• 7% for large corporate underpayments. 
• The federal short-term rate + 3% for taxpayers besides corporations (for underpayments).
• The federal short-term rate + 2% for taxpayers besides corporations (for overpayments). 

Remember that all rates are determined on a quarterly basis. 

How Much Is the Penalty For Not Paying Estimated Taxes?

The estimated tax penalty is, at its core, an interest charge for not making estimated payments throughout the year (or sufficient estimated payments). The IRS-set quarterly rate for underpayments was 5% in the first and second quarter of 2020 and 3% in the third. This shows that taxpayers were called to pay a higher percentage quarterly rate on the first two quarter balances in 2020. It should be noted that interest is accumulated on a daily basis and is usually added to any tax you have not paid from the time of the due payment to the date you eventually pay the tax. As for the rates, they are set every three months and range around the federal short-term rate plus 3%. 

What Is the Tax Penalty For an Early Pension Withdrawal?

Tax breaks such as the Retirement Savings Contribution Credit comes with penalties for early withdrawal. This is the government’s measure to prevent individuals from using their retirement savings for things other than their retirement income. Generally speaking, an early withdrawal or distribution of your retirement plan is any money you cash out before you reach 59 ½ years of age. 

Note that qualified retirement plans do NOT include local or state government 457 plans, rather than:

• A 403(b) plan (or anything similar) for public school employees and organizations that are tax exempt. 
• A 403(a) or similar employee annuity plan.
• A 401(k) or similar employee plan.
• A Roth IRA
• A Traditional IRA

The amount you withdraw from your retirement plan (a qualified one, that is) is added to your gross income. This means that you will owe the normal income tax PLUS an extra tax 10% tax penalty on the amount you have withdrawn from your retirement plan. Of course, there are exceptions for early withdrawal as well, where this is not applied. 

Note that not all distributions are taxable and subject to the 10% extra tax penalty, such as the ones you roll over to another retirement plan. Also, the following exceptions to the 10% additional tax penalty for early pension withdrawals apply (these are only some of the existing exceptions – contact us for more details):

• You made a series of periodic and equal payments over your life expectancy, and the distribution was an installment in them. This provides that you have left employment before starting the payments if your retirement plan is not an IRA. 
• You made a series of periodic and equal payments over the life expectancy of your beneficiary (or beneficiaries) and yourself, and the distribution was an installment in them. This provides that you have left employment before starting the payments if your retirement plan is not an IRA. 
• You made the distribution to pay for an IRS levy.
• You made the withdrawal to cover deductible medical expenses.
• You made the withdrawal to cover post-secondary education expenses (applies to IRAs only).
• You made the distribution due to permanent or total disability.
• A beneficiary made the distribution after your death. 

Note: Reporting your withdrawal is income is still required even if you qualify for any of the exceptions. 

Here is the current tax regime of penalties for withdrawing from 401k and IRA accounts:

For distributions of up to $100,000 related to the coronavirus, the 10% is waived. The same applies to higher education expenses, first-time home purchases or new builds, medical expenses or insurance, or family circumstances (i.e., provide funds to a divorced spouse). The distributions may still be considered as income, though. Early withdrawals from these accounts are expensive unless you are over 59 ½ years old. In any other case, you may pay a 10% penalty on the account you cashed out money and federal income tax. Exceptions apply to the 10% penalty rule, though. Ask us for more details. 

Civil Tax Penalties

Taxpayers that are late on filing tax returns and paying tax, not prepay a sufficient sum of tax liability, or face accuracy-related problems are called to pay penalties for not meeting the given deadlines. 

In detail, the penalty for late filing applies to both non-filing and late filing and is the rate of 5% per month of the tax due (up to 25% max). For failing to pay the tax shown on the return by the due date of the payment and not paying an asserted deficiency within a short time frame after notice and demand, taxpayers face section 6651(a)(3) and 6651(a)(2) penalties, which are 0.5% per month of the sum shown as tax due (up to 25% max). Finally, taxpayers that do not prepay 90% of their tax liability via applying a prior year’s tax refund, making voluntary installment payments throughout the year, or withholding fall under Section 6654. The estimated tax penalty, in this case, applies automatically unless you can prove that you qualify for an exception (i.e., the paid sum during the subject year was greater than or equal to the tax liability for the previous year).

The failure to file penalty depends on the net tax sum required to be shown on the return, the penalty period, and the penalty rate (usually 5%). Plus, it is imposed according to the number of months during which the taxpayer has not filed, with the maximum being 4 months and one day. 

As for time extensions to file or pay, they do not affect the period for calculating the penalty for the late payment as they do not extend the due date to pay. Nevertheless, if you have paid at least 90% of the tax shown on the return by the due date, an automatic extension of time to file a tax return is treated as a time extension to repay the tax (Form 4868). This also entails that the balance is paid with the tax return as well. In any other case, the penalty applies to the total balance due from the initial due date. 

Lastly, if the IRS decides that you need to pay an additional tax that was not shown on a return. You will receive a notice that the Service has assessed an extra sum on top of what you have paid. Failure to pay this tax is subject to additional tax (0.5% for each month that the assessment is unpaid) for failure to pay (it should be paid within 21 days after your notice was issued).

Exception to Apply – General Requirements 

You can demonstrate an absence of willful neglect (reckless indifference or intentional failure) and reasonable cause for the failure to file a return.  The IRS considers the following factors, among others, to decide whether to abate the penalties or not:

• The length of time between the event incident that was regarded as reason for noncompliance and the following compliance.
• The taxpayer’s penalty history.
• The taxpayer’s payment history. 
• Whether the reasons of the taxpayer address the imposed penalty. 

Note: Record unavailability is usually not considered a reasonable cause, nor does ignorance of the law. You can also NOT claim things like unavailability of the needed information to complete the return, invalid extension, time or business pressures, forgetfulness or mistake, or a belief that no tax was due. The IRS might consider the following as constituting reasonable cause:

• Unavoidable absence
• Serious illness or death of the taxpayer
• Natural disasters
• Fire
• Casualty

Accuracy-Related Civil Penalties

These are a group of civil penalties, including those imposed for substantially misstated valuations, those for reporting positions without adequate disclosure or substantial authority, or those for negligent reporting positions. In these cases, the taxpayer is called to pay an accuracy-related penalty. However, exceptions apply while there are several possible defenses tax practitioners can raise to help avoid these penalties.

Are Tax Penalties Tax Deductible?

According to the Code, no deductions can be taken for a penalty or fine that is issued for any law violation, including claiming false tax credits or deductions or misreporting income. It should be noted that a fine refers to both civil penalties and sums paid in settlement of potential liability for a penalty or fine that is not deductible. Compensatory damages paid to the government, though, is not considered as a penalty or fine. The IRS usually assesses penalties along with interest (not tax-deductible) on the due balance owed by the taxpayer. 

Let us note, at this point, that taxpayers may qualify for relief despite the fact that they cannot deduct penalties. For extenuating circumstances, and only if the IRS approves it, taxpayers may see some or all of their penalty being relieved. Nevertheless, until the due amount is paid in full, they will have to pay interest. 

What is also known is that legal expenses incurred in trying to collect or produce taxable income are not deductible anymore, according to IRS Publication 529. You can, however, fill out Schedule C to deduct expenses related to resolving tax problems linked to loss or profit from your business, or Schedule E for farm expenses and income, or Schedule E for royalties and rentals on the appropriate schedule. Nonbusiness-related expenses used to resolve tax issues are no longer deductible. 

How to Get a Tax Penalty Waived

Taxpayers that fail to file, pay, or deposit penalties may qualify for the first-time penalty abatement (FTA) waiver (only applies if there is reasonable cause for not paying or filing taxes on time). The IRS may grant relief to relieve this administrative waiver if certain criteria are met, such as having a clean compliance history (no penalties owed) for at least three years. You may also be eligible for the FTA waiver if you have:

• Paid all tax due.
• Made arrangements to pay all tax due (i.e., via an installment agreement – applies to current payments). 
• Filed all necessary returns and cannot file an outstanding claim for a tax return.
• Filed a valid extension for the necessary returns and cannot make an outstanding request for a tax return. 

To request penalty abatement over the telephone, you need to provide your tax practitioner with a Power of Attorney authorization to request the penalty on your behalf, especially if your case is being handled by a specific compliance unit. If you don’t receive a letter from the IRS indicating that you meet the FTA criteria and that your penalties have been removed within 30 days from the day you (or your tax practitioner) called them, it is strongly advised to follow up with the IRS. You may, nevertheless, request a penalty abatement by letter or mail, provided that you attach all relevant documents and information, such as transcripts that prove payment or filing compliance and/or a valid power of attorney, among others. 

Important Notes:.

• If you have paid the penalty, you can file Form 843 and ask for a refund. 
• First-time penalty abatement applies to one tax period. If you request for penalty relief for more than one year, your penalty relief will apply to the earliest tax period, as long as you meet the FTA criteria. The subsequent tax years may have a penalty relief based on reasonable cause criteria and other relief provisions. 
• You may take your case to Appeals if you believe that you can receive penalty relief on hazards of litigation on other factors.

Conclusion 

Filing your tax returns and paying your tax bill on time is key to avoiding getting penalties. Nevertheless, in any other case, there are always reasonable IRS payment plans that you could consider. These offer significantly lower interest rates and may even allow you to settle your bill for less than the due amount, such as the Offer in Compromise.

Let’s talk about your options and see what is the best course of action based on your individual case so that you can enjoy a happier and more stress (and liability)-free life from now on. Contact us now and schedule your appointment for a free consultation.