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5 Ways the IRS Can Fine & Penalize Taxpayers

Ines Zemelman, EA
01-Aug-17

Ines Zemelman, EAAug-01-2017

You’ve done the work and your tax return is prepared - now what? In the unfortunate circumstance that you owe the IRS tax, your project is not done until you’ve paid the piper. 

Let’s examine separately the various fees the IRS may charge you:

• Interest

• Failure to Pay Estimated Payments

• Failure to Pay Tax

• Failure to File

• Negligence and Fraud


Interest

There is a big difference between the date when you must file your return, and the date when the IRS expects their money. If you owe tax to the IRS, they expect to be paid on April 15th.

Even if you reside abroad and have until Jun 15 to file https://www.taxesforexpats.com/expat-tax-advice/filing-deadlines.html - if you owe any tax, interest starts to accrue from April 15th.  You can request an extension to file until October 15, but interest will still accrue from April 15the.

However - interest charged by the IRS is fairly small on a monthly basis. The rate the IRS charges in 2017 is 4% annually (0.33% per month). In practice, if you owe the IRS $1000 and pay in October, you will only owe them $20 in interest.

April to October = 6 months

6 * 0.33% * 1000 = $20 interest due

Now, small numbers can add up over time. Floyd Mayweather, the world’s highest paid boxer, is 15 months overdue on his tax payment and owes the IRS 7.5% interest on top of what he was already scheduled to pay, $220 million; $16,500,000.

Failure to Pay Penalty

Penalty and interest are different plagues. Interest is not considered a fine - it is just payment to the IRS for the privilege of using Government money after the moment the payment was due. Therefore, interest is linked to the federal short-term rate of loan. Interest rates are now at historical lows, therefore interest is low. If rates go up, so will the amount due to IRS for delayed payment.

The penalty is different. It is a fine for a violation, and it is equal to another 0.5% per month - add another $30 for for underpayment of $1,000 for 6 months.

Failure to Pay Estimated Payments

If you owed more than $1,000 in tax, the IRS expects you to make estimated payments for the next year. Failure to do so may lead to a ‘failure to pay estimated payment’ penalty.

• If you did not owe any tax last year, you do not need to make estimated payments before April 15.

If you anticipate you may owe tax this year, please get your documents in early so that we can prepare your return ahead of April 15 (tax due from this date accrues interest).

If you owed U.S. federal tax last year and did not anticipate tax withholding through your employer, the IRS expects you to pay quarterly estimated taxes.

By default, quarterly payments are calculated under the assumption of 10% income increase in the following year.

Failure to file penalty

This is the most onerous of penalties - you want to avoid this at all costs. This means that the IRS did not receive a filed return on time from you. The deadline is particular to your situation and includes applicable extensions.

1. If you live in the US, but do not file your return by April 15 - you will receive this penalty.

a) If you filed for an extension on or before April 15th, and filed your return on or before October 15th - you will not receive this penalty.

2. If you live abroad but do not file your US federal return by June 15 - you will receive this penalty

b) If you filed for an extension on or before June 15th, and filed your return on or before October 15th - you will not receive this penalty.

This penalty is 15 times greater than interest: the penalty is 5% for each month the tax return is late, up to a total maximum penalty of 25%. The percentage is of the tax due as shown on the tax return. If your tax return is more than five months late, simply multiply your balance due by 25% to calculate your failure to file penalty. But interest accrues on the penalties at the same rate it accrues on principal balance.

Negligence and Fraud

All of the aforementioned penalties are based on lateness. Assessment of those assumes the good faith on behalf of the taxpayer and the IRS only penalizes them  for lateness.

If the IRS assumes negligence or fraud, the potential penalties can be far higher. The  return could be timely filed and payment timely made -  but if the IRS discovers that income was underreported or tax was miscalculated.

The substantial understatement component of the penalty provides for a dollar criteria; the understatement exceeds the greater of 10% of the tax required to be shown on the return, or $5,000. These penalties are calculated as a flat 20% of the understatement of tax.

The Substantial Tax Understatement Penalty: if tax understated by at least  $5K or if tax understated by at least 10% of what it should be

The substantial understatement component of the penalty is applied when:

The understatement is over 10% of the tax required to be shown on the return

OR

If tax understatement is over $5K.

Penalty is calculated as 20% of the understatement of tax.  I.e., if tax on the return shown as $9K but should be $15K the penalty is $1,200 (20% of $6K).

Fraudulent Failure to File Civil Penalty

If you did not file a tax return at all, and the IRS can prove that you did not file to evade taxes, then, instead of incurring the normal 5% per month penalty on the amount owed for up to 25%, you would be facing a 15% percent per month penalty with a maximum 75% total penalty.

Summary

1. If you do not pay tax due by April 15 - you will receive an interest bill - but it is very small (0.33 % per month)

2. If you timely file an extension but do not send payment on time that will trigger failure to pay penalty (0.5% per month).

3. If your tax due was over $1k and you do not make estimated payments for your tax return, you will receive failure to pay estimated tax penalties.

4. If you do not file your return on time (including applicable extensions) - you will receive the most onerous of penalties - failure to file, which is 5% per month, capped at 25%.

5. Interest will accrue on the balance, on  the penalties, and on the interest itself. The interest is compounded daily.

Ines Zemelman, EA