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The Truth About Penalties for Those Late on Their Taxes

The Truth About Penalties for Those Late on Their Taxes
Ines Zemelman, EA
10 July 2014

The old saying about death and taxes notwithstanding, the (for some) dreaded April 15 (and June 15th for those living abroad) deadline for federal income tax filing is far from a hard-and-fast time limit. There are plenty of exceptions, some of which we’ll examine here. Generally speaking, there is one thing you can count on: the IRS wants whatever money is coming to it. The main exception is for tax relief offered in disaster situations such as hurricanes, which normally provides an extension for both filing and paying, but suffering through a natural disaster is hardly the preferred method to delay your tax return.

Penalties can also be waived for the taxpayers serving in the presidentially declared Combat Zones. Exceptions for disaster situation and for serving in combat zones are referred to as “statutory waivers” authorized by law.

Ask the IRS for an extension, and the answer will probably be yes

For the individual taxpayer, obtaining an extension of time to file a return is extremely simple: Form 4868, which probably holds the title of shortest tax form and if not is a strong contender. The only information required is your name, address, SSN (and spouse’s SSN if applicable), an estimate of your tax liability for the relevant year, your prior payments toward that liability, the balance due, and the amount you are paying when you file the 4868. There are also two boxes that can be checked if they apply; one is for those who are “out of the country” and a U.S. citizen or resident.

Form 4868 produces an almost automatic six-month extension of the filing deadline to October 15. In some documents the IRS distinguishes the six-month extension granted to those living in the U.S. from the four-month extension granted to those living abroad. At first glance this might seem unfair, but in fact under the tax code expats receive an automatic two-month extension to June 15, so the ultimate October deadline is the same for both groups.

Understanding the penalties for not filing and not paying

There are actually three separate penalties that may apply in this situation.

One is for failure to file a return; the other is for failing to pay taxes owed. The IRS is quite stern about failure to file but (at least initially) more forgiving about not paying. The penalty for failure to file is typically 5 percent of the unpaid tax liability for each month or portion of a month the return is late starting the day after the due date, up to a maximum of 25 percent. A return filed more than 60 days beyond the deadline (whether that is April 15, June 15, or October 15) is subject to a minimum penalty that is the lesser of $135 or 100 percent of the taxes owed

Failure to pay, by contrast, carries a penalty of 0.5 percent (yes, half a percent, or one-tenth the failure-to-file penalty) per month or portion of a month. As with the filing penalties, the maximum failure-to-pay penalty is 25 percent. It is important for expats to understand that June 15 is not a “different” filing deadline; it merely represents an automatic extension. Just as with any other extension, the taxes are due on April 15 or else subject to the penalty.

Third type of common penalties is for underpayment of estimated taxes. Tax must be paid as you earn or receive your income during the year. You can do this either through withholding or by making estimated tax payments. If you did not pay enough tax throughout the year you may have to pay a penalty for underpayment of estimated tax. Penalty can be avoided if the final tax bill on tax return is than $1,000 or if you paid at least 90% of the tax for the current year, or 100% of the tax shown on the return for the prior year, whichever is smaller.

The lesson is (or at least should be) that if you are unable to pay the full amount of tax that you owe, you should nevertheless file your return. Pay a portion if you can; the IRS is fairly easy to work with when it comes to setting up payment plans. The agency has gone so far as to offer an online payment agreement tool that allows you to set up a payment plan without even speaking to a human being (though there are limits on what is offered, and you will be expected to set up a payment mechanism—preferably automatic bank draft—and choose a due date).

What you can do to avoid penalties—maybe

The IRS does bend a bit when it comes to penalties—in certain circumstances. The rule is that if a taxpayer owes both failure-to-file and failure-to-pay penalties in any given month, the maximum penalty is 5 percent, not 5.5 percent. Allowed to linger unresolved, however, these penalties will mount up—once the IRS issues a levy, the failure-to-pay penalty increases to 1 percent, and the permissible ultimate maximum combined penalty is 47.5 percent, of which 25 percent is for late payment and 22.5 percent for late filing.

Also, if you request an extension and pay at least 90 percent of your tax liability at that time (that is, at or before the deadline), the IRS may waive the failure-to-pay penalty. However, any remaining taxes must be paid by the extended deadline, and any amounts paid after the initial deadline will still be subject to interest. If you file timely and enter into an installment agreement, the failure-to-pay penalty is reduced to 0.25 percent per month.

This 90 percent exception is actually part of another topic that bears discussing: the “reasonable explanation” rule. If you can provide a reasonable explanation (in writing, attached to your return, not to Form 4868) as to why you filed and/or paid late, the IRS may at its discretion waive the penalties. Paying at least 90 percent of your taxes owed is considered to automatically constitute a “reasonable explanation,” hence the aforementioned waiver.

Finally, although we haven’t mentioned it much, interest will also accrue on your tax liability until it is paid. This holds true regardless of whether you file an extension and regardless of whether the IRS agrees that you did have reasonable cause for your tardiness and waives the penalties. The interest rate varies quarterly and is calculated at the current Federal Reserve short-term rate plus 3 percent; since the “Fed funds” rate has been zero for some time now, the interest rate has likewise remained unchanged at 3 percent.

Ines Zemelman, EA
founder of Taxes for Expats