Penalties and interest may be impose
d by the IRS relating to various tax underpayments. Taxpayers should understand some of the basic tax penalties detailed in this article (many of which can be quite sever) in order to avoid such penalties if possible, and to perhaps mitigate any imposed penalties.
An accuracy-related penalty of 20% of a tax underpayment may be imposed by the IRS if the underpayment is attributable to one or more of the following: (1) negligence or disregard of the rules and regulations; (2) any substantial understatement of income tax; (3) any substantial valuation overstatement; (4) any substantial overstatement of pension liabilities; and/or
(5) any substantial gift or estate tax valuation understatement.
If a taxpayer files a late tax return, unless he/she can demonstrate “reasonable cause” to the IRS for not filing on time, a late filing penalty of 5% of the net tax due for each month the return is due, up to five months (25% maximum) can be imposed. In addition, there is a minimum
penalty, equal to the lesser of $135 or the net amount required to be shown on the tax return, for returns that are more than 60 days late (including extensions).
The late filing penalty does not apply if a return is filed late but no taxes are owed.
Failure to Pay Penalty
In general, if a taxpayer is late in paying taxes owed, the IRS can impose a failure to pay penalty of 0.5% (0.5 of 1%) upon the net amount of tax due and unpaid by the due date. The penalty begins on April 16th, and stops accruing when the IRS receives the payment amount. The maximum penalty that can be imposed is 25%.
Taxpayers may also be subject to combined penalties, with special rules. For example, if both late-filing and late-payment penalties are imposed on a taxpayer, a combined penalty of 5% per month will be applied for the duration in which both penalties apply at the same time (maximum penalty of 25%). The combined penalty is made up of a reduced late-filing penalty (4.5% instead of the standard 5%) added to the 0.5% late-payment penalty. After the maximum 25% penalty is met, the late-filing portion of the penalty ends, but the late-payment portion will continue at 0.5% up to a maximum of 22.5%.
Other penalties may also be imposed in addition to the combined penalty.
Civil Fraud Penalties
If the IRS can establish by clear and convincing evidence that a taxpayer has fraudulently underreported income, it can impose a penalty equal to 75% of the entire amount underreported. After such determination, the burden of proof rests upon the taxpayer to establish that fraud did not constitute the entire underreported amount. Fraud is defined to be an intentional wrongdoing by the taxpayer with the specific intent to evade a tax known or believed to be owing.
Furthermore, if the IRS determines that a taxpayer fraudulently failed to file a tax return, a penalty equal to 15% of the net tax due for every month that a return is due and not filed, up to five months (for a maximum of 75%) can be imposed.
Interest on Tax Underpayments
In addition to the various penalties, interest on tax underpayments may also be imposed. For individual taxpayers, the interest rate is equal to the short-term Federal rate plus 3%. Interest is compounded daily in most cases, and begins to accrue from the due date of the return.