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The Essential Guide To Federal Tax Penalties and Interest

The essential guide to federal tax penalties and interest

There is no question that the Internal Revenue Code is complex. Becoming familiar with the thousands of pages it contains, along with accompanying treasury regulations and Tax Court decisions, is a daunting task for even tax professionals to keep up with. However, ignorance of the law is no defense. The Internal Revenue Service is empowered by Congress to assess penalties and interest when taxpayers fail to pay taxes or file their returns according to law. Additionally, there are sanctions that can be levied for failing to distribute certain tax forms to recipients, wrongfully claiming certain credits, and for taking fraudulent and unreasonable positions on your tax returns. Here is an overview of penalties that may be assessed by the IRS:

  • FAILURE TO FILE PENALTY (26 U.S.C. §6651(a)(1)) – A taxpayer who fails to file a return on or before its due date will be subject to a penalty of 5% of the tax due (minus any credits the taxpayer is entitled to and any tax payments made by the due date) for each month or partial month the return is late, up to a maximum of 25%, unless the failure is due to reasonable cause and NOT willful neglect.
  1. This penalty does not apply during periods that the taxpayer was granted an extension to file a tax return.
  2. This penalty applies to income, estate, gift, employment, self-employment and excise tax returns.
  3. When applied in the same month as the failure to pay penalty, the amount of the failure to file penalty is reduced by 0.5% with respect to the 5% maximum. The failure to file penalty will max out at 22.5% and the failure to pay penalty will max out at 2.5% when applied simultaneously. 26 U.S.C. §6651(c)(1).
  • FAILURE TO PAY PENALTY (26 U.S.C. §6651(a)(2)) – A taxpayer who fails to pay an amount shown as tax on his or her return will be subject to a penalty of 0.5% of the unpaid balance per month as long as the balance due remains unpaid, up to a maximum of 25% of the amount due unless the failure to due to reasonable cause (e.g. taxpayer exercised ordinary business care and prudence and still could not pay, or the payment on the due date would have been an undue hardship).
  1. The taxpayer is still liable for failure to pay penalties EVEN if he or she was granted an extension to file.
  2. This penalty applies to income, estate, gift, employment, self-employment and excise tax returns.
  3. If the taxpayer timely file the return and an installment agreement is in place, the failure to pay penalty will accrue at a lower rate of 0.25% per month. 26 U.S.C. §6651(h).
  4. When applied in the same month, the failure to file penalty will max out at 22.5% and the failure to pay penalty will max out at 2.5% when applied simultaneously. 26 U.S.C. §6651(c)(1).
  • FAILURE TO PAY OR UNDERPAYMENT OF ESTIMATED TAXES (26 U.S.C. §6654) – If an individual, estate, or trust is liable for estimated tax during the tax year and fails to make the required annual payment of the LESSER OF EITHER 90% of the tax due for the current tax year OR 100% of the tax due for the previous tax year, then the IRS will assess a penalty by applying the underpayment rate in 26 U.S.C. §6621 (e.g. the federal short term rate plus 3%). The taxpayer can avoid the penalty under ANY of the following exceptions:
  1. The tax due for the year (after accounting for any federal income tax withheld) is less than $1,000.00. 26 U.S.C. §6654(e)(1).
  2. The taxpayer was a U.S. citizen or resident all year and had no tax liability for the preceding tax year. 26 U.S.C. §6654(e)(2).
  3. The IRS determined that the penalty would be against equity and good conscience because of casualty, disaster or other unusual circumstances. 26 U.S.C. §6654(e)(3)(A).
  4. The taxpayer retired after reaching age 62 or became disabled in the tax year in which estimated payments were due, and the underpayment was due to reasonable cause and NOT willful neglect. 26 U.S.C. §6654(e)(3)(B).
  • FAILURE TO PAY OR UNDERPAYMENT OF EMPLOYEE WITHHOLDING OR EXCISE TAXES (26 U.S.C. §6656) – If any person fails to deposit certain required taxes (e.g. employee withholding or excise taxes) to the applicable government depository on the dates required by law AND the failure is due to reasonable cause and not willful neglect, THEN that person is subject to a penalty equal to a percentage of the underpayment as follows:
  1. 2% if the underpayment is 5 days or less late.
  2. 5% if the underpayment is between 6 days and 15 days late.
  3. 10% if the underpayment is more than 15 days late.
  4. 15% if the underpayment is not deposited either within 10 days of the first IRS delinquency notice or on the day in which notice and demand for immediate payment is made.
  • DISHONORED CHECK PENALTY (26 U.S.C. §6657) – Any person who tenders an instrument to pay any amount to the IRS and that instrument is dishonored, then that person is subject to a penalty of 2% of the amount shown on the instrument (If the check is less than $1,250, the penalty is either $25 or 2% of the amount, whichever is lesser).
  • ACCURACY-RELATED PENALTY ON UNDERPAYMENT (26 U.S.C. §6662) – An accuracy-related penalty of 20% applies to the portion of any underpayment, unless the taxpayer had reasonable cause or acted in good faith (e.g., shows substantial authority and discloses the facts for the reasonable basis of the tax treatment), for the following:
  1. An underpayment attributable to a taxpayer’s negligence or disregard of rules and regulations, a substantial understatement of income tax, a substantial misstatement of valuation (e.g. basis or adjusted basis of property), a substantial overstatement of pension liability, or a substantial estate or gift tax valuation understatement.
  2. A substantial understatement of income tax on the return for the taxable year if the amount of the understatement for the taxable year exceeds THE GREATER OF 10% of the tax required to be shown OR $5,000.00 ($10,000,000.00 for corporations).
  3. An understatement related to a “listed transaction” or any reportable transaction if a significant purpose of the transaction is to avoid or evade federal income tax, according to 26 U.S.C. §6662A. A listed transaction is a transaction that is the same or substantially similar to one that the Internal Revenue has determined to be a tax avoidance transaction and is identified by a published IRS notice.
  • FRAUD PENALTY ON UNDERPAYMENT (26 U.S.C. §6663) – A fraud-related penalty of 75% applies to any portion of the underpayment if any part of the underpayment of tax required to be shown on a return is due to fraud, unless the taxpayer had reasonable cause or acted in good faith. Unlike negligence or disregard in the accuracy-related penalties, fraud is the WILLFUL and INTENTIONAL violation of the law, rules and regulations with the purpose of evading or defeating federal taxes.
  • FRAUDULENT STATEMENT OR FAILURE TO FURNISH STATEMENT TO EMPLOYEE (26 U.S.C. §6674) – Any employer who furnishes a fraudulent statement (e.g. W-2) of fails to furnish a fraudulent statement to an employee is liable for a penalty of $50.00.
  • ERRONEOUS CLAIM FOR REFUND OR CREDIT (26 U.S.C. §6676) – A person who makes a claim or a refund or credit does so for an excessive amount, then that person is liable for a penalty equal to 20% of the excessive amount, unless it is shown that the excessive amount is due to reasonable cause.
  • FAILURE TO FILE RETURNS WITH RESPECT TO FOREIGN TRUSTS, PARTNERSHIPS AND CORPORATIONS (26 U.S.C. §6677 and §6679) – A person who fails to file Form 5471, Form 8865 or Form 5472 if required to do so by law, unless reasonable cause can be shown, is liable for an initial penalty of $10,000.00 for each accounting period, and an additional $10,000.00 per month up to $60,000.00 per return beginning 90-days after the IRS informs the taxpayer of such failure and it is not rectified.
  • FAILURE TO FILE FOREIGN BANK AND FINANCIAL REPORT (FBAR)(31 U.S.C. §5321) – A person required to file a FinCEN 114 (FBAR) as required by law and fails to do so is liable for penalties as follows:
  1. If the failure to file is non-willful (e.g. you didn’t know you had to file), then the penalty is up to $10,000.00 per foreign account per year.
  2. If the failure to file is willful, then the penalty is THE GREATER OF up to $100,000 per account OR 50% of the account’s value, per year.
  • FALSE INFORMATION WITH RESPECT TO TAX WITHHOLDING (26 U.S.C. §6682) – A person who makes a statement with respect to tax withholding that results in a decrease in the amounts deducted or withheld, and knew at the time the statement was made that there was no reasonable basis for such a statement, shall pay a penalty of $500.00 per statement.
  • FRAUDULENT STATEMENT OR FAILURE TO FURNISH STATEMENT TO PLAN PARTICIPANT (26 U.S.C. §6690) – Any plan administrator who furnishes a fraudulent statement (e.g. 1099-R) of fails to furnish a fraudulent statement to a plan participant is liable for a penalty of $50.00.
  • SUBSTANTIAL AND GROSS VALUATION MISSTATEMENTS ATTRRIBUTABLE TO INCORRECT APPRAISALS (26 U.S.C. §6695A) – IF a person prepares an appraisal for the value of property and knows (or has reason to know), that the appraisal would be used in connection with a return or a claim for refund AND the claimed value results in a substantial valuation misstatement, a substantial estate or gift tax valuation understatement, or a gross valuation misstatement, THEN that person is liable for a penalty that is THE GREATER OF EITHER 10% of the amount of the underpayment attributed to the misstatement OR $1,000.00 OR 125% of the gross income received by the person for the preparation the appraisal.
  • FAILURE TO FILE FORM 1065 PARTNERSHIP RETURN (26 U.S.C. §6698) – A partnership that fails to file a return as require by law is liable for a penalty of $200.00 (in 2018) multiplied by the number of partners in the partnership during the tax year, assessed every month or partial month that the return is late up to 12 months.
  • FAILURE TO FILE FORM 1020S S-CORPORATION RETURN (26 U.S.C. §6699) – A S-Corporation that fails to file a return as require by law is liable for a penalty of $200.00 (in 2018) multiplied by the number of shareholders in the S-Corporation during the tax year, assessed every month or partial month that the return is late up to 12 months.
  • PROMOTING ABUSIVE TAX SHELTERS (26 U.S.C. §6700) – Any person who organizes or participates in a plan or arrangement that makes, furnishes or causes another person to make a statement with respect to a tax benefit or income that the person knows (or has reason to know) is false or a gross valuation statement (more than 200% of correct value) shall pay a penalty equal to THE LESSER OF $1,000.00 OR the gross income that the person derived from the activity.
  • AIDING AND ABETTING UNDERSTATEMENT OF TAX LIABILITY (26 U.S.C. §6701) – Any person who aids or assists in the preparation or presentation of any portion of a return, affidavit or claim who knows (or has reason to know) that the portion will be used for tax purposes and will result in the understatement of the tax liability of another person is liable for a penalty of $1,000.00 ($10,000.00 if it relates to the tax liability of a corporation). The penalty can be assessed even if the taxpayer had no knowledge of the aiding and abetting activity.
  • FRIVOLOUS TAX SUBMISSIONS (26 U.S.C. §6702) – Any person who files what purports to be a tax return that does not contain information on which the substantial correctness of the self-assessed taxes can be judged or contains information on its face that indicates the self-assessment is substantially incorrect is liable for a penalty of $5,000.00.
  • FAILURE TO KEEP RECORDS NECESSARY FOR REPORTING REQUIREMENTS (26 U.S.C. §6704) – A person who has a duty to report specific information to the IRS (e.g. W-2, Form 1099) and fails to keep the records necessary to report the necessary data either now or in the future, unless the person can show the failure is due to reasonable cause and not willful neglect, is liable for a penalty of $50.00 per individual with respect to which the failure occurred per calendar year up to a maximum of $50,000.00.
  • FAILURE TO FURNISH OR FILE INFORMATION REGARDING REPORTABLE TRANSACTIONS (26 U.S.C. §6707 and §6707A) – A person who fails to furnish or file reportable transactions as required by law to the Internal Revenue Service is liable as follows:
  1. If it was a “listed transaction” that the IRS previously published written notice of, the amount of the penalty is 75% of the decrease in tax show as a result of the transaction not to exceed $200,000 ($100,000 if natural person).
  2. If it was any other reportable transaction where the purpose was to evade or defeat federal tax, the amount of the penalty is 75% of the decrease in tax show as a result of the transaction not to exceed $50,000 ($10,000 if natural person).
  • FAILURE TO FILE OR FURNISH CORRECT INFORMATION RETURNS (26 U.S.C. §6721 and §6722) – A person who fails to file Form W-2, Form W-3 and certain Forms 1099-MISC as required by law and fails to furnish said forms to the payees as required by law in 2018 is liable for penalties:

If the taxpayer is a large company with gross receipts of more than $5 million and government entity, then the penalty is:

  1. If not more than 30 days late, $50 per return up to a $536,000 maximum.
  2. If 31 days or more late up to August 1st, $100 per return up to $1,609,000 maximum.
  3. If later than August 1st or not at all, $260 per return up to a $3,218,500 maximum.
  4. If the taxpayer intentionally disregarded filing or furnishing the information return, then $530 per return with no maximum limit.

If the taxpayer is a small business with gross receipts of $5 million or less, then the penalty is:

  1. If not more than 30 days late, $50 per return up to a $187,500 maximum.
  2. If 31 days or more late up to August 1st, $100 per return up to $536,00 maximum.
  3. If later than August 1st or not at all, $260 per return up to a $1,072,500 maximum.
  4. If the taxpayer intentionally disregarded filing or furnishing the information return, then $530 per return with no maximum limit.

A person is liable for the 26 U.S.C. §6721 filing penalty if any of the following occurred:

  1. The information was not filed by the due date AND reasonable cause is not shown.
  2. Filed on paper instead of electronically when required to do so.
  3. Failed to report or incorrectly reported a TIN (Taxpayer Identification Number)

A person is liable for the 26 U.S.C. §6722 furnishing penalty if any of the following occurred:

  1. The payee did not get the correct information statement by the applicable date AND reasonable cause is not shown.
  2. Provided incorrected information or omitted information on the information statement.

Several of the penalties listed above allow for an abatement or non-assessment of the penalty if the taxpayer shows reasonable cause to the IRS or the U.S. Tax Court that explains or justifies the failure. The Internal Revenue Manual lists several factors for IRS employees to consider in determining whether reasonable cause exists to relieve a taxpayer from a penalty. This is not an exclusive list, but reasons stated to the IRS outside of these enumerated factors will have much more difficult getting approval:

  • Ordinary Business Care and Prudence (IRM 20.1.1.3.2.2) – “A taxpayer may establish reasonable cause by providing facts and circumstances showing that he or she exercised ordinary business care and prudence (taking that degree of care that a reasonably prudent person would exercise), but nevertheless were unable to comply with the law.” The IRS will review information relating to the taxpayer’s reason for noncompliance, the taxpayer’s overall compliance history, the length of time to get back to compliance and those circumstances beyond the taxpayer’s control.
  • Death, Serious Illness or Unavoidable Absence (IRM 20.1.1.3.2.2.1) – “Death, serious illness, or unavoidable absence of the taxpayer, or a death or serious illness in the taxpayer’s immediate family, may establish reasonable cause for filing, paying, or depositing late…”. The IRS will consider the date of death, the duration or severity of the illnesses, the duration and reasons for absence, how the event prevented compliance, and if other business obligations were hampered.
  • Fire, Casualty, Natural Disaster or Other Disturbance (IRM 20.1.1.3.2.2.2) – Was the taxpayer not in timely compliance because he or she was an “affected person” eligible for disaster relief? The IRS will consider the timing of the disaster, the effect on the taxpayer’s business, steps taken to comply and if the taxpayer actually complied when possible.
  • Unable to Obtain Records (IRM 20.1.1.3.2.2.3) – If the taxpayer alleges that he or she was unable to obtain the necessary records to comply with the law, the IRS will consider why particular records were unnecessary, why they were unavailable, how the taxpayer became aware of the unavailability, attempts to secure and replace the missing information, whether the IRS was contacted for instructions on how to proceed without information, and if the taxpayer complied once information was received.
  • Mistake Was Made (IRM 20.1.1.3.2.2.4) – A mistake may be justifiable if the taxpayer exercised ordinary business care and prudence and the IRS considers how the taxpayer became aware of the mistake, the extent the taxpayer corrected the mistake, and the timely steps taken to correct mistake.
  • Erroneous Advice or Reliance (IRM 20.1.1.3.2.2.5) – Generally, a taxpayer cannot claim that they relied on another party to comply with tax obligations because each taxpayer is responsible for their own compliance and it cannot be delegated (e.g. accountant did not file before due date). However, relief may be appropriate where the taxpayer relied on the specific advice, whether orally or in writing, on a tax professional or the IRS and it was not unreasonable under the circumstances.
  • Ignorance of the Law (IRM 20.1.1.3.2.2.6) – “The ordinary business care and prudence standard requires that taxpayers make reasonable efforts to determine their tax obligations.” However, the IRS can consider abatement based on whether the particular tax or compliance issue is complex, there was recent change in the law that the taxpayer could not be expected to know, the taxpayer’s education, whether the taxpayer was subject to the tax before and whether the taxpayer was penalized before.
  • Forgetfulness (IRM 20.1.1.3.2.2.7) – Generally, forgetfulness is “not in keeping with the ordinary business care and prudence standard and does not provide a basis for reasonable cause. The IRS will not allow abatement for the taxpayer’s reliance on another person to file a timely return or make the required deposits or payments.

In addition to penalties, interest accrues on any unpaid tax from the due date until the full balance is paid in full. The interest rate is determined quarterly and is equal to the federal short-term interest rate plus 3%. Interest compounds daily on unpaid balances and, unlike tax penalties, it cannot be waived.

This list of penalties is not exhaustive and the tax laws are constantly changing. Furthermore, the taxpayer can be liable for multiple penalties for the same act and are cumulatively assessed. Finally, the federal government may still pursue criminal tax prosecutions for illegal conduct (e.g. tax evasion, tax fraud) in addition to the civil penalties, which could result in fines, jail or prison. If you have questions about tax penalties and interest, do not hesitate to contact the tax professionals at Kershaw, Vititoe & Jedinak PLC.

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