The collection of taxes depends on voluntary compliance. The Internal Revenue Service (IRS) is the federal agency assigned to enforce tax collections. Currently, the IRS uses statistical methods to determine which taxpayers would be most profitably audited. To enforce compliance with tax laws, the IRS generally assesses both interest and penalties that are commensurate with the amount of the unpaid tax due and the length of time that the unpaid taxes were outstanding.
Taxpayer penalties consist of both criminal and civil penalties. Criminal tax penalties are only imposed for severe circumstances. The IRS rarely attempts a criminal prosecution because the taxpayer is entitled to the same constitutional guarantees as nontax criminal defendants. However, criminal penalties may provide for imprisonment, as Al Capone discovered.
Civil tax penalties are almost always assessed as monetary fines. Both criminal and civil penalties may be applied to the same individual, and tax penalties, like most civil penalties, are nondeductible. Ad valorem penalties are additions to taxes that are based on the percentage of the owed tax. Assessable penalties are a flat dollar amount, such as the $5,000 tax penalty that is imposed for a frivolous return (See Notice 2010-33). The amount of assessable penalties are not subject to review by the tax court since the amount is set by law, but ad valorem penalties are subject to the same deficiency procedures that apply to the underlying tax, since there may be a question as to how much tax is outstanding, especially when it involves property appraisals.
There are many types of tax penalties, but most penalties relate to the underpayment or late payment of taxes, or to either not filing a required tax return or filing it late.
Under the new tax package passed by the Republicans at the end of 2017, known as the Tax Cuts and Jobs Act, the IRS has additional options for penalties. The IRS can revoke passports for taxpayers who owe more than $50,000 in taxes, penalties, and interest. Moreover, the IRS can now also hire private contractors to collect delinquent taxes and penalties. Some tax penalties have also been increased.
The Setting Every Community Up for Retirement Enhancement (SECURE) Act of 2019 (SECURE Act) increases the penalty for the failure to file a tax return within 60 days of the due date, without regarding extensions, to the lesser of $435 or 100% of the tax due for tax years after 2019.
Interest Assessed on Outstanding Tax
Interest is always charged on the outstanding taxes to compensate the federal government for the lost time value of the revenue. Applicable federal rates (AFR) are determined and published monthly by the IRS based on the existing federal short-term rate + 3%, compounded daily. The rates for tax refunds and deficiency assessments are the same, but IRS interest rates are usually much lower than interest rates on personal loans. Interest rates on assessments begins running from the due date, excluding extensions, of the return.
Although the IRS pays interest on overpayments of tax, no interest is paid if the overpayments are refunded to the taxpayer within 45 days of the due date of the return, even if the return was filed earlier. Note that if an extension was filed, but the taxpayer failed to file even by the extended date, then any penalties are calculated from the original due date of the return, without the extension.
Failure to Pay Estimated Tax Penalty
Only uncompounded interest is charged for a failure-to-pay estimated tax penalty in which interest is charged on the underpayment if the amount of the total estimated tax for the year not paid is $1000 or more, or $500 for corporations; there is no penalty for lesser amounts. The underpayment of estimated tax penalty can be avoided if the taxpayer paid at least 90% of the current year tax or 100% of the prior year tax where the tax year was a full 12 months and a return was filed, or if 90% of the tax was paid that would be due on an annualized income computation for the period running to the end of the quarter. If adjusted gross income (AGI) exceeds $150,000, then the required payment percentage of the prior year is 110%. The penalty is calculated by filing Form 2210, Underpayment of Estimated Tax by Individuals, Estates, and Trusts.
A corporation's underpayment of estimated tax is the difference between the estimated tax paid and the least of the tax liability for:
- the current tax year
- the prior year
- the tax based on an annualized income computation calculated according to the 3 methods provided by the tax code.
The prior year must have been an entire tax year and the tax amount must have been more than zero. Corporations with a taxable income of more than $1 million in any of the 3 immediately preceding tax years can use the alternative method only for the first installment of the year. Corporations calculate their penalty on Form 2220, Underpayment of Estimated Tax by Corporations.
Tax Penalties Relating to Underpayment, Late Payments, and Not Filing by the Due Date
In addition to interest, various penalties also apply for lack of taxpayer compliance. Although penalties are calculated as a percentage of the outstanding tax, just like interest, they differ from interest in that the rate is statutory, or set by law, regardless of the federal interest rate. Tax penalties are imposed to punish the taxpayer while interest simply compensates the federal government for the lost time value of the tax. Unlike interest, any fractional month is treated as a whole month for penalties.
There is a penalty for failure to file a tax return by the due date, including extensions: 5% per month until a maximum of 25% is imposed on the amount of tax due. If a return is more than 60 days late, then the minimum failure to file penalty is the lesser of 100% of the tax or the following, depending on the tax year, since it is adjusted for inflation:
- 2023: $485
- 2019 - 2020: $330
- 2018: $215
The penalty for failure to pay the tax as shown on the return is 0.5% per month until the maximum 25% of the due tax is charged. The late payment penalty does not apply to estimated tax payments and will not apply if the taxpayer can show that the failure to pay was due to reasonable cause and not willful neglect. The penalty is also avoided if at least 90% of the tax liability was paid through withholdings, estimated tax payments, or payments made with an extension request. If the IRS gives notice and demand for payment of less than $100,000, then failure to pay the deficiency within 21 calendar days will result in a 0.5% monthly penalty; if the tax is $100,000 or more, then the penalty-free period is 10 business days.
Whenever the failure to file penalty and the failure to pay penalty apply for the same periods, then the failure to file penalty is reduced by the amount of the failure to pay penalty.
Example: Failure to Pay and Failure to File Penalties
A taxpayer failed to file a return until 1 month after the due date. He owes $10,000. Disregarding interest, the total penalties that will be assessed include:
- Failure to File Penalty = $10,000 × 5% = $500
- Failure to Pay Penalty = $10,000 × 0.5% = $50
- - $50, subtract the pay penalty for the same period
- = $500 + $50 − $50 = $500, so the Total Penalty = Failure-To-File Penalty!
Note: the IRS uses circuitous reasoning here. You are first asked to add the failure-to-pay penalty to the failure-to-file penalty, then you subtract that which you added. Hence, the net result is that when both penalties apply, the net penalty = the failure-to-file penalty.
A negligence penalty of 20% is imposed for any underpayment of tax as the result of intentional disregard of rules and regulations where no fraud was intended. The 20% penalty applies only to the portion attributable to negligence.
Accuracy-related penalties are assessed on misstatements due to the taxpayer's negligence and underreporting income, overstating deductions, and undervaluing assets. Accuracy-related penalties amount to 20% of the portion of the tax underpayment which is attributable to one of the following infractions:
- negligence or disregard of rules and regulations
- substantial understatement of tax liability or taxable assets
- substantial overstatement of deductions
- failure to keep adequate records.
Accuracy-related penalties only apply if the taxpayer fails to show a reasonable basis for the position taken. In regard to the accuracy-related penalty, negligence includes any failure to make a reasonable attempt to comply with the provisions of the tax law or to any disregard of rules and regulations. The negligence penalty may be waived if the taxpayer had a reasonable basis for the interpretation of the code and has disclosed the disputed position on Form 8275, Disclosure Statement, or Form 8275-R, Regulation Disclosure Statement to support a position that is contrary to Treasury regulations.
There is a substantial understatement of tax liability penalty for higher income taxpayers who play the audit lottery. A substantial understatement of the tax liability occurs when the understatement exceeds the larger of 10% of the tax due or $5,000 for an individual or $10,000 for a C corporation. The penalty only applies to the difference between the amount of tax assessed and the amount of tax actually shown on the return.
The penalty can be avoided if any of the following are true:
- The taxpayer has substantial authority for the treatment that resulted in the substantial understatement and the relevant facts were adequately disclosed on the return by attaching Form 8275.
- The taxpayer had a reasonable basis for taking the disputed position.
There is also a penalty for the overvaluation of deductible property, such as for charitable contributions, equal to 20% of the additional tax that results from a reappraisal of the property. Because it is difficult to assign an exact value to most types of property, the penalty only applies if the reappraised basis is 150% or more of the claimed value. However, the penalty is doubled to 40% if the valuation is overstated by 200% or more. For the penalty to apply, the tax understatement must exceed $5,000 or $10,000 for C corporations. The overvaluation penalty can be avoided if the taxpayer can show reasonable cause and good faith. However, for charitable deduction property, other factors must be satisfied:
- the claimed value of the property was based on a qualified appraisal made by a qualified appraiser
- the taxpayer made a good-faith investigation of the value of the contributed property.
There is also a penalty for undervaluation of property to reduce wealth transfer taxes, = 20% of the additional transfer tax assessed, but only if the reappraised value is 65% or less than the amount claimed. The penalty is doubled to 40% if the reported valuation was 40% or less of the reappraised value. The penalty only applies if the additional transfer tax liability exceeds $5,000.
A 40% penalty is applied to any understatement of income attributable to an unreported foreign financial asset that should have been reported on Form 8938, Statement of Specified Foreign Financial Assets.
A due diligence penalty, adjusted for inflation, is assessed for incorrectly determining the eligibility for the earned income credit, the child tax credit, head of household status, or the American Opportunity tax credit. In 2022, this penalty is $560 per failure. This penalty especially applies to tax preparers if they fail to correctly qualify the taxpayer for these credits or for head of household status.
Civil fraud penalties may also be imposed, which is generally defined as a deliberate action by the taxpayer to evade taxes. The civil fraud penalty is assessed on any underpayment of tax due to fraud, which includes:
- manipulation of accounting records
- substantial omissions from income
- erroneous deductions.
The civil fraud penalty is 75% on any underpayment of tax. The IRS must show by a preponderance of the evidence that the taxpayer had specifically intended to evade the tax. However once established, then the taxpayer bears the burden to show by the preponderance of the evidence that the portion of the underpayment is not attributable to fraud. If the underpayment of tax is attributable to both negligence and fraud, then the fraud penalty applies first.
Criminal penalties are assessed on any person who willfully attempts to evade or defeat any tax. In addition to other penalties, the convicted tax evader will be guilty of a felony and fined not more than $100,000, or $500,000 in the case of a corporation, or imprisoned not more than 5 years or both together with costs of prosecution. However, the IRS has the burden of proof to show willful evasion beyond a shadow of any reasonable doubt. Hence, the main difference between the fraud penalty and the criminal penalty for the IRS is the amount of evidence that they need for a conviction.
Employer and Employee Penalties
Some employees try to avoid withholding taxes by providing false information, such as by claiming more exemptions than allowed. To discourage this, there is a civil penalty of $500 on any taxpayer who claims withholding allowances based on false information. For employers, the criminal penalty for willfully failing to supply information or for willfully supplying false or fraudulent information in connection with wage withholding is an additional fine of up to $1000 and/or up to 1 year imprisonment.
There are steep penalties for not depositing or paying payroll taxes. Failure to make deposits of taxes and overstatements of deposits can result in a 15% penalty on any money that is not deposited as required unless reasonable cause can be shown. There are also various criminal penalties, including 100% of the amount of the evaded tax if the employer's actions were willful. Not only is there no statute of limitations for collecting unpaid payroll taxes, but the IRS may assess the penalty against 1 or more persons who were responsible for payroll taxes, even if the responsible people were employees of a corporation. An employer will be liable for any taxes not withheld even if the taxes were not taken out of employees' wages.
Contesting Tax Penalties
Failure to pay after a notice of a levy will result in a monthly penalty of 1%. The increased penalty applies starting in the month that begins after the earlier of the following IRS notices:
- a notice that the IRS will levy upon the taxpayer's assets within 10 days unless payment is made, or
- a notice demanding immediate payment where the IRS suspects that the collection of taxes may be in jeopardy. If the demand for immediate payment is not met, then the IRS may levy upon the taxpayer's assets without waiting 10 days.
Tax penalties can usually be avoided if the taxpayer can show reasonable cause for the penalized action. Reasonable cause is defined by the courts as including relying on the advice of a competent tax advisor given in good faith and where the facts were fully disclosed to the advisor and that he or she considered that the specific question represented reasonable cause. However, reasonable cause was not found for any taxpayer who simply delegated the filing task to someone else, even if the delegate was a lawyer or accountant. Likewise, the reasonable cause standard is not satisfied because the taxpayer lacked information by the due date of the return, or because of ignorance or misunderstanding of the tax law, since anyone can give these excuses.
The taxpayer bears the burden of proof in resolving tax disputes prior to a court proceeding, but the burden of proof shifts to the IRS in court. However, the IRS always bears the burden of proof where fraud or frivolous tax return charges are prosecuted.
The taxpayer can avoid paying interest on the tax underpayments by depositing the disputed taxes with the IRS until they make a determination of the underpayment. If an underpayment penalty is assessed later by the IRS, then the deposit can be used to pay the assessment. If the IRS rules in the taxpayer's favor, then he will receive his deposit back along with interest. The taxpayer may also request the return of all or part of the deposit at any time before the IRS has made its determination unless the IRS believes that the collection may be in jeopardy. Revenue Procedure 2005-18 has details for making and recouping deposits.
The Tax Cuts and Jobs Act extended the time limit for individuals and businesses to file an administrative claim or to bring a civil action for wrongful levy or seizure from 9 months to 2 years.
The IRS has the authority to lower penalties, and the IRS may do so if there is a good reason for the taxpayer's mistake. Factors that will help the taxpayer include:
- having a good history of compliance with the tax code;
- there was something that specifically prevented compliance with the tax code, but as soon as the problem was overcome, then the taxpayer complied with the rules.