IRS penalties and how to avoid them

As almost every taxpayer knows, IRS penalties are no joke. During the Fiscal Year of 2021, the IRS collected more than $92.6 billion in unpaid assessments alone. There are many ways in which you can incur an IRS penalty, from failure to file to a credit penalty. Needless to say, many taxpayers opt to involve the best tax relief companies to help them deal with their taxes. There is another option, however. You can understand the penalties and take steps to avoid them. In this article, we will go through all of the common IRS penalties, show you how you can avoid them, and provide you with two ways in which you can remove the penalties altogether.

Common IRS penalties

It is practically impossible to list every single penalty that the IRS may issue, as many of them are on a case-to-case basis. Some penalties are more common than others, however, and they include:

• Failure to file
• Underpayment
• Failure to deposit
• Failure to pay
• Accuracy-related penalties
• Dishonored check
• Erroneous claim for refund/Credit penalty

The important thing to note about each and every penalty is that IRS penalties will accrue interest. The date from which the penalty starts depends on the penalty type. Interest itself will increase the amount you owe until your balance is paid in full. It is possible, in some cases, to enroll in the IRS debt forgiveness program, but it is not something you might want to count on. It is much better to simply avoid incurring the penalties in the first place. With that in mind, let’s take a look at these penalties and how you may be able to avoid them.

Failure to file

You will know that you have incurred a failure to file a penalty (or any other IRS penalty) by receiving a notice from the IRS. The first thing you will want to do after getting the notice is to get in touch with IRS directly. Even if the notice looks genuine, you will want to refrain from calling any numbers before verifying them first. The reason for this is that many scammers use notices that look similar to the IRS ones to try and steal your tax identity. The best way to handle tax identity theft is to not allow it to happen in the first place. Once you’ve established that it is, indeed, the IRS that sent you the notice, you can then proceed further.

The failure to file penalty amount is 5% of the unpaid taxes for each month (or part of a month) that your tax return is late. This penalty accrues up to 25% of your unpaid taxes. Furthermore, the minimum amount that you will need to pay for these IRS penalties will be either $435 or 100% of the tax required to be shown on the return, whichever amount happens to be less.

How to avoid this penalty

The only way to avoid the failure to file a penalty is to file your taxes on time. If you find yourself in a situation where you simply cannot pay on time, you can apply for an extension of time to file. Note that this extension does not grant you any additional time to pay your taxes. The deadline for filing your tax return for this year is April 18, 2023.

Underpayment

Due to the nature of how the U.S. tax system works, it is entirely possible to underpay your taxes. If you do so, however, the IRS will inevitably send you an underpayment of estimated tax by individual penalty. Do note that you may also incur this penalty if you happen to pay your taxes late. Furthermore, this penalty will still apply even if the IRS owes you a refund.

The underpayment penalty is calculated based on the amount of underpayment, the interest rate for underpayments, and the period when the underpayment was due. In other words, the more time it takes for you to pay, the greater the penalty. If you want to cut your tax bills, it is in your best interest not to tarry on your payments. You may not pay fewer taxes, but you will avoid being saddled with a penalty.

How to avoid this penalty

To avoid the underpayment penalty, all you need to do is pay the correct estimated taxes on time. Furthermore, you can avoid the penalty if you pay at least 90% of the tax for the taxable year, or 100% of the tax return for the prior year, whichever amount happens to be less. Lastly, you can avoid this penalty if your filed tax return shows that you owe less than $1,000.

Failure to deposit

The failure to deposit penalty can be issued to employers that fail to make their employment tax deposits in the right way, in the right amount, and on time. These tax deposits include the Federal Unemployment Tax, Social Security, Medicare, and federal income tax. We’ve gone through each of these in our business tax tips for entrepreneurs already. In a nutshell, failure to pay your employment taxes can be rather devastating, depending on the size of your business.

The exact amount of this penalty depends on the number of days your deposit is late. If you make the deposit within 1-5 calendar days after the deadline, the penalty will be 2% of the unpaid deposit. After that, the penalty increases to 5% for 6-15 calendar days over the deadline, 10% for more than 15 calendar days, and caps at 15% if 10 or more calendar days pass after the date of your first letter or notice. If you happen to get a letter or notice for immediate payment (e.g. CP504J Notice), the penalty will also cap at 15%.

How to avoid this penalty

The most obvious way of avoiding these IRS penalties is to fully understand due dates, schedules, and forms for depositing and reporting employment tax and make your deposits on time.

If you don’t happen to have a bank account, you may be able to send a request to the IRS to prevent the penalty from being applied to you. To do so, you will need to go through the following steps:

1. Get a dated and signed statement from your bank that they declined your account. Note that this statement cannot be less than two years old.
2. When filing your employment tax return, write the word “Unbanked” at the top. This pertains to Forms 941,943,944, or 945.
3. Write a letter to the IRS, asking them not to apply the penalty to you. You will need to provide a detailed description of what steps you took to get a bank account.
4. Attach both the letter and the bank statement to your employment tax return.
5. Mail the request as per Form instructions.

Failure to Pay

As you may already know, the IRS offers a “pay as you go” system to their taxpayers. What this means is that you are supposed to pay taxes as you get income, as opposed to sending a lump sum at the end of the year. The failure to pay the penalty will be applied if you owe more than $1,000 when you calculate your taxes.

The failure to pay the penalty amount depends on how much time has passed without you making the payment. For each month (or part of a month) that your taxes remain unpaid, you will accrue a 0.5% penalty on your unpaid taxes. This penalty will increase every month, but it caps at 25%.

If you happen to accrue both the failure to file a penalty and failure to pay the penalty, the total penalty will never exceed 5% for any given month. What happens is that your failure to file a penalty gets reduced by the amount of the failure to pay the penalty. Here’s an example:

You have a 5% failure to file penalty applied against you and a 0.5% failure to pay the penalty applied against you. Your failure to file a penalty becomes 4.5% (5% – 0.5%), and you still need to pay a 0.5% failure to pay the penalty. The total amount will never exceed 5%.

Additionally, if you have an approved payment plan or get an IRS tax settlement, the failure to pay the penalty will be reduced to 0.25% per month. However, if you do not pay the tax within 10 days of getting the IRS notice, the failure to pay the penalty increases to 1% per month or a partial month.

How to avoid this penalty

The only way to avoid failure to pay the penalty is to pay your taxes on time. If this is not possible, you may apply for an extension of time to file or for a payment plan. Do note that in the latter case, you will still need to pay what you can now.

Accuracy-related penalties

There are two notable accuracy-related IRS penalties. The first is the substantial understatement of income tax penalty, where you may get a penalty if you understate your tax liability by either $5,000 or 10% of the tax that is required to be shown on your return. The second accuracy-related penalty is the IRS negligence penalty. Both penalties will require you to pay 20% of the portion of the underpayment of tax.

It is possible to reduce the substantial understatement of income tax penalty by 5% if you claim a Section 199A Qualified Business Income Deduction on your tax return.

How to avoid this penalty

The best way to avoid this penalty is to make sure that your tax report is completely accurate. If you have trouble calculating your tax return, you may want to consider hiring a professional tax consultant. Working with a certified CPA will teach you about filing your taxes according to the rules and all but eliminate the chances of filing an inaccurate tax return.

Dishonored check

The dishonored check penalty will be issued if you write a check to pay for your tax bill, but you don’t have enough money in your bank account to cover it. The amount that you will need to pay for the penalty will be either $25, the amount of the check, or 2% of the check’s amount. You will only be required to pay for the latter if the check amount is higher than $1,250. Otherwise, you pay whichever amount is lower, $25 or the amount of the check.

How to avoid this penalty

The simplest way to avoid the dishonored check penalty is to ensure that you have enough funds in your bank account to cover the tax payment.

Erroneous claim for refund/Credit penalty

This penalty will apply if you happen to submit either a claim for a refund or a credit for an excessive amount, provided that you do not have a reasonable cause. The amount that you will need to pay for this penalty is 20% of any excessive amount you’ve tried to claim.

Any amount that exceeds the amount you are allowed to claim is considered to be excessive.

How to avoid this penalty

Similar to other accuracy-related penalties, the best way to avoid an erroneous claim for refund/credit penalty is to work with a professional tax consultant.

How to remove IRS penalties

Receiving any IRS penalties does not necessarily mean that you have to pay them. There are two distinct situations when you can try and negotiate with the IRS for a penalty abatement:

• You have reasonable cause
• This is your first penalty abatement

The IRS is well aware that there can be extenuating circumstances that may have prevented you from filing or paying your taxes in a correct and timely manner. Reasonable cause is determined on a case-by-case basis, and it may include the following situations:

• Your home/office was struck by a natural disaster
• Death of an immediate family member
• House fire
• Illness

To maximize your chances of penalty abatement, it is always best to talk to a tax professional before trying to prove a reasonable cause. Alternatively, you may look at the IRS penalty relief for reasonable cause. The second option is reserved for those that are normally on top of their tax responsibilities. If you happen to miss a single filing deadline or a single payment, the IRS is usually willing to look the other way, so to speak. To qualify for this privilege, you must have paid all your outstanding balance/set up an installment agreement, filed your taxes (up to that point) on time, and had no prior penalties in the last three years.

Dealing with IRS penalties can be extremely daunting, especially if you have never encountered them before. If you need to find any other tax-related information or find the best tax consultants in your area, you can always refer to the Consumer Opinion Guide. Our expert articles will provide you with any and all information you might need!