The federal taxation system is conducted under the expectation that taxpayers will file their returns, and make applicable payment, within a timely manner.
That being said, the Internal Revenue Service recognizes that not all individuals will do so. The IRS goes to great lengths to educate taxpayers on their compliance responsibilities, and has abundant procedures in place to deliver free assistance with the filing, and paying, of one’s tax obligations.
Despite the above measures, if a tax return is filed late the IRS may charge both interest and penalties.
It’s important to recognize that the IRS is not a lending institution, and amounts payable will be subject to penalty and interest rates that are designed to be high in order to encourage voluntary compliance. Each individual who is legally required to file has an accountability to ensure they have not put themselves into a position whereby April 15th rolls around, and they are staring down the sharp end of an auditor’s pencil.
The easiest way to avoid penalties and interest, simply stated, is not to owe. Although springtime is mainly when taxes are in the spotlight, remember that it is up to each taxpayer, throughout the year, to make certain they have the appropriate amounts withheld for tax.
For wage earners, make sure your form W-4 is filled out not only correctly, but also appropriately. An individual may be entitled to multiple exemptions from tax, but by claiming that maximum allowance, they have created a year-end tax debt for themselves.
For those who are self-employed, remember that you are required to make quarterly estimated tax payments. The IRS has tools available to assist taxpayers with their withholdings. The Withholding Calculator on IRS.gov is one of them. Publication 505, Tax Withholding and Estimated Tax, will assist you as well.
Let’s get back to penalties and interest. At the outset, know that if you file a tax return demonstrating a refund, the IRS will not charge you penalties or interest for late filing. A taxpayer has three years from the due date of a return to claim a refund; once that three year timeframe passes, the refund is lost to the statute.
An individual may still be required to file, because their income and earnings dictate such, but they would no longer be eligible for any refund. Also, keep in mind that if any additional assessment is made via an audit, the IRS will backdate penalty and interest charges to the due date of the return.
There are two primary penalty charges that a balance-due return may incur. They are a Failure to File penalty and a Failure to Pay penalty.
Failure to File
A late filing, or a Failure to File penalty is charged at 5 percent of the net tax due, for each month, or part of a month, that the return was late, for a maximum of 5 months. This penalty will continue to accrue until the maximum penalty amount reaches 25 percent of the net tax due, or until the 5 month cap has been reached, whichever is earlier.
The minimum Failure to File penalty is the smaller of $100 or 100 percent of the tax due on the return. Starting with the 2008 returns, the minimum charge has been upped to $135. If a Failure to Pay penalty, discussed next, is running concurrently with the Failure to File penalty, the IRS reduces the Failure to File penalty from 5 percent to 4.5 percent.
Failure to Pay
Along with the Failure to File penalty, the IRS will charge a Failure to Pay penalty. This late payment penalty is ½ of one percent of the net tax due, for each month, or part of a month, that the tax remains unpaid after the due date of the return. There is no 5 month expiration on this penalty as there is with the Failure to File penalty.
Failure to Pay is also subject to a potential increase to a full percentage point. When a balance becomes severely delinquent, the IRS will charge a one percent Failure to Pay penalty. On the other hand, if you filed the return timely, and have set up an installment plan to repay your tax debt, the IRS will reduce the Failure to Pay penalty to ¼ of one percent, as long as your installment plan remains current. The Failure to Pay penalty also caps out when it reaches the 25 percent net tax due threshold.
Extension to Pay?
A critical mistake of many well-intentioned taxpayers is that they misunderstand IRS expectations regarding an extension of time to file. Form 4868 is used to request an automatic six-month extension of time to file.
However, the IRS still requires a taxpayer to make an estimation of the taxes that will be owed, and to send in a payment that equates to 90 percent of that tax obligation by April 15th. Failure to do so will cause a Failure to Pay penalty to kick in, which will be assessed using the original April 15th due date, not the legally extended October 15th extension date.
The IRS also charges interest. Interest is assessed on the original or adjusted amount of tax, any applicable penalties, and on interest as well. This is known as compounded interest.
Interest is charged on any unpaid tax from the due date of the return until the balance has been paid in full. The interest rate is determined quarterly, based on the federal short term rate plus 3 percent.
Compounded interest and penalties easily can equate to an accruing balance that is well over 20 percent annually. For this reason, the IRS will encourage you to borrow funds from another source, rather than setting up an installment plan with them. Although the penalties may drop off, interest continues to accrue on any unpaid balance, whether or not a taxpayer is established on an installment plan. Interest is not negotiable.
Other potential penalties one may incur:
• A bad check penalty. If you bounce a check to the IRS, you will be charged 2 percent of any check amount that is $1,250 or more. A bounced check for less than that will yield a $25 fee.
• Estimated Tax Penalty. This is a penalty assessed for being under-withheld for federal tax withholding. If a taxpayer expects to owe at least $1,000 in tax for the year, then this penalty may be charged if withholdings and any estimated tax payments made during the year do not equal at least 90 percent of the tax liability.
• Miscellaneous Penalty. Civil Penalties for willful criminal acts, penalties for negligence, accuracy related tax shortfall penalties, and fraudulent return penalties can vary from $500 to $5000, or up to a percentage of the tax due.
Failure to File and Failure to Pay penalties can sometimes be abated under the provisions of what the IRS calls “Reasonable Cause.” If an individual was prevented from timely filing, perhaps due to a loss of records from a fire or flood for example, or if a hardship situation prohibited a taxpayer from contacting the IRS in a timely manner to make arrangements for a balance owing, the IRS may be able to abate the above penalties if a Reasonable Cause basis is determined.
Contact the IRS and discuss this. If the penalty charges are under a certain threshold, you may qualify for relief based on your oral testimony. Otherwise, a written request will be needed; the representative that you speak to should tell you if the dollar amounts exceed this threshold.
Failure to File can be considered for abatement under Reasonable Cause provisions even if the tax remains unpaid. However, the Failure to Pay penalty can only be abated once you have paid the tax due in full.
If the IRS denies your request to abate either of the above penalties (but not the interest remember – this is not negotiable) you will receive a response in writing, which also carries your right to an appeal.
For more information, visit IRS.gov under the heading Collection Procedural Questions.