I have heard many clients tell me that the IRS is killing them with the interest charges. Actually, in many cases, it is the tax penalties which are more costly than the interest. Therefore, I will start by explaining the common income tax penalties provided by the Internal Revenue Code.
- The Fraud Penalty applies when there is “fraud” in the underpayment of tax required to be shown on a return. The fraud is equal to 75% of the tax underpayment associated with the fraud. Generally, if there is an underpayment of tax on a return, there is presumption that the entire underpayment is associated with the fraud.
The Internal Revenue Manual gives the definition of “fraud” as follows – “a deception or misrepresentation of material facts, or silence when good faith requires expression, resulting in material damage to one who relies on it.” Fraud requires a tax due and owing and fraudulent intent. Section 25.1.1 of the Internal Revenue Manual.
Most common situations of fraud are intentional understatement of income, or improper deductions. For example, you use a scheme to hide income, or you have business income which you intentionally fail to report. Or you take a large deduction for an expense which was never paid or incurred.
The penalty is 75% of the tax which should have been paid, so if the tax due is $10,000, the penalty added on is $7,500, then interest is added to the $17,500 due.
A taxpayer can be separately charged with a crime for tax fraud, but that is a whole other topic.
- A Failure to File Penalty applies when a taxpayer fails to timely file a tax return. Income tax returns are generally due on the 15th of April. You can file for an automatic extension.
Generally the penalty is 5% of the amount due for the first month, plus 5% for each month until the return is filed. The maximum penalty is 25% of the tax due.
In the case of a fraudulent failure to file, the penalty goes up to 15% per month, to a maximum of 75% .
Therefore, even if a tax is due and you don’t have the money, file the return.
2. A Failure to Pay Penalty applies for late payment of a tax due. You are expected to pay a tax when it is due. The filing of an extension does not extend the time to pay an income tax due on filing. Therefore, you may receive a penalty even if you file an extension. The extension form requests the estimated amount due at filing – which needs to be paid when the extension is requested.
Generally, the penalty each month is 5% of the tax due for each month past due, up to 25% of the total tax due. (Note, there can be two penalties at the same time – typically failure to file and failure to pay penalties – which can easily add on 50% to the tax already outstanding).
3. Accuracy Related Penalties apply for making an error, on a tax return, which results in a deficiency. I will only cover the errors which I have most commonly seen with taxpayers
Internal Revenue Code Section 6662 provides for a penalty for negligence or disregard of the rules or regulations, and substantial understatement of income tax. See Internal Revenue Manual Section 20. Section 6676 imposes a penalty for an improper claim for refund or credit concerning income taxes.
Let’s start with the “substantial understatement of income.” Generally, an understatement is the tax amount required to be shown on the return in excess of the tax shown on the return. Basically, your correct tax bill exceeds the tax bill due on the return which you filed. An understatement is substantial if it is greater than $5,000 or 10% of the tax return to be show on the return. So if the actual tax due is $24,000, the understatement is substantial if it is greater than $5,000 or $2,400.
“Negligence” includes “any failure to make a reasonable attempt to ascertain the correctness of a reported item “which would seem to a reasonable and prudent person to be ‘too good to be true’ under the circumstances.” See Internal Revenue Manaual Section 20.1.5.7.1 2. When disregarding rules, the action includes “careless, reckless, or intentional disregard.” Unfortunately, even if there is no substantial understatement of income, the IRS is likely to assess the negligence penalty, unless the taxpayer can show a good faith basis for reporting a particular tax item in a particular way, such as reference to the Internal Revenue Code, or Regulations.
However, if the taxpayer does not prepare his or her own return, the taxpayer can blame the tax preparer. The IRS is supposed to consider the “experience, knowledge and sophistication and education of the taxpayer. IRM 20.1.5.6.3 1. Reliance on a tax opinion … may serve as a basis for .. good faith exception to the accuracy related penalty.
The penalties are equal to 20% of the additional tax due to the error.
To avoid tax trouble with the IRS, people with any type of complicated tax return need to use a tax preparation service, and provide all relevant and accurate information to the service. Turbo Tax won’t do.
Attorney Robert M. Singer
Law Offices of Robert M. Singer, LLC
2572 Whitney Avenue
Hamden, CT 06518
203-248-8278