The IRS assesses penalties to encourage taxpayers to be in compliance with their tax filings and tax payments. If taxpayers are not in compliance with the filing of their tax returns and/or do not pay their tax liabilities in full, the IRS will assess the failure to file penalty, failure to pay penalty and/or the failure to make sufficient estimated tax payment penalty.
The IRS, per IRC section 6651(a)(1), will generally assess a failure to file penalty, when a taxpayer does not timely file their tax return by the filing due date (usually April 15th) or by the extension date. If a taxpayer files an extension to file their tax return by April 15th, the taxpayer has until October 15th to timely file the return. If the return is not timely filed by the extension date (usually October 15th), the IRS will assess the failure to file penalty.
The penalty for filing the return late is 5 percent of the unpaid taxes for each month (or for part of a month) that the tax return is late. If the tax return is more than 60 days late, the minimum penalty is the lesser of $135 or 100 percent of the unpaid tax. The maximum penalty is 25 percent of the unpaid tax. For example, if a taxpayer is 5 months late with filing their tax return, the taxpayer will be assessed the maximum penalty of 25 percent (5 months multiplied by 5 percent of the unpaid tax). If both the failure to file and failure to pay penalty apply in any month, the failure to file penalty of 5 percent is reduced by the failure to pay penalty.
The IRS, per IRC section 6651(a)(2), will generally assess a failure to pay penalty when a taxpayer does not timely pay their tax liability by the April 15th due date. A taxpayer cannot extend the tax due deadline. If a taxpayer files an extension to file their tax return, an extension to file a return, is not an extension to pay. The IRS will assess the failure to pay penalty on any unpaid taxes unless 90 percent of the tax liability was paid by the April 15th due date.
The penalty for failing to pay the taxes by the due date is one-half of 1 percent of the unpaid taxes for each month (or for part of a month) the taxes are not paid. However, if a taxpayer pays at least 90 percent of the actual tax liability on or before the due date (usually April 15th), the failure to pay penalty will not apply during the six month extension. The maximum penalty is 25 percent of the unpaid tax.
Please note that if a taxpayer filed on time and is in an installment agreement the failure to pay penalty is reduced. However, once the IRS makes a demand for payment, the failure to pay penalty is increased to 1 percent per month. If both the failure to file and failure to pay penalty apply in any month, the failure to file penalty of 5 percent is reduced by the failure to pay penalty.
The IRS offers the first-time penalty abatement waiver on the failure to file penalty, failure to pay penalty, and failure to deposit penalty based on a taxpayer’s past history. However, this first-time penalty abatement only applies to one tax period. If a taxpayer did not have a filing requirement or has not had any prior penalties for the preceding three years, and is in filing compliance and has paid or made an arrangement to pay any tax due, the IRS will remove the penalties on one tax period. Any subsequent years with assessed penalties would have to be abated based on “reasonable cause” which is discussed below.
If the taxpayer does not qualify for the first-time penalty waiver, a taxpayer seeking to remove the failure to file penalty must establish “reasonable cause” and that the failure to file was not due to willful neglect. Did the taxpayer act in a reasonable manner? Did the taxpayer exercise reasonable cause under the circumstances? Contrary to willful neglect, which was defined in United States v. Boyle, as a conscious, intentional failure or reckless indifference to the filing requirement.
Reasonable cause is based on all the relevant facts and circumstances of a taxpayer’s particular situation. In determining whether reasonable cause exists for a failure to file a tax return is whether the taxpayer was unable to file the tax return on time despite the exercise of ordinary business care and prudence. In determining if a taxpayer exercised ordinary business care and prudence, the IRS will consider the following factors; (1) the taxpayer’s reason to include the dates and explanations of events that correspond to the time frame that the penalties were assessed, (2) taxpayer’s compliance history, (3) length of time between the event and the reason for noncompliance, and (4) circumstances beyond the taxpayer’s control such as death, illness, natural disaster that led to the noncompliance.
Similarly to the failure to file penalty, the failure to pay penalty may be removed if the taxpayer establishes reasonable cause. The taxpayer must show that regardless of the exercise of ordinary business care and prudence, the taxpayer was unable to pay the tax when due or would have suffered undue hardship if the taxes were paid. The IRS usually defines undue hardship as more than an inconvenience. For example, a payment of the tax would have resulted in a substantial financial loss on a sale of real property, in other words, the taxpayer does not have enough cash or assets to pay the taxes and cannot borrow.
Usually, if a taxpayer does not have enough tax withholdings withheld from their pay, they are required to increase their withholdings or make prepayments. If a taxpayer is self-employed, or receives 1099 income, usually taxes are not withheld from their pay. Therefore, it is the taxpayer’s responsibility to ensure that they are making prepayments throughout the year for taxes to the taxing authorities, so that the taxpayer is not stuck at the end of tax season with a large tax bill that they cannot afford to pay. The IRS refers to the prepayments as “estimated tax payments.” Estimated tax payments are generally made in four equal payments throughout the year (one payment per quarter). However, sometimes it is easier for taxpayers to make monthly prepayments, which is also acceptable.
The IRS, per IRC section 6654, will generally assess a penalty for failure to make sufficient estimated tax payments throughout the current tax year. Generally, to avoid this penalty, the taxpayer must pay at least 90 percent of the tax for the current year or 100 percent of the tax shown on the prior year’s tax return, whichever is lower. However, there are two exceptions to the general rule. If a taxpayer’s total tax is under $1,000 or the taxpayer had no tax liability in the prior tax year, the taxpayer will not be assessed a penalty.
The IRS will consider removing the penalty for failing to make sufficient estimated tax payments in two different situations. The first situation is when a taxpayer did not make the required payments because something happened that was outside of his/her control, such as a casualty, natural disaster, or other unusual circumstance that it would be unfair to assess the penalty. The second situation is when a taxpayer is retired (after age 62) or disabled and the underpayments were due to reasonable cause and not willful neglect.
A taxpayer’s liability will not only be increased by the assessed penalties, but also from the accrual of interest. Interest is required to be paid on any tax owed at a rate established on a quarterly basis. The interest rate is usually the same as the federal interest rate and the interest is compounded daily. Per IRC 6404(e)(1), the only way the IRS will consider removing interest is if the accrual of interest, results from an error or delay on the part of an IRS employee to perform a ministerial or managerial act. Otherwise, the interest continues to accrue until the tax is paid. Note that if penalties are removed, the interest on the penalties will also be removed. However, the interest on the tax remains.