When the IRS hits you or your business with a tax bill, it usually adds penalties and interest charges. These extra charges can be shocking—an old $7,000 tax bill could have $15,000 in penalties and interest tacked on to it. Some penalties, such as for late payments, are added automatically by IRS computers. Or, IRS personnel may impose penalties if you violated a tax code provision, such as filing a return late. The IRS doesn’t just dream up penalties—each one has been authorized by the elected representatives in Washington. Once penalties are decreed, if you don’t complain, the IRS assumes you accept them. Happily, the IRS can remove a penalty just as easily as it added one. The key to the kingdom of tax penalty relief is showing a reasonable cause for your failure to comply with tax law . This post provides basic knowledge and light tips to get your tax penalties or interest reduced [or even removed at all]. Before the main topics, we are going to discuss some basic knowledge about tax penalties and interest: Common Reasons for Penalties, Underpaying Estimated Taxes. Interest on Tax Bills, Understanding Penalty and Interest Notices. Right after those basic sections, you can find the main “how to ” topics. How to Get Penalties Reduced or Eliminated, How to Request a Penalty Abatement [ with abatement request letter example ], what to do “If Your Abatement Request Is Rejected ”? and; How to Get Interest Charges Removed .
Common Reasons for Penalties
The number of different tax code penalties is staggering. This section covers only the penalties most likely to be imposed on a small business [or and its owner]. Here are common reasons for penalties :
Inaccuracies – The IRS can hit you with a 20% penalty if you were negligent (unreasonably careless) or substantially understated your taxes. This accuracy related penalty is applied when you can’t prove a deduction in an audit, or you didn’t report all of your income and the IRS discovers it.
Civil Fraud – If the IRS finds that you underreported your income with a fraudulent intent (it doesn’t look like an honest mistake to the IRS), a fine of 75% can be added. Breathe easy—this civil (non-criminal) tax fraud penalty is imposed in fewer than 2% of all audits. (You may also be charged with the crime of tax fraud, which is even rarer)
Late Payment – The IRS usually adds a penalty from 1/4% to 1% per month to an income tax bill that’s not paid on time. This late payment penalty is automatically tacked on by the IRS computer whenever you file a return without paying the balance owed, or when you pay it late. Penalties for failing to make payroll tax deposits on time are much higher.
Late Filing – If you’re late in filing required forms, the IRS can penalize you an additional 5% per month on any balance due. However, this penalty can be applied only for the first five months following the return’s due date, up to a 25% maximum charge. If there is no balance due, the IRS can still tack on lesser penalties.
Note. An extension to file your tax return does not extend your time to pay any taxes due.
Filing and Paying Late A special rule applies if you both file late and underpay. Tax penalties are not tax deductible for individuals.
The IRS can ( and probably will ) impose a combined penalty of 25% of the amount owed if not paid in the first five months after the return and tax are due. After five months, the failure to pay penalty continues at 1/2% per month until the two penalties reach a combined maximum of 471/2%. This is a slightly lower (21/2% less overall) penalty than if the two penalties were applied separately. Wow, those IRS folks sure can be generous.
Example. Lie Dharma Putra, lets April 15 pass without filing his tax return or making any payment. He finally gets around to filing on September 16 and owes $4,000. The IRS will tack on a 25% penalty ($1,000), bringing the bill up to $5,000. Interest will be charged as well. In recent years, the IRS has charged 6%–8% interest annually.
penalties are stackable. Late filing and paying penalties can be imposed by the IRS in addition to any other penalties, such as for fraud or filing an inaccurate return. Congress and the IRS believe the more the merrier when it comes to penalizing delinquent or erring taxpayers.
Underpaying Estimated Taxes
Self-employed folks occasionally get dinged for the estimated tax penalty. All self-employed individuals must estimate their income tax for the year ahead and pay it in quarterly installments. Quarterly estimated tax payments are due on April 15, June 15, September 15, and January 15 of each year. Quarterly payments should be equal—generally you can’t play catch-up with larger payments later in the year and still avoid this penalty.
You must come pretty close to paying everything you will owe, although you don’t have to guess the total amount precisely. Here are the rules for avoiding the penalty :
- If you earn less than $150,000, your quarterly tax payments must equal at least 90% of your final income tax bill, or at least 100% of your last year’s tax bill.
- If you earn more than $150,000, you must pay at least 110% of your last year’s tax bill in estimated payments or risk the underpayment penalty on whatever amount you come up short.
Interest on Tax Bills
Congress requires the IRS to charge interest on delinquent tax bills and has given the IRS very limited discretion in canceling interest charges. The interest rate is adjusted every quarter by a formula and compounded daily—recently ranging from 6%–8% per year. It is charged on a monthly basis. If you are audited and end up owing more tax, interest is charged starting on the original date the tax return was due .
Understanding Penalty and Interest Notices
If you receive a tax bill with penalty and interest charges, it may not show how these charges were computed. For an explanation, call the IRS taxpayer assistance line (800-829-1040) and/or request that a penalty and interest explanation notice (PIN EX ) be sent to you.
A PIN EX is a multi-paged computer printout that includes :
- a listing of your business (or personal) tax accounts for the specific years or tax periods you request, showing all tax penalty and interest computations.
- dates, interest rates, penalties assessed, and any credits to your account, such as your quarterly payments, abatements (reductions) by the IRS, or any refunds applied.
- explanations of why particular penalties were charged, with tax code citations authorizing each penalty.
- a summary of your account with balance due, including up-to-date penalty and interest amounts.
How to Get Penalties Reduced or Eliminated
Once you understand why and how the IRS hit you with penalties, you may request that they be reduced or eliminated. The IRS term for this process is abatement. About one-third of all penalties are eventually abated. I suspect that even more penalties would be canceled if people knew how to contest them .
Just telling the IRS that you don’t like a penalty, or can’t afford to pay it, won’t work. You must show reasonable cause, meaning a good excuse. The IRS instruction book for its agents, called The Internal Revenue Manual (IRM), says ;
Any sound reason advanced by a taxpayer as the cause for delay in filing a return, making deposits … or paying tax when due will be carefully analyzed.
The IRM lists seven categories of excuses for abating any tax penalty except fraud :
- Death or serious illness of the taxpayer or immediate family
- Unavoidable absence
- Destruction by fire or other casualty of the business or records
- Inability to determine the tax because of reasons beyond the taxpayer’s control
- Civil disturbances
- Lack of funds, but only when the taxpayer can demonstrate the exercise of ordinary business care and prudence
- Other reasons establishing that the taxpayer exercised ordinary business care but couldn’t comply within the time limits.
TIPS. When requesting an abatement, try to fit your excuse into categories 1 to 6 first. If you honestly can’t, try the catch-all number 7. This category covers just about any excuse you can come up with.