If left unchecked, penalties will spiral out of control rapidly, often adding tens of thousands of dollars (or more) of tax burden.
Even for a professional, tax penalties can be overwhelming if you are unfamiliar with how they work. If left unchecked, penalties will spiral out of control rapidly, often adding tens of thousands of dollars (or more) of tax burden. Working with the IRS to abate penalties can be a complex, high-stakes process. Luckily, we're here to arm you with knowledge so you can face the penalty abatement process with confidence.
Penalties are intended to make non-compliance—neglecting to pay the right amount of taxes, on time, in the right way—more painful than paying voluntarily.
To help familiarize you, we'll take a quick look at the two most common tax penalties—Failure to Pay and Failure to File—as well as the interest charged on unpaid tax.
The first and most common penalty is Failure to Pay. If taxes are not paid in full by their due date (generally the infamous April 15th), then the Failure to Pay penalty kicks in. The penalty is one-half of one percent (.5%) of the unpaid balance, added every month or partial month the payment is late. That penalty will continue to grow until it either reaches the maximum 25%, or the balance is paid in full.
Failure to Pay penalties aren’t fun by anyone’s definition of the word, but they don’t have to be a big deal as long as you don’t let them go unpaid for too long.
The Failure to File penalty is another of the most common penalties. FTF applies–as the name suggests–when someone does not file a return by the required due date. The penalty is 4.5% of the unpaid tax per month. However, because a person cannot pay taxes without having filed a return, FTF is inevitably combined with a Failure to Pay penalty, making the effective penalty 5%.
FTF is obviously much more severe than Failure to Pay (9x more severe, to be exact), but it maxes out at five months, or 22.5%. Unlike the Failure to Pay penalty which can be relatively mild if not left to fester, the Failure to File penalty becomes painful quickly. Additionally, if a taxpayer does not file their own return the IRS will eventually file a Substitute For Return (SFR), which calculates taxes without accounting for deductions or exemptions. The result is owing far more tax than if a proper return had been filed.
As if the penalties alone weren’t enough, the IRS charges interest on unpaid tax. Interest is charged only on unpaid tax, not including any penalties the taxpayer has incurred.
Interest on unpaid tax is compounded daily, with a rate equal to the current Federal short-term interest rate (determined quarterly) plus 3%. As of July of 2016, the combined interest rate for unpaid tax was 3.71%. Unlike the penalties we discussed above, interest is not eligible to be abated.
Understanding penalties is important, but that's only half of the penalty abatement equation. Luckily, this article is an amended excerpt from our new Penalty Abatement Basics and Techniques ebook. Download it for free today.