Understanding Tax Penalties and How to Avoid Paying Them

Anthony Finochio (Jan, 2017)

Income tax filing season is upon us once again.  As millions of taxpayers hurry to gather up all their pertinent tax documentation and applicable support, thoughts race through their minds as to whether or not they included everything that their accountant needs to get their tax return prepared.  They worry about having received all of the required 1099s, W-2s, and other forms, and whether or not they have phone calls to make in order to obtain those missing records.  They want to make sure that they are prepared for the process in the hopes that it will be quick and painless as it might have been in past years.  Once all the forms have been prepared and the dust settles, the final apprehensive questions are asked - do I owe and if so, how much?     

It is understandable that if you do owe additional taxes when you file your return, the circumstances can be quite upsetting. When the IRS decides to add on additional penalties and interest on top of the taxes, the situation can easily go from bad to worse.  In order to mitigate the amount of taxes owed when filing your return, it is important to consult with your tax advisor during the year.  We can utilize several tax planning tools and techniques to best help you lower the tax burden due with filing and take the surprise out of the end result.  More importantly, these tools can help you avoid having to pay costly penalties. 

In order for any taxpayer to take the necessary steps to avoid paying those additional penalties, they must first be informed as to what they are and how much it could cost them.  The United States system for taxation is referred to as a pay-as-you-go system.  This simply means that as you earn or constructively receive income throughout the year, you are required to pay tax on that income.  If you do not pay as you go, you face a possible underpayment penalty on the underpayment.

The underpayment penalty is assessed by the IRS when the total amount of tax payments, either through withholding or estimated payments, do not equal the lesser of  90% of your current year tax or 100% of your prior year tax.  It is important to note that if your adjusted gross income (AGI) for 2015 was greater than $150,000 then the safe harbor amount is 110% of the previous year’s tax.  Proper tax planning during the year, particularly if you have dramatic changes in income, can help you ensure that you have paid in these threshold amounts.  If you owed no tax last year or the amount due is less than $1,000, then there is no penalty.  The current underpayment penalty rate is 4% and is calculated quarter by quarter based on the method that produces the least penalty.

The next penalty that may be considered is the failure to pay penalty.  This is calculated from the due date of the return on underpayments of tax.  This penalty is ½ of one percent per month up to 25% of the tax that is due.  The IRS will also impose the underpayment penalty on the amount due.  This loan from the Government is a bit more expensive with an annual rate of 10%.

The last penalty we will discuss today is the failure-to-file penalty.  Under the rules established by the IRS, taxpayers will be assessed a penalty for failing to file a tax return by the deadline of April 15th.  This penalty is 5% per month up to 25% of the amount unpaid. This computes to a 60% interest rate and comes along with the failure to file and underpayment penalties to rack up an impressive 70% annual interest rate.  If you do not have the money and are unsure of the amount you owe you can file an extension indicating the estimated amount owed, but unpaid.  The failure to pay penalty will accrue along with the underpayment penalty, but you do save the onerous failure to file penalty.  It is vitally important that you file a complete return by the extended due date whether you have the money or not.         

No one likes a big tax bill when they file their annual return.  Planning ahead will allow you to be prepared for the unfortunate event.  If for whatever reason you cannot make the payment, do not panic and make sure you file your return regardless.  It is tough enough to pay additional taxes when you file your tax return.  By taking some extra time throughout the year to be well informed and to consult with your tax professional, you can take the necessary steps to avoid a heavy tax burden and having to pay those costly penalties.  As always, please contact your Dermody, Burke, and Brown tax advisor if you have any questions regarding the subject.


The information reflected in this article was current at the time of publication.  This information will not be modified or updated for any subsequent tax law changes, if any.

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