Most Taxpayers are aware that the IRS has rules and regulations regarding filing tax Returns and paying taxes. Of course, if there are rules and regulations, it follows that there must be consequences for failing to comply. This is particularly important since, for the most part, the Federal Income Tax system is based upon Taxpayer’s voluntary compliance. That is, the IRS depends upon Taxpayers to follow the laws, file complete and accurate Returns on a timely basis, pay the tax on a timely basis, etc. Most Taxpayers dread getting Notices from the IRS but few know the consequences of noncompliance.
The Federal Income Tax laws provide for consequences that range from money (i.e. interest and penalties) to jail time. The imposition and severity of the interest, penalties and jail time depends upon the nature and size of the problem as well as extenuating circumstances (e.g. inadvertent error versus intentional fraud). Most of the rules and consequences can be found in Title 26 of the United States Code, Subtitle F. Below is a brief summary of the most common problems and potential consequences:
Failure to File a Return:
If a Taxpayer fails to file a tax Return by the due date, the IRS can charge 5% of the unpaid balance due for each month (or part of a month) the Return is late, up to a maximum of 25%.
If the Return is more than 60 days late, the minimum penalty is the lesser of $135 or the tax due. The good news is that there is no late filing penalty if there is no balance due.
Late Payment-After Filing Date:
The penalty for a late payment (after the due date of the Return) is generally .5% of the unpaid balance for each month (or part of a month) that the payment is late. This penalty continues to accrue until it hits a cap of 25% at which point this penalty stops accruing. Since the penalty is .5%, it hits the cap after 50 months. If both the failure-to-file penalty and the failure-to-pay penalty apply in any month, the 5% failure-to-file penalty is reduced by the failure-to-pay penalty.
Please note, a timely extension of the time to file a Return does not extend the time to pay a tax due. The late payment penalty begins to accrue in the original month due, not the extended date.
Underpayment of Estimated Tax-Before Filing Date:
Unless a safe harbor rule applies, an underpayment occurs if the Taxpayer does not pay enough throughout the year and has a tax due at the end of the year. If there is an underpayment of tax, the underpaid amount is subject to an underpayment penalty at the applicable Federal rate for the affected time periods. Please note that this is technically called a penalty, but it is essentially interest.
Briefly, a safe harbor rule relieves the Taxpayer of paying an underpayment penalty on the underpayment of tax if the Taxpayer can get themselves into one of designated categories (e.g. paying 100% of the tax due of the previous year’s Return-110% if the adjusted gross income was over $150,000).
There are a number of categories that fall under the “Accuracy-Related” heading, but for the most part they have the same penalty. An Accuracy-Related penalty of up to 20% of the underpaid tax can be assessed if any of the following exist:
Negligence– A Taxpayer must make a reasonable effort to comply with the laws, including using ordinary and reasonable care when preparing a tax Return, as well as keeping proper records. If the Taxpayer is negligent or has a disregard for the laws, the Accuracy-Related penalty can be assessed.
Substantial Understatement of Income Tax– If a Taxpayer substantially understates income, the Accuracy-Related penalty may be assessed. To be a substantial understatement, one would have to understate income tax due by more than 10% of the correct tax and be greater than $5,000.
Substantial valuation misstatement- If a Taxpayer substantially misstates a value the Accuracy-Related penalty may be assessed. A substantial valuation misstatement exists if a valuation is 150% or more of the actual determined value and the misstatement causes a tax understatement of more than $5,000. In that event, a penalty can be assessed. To make matters worse, the penalty can be raised up to 40% of the underpaid amount if it is determined there was a gross valuation misstatement.
Substantial estate or gift tax valuation understatement- If a Taxpayer substantially understates an estate or gift tax valuation the Accuracy-Related penalty may be assessed. A substantial understatement is considered to be 65% or less of the actual determined value and the valuation causes a tax understatement of more than $5,000.
Fraud: An underpayment that is caused by fraud is subject to a 75% penalty of the underpaid amount.
Frivolous Return: A frivolous tax Return is subject to a $5,000 penalty.
A frivolous Return is considered to be a Return that:
- Does not contain information upon which the substantial correctness of the self-assessment may be judged; or
- Contains information that, on its face, indicates that the self-assessment is substantially incorrect; and
- The conduct is deemed by the Secretary to be of a frivolous nature or intended to delay or impeded the administration of Federal Tax Laws.
Willful Making and Subscribing to False Return: Each Return must be signed by the Taxpayer in which the Taxpayer essentially swears that it is complete and accurate.
The willful making and subscribing to a false Return is a Felony, with a fine up to $100,000 and up to 3 years in prison.
Willful Attempt to Evade or Defeat Tax: The U.S. Supreme Court decreed many years ago that it is ok to legally arrange one’s actions to avoid a tax but it is not legal to evade a tax. The willful attempt to evade a Federal tax is a Felony, with a fine up to $100,000 and up to 5 years in prison.
Willful Failure to Pay Tax or File Return: The willful failure to pay or file a Return is considered to be a misdemeanor with a fine up to $25,000 and up to 1 year in jail.
The IRS wants Taxpayers to be appropriately concerned about violating a Federal Income Tax law. This helps Taxpayers make the decision to voluntarily comply. Most Taxpayers do not know the possible interest, penalties and jail time that they could face for noncompliance. For some, the fear is actually worse than the reality. However, for others, the reality is a grim surprise.
Under some circumstances the IRS will waive one or more of the penalties.
Copyright ©, Keith B. Baker – 2012
This article is designed to be a public resource of general information. It does not constitute “legal advice” nor does it create a “client-attorney” relationship. While the information is intended to be accurate, this cannot be guaranteed. Tax laws are complex and constantly changing as a result of new laws, regulations, court interpretations and IRS pronouncements. Often, there are also various possible interpretations. Further, the applicable rules can be affected by the facts and circumstances of a particular situation. Because of this, some of the information may no longer be correct or may not apply to all situations. We are not responsible for any consequences or losses resulting from your reliance on such information. You are urged to consult an experienced lawyer concerning your particular factual situation and any specific legal questions you may have.
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