How Are Tax Penalties Calculated?

Most taxpayers don’t intentionally incur tax penalties, but many who are penalized are simply unaware of the penalties or the possible damage they can do to their wallets. As tax season approaches, let’s look at some of the more commonly encountered penalties and how they may be avoided.

See Relax Tax's Amending a Tax Return at relaxtax.com/debtreview

Underpayment of Estimated Taxes and Withholding Penalty 

The United States’ income tax system is a pay-as-you-earn tax system, which means that taxpayers are required to pay their tax liability as they receive income during the year through withholding or by making estimated tax payments. Normally, estimated tax payments are made in four installments that are due by April 15, June 15, September 15, and January 15 of the subsequent year. If a taxpayer owes more than $1,000 when filing their return for the year, the IRS will assess the penalty for underpayment of estimated tax, which is currently 3% of the underpayment. “Safe harbor” payments can protect you from this penalty, which are payments of 90% of the current year’s tax liability or 100% (110% for high-income taxpayers) of the prior year’s tax liability. Farmers and fishermen need only prepay 66-2/3% of their current liability or 100% of their prior year’s liability. 

See this related post from Dennis Harabin: The Different Ways to Pay Your Taxes

Although most (74% in 2020) American taxpayers receive a refund each year when they file their income tax returns, there are those who for one reason or another end up owing. Of those who owe Uncle Sam many don’t have the means to pay what they owe by the return due date (usually in April). Generally, tax due occurs when a wage earner has under-withheld on his or her payroll or a self-employed individual failed to make adequate estimated tax payments during the year. This can be a huge problem for those who are unable to pay their liability.   

The 100%/110% safe harbor works well when the taxpayer’s tax will be higher than that of the prior year. But when a taxpayer anticipates a large drop in income as compared to the prior year, there can be a huge impact on the necessity of estimated tax payments. The 100% and 110% of the prior year’s tax liability are most likely not viable safe harbor amounts for estimated tax in the lower-income year, and most taxpayers will want to pay 90% of the current year’s tax liability. Please contact this office at 551-249-1040 to see if you need to make any payments and, if so, how much.

Required Minimum Distribution (RMD) Penalty 

To prevent an individual from investing in tax-deferred retirement plans, including traditional IRAs, but never withdrawing funds from the plans (which would mean the government wouldn’t ever collect taxes on the retirement funds), retirees must take an RMD each year after reaching the mandatory RMD age. The mandatory distribution age is currently 72. Failing to take the correct minimum distribution (also known as excess accumulation) results in a penalty of 50% of the difference between what should have been withdrawn and what was actually withdrawn. However, the IRS generally is very liberal about abating the penalty in most situations when corrective action is taken.

Late-Filing Penalty 

If a return is filed after the due date, including after extensions, a late-filing penalty of 4.5% per month (maximum 22.5%) will be applied. The normal due date for returns is April 15 of the subsequent year. Because of COVID-19, the original due date for 2020 returns was extended to May 17, 2021. Those who had not filed by that date could have requested a further extension to October 15, 2021. If you have not filed your 2019, 2020, or any earlier year’s return, you are encouraged to do so as soon as possible to minimize late-filing penalties. 

If a return is over 60 days late, the minimum penalty for failure to file is the lesser of $435 ($450 in 2022) or 100% of the tax shown on the return. While the obvious way to avoid a late-filing penalty is to file in a timely fashion, the IRS will consider abating the penalty if it can be proven that there was reasonable cause and no willful neglect.

Late-Paying Penalty 

If the tax owed on a return is paid after the unextended due date of the tax return (usually April 15 but is May 17 for 2020 returns filed in 2021), then the taxpayer will be subjected to a penalty of 1/2% per month (maximum 25%) of the unpaid balance. Taxpayers are frequently caught by this penalty when they need an extension to file their tax return; many fail to realize that the extension does not include an extension on paying. The only way to avoid or minimize this penalty is to have no or little balance due on the return when it is finally filed. The extension form includes a provision to pay the projected balance owed when filing the extension. 

Negligence

 When underpayment is due to taxpayer negligence or when there are errors in tax valuations, a penalty of 20% of the tax underpayment will be charged. This penalty is frequently encountered when the IRS adjusts a filed return due to unreported income or overstated deductions. 

Fraud 

The fraud penalty is 75% of the tax unpaid due to fraud. 

Dishonored Check

The penalty for dishonored checks of over $1,250 is 2% of the check amount. If the amount is $1,250 or less, the penalty is the amount of the check or $25, whichever is less. If you don’t have sufficient funds to pay your tax when you file your return, rather than writing a check that you know will bounce, you may be able to arrange an installment payment plan with the IRS. You may still incur late-payment charges, but the penalty rate will be lower if you are on a payment plan.

Missing ID Number

A $50 penalty for each missing number applies when a taxpayer doesn’t provide a required Social Security number (SSN) for themselves, a dependent, or another person on their tax return. It is also charged when the taxpayer doesn’t provide their SSN to another person or entity when required. 

Early Withdrawal Penalty 

 If a taxpayer is under age 59½ and withdraws assets (money or other property) from a qualified retirement plan, including traditional IRAs, the taxpayer must pay a 10% additional tax, commonly referred to as the early withdrawal penalty. This tax is 10% of the part of the distribution that the taxpayer was required to include in their gross income for the year of the distribution. A number of exceptions apply to this penalty.

As part of COVID-19 relief, this penalty was waived on distributions of up to $100,000 from qualified retirement plans and traditional IRAs during 2020. Early withdrawals in 2021 and later years are subject to the penalty unless one of the several exceptions applies. 

Failure to Report Tips

A penalty will be charged if a taxpayer didn’t report tips to their employer. It equals 50% of the Social Security tax on the unreported tips. 

Reporting Foreign Accounts and Assets 

There are numerous and substantial penalties for failures to report a variety of foreign accounts and assets, and some of the penalties are even draconian. Please contact this office if you have a foreign financial account, foreign trusts, ownership in a foreign corporation, received foreign gifts, and so on. 

Excessive Claim Penalty

 If a claim for refund or credit for income tax is made for an excessive amount, the person making the claim is liable for a penalty equal to 20% of the excessive amount. The excessive amount is the amount by which one’s claim for any tax year exceeds the amount of the claim allowable for that tax year. 

The penalty doesn’t apply if it is shown that the claim for the excessive amount was made with reasonable cause. The penalty also does not apply if any portion of the excessive amount or credit is subject to an accuracy-related penalty. 

Accuracy-Related Penalty for Non-Itemizers 

For 2021, taxpayers are allowed a deduction up to $300 ($600 on married joint returns) for cash contributions to qualified charitable organizations. Usually, only individuals who itemize their deductions can deduct donations to charities. As part of the accuracy-related penalty, a non-itemizing taxpayer who overstates their charitable donation can be penalized by 50% of the tax attributable to the overstatement, rather than the normal 20% penalty.

Frivolous Return

 In addition to any other penalties, the law imposes a $5,000 penalty for filing a frivolous return – one that does not contain information needed to establish the correct tax or that shows a substantially incorrect tax because the taxpayer takes a frivolous position or displays a desire to delay or interfere with the tax laws. This includes altering or striking out the preprinted language above the space where the taxpayer signs. Under limited circumstances, the IRS may reduce the penalty from $5,000 to $500.

Failure to File Information Returns

A taxpayer who, without reasonable cause, fails to file a required information return in the manner the law specifies or by the proper deadline, fails to include all of the information required, or includes incorrect information will be subjected to a penalty of $280 for each return required to be filed during 2021 or 2022. The penalty will be reduced to $50 if the failure is corrected within 30 days of the due date and $110 if corrected by August 1.

Please call us at 551-249-1040 if any of these penalties has been assessed against you, to see if it is possible to have them reduced or removed. 

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