Tax penalties are a common and significant issue for many taxpayers in the United States. The Internal Revenue Service (IRS) assesses millions of penalties each year, affecting both individuals and businesses.

In fact, the IRS provided penalty relief on nearly 5 million tax returns for the 2020 and 2021 tax years, highlighting the prevalence of this issue.

“In a major step to help people who owe back taxes, the Internal Revenue Service today announced new penalty relief for approximately 4.7 million individuals, businesses and tax-exempt organizations that were not sent automated collection reminder notices during the pandemic,” the IRS announced in December 2023. “The IRS will be providing about $1 billion in penalty relief. Most of those receiving the penalty relief make under $400,000 a year.”

Understanding tax penalties is crucial for maintaining financial health and avoiding costly mistakes.

Tax Penalties are Far from Rare Occurrences

Tax penalties can be costly and stressful.

“Tax penalties are far from rare occurrences. They affect millions of taxpayers annually and can have substantial financial consequences,” says tax pro Steve Powell of Texas-based Powell Tax Law.

The failure-to-file penalty alone is typically 5 percent of the unpaid tax owed for each month or part of a month that the return is late, up to a maximum of 25 percent.

“This means that even a relatively small tax debt can quickly balloon into a significant financial burden,” Powell said.

7 Common Types of Tax Penalties

Here are seven common types of tax penalties:

IRS Notes: If both a Failure to File and a Failure to Pay penalty are applied in the same month, the Failure to File penalty is reduced by the amount of the Failure to Pay penalty for that month, for a combined penalty of 5 percent for each month or part of a month that your return was late. If after 5 months you still haven't paid, the Failure to File penalty will max out, but the Failure to Pay penalty continues until the tax is paid, up to its maximum of 25 percent of the unpaid tax as of the due date. If the return is more than 60 days late, the minimum Failure to File penalty is $485 (for 2024) or 100 percent of the underpayment, whichever is less:

IRS Notes: “Negligence” includes (but is not limited to ) any failure to make a reasonable attempt to comply with the internal revenue laws, exercise ordinary and reasonable care in preparation of a tax return, or keep adequate books and records to substantiate items properly. This penalty may be asserted if you carelessly, recklessly or intentionally disregard IRS rules and regulations - by taking a position on your return with little or no effort to determine whether the position is correct or knowingly taking a position that is incorrect. You will not have to pay a negligence penalty if there was a reasonable cause for a position you took and you acted in good faith.

4. Estimated Tax Penalty: If you don't pay enough taxes throughout the year through withholding or estimated tax payments, you may owe an estimated tax penalty. This is essentially an interest charge on the amount you should have paid in estimated taxes.

5. Fraud Penalty: For cases involving tax fraud, the IRS can impose a penalty of up to 75 percent of the unpaid tax attributable to fraud.

IRS Notes: The fraud penalty on a joint return does not apply to a spouse unless some part of the underpayment is due to the fraud of that spouse. Negligence or ignorance of the law does not constitute fraud.

Typically, IRS examiners who find strong evidence of fraud will refer the case to the Internal Revenue Service Criminal Investigation Division for possible criminal prosecution. Keep in mind that both civil sanctions and criminal prosecution may be imposed.

6. Bad Check Penalty: If you pay your taxes with a check that bounces, you may face a bad check penalty. This can be 2 percent of the check amount if it's over $1,250. If the check is under $1,250 then the penalty is the amount of the check or $25, whichever is less.

7. Early Withdrawal Penalty: Withdrawing money from certain retirement accounts before age 59½ can result in a 10 percent early withdrawal penalty on top of the regular income tax due.

Consequences of Tax Penalties

Tax penalties can have significant financial and legal consequences:

• Financial Burden: Penalties and interest can substantially increase your tax liability, sometimes doubling or tripling the original amount owed.
  
  
• Credit Score Impact: Unpaid tax debts can be reported to credit agencies, potentially damaging your credit score.
  
  
• Legal Consequences: In severe cases of tax evasion or fraud, you may face criminal charges and potential imprisonment.
  
  
• Business Implications: For business owners, tax penalties can affect your company's financial health and reputation.
  
  
• Future Audit Risk: A history of penalties may increase your chances of being audited in the future.

Strategies to Avoid Tax Penalties

While tax penalties can be costly, you can avoid them with the right strategies:

• File and Pay on Time: Always file your tax returns and pay any taxes owed by the due date. If you can't pay the full amount, still file on time and pay as much as you can to reduce penalties.
  
  
• Use Tax Preparation Software or Professional Services: These can help ensure accuracy and timely filing. Consider working with a reputable tax professional like Powell Tax Law for complex tax situations.
  
  
• Keep Accurate Records: Maintain organized records of income, expenses, and deductions throughout the year. This makes tax preparation easier and helps support your tax positions if questioned.
  
  
• Stay Informed About Tax Law Changes: Tax laws change frequently. Stay updated on new regulations that may affect your tax situation.
  
  
• Make Estimated Tax Payments: If you're self-employed or have significant non-wage income, make quarterly estimated tax payments to avoid underpayment penalties.
  
  
• Double-Check Your Return: Before filing, review your return carefully for errors in calculations, Social Security numbers, and other details.
  
  
• Request an Extension if Needed: If you can't file by the deadline, request an extension. Remember, this extends the time to file, not to pay, so estimate and pay any taxes due by the original deadline.
  
  
• Communicate with the IRS: If you're facing financial hardship, contact the IRS about payment options or hardship status. They may be able to waive certain penalties.
  
  
• Contribute to Retirement Accounts: Maximize contributions to tax-advantaged retirement accounts to reduce your taxable income and potentially lower your tax liability.
  
  
• Understand Deductions and Credits: Take advantage of all applicable deductions and credits to legally minimize your tax liability.
  
  

What to Do If You Incur a Tax Penalty

If you find yourself facing a tax penalty, don't panic. Here are some steps you can take:

• Review the Penalty Notice: Carefully read the IRS notice to understand the type and amount of the penalty.
  
  
• Verify the Accuracy: Ensure that the information on the notice is correct. If you find any errors, contact the IRS immediately.
  
  
• Consider Penalty Abatement: In some cases, you may be eligible for penalty abatement, especially if you have a history of compliance and a reasonable cause for the violation.
  
  
• Set Up a Payment Plan: If you can't pay the full amount, consider setting up an installment agreement with the IRS to pay over time.
  
  
• Consult a Tax Professional: For complex situations or significant penalties, it's wise to consult a tax professional. An experienced tax attorney, like those at Powell Tax Law, can help you understand your options and potentially negotiate with the IRS on your behalf.
  
  
• File an Appeal: If you disagree with the penalty and have supporting documentation, you may be able to file an appeal with the IRS.
  
  

“Remember, tax laws can be complex and ever-changing, so don't hesitate to seek professional help when needed,” Powell said. “Your diligence in managing your tax responsibilities effectively will pay off in the long run.”

If you are under the threat of IRS tax penalties, contact Powell Tax Law today for help in solving your case.