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The Most Common IRS Penalties and How to Avoid Them

common IRS penalties

There are three (3) common IRS penalties that hit individual taxpayers the most. They can easily be avoided with a little planning. Listen…paying taxes is difficult enough, don’t add insult to injury by having to pay penalties and interest on top of income taxes.

  • The Late Payment Penalty – Not paying what I owe by April 15th.
  • Failure-to-File Penalty – Not filing by April 15th or October 15th if you filed an Extension. 
  • Penalty for Underpayment of Estimated Taxes – Not paying what you owe throughout the year 

The IRS penalties ALONG WITH interest can add up quickly. It is CRITICAL to know your deadlines and responsibilities when paying and filing taxes.

Becoming aware of these penalties and how they occur is half the battle. THEN it’s simply planning and noting your calendar to stay ahead of the curve. They can all easily be avoided by paying attention to some important deadlines.

The end of the year is coming and it is important to stay updated on tax and legal requirements. Join my Year-End Tax Strategy Workshop to learn more and stay “in the know.”

#1 Late Payment Penalty 

This is one of the common IRS penalties. It kicks in if you don’t pay any remaining taxes you owe for the prior year by April 15th.

The Damage: The penalty accrues at the rate of one-half a percent (.05%) per month, or part of a month, on the amount shown as due on the return…AND keeps accruing to a maximum of 25% until you pay the bill!

The interest on any unpaid taxes accrues at the annual rate of six percent (6%). Not too bad, but it’s the penalty that will catch up to you.

You can still file an extension to ‘File’ your taxes. However, the IRS wants you to deposit what you owe by this important deadline. If you don’t, they’re going to tack on interest as well.

How to Avoid the Late Payment Penalty

To start off, if you can pay on time, you can avoid this penalty altogether. Make plans during the current tax year by setting up a savings account specifically for taxes. Along with that, set aside 20% of the income from your small business or investments. If you have a ‘day job’ with a W-2, the withholdings from your paycheck should suffice for the taxes you owe from your employment. Typically the problem comes from a side-gig 1099 situation.

Now…if you haven’t saved up the money for your taxes OR made the necessary Estimated Payments (See below – the Penalty for Underpayment of Estimated Taxes). Then it’s time to ‘guestimate’ what you think you might own.

I realize that sometimes it may be hard to estimate how much you owe in taxes. Maybe you haven’t gathered your records or even have a draft of your tax return. However, the first step is to try and at least estimate what you think you might owe.

Next, estimate high. If you send in a little too much, you’ll simply get a refund when you ultimately do file, but at least you won’t be paying penalties or taxes on the unpaid balance.

Finally, borrow the money from someone if you have to. Get a zero-interest credit card, or tap into a home equity line of credit (HELOC). The bottom line is try to own anyone else other than the IRS. They are unforgiving and again the penalties and interest can add up fast!

Example:

FILING EXTENSION, BUT NOT PAYING: In real numbers, if you file an Extension on April 15th, and take the next six (6) months to ultimately pay your $10,000 tax (let’s assume before October 15th), your interest and penalties would be as follows: 3% in compounding interest for approximately 1/2 of the year, AND 3% in penalties (.05% x 6 months). The total would be approximately $550 in penalties and interest. Again, not the end of the world and not too bad of an interest rate either. REMEMBER, you have to work quickly because those penalties add up fast.

If you can’t pay your taxes by April 15th, and even worse…you can’t pay by October 15th, things will start to get a lot more serious with the IRS. There are several options like a grace period, installment agreement, or Offer In Compromise, but it’s a whole other conversation. You can learn way more about this by checking out my article, “What to do if I can’t pay my Taxes by October 15th.”

#2 Failure-to-File Penalty 

This onerous penalty applies if a taxpayer fails to file an Extension, and misses the April 15th deadline, OR misses the October 15th deadline with an Extension.

The Damage: The penalty accrues at the rate of five percent (5%) per month, or part of a month. Again, the interest on any unpaid taxes accrues at the annual rate of six percent (6%). Not too bad, but it’s the penalty that will catch up to you.

The real problem is if you don’t file the Extension AND owe…The maximum combined penalty for the first five months is 25%. Thereafter the failure-to-pay penalty can continue at 1/2% per month for 45 more months (an additional 22.5%). Thus, the combined penalties can reach a total of 47.5% over time. Both of these penalties are in addition to the interest you will be charged for late payment!! 

Avoiding Failure-to-File Penalty

Now I know this might sound obvious, but you can avoid the failure-to-file penalty by filing!! Make sure to file your return on April 15th, or by October 15th if you filed an Extension.

Even if you have to amend your tax return later, it’s better than not filing at all.  Now if you are expecting to get a refund on your return then you have way less to worry about. The IRS is not going to charge you the failure-to-file penalty if your tax return is late and you are getting a refund. 

TIP: I strongly suggest that you ALWAYS want to file an extension. Once you file it, then figure out what you think you might owe then pay what you can. If you can’t pay it is not the end of the world. Although some penalties and interest will start to collect. There will be less to pay if you file an Extension and then ultimately file before October 15th. 

The moral of the story is…ALWAYS file an extension, AND always file your tax return by October 15th, even if you have to amend it later.

#3 Penalty for Underpayment of Estimated Taxes

This is one of the next common IRS penalties. The IRS doesn’t want you to wait until April 15th to pay your dues. They want you to pay your taxes and the money ‘deposited’ throughout the year. If you have a W-2 paycheck, this is already deducted from your check and sent into the IRS by your employer. IF you have an S-Corporation, you are doing this on your own payroll allocation and depositing quarterly.

This penalty applies if taxpayers didn’t deposit during the prior year at least 90% of their current year tax bill, or 100% of what they owed the year before (110% if they made over $150K).

IMPORTANT: Again, don’t wait until April 15th for you to pay your taxes. The IRS does not want that. They want you to make deposits throughout the preceding year so you don’t leave them high and dry. ALSO, the IRS prefers these payments to be made in equal installments and the bad news is they will charge a penalty if less is paid early and more was paid later. 

If the IRS finds that you made errors on your tax return due to negligence or there was a substantial understatement of the taxes owed, the IRS will charge a 20% penalty. This penalty is charged after an audit if you cannot prove you were allowed to take the deductions you claimed or failed to report all your income.

Ways to Avoid Penalty for Underpayment of Estimated Taxes

If you owe more than $1,000 at the end of the year you can do two things so that the IRS won’t charge you an estimated tax penalty. The first one is estimating what you owe and then paying at least 90% of what you owe for the current year. It must be in four installment payments that are equal. 

The next thing you can do is pay 100% of the tax on your prior-year tax return. You are looking for that tax that is stated on your return before you apply payments, withholding, and refundable tax credits. If your adjusted gross income is more than $150K then you would pay 110% of the tax on your prior year’s return. 

Conclusion

Bottomline, Always try to stay ahead of these common IRS Penalties & Interest. The worst thing you can do is ignore the situation and ignore the IRS. If the IRS is sending you a letter, you need to call them. Also, know that the IRS is never going to call you. If the “IRS” is calling you it is a scam artist. 

Find a solution with the IRS instead of letting it snowball into something disastrous. Keep in mind the most common IRS Penalties as you think about filing your taxes this year. 

Finally, to help business owners and investors I have created a Calendar with important tax and legal filing deadlines. It also has important resources and tips that should help you save thousands in tax planning. Check out my 2023 MJK Calendar here.

* To sign up for Mark’s weekly Free Newsletter and receive his Free E-Book “The Ultimate Tax Strategy Guide – 30 Steps to Saving the Most Money on Your Taxes” visit www.markjkohler.com.

Mark J. Kohler is a CPA, Attorney, co-host of the PodCasts “The Main Street Business Podcast” and “The Directed IRA Podcast”, and the author of “The Business Owner’s Guide to Financial Freedom- What Wall Street Isn’t Telling You” and, “The Tax and Legal Playbook- Game Changing Solutions For Your Small Business Questions”, as well as several other well-known books. He is also the CFO of Directed IRA Trust Company, and a senior partner at the law firm Kyler Kohler Ostermiller & Sorensen, LLP, and the accounting firm K&E CPAs, LLP. 

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