Paying IRS tax penalties is painful and wasteful, but knowing where the tripwires are and proactively avoiding them will save you money and headaches. Here’s a summary of what penalties to be aware of and simple ways to prevent them.
Income Tax Penalties
- Underpayment penalty — Problem: If you don’t pay enough tax in during the year and come up materially short, you can find yourself penalized for ‘underpayment’. Amount: The penalty amount is calculated based on how long the amount went underpaid, multiplied by the prevailing IRS interest rate, which is around 4-5% currently. Solutions: (a) Have financial processes that easily keep your books up-to-date, (b) Perform a tax projection to evaluate income and withholding sources, then send in the right estimated tax amounts each quarter. (c) Alternatively, ensure that you at least meet the ‘safe harbor’ level which avoids this penalty regardless of taxable income (90% of your current year tax, or 100/110% of your prior year tax).
- Late filing penalty — Problem: If you fail to file a return by its due date or extended due date and you owe a tax, you’ll get a letter from the IRS assessing a late filing penalty. Amount: For the IRS, it’s generally 5% of the unpaid tax each month up to a maximum of 25%. (Note: Non-tax forms like pass-through returns for S-corps and Partnerships carry different penalties equal to $200/$210 per shareholder/partner per month.) Solutions: (a) Have financial processes that easily keep your books up-to-date, (b) Work with a tax adviser that sends you reminders around tax filing deadlines, (c) File your tax returns timely even if you don’t have the money for the tax.
- Late payment penalty — Problem: If you pay your tax after its original due date (extensions don’t count for this penalty), the IRS is going to want additional money. Amount: The penalty is effectively an interest calculation which for the IRS 0.5% of the unpaid tax each month up to a maximum of 25%. (Note: The rate drops to 0.25% if you’re in an approved installment plan.) Solutions: (a) Set aside funds for taxes in a separate bank account each month/quarter to avoid scrambling for cash, (b) If you’re extending your return, have your tax adviser calculate your tax as best possible and send that with your extension, (c) And for added protection, be sure to include your first quarter estimated tax payment with your extension payment (later rolling it forward if it’s not needed).
- IRS audit adjustments — Problem: This isn’t so much a penalty, as an additional tax assessed when line items on your return are adjusted during an IRS audit. Amount: The increased tax will depend on the amount of the additional income or disallowed deduction, plus late payment penalty interest (often significant because audit adjustments typically occur years after the return is filed). Solutions: (a) Have your tax adviser review your normal transaction types to confirm they’re being categorized correctly in your books, (b) Keep a digital ‘file cabinet’ of all business receipts and statements (we’ve seen more adjustments come from simply not having a receipt), (c) Be sure to contact your tax adviser any time you have a non-standard or large transaction to ensure it’s handled properly.
- Accuracy related penalty — Problem: If an IRS audit adjustment is greater than 10% of the amount due or $5,000, -or- you’re found negligent when filing your return, -or- you make a substantial valuation error, the IRS can assess an additional penalty on top of all of the above. Amount: 20% of the understated tax. (Ouch!) Solutions: (a) The prevention strategies are the same as those for IRS audit adjustments listed above, plus (b) Be sure you look over your tax return with a critical eye each year ask yourself if any big is missing.
Other Tax Penalties
- Undisclosed international accounts — Problem: If you have bank or other financial accounts overseas (e.g. investments) that are supposed to be disclosed, failure to do so can lead to some hefty penalties. Amount: Not submitting the annual account disclosure statement (FinCen 114) can lead to a $10,000 penalty per violation for non-willful violations, and the greater of $100,000 or 50% of the account balance for willful violation. And not reporting financial assets over the threshold (Form 8938) results in a $10,000 penalty, and $10,000 per month up to $60,000 after you receive an IRS notice. Solutions: (a) If you have any international activity, talk to your tax adviser right away to walk through how the rules apply your situation, (b) Maintaining a U.S bank account that is accessible when you’re overseas can be the simplest solution, (b) Be sure to consider accounts that aren’t yours but over which you have signature authority.
- Payroll related penalties — Problem: Payroll tax payments and payroll forms each have different due dates which will trigger penalty notices if missed. Amount: Payroll tax payments can carry penalties between 2% and 15% depending on how late they are, and payroll forms (e.g. Form 941) carry a penalty of 5% of unpaid tax due per month up to 25% – if both apply, they will offset each other, but interest also accrues. Solutions: (a) Use a cloud payroll solution which automatically pulls payroll taxes each pay run and automatically files forms without requiring your intervention, (b) Have a payroll adviser evaluate your compensation, benefits, and other employee perks to be sure they’re properly being captured in your payroll system, (c) Be sure any off cycle compensation transactions run through the payroll system so they’re properly included in totals and any tax is appropriately calculated.
- W-2/1099 Information returns — Problem: Failure to send Form W-2’s and 1099-MISC’s to employees and contractors and the IRS by January 31 each year can trigger some pretty serious penalties. Amount: The amount depends on the number of forms and the length of time they’re late – $50/form if filed within 30 days, $100/form if filed between 30 days and August 2, $270/form if filed after August 1 or not at all, and $540/form with no maximum limit if due to intentional disregard. Solutions: (a) Use a cloud payroll solution that automatically prepares and files information returns for you, (b) Use a cloud solutions to easily collect Form W-9 each time a contractor starts work, then tag the contractor as ‘1099 eligible’ in your cloud accounting system to run a simple report at year-end, (c) Use a cloud 1099 solution to easily synchronize year-end contractor information, automatically e-mail digital forms to your contractors, and automatically e-file 1099’s with the IRS.
- State tax returns — Problem: We’ve listed a number of IRS penalties above, but most states have similar penalties for their returns, so mis-steps often lead to double-whammies. Amount: Every state decides its own penalty amounts, and often they’re higher than the IRS’ (though often the state tax liability is overall lower). For example, Maryland has an up to 25% late filing penalty, up to 25% late payment penalty, and 13% underpayment penalty. Solutions: (a) The same as those identified for the federal tax penalties.
Design penalties out of your tax life
We never want to see entrepreneurs incur any tax penalties and there’s few, if any, cases when they’re unavoidable. With a business tax adviser who knows you and your company’s situation, coupled with simple enhancements to modernize your business’ finance processes, you can automate your way out of many penalties and sleep easy knowing you’ve designed safeguards to prevent the rest.
To benefit from having the Elements CPA Tax Designers on your side, reach out to schedule your business’ Coffee Conversation.