The IRS imposes penalties to encourage compliance with tax laws and to deter non-compliance. These penalties are added to your tax bill when you fail to meet your tax obligations, such as filing returns on time or paying the full amount owed by the due date. This guide will help you understand the types of IRS penalties and fees, how they’re calculated, and most importantly, the strategies you can use to reduce or eliminate them.

Common Triggers for Tax Penalties

Understanding what triggers penalties is the first step in avoiding them. The most common reasons the IRS assesses penalties include:

1. Late filing of tax returns: When you miss the filing deadline (including extensions), the IRS imposes a failure-to-file penalty.
2. Late payment of taxes: If you don’t pay your taxes by the due date, you’ll face a failure-to-pay penalty, even if you filed your return on time.
3. Underpayment of estimated taxes: If you don’t pay enough tax throughout the year through withholding or estimated tax payments, you may be charged an underpayment penalty.
4. Accuracy-related issues: Substantial understatements of income, negligence, or disregard of rules can result in accuracy-related penalties.
5. Bad checks or dishonored payments: If your payment is rejected due to insufficient funds, you’ll face an additional penalty.
6. Trust fund recovery penalties: Business owners and responsible parties can be personally liable for unpaid employment taxes.
7. Failing to disclose foreign bank accounts: If you own foreign accounts or interests that exceed $10,000 at any point during the year, then you must file a Foreign Bank Account Report (FBAR). Failure to do so will result in a penalty.

How Are Tax Penalties Calculated?

Percentage of the Penalty

The IRS calculates most penalties as a percentage of the unpaid tax amount. The specific percentage varies depending on the type of penalty:

Failure-to-File Penalty: This penalty equals 5% of the unpaid taxes for each month or part of a month that a tax return is late, up to 25% of your unpaid taxes. If your return is more than 60 days late, the minimum failure to file penalty is either:

1. $435 (for returns due between January 1, 2020 and 12/31/2023);
2. $450 for returns due in 2023;
3. $485 for returns due in 2024;
4. $510 for returns due after 12/31/2024; OR
5. 100% of the tax required to be shown on the return, whichever is less.

Failure-to-Pay Penalty: This equals 0.5% of your unpaid taxes for each month or part of a month after the due date, up to 25% of your unpaid taxes. If both the failure-to-file and failure-to-pay penalties apply in the same month, the failure-to-file penalty is reduced by the amount of the failure-to-pay penalty for that month.

Accuracy-Related Penalty: This equals 20% of the portion of the underpayment related to negligence or disregard of rules or regulations, or substantial understatement of income tax.

Underpayment of Estimated Tax: This penalty is calculated using the federal short-term rate plus 3 percentage points, applied to the amount of underpayment for the period of underpayment.

These penalties are federal and apply regardless of which state you live in. However, states may impose their own additional penalties for state tax issues.

Strategies to Reduce or Avoid Tax Penalties

File and Pay on Time

The most straightforward way to avoid penalties is to file your returns and pay your taxes on time. If you can’t pay the full amount owed, you should still file your return by the deadline and pay as much as you can to minimize penalties and interest.

According to the IRS Collection Process, “It’s in your best interest to pay your tax liability in full as soon as you can to minimize the penalty and interest charges.”

Request Penalty Abatement

The IRS offers several ways to have penalties reduced or removed:

First-Time Penalty Abatement (FTA): If you have a clean compliance history (meaning you’ve filed all required returns and haven’t had penalties in the past three years), you may qualify for FTA. This administrative waiver can remove certain penalties for a single tax period.

According to the IRS Administrative Penalty Relief guidelines, “You may qualify for First Time Abate for a penalty if you have a history of good tax compliance.”

Reasonable Cause: If you can demonstrate that you failed to file or pay on time due to reasonable cause and not willful neglect, the IRS may waive the penalty. Valid reasons might include:

• Serious illness or death in the family
• Natural disasters or civil disturbances
• Inability to obtain necessary records

The IRS Reasonable Cause guidelines state that “Reasonable cause is determined on a case by case basis considering all the facts and circumstances of your situation.” All these instances require documentation to prove they happened. 

Statutory Exceptions: In some cases, you may qualify for relief under specific statutory provisions, such as:

• Incorrect written advice from the IRS
• Timely mailed returns (postmark rule)
• Disaster areas and combat zones

The IRS Statutory Exception guidelines provide more details on these exceptions.

Set Up a Payment Plan

If you can’t pay your tax debt in full, setting up an installment agreement can help you avoid additional penalties and prevent more aggressive collection actions like levies or liens.

The IRS offers several types of payment plans:

Short-term payment plan: Pay your full tax debt within 180 days with no setup fee.

Long-term payment plan (installment agreement): Make monthly payments over a longer period. Setup fees range from $31 to $225, depending on how you apply and how you choose to make your payments.

According to the IRS Payment Plans information, “If you qualify for a short-term payment plan you will not be liable for a user fee.”

Direct Debit Installment Agreements (where payments are automatically withdrawn from your bank account) generally have lower setup fees and may help you avoid defaulting on your agreement.

Consult with a Tax Professional

A tax attorney can help you navigate the complex process of dealing with IRS penalties. They can:

• Determine which penalty relief options you qualify for
• Prepare and submit the necessary documentation
• Negotiate with the IRS on your behalf
• Develop a comprehensive strategy to address your tax issues

Tax professionals have experience dealing with the IRS and understand the nuances of tax law that may help reduce your penalties. An initial consultation with a tax attorney can help you understand your options and develop a plan to address your tax issues.

Proactive Tips to Avoid Tax Penalties in the Future

Accurate Filing

Take the time to ensure your tax returns are accurate before filing. Double-check all figures, verify that you’ve included all required forms and schedules, and make sure you’ve reported all your income.

Consider using tax preparation software or hiring a professional tax preparer to reduce the risk of errors. Remember that you’re ultimately responsible for the accuracy of your return, even if someone else prepares it.

Estimated Tax Payments

If you’re self-employed or have income that isn’t subject to withholding, you may need to make quarterly estimated tax payments to avoid underpayment penalties.

To determine if you need to make estimated tax payments, consider:

• If you expect to owe at least $1,000 in tax for the year after subtracting withholding and credits
• If you expect your withholding and credits to be less than 90% of your current year’s tax or 100% of your previous year’s tax (110% if your AGI was over $150,000)

Make your estimated tax payments by the quarterly due dates (generally April 15, June 15, September 15, and January 15 of the following year) to avoid penalties.

Keep Financial Records Organized

Maintaining organized financial records throughout the year makes tax preparation easier and helps ensure accuracy. Keep track of:

• Income documents (W-2s, 1099s, etc.)
• Expense receipts and documentation
• Investment statements
• Previous tax returns
• Any correspondence with the IRS

Good record-keeping not only helps you file accurate returns but also provides the documentation you may need if the IRS questions your return or if you need to request penalty abatement.

When to Seek Professional Assistance

While many tax issues can be handled on your own, certain situations warrant professional help. Consider consulting a tax professional if:

• You’ve received multiple IRS notices or have unresolved tax issues
• You’re facing substantial penalties or interest charges
• You need to request penalty abatement but aren’t sure which option is best for your situation
• You’re being audited or investigated by the IRS
• You need to negotiate a complex payment arrangement

A tax attorney can provide valuable guidance and representation when dealing with the IRS. At Ayar Law, we offer a free case review so we can recommend the best course of action.