An unexpected tax notice can be a bit of a shock. Unexpectedly needing to pay hefty tax penalties and interest is a reality for many individuals, with some even needing to serve time for tax fraud. The IRS has seen a recent surge in IRS penalties issued, with many average Americans suddenly seeing more notices. Our short guide covers how to avoid tax penalties and interest as well as what to do if you’ve been suddenly served a notice.
What are the most common reasons for severe tax penalties and interest?
If you’re wondering how to avoid tax penalties, the easiest way to avoid the issue is to file your tax return and pay taxes on time. Here are some of the top reasons why individuals receive a penalty from the IRS:
Reason #1: Failure to file
- Filing late: The top way to avoid this type of penalty is to file on time. A failure to file penalty is assessed at 5% of the unpaid tax balance for each month that the return is late, up to a maximum of 25% of the unpaid taxes.
Reason #2: Failure to pay
- Late payments: If you don’t pay your taxes due on time, you are subject to late payment penalties and interest on the unpaid taxes due. A late payment penalty is assessed at 0.5% of the unpaid tax balance per month. This penalty appliese for every month (or part of a month) the tax remains unpaid after the due date, up to a maximum of 25% of the unpaid taxes.
- Underpayment: Underpayment refers to not paying enough in estimated tax throughout the year. Individuals, trusts and companies are all subject to this penalty if you earn income and do not have enough tax withholding, estimated taxes or credits to offset your tax liability. To avoid this penalty, you must pay at least 90% of your current year’s tax liability or 100%/110% of your prior year’s tax liability.
- Dishonored checks: “Bounced” checks experience a two percent penalty on the tax amount.
Reason #3: Inaccurate returns
- Accuracy issues: If you substantially underestimate your income for the year, you will be penalized for accuracy issues, for example.
- Erroneous claims: If you claim a credit that does not apply for an unreasonable amount, you will be hit with a penalty.
- Tax preparer penalties: Your tax preparer, attorney, enrolled agent, or public accountant may receive their own notices if they consistently don’t respect tax laws and regulations.
- International reporting: Foreign financial activity must also be reported to the IRS in a timely manner.
Reason #4: Forgetting the interest
- Not paying interest: If you’ve underpaid taxes and owe a balance due after the filing due date, you are required to pay interest on your unpaid tax liability. This can be a large amount so to avoid this you should pay 100% of your expected tax liability with your annual tax extension, if you cannot file your return on time.
What happens if you get a tax penalty?
If you have received a tax penalty, don’t panic. Take the following steps to handle this information.
What’s the first thing to do if you get a tax penalty?
First, it’s advisable to make sure that the notice is real and not a scam. There are many types of fraud committed by imitating the IRS. Here are some important tips for recognizing IRS penalty scams:
- The IRS does NOT first contact the taxpayer through text, email, or social media. You should receive a letter in the mail or via your IRS account as your first point of contact.
- If you receive a letter, you should be able to log into your IRS account to confirm that the information is true.
- Phone calls should only happen after you’ve received a written letter.
- If you do owe a penalty, you will likely need to make a payment through the IRS website, not via other means. You will NEVER need to pay using a pre-paid card, gift card, cryptocurrency, or store card. Scammers tend to ask for money via a strange or specific way and demand the amount is paid instantly. The IRS tends to give you a payment deadline that’s clear on your notice letter.
- The IRS does not conduct unexpected, in-person visits.
- If this is through a state government (rather than the IRS), you will likely be able to log into a state system to confirm. For example, Georgia has the Georgia Tax Center. The state will have its own way of dealing with fraud cases.
- The IRS is legally required to provide accessible notices, including notices in audio files, Braille or other means. Fill out Form 9000 for an alternative media preference.
Once you have confirmed that the notice is from the government, you’ll need to review its contents to find out whether you agree with the next steps or want to file a dispute. We recommend the help of an accountant with disputes. Disputes tend to be returned in the form of a letter with evidence and reasoning as to why.
If you have an amount due, your IRS letter will include a due date for payment. Payments need to be made by that due date or you’ll incur additional interest. Furthermore, ignoring the letters will result in escalating collection measures and should be avoided if at all possible. Your letter will be your source of truth regarding the next necessary steps.
Is a tax penalty deductible?
No, taxpayers should not deduct penalties on their next tax return. This is also the case for interest.
How does interest work?
Interest on past due taxes accrues monthly until it’s paid. As of 2024, this interest rate is as much as 8%.
Can tax penalties be waived?
If your notice cannot be disputed, penalty relief is rare but possible, so long as you’re eligible for one of the following:
- Reasonable cause: Determined on a case-by-case basis by the IRS, reasonable cause may include natural disasters, lack of records, death, or systemic issues. Lack of funds is typically not reasonable cause.
- Statutory exception: This relates to tax law, and may result from incorrect written advice from the IRS, combat zones, or mailing issues.
- First-time penalty abate and administrative waiver: If your notice was regarding failure to file, failure to pay, and/or failure to deposit, and you have a history of tax compliance, you may qualify for this first-time penalty abatement.
When handling IRS notices, it is strongly advised to consult a Tax Professional who can provide guidance on responding accurately and effectively.
