Dear Bonnie: I didn’t file my taxes on time. I forgot to file an extension too. I didn’t have the money to pay them anyway. I mean, with the economy the way it’s been, I didn’t make any of my estimated tax payments. And now I owe a lot. The good news is that I just paid it off. But I wonder what’s going to happen now? Are there going to be a lot of penalties for this? Thanks for taking the time to answer my questions. – Jennifer, Sonoma
Dear Jennifer: I tell people to file even if they can’t afford to pay. It might keep the penalties down a bit. And believe me, those penalties and the interest, too can be expensive. Of course, like good parents, the IRS has lots of penalties for us taxpayers. So let me just give you a listing of the most common ones:
Filing late. If you do not file your return by the due date (including extensions), you may have to pay a penalty of 5 percent for each month or part of a month that a return is late, not to exceed 25 percent. The penalty is based on the tax not paid by the due date (without regard to extensions). That’s why it is prudent to file your tax return even if you can’t afford to pay the tax bill.
Late Payment Penalty. You will have to pay a failure-to-pay penalty of f 1 percent (.50 percent) of your unpaid taxes for each month, or part of a month, after the due date that the tax is not paid. If you filed for an extension, please note that the extension is only for filing, not paying. But you will not be penalized during the automatic 6-month extension of time to file period if you paid at least 90 percent of your actual tax liability on or before the due date of your return and pay the balance when you file the return.
If you contract with the IRS for an installment agreement, you will still incur late payment penalties. But the penalty rate will be only .25 percent of the unpaid balance. You only enjoy this reduced rate if you filed your tax return on time.
Filing and Paying Late. If you experience both late filing and late payment in any given month, the failure to file penalty is reduced by the failure to pay penalty. If you are more than 60 days late in filing and paying, the minimum penalty is the smaller of $135 or 100 percent of the remaining tax owed at the time of filing.
Underpayment of Estimated Taxes. This penalty calculation is not at all straightforward. Depending upon circumstances, you may not incur a penalty even if you miss an installment. When you miss an installment payment, the IRS does nothing. They don’t take note nor do they care. There may be a good reason why you missed. First of all, it’s an “estimated tax,” which means it’s subject to change. Maybe business nose-dived and you will have a loss for the year. You will have no need to make an estimated tax payment if nothing will be due. The IRS won’t figure it out until you file your income tax return. Almost every tax software tax program can make the calculation for you. You must complete form 2210 and file it with your tax return in order to determine how much the penalty, if any, will be. The rate can be as small as .00008 or as high as .02383. But check out the form. At the top of page one is a flow chart to determine if you are subject to a penalty. You may also get a break by annualizing income. For example, business was good the first two quarters of the year and you made your estimates on time. Then suddenly you experienced business reversals which lasted five months. So you paid no estimate for third quarter. The last month of the year business rebounded and you were going to owe more than what you had paid in for the first two quarters. So you make your fourth quarter installment then pay the remaining balance on April 15 when you file your tax return. There is a worksheet on Form 2210 where you can show how much taxable income was earned during each quarter and escape penalty for the quarters in which your liability was covered by the estimates that were made.
Accuracy-related penalty. You may have to pay an accuracy-related penalty if you underpay your tax because:
You show negligence or disregard of the rules or regulations. Negligence includes not keeping good books and records as well as intentional disregard for the rules and regulations.
You substantially understate your income tax. This means you paid less than the larger of 10 percent of the correct tax liability or $5,000.
You claim tax benefits for a transaction that lacks economic substance. Economic substance is defined in the Internal Revenue Code as (A) the transaction changes in a meaningful way (apart from Federal income tax effects) the taxpayer’s economic position, and (B) the taxpayer has a substantial purpose (apart from Federal income tax effects) for entering into such transaction.
You fail to disclose a foreign financial asset.
An accuracy-related penalty is equal to 20 percent of the underpayment. The penalty is 40 percent of any portion of the underpayment that is attributable to an undisclosed noneconomic substance transaction or an undisclosed foreign financial asset transaction. The penalty will not be figured on any part of an underpayment on which the fraud penalty is charged.
An accuracy-related penalty can be abated fairly easily for #1 and #2 above if you made adequate disclosure of your position on the tax return and you thought you had a reasonable basis for taking that particular position. It’s a fairly subjective area and one in which the complexity of the tax code can prove to your benefit. If your tax preparer made an error resulting in an accuracy-related penalty, you will usually have no trouble having it abated.
In fact, many penalties can be abated for reasonable cause. I prepared 20 years of tax returns for a new client. He escaped failure to file penalties because he had gone through a horrible divorce and was under a doctor’s care for severe depression.
If you have a question for Bonnie Lee, write to her at bonnie@taxpertise.com
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