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IRS Penalties Most Likely to Affect Small Businesses

© by Fred W. Daily

The number of penalties available to the IRS to punish wrongdoers is staggering. This section covers the ones that are most likely to be imposed on a small business person.


  1. Inaccuracies

    The IRS can hit you with a 20% penalty if it finds you were negligent (unreasonably careless) or substantially understated your taxes. You typically incur this "accuracy related" penalty when you can’t prove a deduction on an audit, or you forgot to report all of your income and the IRS discovers it.

  2. Civil Fraud

    If the IRS finds that you underreported your income with a fraudulent intent (it doesn’t look like a mistake to the IRS), you can be fined 75% of the amount of the resulting tax deficiency. Don’t worry too much about this civil (noncriminal) tax fraud penalty -- it’s imposed in less than 2% of all audits. (You may also be charged with the crime of tax fraud, which is even rarer).

  3. Failure to Pay on Time

    The IRS usually adds a penalty of 1/2% to 1% per month to an income tax bill that’s not paid on time. This penalty is automatically tacked on by the IRS computer whenever you file a return but don’t pay the full amount owed, or pay it late.

    Late payment penalties for failing to make payroll tax deposits on time are much higher.

  4. Filing Late

    If you’re late in filing certain income tax returns or other forms, the IRS can penalize you an additional 5% per month on any balance due. However, this penalty can be applied only for the first five months following the return’s due date, up to a 25% maximum charge.

  5. Filing and Paying Late

    A special rule applies if you both file late and underpay. The IRS can (and probably will) impose a "combined penalty" of 25% of the amount owed if you don’t pay in the first five months after the return and tax are due. After five months, the "failure to pay" penalty continues at 1/2% per month until the two penalties reach a combined maximum of 47-1/2%. This is a slightly lower (2-1/2% less overall) penalty than if the two penalties were applied separately. Wow, those IRS folks sure can be generous.

    IRS penalties are "stackable." Late filing and paying penalties can be imposed by the IRS in addition to any other penalties, such as for fraud and filing an inaccurate return. Congress and the IRS believes the more the merrier when it comes to penalizing taxpayers.

  6. Underpaying Estimated Taxes

    Undoubtedly, many of you will get hit with the estimated tax penalty. I know I have been, for whatever that is worth to you. All self-employed individuals must estimate their income tax for the year and pay it in quarterly installments throughout the year. You must come pretty close to paying everything you will owe, although you don’t have to guess the amount precisely. Here are the rules:

  7. If you earn less than $150,000, your quarterly tax payments must equal at least 90% of your final income tax bill, or at least 100% of your last year’s tax bill.
  8. If you earn more than $150,000, you must pay at least 110% of your last year’s tax bill in estimated payments or risk the underpayment penalty on whatever amount you come up short.
  9. The penalty for not complying is currently calculated at a 9% annual rate on the amount that was underpaid for each quarter. Quarterly payments should be equal -- you can’t play catch-up with larger payments later in the year and still avoid this penalty.

By: Frederick W. Daily, Tax Attorney,
John Raymond, Bankruptcy Attorney, and
Allan H. Rosenthal, paralegal.
All of the three have offices in San Francisco.

© 1997

(This article was originally written for tax practitioners who represent clients before the IRS. But the information presented here is valuable for all taxpayers.)

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