- Learn about the underpayment of estimated tax and withholding penalty.
- Discover what the Required Minimum Distribution penalty means for you.
- Find out about more about the late filing penalty.
- Learn more about the late payment penalty (and beware if you asked for extension!).
- What is the negligence penalty?
- Find out how much a fraud penalty will cost you.
- Discover how to avoid a dishonored check penalty.
- There’s a penalty for a missing ID number–find out how much it is.
- What is the early withdrawal penalty for withdrawals from qualified retirement plans?
- Find out what you’ll be penalized for failing to report tips.
- The rules around foreign reporting can be tricky. Find out how to handle this topic.
- Find out more about the excessive claim penalty.
- Discover the consequences of filing a frivolous return.
- Learn how a failure to file a required information return could cost you.
Most taxpayers don’t intentionally incur tax penalties, but many who are penalized are simply not aware of the penalties or the possible impact on their wallets. As tax season approaches, let’s look at some of the more commonly encountered tax penalties and how they may be avoided.
Underpayment of estimated taxes and withholding penalties
The United States income tax system is a pay-as-you-earn tax system. This means that taxpayers must pay their tax liability as they receive income during the year. Taxpayers pay their taxes through withholding or by making estimated tax payments. If a taxpayer owes more than $1,000 when filing their return for the year, the IRS will assess the underpayment of the estimated tax penalty. This tax penalty currently equals 3% of the underpayment.
There are “safe harbor” payments that can protect you from this penalty, which include payments in the following amounts: 90% of the current year’s tax liability or 100% (110% for high-income taxpayers) of the prior year’s tax liability. Farmers and fishermen need only prepay 66-2/3% of the current liability or 100% of the prior year’s liability.
How COVID-19 affected estimated taxes and withholding
Because of the COVID-19 pandemic, 2020 has been a horrific year for many individuals and businesses. Many have seen incomes severely reduced, if not eliminated, because of government-mandated shutdowns and social distancing. This large drop in income can have a huge impact on the necessity of estimated tax payments.
Normally, taxpayers make estimated tax payments in four installments. These payments have a due date of April 15, June 15, September 15 and January 15 of the subsequent year. The IRS suspended estimated payments for April 15 and June 15, 2020, until July 15. The 100% and 110% of the prior year’s tax liability are most likely not viable safe harbor amounts for 2020 estimated tax. Most taxpayers will have to rely on 90% of the current year’s tax liability. If you need help calculating your tax , call your Fiducial representative.
Required Minimum Distribution (RMD) penalty
To prevent an individual from investing in tax-deferred retirement plans, including traditional IRAs, but never withdrawing funds from the plans (which would mean the government wouldn’t ever collect taxes on the distribution), retirees must take an RMD each year after reaching the mandatory RMD age. The mandatory distribution age has recently changed from 70½ for years before 2020 to 72 in 2020 and later years. Failing to take the correct minimum distribution (also known as excess accumulation) results in a penalty of 50% of the difference of what should have been withdrawn and what was actually withdrawn.
The IRS is very liberal in general and will abate the penalty in most situations. However, this penalty is not an issue in 2020. RMDs to be made during 2020 have been suspended as part of COVID-19 tax relief.
Late filing penalty
Returns filed after the due date, including extensions, will receive a late filing penalty of 4.5% per month (maximum 22.5%). The normal due date for returns is April 15 of the subsequent year. Because of COVID-19, the due date for 2019 returns was extended to July 15, 2020. The penalty for filing a late 2019 1040 return does not begin until after July 15, 2020. If you have not filed your 2019 return and did not file an extension by July 15, 2020, you should do so ASAP. This will minimize your tax penalties.
If a return is over 60 days late, the minimum penalty for failure to file is the lesser of $435 or 100% of the tax shown on the return. The obvious way to avoid a late filing penalty is to file in a timely fashion. However, the IRS may abate the penalty if it can be proven that there was reasonable cause, not willful neglect.
Late paying penalty
Paying the tax owed on a return after the unextended due date of the tax return (July 15 for 2019 returns filed in 2020) will earn taxpayers a penalty of 1/2% per month (maximum 25%) on the unpaid balance. This penalty often catches taxpayers when they need an extension to file their tax return; many fail to realize that the extension does not include an extension to pay. To avoid or minimize this penalty, you should have no or little balance due on the return when filing. The extension form includes a provision to pay the projected balance owed when filing the extension.
Underpayment due to negligence on the part of the taxpayer or errors in tax valuations will receive a penalty of 20% of the tax underpayment when charged. Taxpayers frequently encounter this penalty when the IRS adjusts a filed return due to unreported income or overstated deductions.
This penalty is 75% of the tax unpaid due to fraud.
The penalty for dishonored checks of over $1,250 is 2% of the check amount. If the amount is $1,250 or less, the penalty is the amount of the check or $25, whichever is less. If you don’t have sufficient funds to pay your tax when you file your return, rather than writing a check that you know will bounce, you may be able to arrange an installment payment plan with the IRS. You may still incur late payment charges, but the penalty rate is lower if you have a payment plan.
Missing ID number
A penalty of $50 for each missing number applies when a taxpayer doesn’t provide a required Social Security Number (SSN) for themselves, a dependent, or another person on their tax return. It is also charged when the taxpayer doesn’t provide their SSN to another person or entity when required.
Early withdrawal penalty
If a taxpayer is under age 59-1/2 and withdraws assets (money or other property) from a qualified retirement plan, including traditional IRAs, the taxpayer must pay a 10% additional tax. The IRS commonly refers to this as the early withdrawal penalty. This tax equals 10% of the part of the distribution required by the taxpayer to include in gross income for the year of the distribution. A number of exceptions apply to this penalty.
Early withdrawal exceptions
As part of COVID-19 relief, the IRS may waive this penalty on distributions up to $100,000 from qualified retirement plans and traditional IRAs if the taxpayer:
- Obtained a diagnosis of SARS-CoV-2 or COVID-19 virus by a test approved by the CDC,
- Has a spouse or dependent who has been diagnosed with such a virus or disease by such a test, or
- Experiences adverse financial consequences as a result of being quarantined, furloughed, or laid off or having work hours reduced due to such a virus or disease, finds themselves unable to work due to lack of child care attributed to such a virus or disease, experiences closure or reduced hours of a business owned or operated by the individual due to such a virus or disease, or other factors determined by the Secretary of the Treasury. These other factors include the following additional situations in which the penalty will be waived if:
o The taxpayer’s spouse or a member of the taxpayer’s household (someone—related or not—who shares the taxpayer’s principal residence) had adverse financial consequences of the type listed above that apply to the taxpayer.
o The taxpayer, the taxpayer’s spouse, or a member of their household had a job offer rescinded or the start date delayed due to COVID-19.
o The taxpayer’s spouse or a member of their household had to close or reduce operation hours of a business they owned or operated due to COVID-19.
Note that the eligible COVID-19 distributions are subject to income tax but escape the early distribution penalty. However, this special COVID-19 provision allows a taxpayer to spread the income from a coronavirus-related distribution over a three-year period. Additionally, taxpayers may recontribute during the 3-year period.
Failure to report tips
A penalty is charged if a taxpayer didn’t report tips to their employer. It equals 50% of the Social Security tax on the unreported tips.
Reporting foreign accounts and assets
There are numerous and substantial penalties for failure to report a variety of foreign accounts and assets. Some taxpayers even describe these penalties as draconian. Call Fiducial if you have a foreign financial account, foreign trusts, ownership in a foreign corporation, received foreign gifts, etc.
Excessive claim penalty
If a taxpayer makes a claim for a refund or credit for income tax for an excessive amount, the person making the claim is liable for a penalty equal to 20% of the excessive amount. The excessive amount equals the amount by which the claim for any tax year exceeds the amount of the claim allowable for that tax year.
The penalty doesn’t apply if it is shown that the claim for the excessive amount is made with reasonable cause. The penalty also does not apply if any portion of the excessive amount or credit is subject to an accuracy-related penalty.
In addition to any other tax penalties, the law imposes a penalty of $5,000 for filing a frivolous return—one that does not contain information needed to establish the correct tax or shows a substantially incorrect tax because the taxpayer takes a frivolous position or displays a desire to delay or interfere with the tax laws. This includes altering or striking out the preprinted language above the space where the taxpayer signs. Under limited circumstances, the IRS may reduce the penalty from $5,000 to $500.
Failure to file information returns
A taxpayer who, without reasonable cause, fails to file a required information return in the manner the law specifies or by the proper deadline, fails to include all of the information required, or includes incorrect information is subject to a penalty of $280 for each return required to be filed during 2020. If the taxpayer corrects the failure within 30 days of the due date, the penalty reduces to $50, and $110 if corrected by August 1.
Had tax penalties assessed against you? Want to find out if you can reduce or remove them? Call Fiducial at 1-866-FIDUCIAL or make an appointment at one of our office locations. Ready to book an appointment now? Click here. Know someone who might need our services? We love referrals.
For more small business COVID-19 resources, visit Fiducial’s Coronavirus Update Center to find information on SBA loans, tax updates, the Paycheck Protection Program, paid sick and family leave, and more.