Being warned about an impending audit can be scary, especially when the IRS knocks on your door. However, in addition to the fact that most taxpayers will have to worry about being audited, the vast majority of IRS audits do not involve a face-to-face confrontation with the IRS – they are primarily conducted via the USPS through mail correspondence. But what if you are facing an audit by the IRS? What could the IRS find? And how might they penalize you for any errors or mistakes made in your recent tax history? Here’s what you need to know about IRS audit penalties.
Understanding IRS Audit Penalties
IRS audits, or IRS investigations, go one of two ways: via correspondence or in-person interviews. The latter is conducted at an IRS office (called an office audit) or your place of business (called a field audit). Most audits are correspondence audits and are pretty straightforward:
- Something triggers the IRS system, such as a fundamental math error or a discrepancy between your reported income and information returns from other businesses and organizations.
- The IRS reviews the red flag and sends you a request for additional information to confirm the discrepancy.
- You provide the information required, and the IRS decides on your account (such as billing you for the additional due tax or deciding that everything is in order but penalizing you for the inaccurate tax return).
- You either agree with the IRS’ decision and pay the tax or challenge it in an appeals process.
If you agree to the IRS’ decision or lose the appeal, you may face a tax debt that consists of a principal amount owed, additional penalties, and accrued interest (based on how long your debt has gone unpaid). Some of these penalties are minor, adding only a few percent of your monthly debt’s total value. Some are far more significant, with large, flat fees or hefty financial punishment. Knowing which penalties to keep an eye out for can prepare you for the worst.
The Most Common IRS Audit Penalties
The IRS can penalize a taxpayer in many ways, but we will review the most common IRS audit penalties today. These are usually related to intentionally inaccurate tax returns, failure to pay an outstanding tax liability, failure to file a tax return before its due date, and failure to adhere to other tax rules.
1. Accuracy-Related Penalty
Accuracy-related penalties are levied against tax accounts that fail to account for all of their income on their latest tax returns or underpay their estimated required tax. The IRS differentiates between negligence or disregard of IRS rules and regulations and substantial understatement of income taxes. In other words, a simple math error won’t get you a heavy-hitting penalty from the IRS. You must make a significant mistake to incur the tax agency’s wrath.
In this case, the IRS requires that your “error” intentionally or unintentionally omits at least $5,000 worth of income, or ten percent of your total income tax liability (as calculated by the IRS), whichever amount is more significant. The IRS may establish negligence or disregard for rules if you fail to keep any records proving that you qualify for the deductions you have claimed. Remember, the IRS officially requires you to hold onto training documents and evidence for at least three years!
if you fail to report income that wasn’t included on your Form 1099 but has been revealed through related information returns (bank statements, etc.). If you try to claim a tax credit, you do not qualify. Tax returns with evidence of negligence owe an additional 20 percent penalty on top of the portion of the underpayment of tax that was caused by negligence or disregard. Tax returns with evidence of understatement of income taxes owe an additional 20 percent penalty on top of the tax liability that constitutes the understated income.
2. Failure to Pay Penalty
Failure to pay an outstanding tax balance by the due date – a tax payment you missed or a tax debt you recently incurred – is penalized at a rate of 0.5 percent of your total tax debt per month. This caps out after 50 months for 25 percent of your debt.
This is perhaps the most common tax penalty that the IRS levies and is also one of the weakest. There are circumstances under which this penalty may be reduced, even as it still implies. Entering a formal payment agreement with the IRS – including monthly payment plans or so-called installment agreements – can reduce the monthly increment to 0.25 percent.
3. Failure to File Penalty
The failure to file penalty goes hand-in-hand with the failure to pay the fine – but instead of only increasing your debt by half a percent a month, a failure to file a missing tax return after Tax Day is five percent per month, for a maximum of 25 percent after five months. Even though the IRS files substitute returns in place of missing tax returns, it still requires taxpayers to retroactively review and file their missing returns, no matter how late.
Failure to do so for several years can result in a hefty consolidated debt. The real kicker? You cannot negotiate a payment plan to address your debt with the IRS before filing your missing returns. If you already owe the IRS, then your penalty is reduced to 4.5 percent every month, where you also owe 0.5 percent for failing to pay.
4. Failure to Deposit Penalty
Suppose an IRS investigation reveals that you did not pay employment taxes when they were due as a business owner or officer in charge of payroll. In that case, you will owe a variable penalty depending on how many calendar days the payment has been delayed.
5. Dishonored Check
Did your check bounce? Dishonored checks will cost you either $25 (if the amount you were supposed to transfer is less than $1,250) or two percent of the payment amount (if the transfer is $1,250 or more). Then the IRS will penalize you.
Working With a Professional
Whether your penalties and tax debt accrue due to a formal audit or a notice, the worst thing you can do is do nothing. Act now! IRS audit penalties can turn even a modest sum into a nightmarish fortune. Don’t let your tax debt catch you off-guard – prepare for the worst by preparing with the best.