IRS Penalties and Individuals
By Nancy Faussett, CPA, Publication date: 03/27/2009
There are more than 150 civil penalties in the IRS Code. While the underlying purpose of any tax penalty is to encourage voluntary compliance, the assessment of penalties also produces revenue and reimburses the IRS for the cost of enforcement. This article provides an overview of the most common tax penalties as they apply to individual taxpayers and tax return preparers.
Six of the most common categories of tax penalties are:
- Failure to File a Return
- Failure to Pay Tax
- Accuracy-Related Penalty
- Civil Fraud Penalty
- Tax Return Preparer Penalties
- Estimated Tax Penalties
Each of these is discussed below. There is also a brief discussion of the reasonable cause exception, which may be used to avoid having certain penalties assessed.
1. Failure to File a Return
The failure to file penalty is imposed when the required tax return is not filed on or before its due date (Section 6651(a)(1)). It is imposed when the failure to file is considered to be due to willful neglect and not because of any reasonable cause. The failure to file penalty may be imposed on individuals, corporations, and fiduciaries for trusts and estates. It does not apply to either information returns or estimated tax payments.
Although a return is actually considered “filed” when it is received by the IRS, as long as it is postmarked by the due date, the burden of proof is met. However, if the return is mailed after the due date, the filing date is the day the IRS receives the return. Furthermore, if, for example, a return is filed 3 months late and the IRS receives the return the following day, the return is considered 4 months late since a fraction of a month is considered a full month. (If the return is filed electronically, there is an electronic postmark given by an authorized electronic return transmitter (ERT).)
If you filed an application for an extension and it was denied, there is a ten-day grace period within which the return can be filed and still avoid the penalty. If the extension application is approved but the return is filed after the extended due date, the penalty will be assessed starting from the extended due date. Filing the return late does not invalidate the extension.
If a taxpayer is in the Armed Forces in a combat zone, or if hospitalized due to the taxpayer’s service in a combat zone, there is an automatic extension for time served, plus another 180 days. In addition, there may also be ignored a period of time up to a year for anyone affected by a Presidentially declared disaster or a military or terrorist action.
The tax return, to be considered a valid filed return, must be signed by the taxpayer or an authorized agent of the taxpayer.
Computation: The failure to file penalty is 5% of the net amount of tax required to be shown* on the tax return for each month (or fraction thereof), generally up to a maximum of 25%. However, if the IRS determines that the failure to file was fraudulent in nature, the penalty is increased to 15% for each month (or fraction thereof), up to a maximum of 75%. For tax returns required to be filed after December 31, 2008, there is a minimum penalty of $135 or the tax owed, whichever is less, but only if the return is more than 60 days late and there is no reasonable cause. (Previously, the minimum penalty was the lesser of $100 or the tax owed.)
*Note: The term “amount of tax required to be shown” on the return is the correct tax liability for the period as finally determined. It is reduced by any applicable credits and by any payments that are made on or before the payment’s due date without regard to any extensions.
2. Failure to Pay Tax
The penalty for failure to timely pay the tax due is assessed under IRS Code Section 6651(a)(2). It is not assessed if there is reasonable cause and no willful neglect. It is also not assessed on a failure to pay estimated taxes or on certain taxes that are being paid in installments.
When determining if the taxpayer paid the tax due in a timely manner, any time served by a taxpayer who is a member of the Armed Services and who is serving in a combat zone (or contingency operation) is ignored. In addition, there may also be ignored a period of time up to a year for anyone affected by a Presidentially declared disaster or a military or terrorist action.
The penalty is assessed on the lesser of the tax actually shown on the return or the amount of tax required to be shown on the return.
Computation: The penalty for failure to timely pay the tax due is 0.5% of the amount due for each month (or fraction thereof), up to a maximum of 25%. However, the rate is increased to 1% per month if either a notice of levy or jeopardy assessment is sent. If this occurs and the monthly rate is increased, the maximum penalty remains at 25%.
In addition to the above, there is a penalty imposed on any bad check used for the payment of taxes. The penalty is 2% of the amount of the check if it is for $1,250 or more. If the check is for less than $1,250, the penalty is the lesser of $25, or the amount of the check. 
Always remember that an extension to file the tax return does not extend the date for payment of the tax due. Any taxes that are owed should be paid with the extension request.
Note: Realize that the penalty for failure to file a return is generally more than the penalty for failure to pay the tax. Therefore, it is always best to file a return even if you cannot pay all of the tax due. You can then look into other payment options available.
3. Accuracy-Related Penalty
The accuracy-related penalty was revised for tax returns due after 1989 and now covers negligence, a substantial understatement of tax, and a substantial valuation misstatement.  The penalty can only be assessed when a return has been filed. Therefore, even if a taxpayer’s failure to file a return is due to negligence and the failure to file penalty is imposed, the accuracy-related penalty cannot also be assessed. However, if a return is filed late, both the accuracy-related penalty and the failure to file penalty may be applied. Furthermore, the accuracy-related penalty will not be applied to any portion of an underpayment on which the fraud penalty is assessed.
The American Jobs Creation Act of 2004 added a separate accuracy-related penalty to be applied to understatements related to a listed transaction and to any other reportable transaction if a “significant purpose” of the transaction is tax evasion. This is supported by IRS Code Section 6662A. IRS Notice 2005-12 provides temporary rules for assessing penalties under this code section.
The accuracy-related penalty applies to any substantial understatement of tax. A substantial understatement is considered to exist when the understatement exceeds the greater of 10% of the tax required to be shown on the return or $5,000. The IRS issues an annual revenue procedure that updates the guidance for how to determine when adequate disclosure is given in order to reduce the understatement of income tax penalty (as well as for avoiding the preparer penalty for understatement of a taxpayer’s liability).
In order to escape the accuracy-related penalty due to there being reasonable cause,  the taxpayer must have acted in good faith, with a preponderance of evidence showing the reliance on another’s advice. Furthermore, the taxpayer must have given the adviser accurate information and the advisor must be a competent professional. In December 2003, the IRS issued final regulations limiting a taxpayer’s ability to establish good faith and reasonable cause as a defense to the accuracy-related penalty. While the IRS agreed that the willingness of the taxpayer to disclose a transaction is considered to be a sign of good faith, the failure to do so, according to these final regulations, is a strong indication of a lack of good faith but does not preclude it. Furthermore, the IRS will no longer accept taxpayers’ claims that they relied on their tax advisor’s advice if the advisor has a financial interest in the tax shelter.
|Computation: The accuracy-related penalty is 20% of the amount of the underpayment of tax that is attributable to negligence or disregard of the rules and regulations. If more than one type of misconduct exists, the penalty is still only 20%. However, if there is a gross valuation misstatement,  the penalty may double to 40%.
If it qualifies as an accuracy-related penalty under Section 6662A,  the penalty is 20% of the understatement. If the transaction is not adequately disclosed, the penalty increases to 30.
Section 6707A, added by the American Jobs Creation Act of 2004, provides for a penalty when required information under Section 6011 about a reportable transaction is omitted. The penalty for an individual is $10,000 but if it is a listed transaction, the penalty is increased to $100,000.
4. Civil Fraud Penalty
The fraud penalty, like the accuracy-related penalty, was also revised for tax returns due after 1989 (Section 6663). When there is an underpayment of tax, a penalty may be assessed on the portion of the underpayment that is attributable to fraud. However, to be considered fraud, it must have been intentional and not simply due to an oversight. The IRS must prove there is fraud by clear and convincing evidence. There must be both an underpayment of tax and an intentional wrongdoing by the taxpayer. Once the IRS establishes that any portion of an underpayment is due to fraud, the entire underpayment automatically is considered fraudulent unless the taxpayer can prove otherwise. In other words, while the initial burden of proof is on the IRS, once fraud is proven, it is then up to the taxpayer to establish that some portion of the deficiency is not due to fraud.
The intent to commit fraud is difficult to prove and each case must be evaluated on its own facts and circumstances. Some factors that are often cited as indications of fraud are:
- Understatement of income,
- Inadequate records,
- Concealment of assets,
- Cash transactions,
- Failure to cooperate with tax authorities, and
- Engaging in illegal activities.
As stated above, the accuracy-related penalty will not be applied to any portion of an underpayment on which the fraud penalty is assessed. Also, like the accuracy-related penalty, the fraud penalty only applies when the return has been filed.
If there is joint return, the penalty will not apply to the spouse unless both spouses committed the fraud.
|Computation: The penalty is 75% of the portion of the underpayment of tax that is attributable to fraud.|
5. Tax Return Preparer Penalties
Congress began regulating income tax preparers in 1976. An income tax return preparer is a person who prepares (or employs others who prepare) all, or a substantial portion of, an income tax return for compensation. An individual providing tax assistance under a Volunteer Income Tax Assistance (VITA) program or similar type of program is not deemed a preparer for this purpose. Furthermore, an employee who prepares a tax return for their employer or for another employee is not a preparer.
Generally, a preparer can rely in good faith on the information furnished by the taxpayer. However, the preparer cannot ignore information that appears incorrect or incomplete and the preparer is then responsible for making reasonable inquiries. The preparer must also determine if the taxpayer can substantiate certain deductions.
The Small Business and Work Opportunity Act of 2007 expanded the preparer penalties to apply to all types of returns, and not just to income tax returns. (Notice 2009-11 lists the various types of returns that are subject to the penalty.) In addition, the 2007 Tax Act changed the “realistic possibility” of success that an undisclosed tax position would be upheld to a “more likely than not” standard in order to avoid incurring tax preparer penalties. There must be “substantial authority” for the position taken. IRS Notice 2008-13 implemented this and explained that the new “more likely than not” standard for tax positions taken by their clients will be met if there is a greater-than-50 percent likelihood that the position will be upheld if challenged by IRS. Furthermore, the requirement that a disclosed position be “not frivolous” was replaced with the requirement that a disclosed position have a “reasonable basis” for the tax treatment of the position. The new law went into effect May 26, 2007 and this latest notice is effective as of January 1, 2008, for all tax returns and February 1, 2008, for all 2007 employment and excise tax returns.
The IRS issues an annual revenue procedure that updates the guidance for how to determine when adequate disclosure is given to avoid the preparer penalty.
|Computation: There are several different preparer penalties:
1. If the preparer understates a taxpayer’s tax liability and claims an “unreasonable position,” the penalty is the greater of $1,000 or 50% of the income derived by the preparer with respect to the return. This may be increased to the greater of $5,000 or 50% of the income derived by the preparer with respect to the return. if there is a willful or reckless disregard of the law. (Sec. 6694(a)-6694(b))
2. If a claim for a refund or credit is made for an excessive amount, the accuracy-related penalty of 20% of the excessive amount is assessed on the person making the claim (either the preparer or taxpayer).  (Sec. 6676)
4. If the preparer fails to furnish the required identification number, the penalty is $50 per failure, with a maximum penalty of $25,000 in any calendar year. (Sec. 6695(c))
5. If the preparer fails to furnish a completed copy of the return to the taxpayer, the penalty is $50 per failure, with a maximum penalty of $25,000 in any calendar year. (Sec. 6107(a))
6. If the preparer fails to retain either a completed copy of the return or a record of the taxpayer’s name, identification number, tax year, and type of return, the penalty is $50 per failure, with a maximum penalty of $25,000 in any return period. (Sec. 6107(b))
7. If you employ a preparer, you must retain the person’s name, identification number, and principal place of work for three years after the close of the return period. The penalty is $50 per failure, with a maximum penalty of $25,000 in any return period. (Sec. 6695(e))
8. If a preparer fails to exercise due diligence with respect to determining a taxpayer’s eligibility (or amount) for the earned income credit, the penalty is $100 per failure. (Sec. 6695(g))
9. If a preparer improperly endorses a taxpayer’s refund check, the penalty is $500 per check. (Sec. 6695(f))
10. If the preparer discloses or uses any information on a tax return (other than to assist in the return’s preparation), a $250 penalty may be assessed on each disclosure or use, with a maximum penalty of $10,000 in any calendar year. (Sec. 6713)
6. Estimated Tax Penalties
If an individual underpays any installment of estimated tax due, a penalty is assessed under Section 6654. Filing an extension for submitting the income tax return does not extend the period for paying the tax. It only allows a longer period for filing the return. Full payment of the tax is due on the return’s original due date.
It should be noted that it is not required to timely pay the tax due in order to obtain the automatic four-month extension of time for filing an individual income tax return. However, if it is not paid, both interest and penalties may be assessed.
Although there is no exception to the estimated tax penalty allowed for reasonable cause, there are certain other exceptions. No penalty is imposed if:
- The tax due is less than $1,000,
- There was no tax liability for the preceding tax year (which must have consisted of 12 months),
- There is an extreme hardship,
- There is a natural disaster or extraordinary event and the IRS waives the penalty if payment is made by a specified date, or
- The individual retired after age 62 or became disabled in the current tax year or in the immediately preceding tax year.
In addition to the above, no penalty will be imposed on the fourth installment if the individual files the tax return before January 31st and pays the balance of the tax owed.
|Computation: The penalty on the underpayment of estimated tax is computed by applying a specified rate to the amount of the underpayment for the underpayment period. Therefore, it is computed in a manner similar to the way that interest is calculated. The specified rate is three percentage points over the federal short-term rate under Sec.1274(d).
In addition to the civil penalty under Section 6654, a criminal penalty may be imposed on any individual who willfully fails to pay estimated taxes due. If convicted, the penalty cannot be more than $25,000 and the individual may be imprisoned for one year.
Additional Penalty Issues
These various penalties sometimes interact with each other. Consider the following:
- The failure to file penalty may be reduced by the failure to pay penalty when the latter is also assessed for the same period of time.
- The accuracy-related penalties under both Sections 6662 and 6662A are not applied to any amount attributable to fraud.
- While an understatement subject to the accuracy-related penalty under Section 6662A is not also subject to the penalty under Section 6662, it is included when determining if the understatement is substantial under Section 6662.
- There can be both a failure to file penalty and a fraud penalty, if the failure to file is considered to be fraudulent.
The rules for most of these penalties have changed over time. I have only described the current rules here, but if you need to understand a penalty assessed several years ago, be aware that the rules may be different today than they once were.
It has long been recognized by Congress that a taxpayer should not be penalized for circumstances beyond his control. Therefore, most of the civil penalties can be waived if the taxpayer can show reasonable cause. Some of the penalties have additional requirements, however, before they can be waived. For example, to waive certain penalties the taxpayer must show both reasonable cause and no willful neglect, or reasonable cause and good faith.
In order for a penalty to be waived for reasonable cause, the burden of proof is on the taxpayer. For a further discussion of the reasonable cause exception, see Reasonable Cause Can Waive Penalties for Individuals.
The purpose of this document is not to describe all penalties. There are too many. However, I have discussed the ones that are most frequently assessed.
Remember that if the taxpayer, on whom the penalty has been assessed, can prove reasonable cause for the offense, the penalty can often be waived.
Obviously, filing the return correctly and on time to avoid penalties is preferable. This is especially true when you consider the time and effort needed to dispute a penalty assessment, as well as the cost of the penalty itself.
 This penalty was increased as of May 26, 2007 by the “Small Business and Work Opportunity Tax Act of 2007.”
 An example of a “substantial valuation misstatement” would be if you misstate the value of any property on a tax return by 150% or more. (For returns filed on or before Aug. 17, 2006, the misstatement needed to be 200% or more.)
 For returns filed after August 17, 2006, there is no reasonable cause exception when there is a gross valuation misstatement.
 An example of a “gross valuation misstatement” would be if you misstate the value of any property on a tax return by 200% or more. Another example, in the case of Section 482 misstatements, would be if you misstate the price by 400% or more, or 25% or less of the correct price.
 Section 6662A does not apply to any understatement on which the gross valuation misstatement is imposed.
 This is a new penalty effective May 26, 2007, created by the “Small Business and Work Opportunity Tax Act of 2007.”