May 15, 2023
So you file a personal income tax return and there’s a tax balance due that you can’t pay. Now what? The IRS or State records the tax debt on your account, and seemingly, overnight, the total balance owed begins to increase. How in the world and why??? To fully understand what happens with a tax debt, we have to start with the Federal and State Government’s viewpoint on tax debt accrual as a philosophy.
Whenever a tax debt is recorded on a taxpayer’s account, the IRS and State want to do whatever is possible to discourage it from happening again. Therefore, the notion of penalties and interest was created. “If we charge you more when you accrue a debt, you’ll never want to do it again.” And there begins the downward spiral.
Let’s talk about penalties first. What comes to mind when you hear the word “penalty”? Is it a box on the side of an ice rink where some big, padded-up, hockey player sits growling at a referee that deemed his check as overly aggressive? Is it an extra stroke a golfer is forced to take when his ball is lost to an alligator in a pond in the middle of the 16th fairway? Any way you slice it, a penalty is something that happens when an out-of-bounds play happens. The same holds true with a tax payment misstep.
What types of penalties are there? Truth be told, enough to make your head spin. Because every State handles tax penalties differently, let’s look at the most common IRS penalties:
- Failure to File: This is charged on the tax period whenever a tax return is not filed by the due date. This penalty is charged on the amount of unpaid tax as of the original payment due date and is calculated at 5% of the unpaid taxes for each month or part of a month that the return is late. This penalty maxes out at 25% of the unpaid tax.
- Failure to Pay: This penalty is charged on a tax period if the taxpayer does not pay the tax due by the due date or approved extended due date. This penalty is assessed at a rate of 0.5% of the unpaid taxes for each month or part of a month the tax remains unpaid, and maxes out at 25% of the unpaid tax. As a friendly reminder, remember that an extension to file a tax return is NOT an extension to pay.
- Accuracy-Related: There are two types of accuracy-related penalties:
- Negligence or disregard of the rules or regulations penalty: This is applied when the taxpayer doesn’t make “reasonable” attempts to follow the tax laws or the taxpayer was careless, reckless or intentionally ignored the tax regulations. This penalty is 20% of the portion of the underpayment of tax that happened because of negligence or disregard.
- Substantial Understatement of Income Tax Penalty: This penalty is applied when a taxpayer understates their tax liability by 10% of the tax required, or $5,000, whichever is greater. This penalty is assessed at 20% of the portion of the underpayment of the tax understated on the return.
- Failure to Deposit: This penalty applies to employers who do not pay employment tax deposits on time per their required schedule, don’t make the payment in the correct amount, or don’t pay the deposit in the proper way. This penalty is assessed based on the number of calendar days the payment is late:
- 1-5 days is 2% of the unpaid deposit
- 6-15 days is 5% of the unpaid deposit
- More than 15 calendar days is 10% of the unpaid deposit
- More than 10 calendar days after the date of the first notice or letter regarding the late payment, or the day the taxpayer gets a notice or letter for immediate payment increases the penalty to 15% of the unpaid deposit
Because the IRS wants to really make a point, a tax period can have all applicable penalties assessed on the debt at one time: if a taxpayer didn’t file their income tax return on time and when they did, a tax balance due was reported, they will be charged for failure to file and failure to pay penalties. However, as with most things with the IRS, there is an asterisk that comes into play here: if both a failure to file and failure to pay penalty are applied in the same month, the failure to file penalty is reduced by the amount of the failure to pay penalty for that month. Clear as mud, yes?
Now penalties are just one-half of the “make them pay more so they don’t do this again” thought process… the other half is charging interest on any balance due carried on a taxpayer’s account. While the states vary with how interest (and sometimes fees) are assessed, the IRS typically sets the tone. Per the IRS’ Internal Revenue Manual, their rulebook for all things administrative and operational within the IRS, in §20.2.1.1.1 it states (in so many words) that interest assessment is mandatory on underpayments unless otherwise specified by law.
And while assessing interest is mandatory, the amount of interest charged changes per quarter in accordance with the Federal short-term rate’s fluctuations. For large corporate underpayments (underpayments of tax exceeding $100,000 by a C-Corporation), the interest rate charged is the Federal short-term rate plus five percentage points. For the rest of the taxpayers in the U.S., individuals, sole proprietors, LLCs, etc., the interest rate charged is the Federal short-term rate plus three percentage points. With the fluctuation of our nation’s economy, the IRS follows suit… and so do many of the States. In the 2nd Quarter of 2022, the interest rate charged by the IRS on an individual’s past due income tax balance was 4%; in the 2nd quarter of 2023, that same debt is being charged 7% interest.
When addressing a taxpayer’s past-due tax debt, the ongoing penalties and interest charged by the IRS and State need to be factored into every good-faith payment made and any resolution agreement considered. The Golden Lion Tax Solutions team incorporates this consideration into their daily practice for their clients and has the knowledge and experience to make sure any payments made to a client’s tax debt are leveraged in the best manner possible with the goal of minimizing penalties and interest. If you or your client has a past due tax debt and it feels like the penalties and interest are mounting faster than fathomable, give us a call!
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For help with your tax debts, email [email protected] or call 833-LION-TAX (833-546-6829)
Disclaimer: There are requirements that must be satisfied in order to qualify for some of the tax solutions we discuss on our website. Not all of our services will be suitable for every client. Golden Lion Tax Solutions is here to help you find the most appropriate solution to fit your situation.
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