Watch Out for Tax Penalties

Article Highlights: 

  • Underpayment of Estimated Tax and Withholding Penalty
  • Required Minimum Distribution Penalty
  • Late Filing Penalty
  • Late Payment Penalty
  • Negligence Penalty
  • Fraud Penalty
  • Dishonored Check Penalty
  • Missing ID Number Penalty
  • Early Withdrawal Penalty
  • Failure to Report Tips Penalty
  • Foreign Reporting
  • Excessive Claim Penalty
  • Frivolous Return Penalty
  • Failure to File Information Returns Penalty

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 penalties and how they may be avoided.

Underpayment of Estimated Taxes and Withholding Penalty – The United States income tax system is a pay-as-you-earn tax system, which means that taxpayers are required to pay their tax liability as they receive income during the year 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 estimated tax penalty, which is currently 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.

Because of the COVID-19 pandemic, 2020 has been a horrific year for many individuals and businesses; their income has been 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, estimated tax payments are made in four installments that are due by April 15, June 15, September 15 and January 15 of the subsequent year. For 2020, the April 15 and June 15 estimated payments were suspended 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, and most taxpayers will have to rely on 90% of the current year’s tax liability. Please contact this office to see if you need to make payments and, if so, how much.

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. However, the IRS is very liberal in general and will abate the penalty in most situations.

However, this penalty is not an issue in 2020, as RMD to be made during 2020 has been suspended as part of COVID-19 tax relief.

Late Filing Penalty – If a return is filed after the due date, including extensions, a late filing penalty of 4.5% per month (maximum 22.5%) applies. 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, and 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 are encouraged to do so as soon as possible to minimize 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. While the obvious way to avoid a late filing penalty is to file in a timely fashion, the IRS will consider abating the penalty if it can be proven that there was reasonable cause and no willful neglect.

Late Paying Penalty – When the tax owed on a return is paid after the unextended due date of the tax return (July 15 for 2019 returns filed in 2020), the taxpayer is subject to a penalty of 1/2% per month (maximum 25%) on the unpaid balance. Taxpayers are frequently caught by this penalty when they need an extension to file their tax return; many fail to realize that the extension does not include an extension to pay. The only way to avoid or minimize this penalty is to have no or little balance due on the return when it is finally filed. The extension form includes a provision to pay the projected balance owed when filing the extension.

Negligence – When underpayment is due to negligence on the part of the taxpayer or there are errors in tax valuations, a penalty of 20% of the tax underpayment is charged. This penalty is frequently encountered when the IRS adjusts a filed return due to unreported income or overstated deductions.

Fraud – This penalty is 75% of the tax unpaid due to fraud.

Dishonored Check – 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 are on 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, commonly referred to as the early withdrawal penalty. This tax is 10% of the part of the distribution that the taxpayer was required to include in gross income for the year of the distribution. There are a number of exceptions that apply to this penalty.

As part of COVID-19 relief, this penalty is waived on distributions up to $100,000 from qualified retirement plans and traditional IRAs if the taxpayer:

  • Has been diagnosed with SARS-CoV-2 or COVID-19 virus by a test approved by the Centers for Disease Control and Prevention (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, is 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 that may be determined by the Secretary of the Treasury. These other factors include the following additional situations in which the penalty will be waived:
  • 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.
  • 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.
  • 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, and the distribution can be recontributed 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, and some of the penalties are even draconian. Please contact this office if you have a foreign financial account, foreign trusts, ownership in a foreign corporation, received foreign gifts, etc.  

Excessive Claim Penalty - If a claim for refund or credit for income tax is made for an excessive amount, the person making the claim is liable for a penalty equal to 20% of the excessive amount. The excessive amount is 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.

Frivolous Return - In addition to any other 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 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. The penalty is reduced to $50 if the failure is corrected within 30 days of the due date and $110 if corrected by August 1.

Please call if any of these penalties have been assessed against you to see if it is possible to have them reduced or removed.