Late Filing and Payment Penalties: How to Avoid or Minimalize Them

I can recall, in my youth, going to my grandparent’s house and watching the old-time tale of Alice in Wonderland.  For those of you familiar with the tale, there was a little white rabbit that seemed to be in a hurry exclaiming “I’m late, I’m late, for a very Important date!”  You see, the rabbit faced harsh penalties if he couldn’t make it to the Queen of Hearts for their arranged appointment.  The penalty was a beheading.  This is not unlike many tax cases I take on throughout the year, minus the beheading. 

I frequently get calls from taxpayers that are not necessarily contesting the amount of tax that they owe but are irritated with the large portion of the liability attributed to penalties.  In some ways, this is a financial beheading that they are incapable of coming back from.  The IRS is much like the Queen of Hearts.  They are quick to impose penalties on a taxpayer that either fails to pay or file their taxes in a timely manner.  Sometimes we even find ourselves relating more to the Mad Hatter who can avoid his demise from the crutch of the Queen by simply stopping time.  Unfortunately, we cannot avoid penalties simply by choosing to “stop time” and avoid filing our tax returns.  In fact, not filing is going to dwindle your checkbook much quicker than not paying.  Let’s look at the failure to file and failure to pay penalties and what you can do to minimize them or avoid them in certain circumstances.

Filing Requirement

There are instances when individuals may not need to file a return.  Alternatively, when certain circumstances exist, taxpayers are required under the law to file an income tax return with the IRS.  Under section 6012 of the Internal Revenue Code, the government provides us with the basic understanding of what is required when filing an income tax return:

  1. The taxpayer must have a requirement to file.  (For Individuals, this means that your income must exceed the combination of your personal exemption and standard deduction.  For Corporations, you are required to file a return regardless of the amount of income.  Finally, for estates and trusts, you must have gross income exceeding $600 before you have a filing requirement)
  2. The tax return must be on the proper form. (Individuals (1040), Corporations (1120), Estates and Trusts (1041), Partnerships (1065), S Corporations (1120S)).
  3. The tax return must be signed by the taxpayer or their authorized agent under penalties of perjury.
  4. Finally, the return must contain sufficient information from which the IRS can calculate the tax liability. 

Once you have determined that you have a filing requirement it is the taxpayer’s obligation to file the return in a timely manner.  Failure to do so can result in you paying a hefty fine for negligently failing to perform your obligation, as a taxpayer, to notify the government of your tax status and liability.  Because the tax system is based on voluntary compliance, there must be some method in place to keep the people in line.  Much like the chopping of your head, the tax penalties keep the citizens from wavering too much when it comes to their tax obligations.  I mean, how many people do you know that look forward to that IRS visit every year?

When am I Late?

The failure to file penalty is only asserted when the taxpayer does not file their tax return in a timely manner.  For purposes of filing a tax return the following are the dates in which your returns must be filed:

  1. 1040 Individual Tax Return – April 15th or the next business day if that day falls on a holiday or weekend.  Or October 15th if you file a Form 4868 and extend the time to file your return by 6 months.
  2. 1120 Corporate Tax Return – Four months and fifteen days after the Corporation’s year-end.  Calendar year end is April 15th.  The only exception is a June 30th year-end.  They are required to file on September 15th.  You can also file a Form 7004 and extend the filing time period by an additional 6-months for Corporations as well.
  3. 1065 Partnership Information Return – March 15th or September 15th with a validly filed Form 7004.
  4. 1120S S-Corporation Return – March 15th or September 15th with a validly file form 7004.

It is important to keep in mind that you are late in the payment of your taxes if you pay any time after the initial filing period.  In other words, just because you extend your return another six months for filing purposes, any payment after that extension due date will still be considered late.  However, you will not be penalized if you pay up to 90% of the total liability at the original due date.

Failure to File Penalty

In terms of the failure to file and the failure to pay penalties, this one takes the cake.  Failure to file a tax return is penalized at a much higher rate and can maximize its value much quicker than the failure to pay.  Look at it from the government’s perspective.  If the tax system is a voluntary compliance system, what would you want more from your taxpayers, filing on time or paying the tax due on time?  If you don’t file your tax return on time, will the IRS be aware of what’s due initially?  No.  They may be able to find out eventually, but we are the first to notify the IRS of our tax obligations along with any deductions that we might have to reduce that liability. 

Because the failure to file a tax return is a more serious offense to the voluntary compliance laws, the IRS charges a penalty of 5% of the net tax amount required to be shown on the return for each month or fraction of a month that the return is late.  This penalty maxes out at 25%, which means you can reach your max penalty amount for filing a late return within four months.  That’s crazy!  When the tax return is more than 60 days late, the penalty is a minimum of $100 or the net tax required to be shown on the return, whichever is LESS.  This means that for lower amounts of tax due, the penalty could potentially be 100% of the liability.  Let’s look at an example:

In 2014, Mary and her husband have prepared all their documents and have presented them to their tax preparer for the filing of their 2013 tax return.  During this busy time of year, the tax preparer neglects to file their return on time, nor does he extend the return another 6 months.  Quickly, he prepares the return and gets it filed on June 15, 2014.  The tax required to be shown on the return is in the amount of $10,000.  Because Mary and her husband are now 2 months late, they will be assessed a penalty of $1,000 ($10,000 x 5% x 2).

As you can see, as the liability increases so does the pain from filing a late tax return.  This could have devastating effects if you have a large tax liability. 

Failure to Pay Penalty

Let’s assume that we filed our return in a timely manner and the IRS is satisfied with the amount that we have shown on our return as the tax due.  However, we don’t have the money needed to pay off the liability today.  This could be the result of bad tax planning or just a case of sticking our head in the sand all year.  Regardless, you will have to pay late this year.  This is going to be a lesser penalty that maximizes out over a longer period.  You see, knowing that there is a liability allows the IRS to enforce payment of that liability.  Therefore, by making the penalty lower for failure to pay the taxes, you are more likely to file on time even if you don’t have the money to pay on time.

The failure to pay penalty equates to one-half of a percent of the net tax amount required to be shown the return for each month you don’t pay.  This penalty, much like the failure to file penalty, maxes out at 25% but that will take approximately fifty months as opposed to four.  This is a much slower pace to penalty accumulation.  In fact, if you file your return and can’t pay the liability, you can set up an Installment Agreement and make payments on the liability over time.  By setting up an Installment Agreement you will be reducing the monthly penalty rate to one-fourth of a percent per month.  Now you can see why it is much more important to file a tax return than it is to worry about the timely payment.  Let’s look at the same example as before:

In 2014, Mary and her husband have prepared all their documents and have presented them to their tax preparer for filing of their 2013 tax return.  However, this time their tax preparer was diligent and filed their tax return on April 15, 2014, as required.  When Mary and her husband saw the bill, they were alarmed to learn their tax liability was $10,000.  So, they approached their family and took out a loan to pay the liability by June 15, 2014.  Under the same time frame Mary and her husband’s tax penalty will only equate to $100.  Much less than that $1,000 liability from before.

Penalty Abatement

Tax penalties can often be removed by what is considered a “first-time abatement” process.  In this scenario the IRS will look at your past three years of payment and penalty history to make sure that you have acted in compliance previously.  If this is the case, they will likely remove the penalties with a “get out of jail free” card.  However, in those times when you have maybe not been so squeaky clean in your dealings with the IRS, you must fit your excuse within a reasonable cause argument.  Reasonable cause is shown when the taxpayer can establish that they exercised ordinary business care and prudence but still were unable to meet their filing or payment obligations because of some circumstance beyond their control.  There must also be an absence of willful neglect which is a conscious, willful failure or reckless indifference to file or pay.  In other words, show the IRS that you care, and your chances will increase significantly.  If you are faced with a tax penalty, it is important to have someone who can assess the reasoning for the failure to file or pay and put together a strong argument as to why you deserve a penalty abatement.  It is imperative that all the relevant information be displayed to the IRS so as not to hurt your chances. 

Much like Alice in the story, we can see the path to where we need to be, but we depend on the advice of others along the way.  Sometimes uncontrollable things happen that pull us off that compliance path.  We also may be faced with some Cheshire Cats that cause more confusion than solutions.  By seeking the advice of our attorneys at Day & Nance, you will not be lead astray.  We will get you to an agreeable starting point and hold your hand along the paths to come.  If you are facing penalties with the IRS and feel like they are not justified, call us today for a free consultation at 702-710-8233.  We look forward to providing you the relief you deserve.

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