Shielding Yourself from IRS Penalties

As a CPA or tax advisor, the last thing you want is for your clients to overpay taxes. But you also don’t want them to underpay and have to deal with penalties.

While you might not be able to help your clients avoid penalties completely and forever, you can educate yourself about the potential penalties so you can inform your clients of the risk.

Avoidance is always preferable to learning the hard way.

Taxpayers are responsible for paying their taxes and reporting them honestly. If impropriety is suspected and investigated, it could result in criminal or civil penalties.

Criminal penalties have to do with fraud or intentional negligence, such as may be the case if the client grossly underreported their income. In this case, the taxpayer could do jail time.

Civil penalties are another matter entirely. Taxpayers won’t go to jail, but they will face penalties, which are often steep.

In some cases, the IRS may assign both civil and criminal penalties.

There are over 140 possible civil penalties—too many to review today—but today, we’ll highlight four that we see all too often.

Four Incredibly Common IRS Civil Penalties to Help Your Clients Avoid

1.      The Accuracy-Related Penalty

The accuracy-related penalty applies to taxpayer negligence or disregarding the rules when filing a return. Such negligence can include grossly underreporting income or overstating an expense deduction.

The IRS considers this intentional disregard for the rules of the tax law.

Such an oversight could be due to a lack of knowledge or simply not double-checking a deduction that is glaringly overinflated.

Mistakes can happen if you’re ill-informed. For example, you might think that gambling losses offset winnings, and therefore, it’s unnecessary to report the income—or the loss. However, you need to do both.

If the IRS feels that the inaccuracy is intentional, the taxpayer will face a penalty of 20% of the underpayment. Let’s say the client’s underpayment is $8,000; the penalty would tack an additional $1,600 on top.

2.      Dishonored Check Penalty

Paper checks? How exotic! For the sake of semantics, this penalty also applies to dishonored direct debits. The dishonored check penalty is $25 if the amount owing is $1250 or less. If it’s more than that, the penalty is 2% of the total.

The only way to avoid the dishonored check penalty is to put a stop order on the check—but it must be for a legitimate, provable reason. You can’t simply stop payment on a check you knew was going to bounce in the first place.

You can also reduce, dispute, or void the penalty by writing to the IRS with documentation explaining why the payment was dishonored. Perhaps the check was written in good faith, and there was money in the account at the time. Things happen, and as long as your rationale is legitimate, you may get some relief.

3.      FAILURE TO FILE PENALTY

Penalties start to accrue the moment the minute hand ticks past the midnight hour after the filing deadline. Failure to file penalties are assessed based on 5% of the unpaid tax owning up to a maximum of 25%.

If the taxpayer is also being levied with a failure to pay penalty, that amount will reduce the failure to file penalty for that month.

If the return is 60 days late or more, the penalty is $485 or 100% of the underpayment, whichever is less.

Corporations, partnerships, and nonprofits are treated differently. Nonprofit penalties are less severe at $20 per day, maxing out at $10,500 or 5% of gross receipts, whichever is less.

Partnerships and S-Corps are most impacted, with monthly penalties of $220 per partner for up to 12 months. For example, an S-Corp with 15 shareholders filing six months late would face a $19,800 penalty.

Ensure your clients understand what penalties they could be liable for if they do not file. Failure to file also brings undue scrutiny, and repeated behavior might result in an audit.

4.      TRUST FUND RECOVERY PENALTY

The Trust Fund Recovery Penalty (TFRP) refers to funds withheld by employers and held in trust, such as social security taxes, Medicare taxes, excise taxes, income, and employment taxes. They are called trust fund taxes because these amounts are held in trust until you make a federal tax deposit.

Should these taxes not be deposited, the IRS may enact the TFRP, which can be incredibly detrimental to businesses, especially if they are already struggling with payroll tax liabilities. The penalty can be up to 100% of the unpaid trust fund tax.

The critical thing to note here is that the IRS can levy this penalty against the company and any responsible individuals. These could include business owners, signatories, payroll administrators, or anyone involved with filing or paying trust fund taxes on behalf of the business.

So, if you are managing payroll taxes for a client, you are considered a responsible party by the IRS, and you could be at risk. If your client is consistently behind in payroll and unable to make trust fund deposits, you might be one of those who pay the price.

How to Deal with IRS Penalties

If you or your client has received an IRS penalty assessment, it doesn’t necessarily mean there are no options besides paying the bill.

Most of the penalties we reviewed here today (with the exception of the TFRP) may qualify for penalty abatement. The taxpayer or their representative must formally request abatement, which can be done over the phone.

Types of penalty relief include first-time penalty abatement, reasonable cause, or statutory exception, the latter two of which may be applicable in cases of federally declared disasters or involvement in military operations.

If you can prove that you mailed your return on time and still received a penalty or your e-filed return was rejected by the IRS system, relief may be granted if evidence is provided.

Staying informed helps to keep you and your clients safe from IRS penalties. Speak to us today to find out how we can help.