REG Chapter 3 Part 3: Taxpayer Penalties

Make sure to avoid these costly penalties!

Welcome to another CPA prep lesson! Today we will learn all about taxpayer penalties. Here are today’s learning outcomes:

1. Recall situations that would result in taxpayer penalties relating to federal tax returns.
2. Calculate taxpayer penalties relating to federal tax returns.

Common Taxpayer Penalties

1. Failure to file – when you don’t file the return by the due date or the extended due date if a proper extension was filed.
2. Failure to pay – when you don’t pay the tax by the due date. An extension doesn’t extend the payment due date. All taxes are due on or before the original due date of the tax return (i.e. on or before April 15th for individuals).
3. Failure to pay proper estimated tax – when you don’t pay enough taxes due for the year with your quarterly estimated tax payments when required (even if you paid 100% of the tax before the due date).
4. Dishonored check – when your payment “bounces” (you don’t have sufficient funds when making a tax payment).

How are These Penalties Calculated?

The calculations for the penalties can be confusing so I’ll try my best to simplify them:

Failure to file – 5% of the tax due per month (up to 25% of unpaid tax which equates to 5 months of penalty). Minimum penalty for returns filed 60 days late is equal to the lessor of the tax due or \$205. The 1st month penalty is assessed even if 30 days hasn’t passed. This means you can still get a penalty even if the return is 1 day late.

• Joe failed to file his income tax return until 3 months after the due date and owed \$5,000 in taxes. His penalty will be \$250 per month (\$5,000 x 5%) for a total penalty of \$750 (\$250 x 3 months).
• Susan filed her income tax return a year late and owed \$5,000 in taxes. Her penalty is \$250 per month (\$5,000 x 5%) but can’t exceed \$1,250 (\$5,000 x 25% or \$250 x 5 months). Her total penalty is \$1,250.
• Robert filed his income tax return 60 days late and owed \$1,000 in taxes. His penalty would be \$50 per month (\$1,000 x 5%) for a total of 2 months. Although you’d think his penalty is \$100 (\$50 x 2 months) it’s actually \$205 because the minimum penalty due kicks in when a return is 60 days late. The minimum penalty is the lesser of the tax due or \$205 (\$100 penalty < \$205 < \$1,000 tax due).
• Bob filed his tax return 4 months late and owed \$50 (\$50 x 5% x 4 months = \$10). The minimum penalty kicks in after 60 days so the minimum penalty due would be the lesser of the tax due or \$205. Therefore, the penalty is \$50 (\$10 penalty < \$50 tax due < \$205).
• Jill filed her tax return 2 days late and owed \$1,000 in taxes. Her penalty is \$50 (\$1,000 x 5%). Even though her return was only 2 days late she’ll be assessed a penalty for the full month. No minimum penalty is due because the return was filed within 60 days of the deadline.
• Jim filed his tax return 20 days late but had no tax due. No penalty is assessed because no tax was due and the return was filed within 60 days after the due date.

Failure to pay and the return wasn’t filed – this is a piggy back on the failure to file penalty. Essentially part of the failure to file penalty is the failure to pay penalty (which is .5% of the tax due). You’re supposed to calculate both separately but it would equal the failure to file penalty after you did all the calculations.

For example, you should calculate the failure the file penalty and the failure to pay penalty separately. Then you would subtract the failure to pay penalty from the failure to file penalty. Then you would add them together… I know, it’s a bit much. Just know this: if you have tax due and you didn’t file the return on time then the total penalty will be the failure to file penalty as illustrated above.

Failure to pay and the return was timely filed – as previously stated, the failure to pay penalty is .5% of the tax due (up to 25% or 50 months worth of penalty). Remember, the tax due is always on the original due date of the return. Filing an extension doesn’t extend the amount of time you have to pay the tax.

• Roberto filed his income tax return before April 15th but didn’t pay the tax until 2 months after the filing deadline. He owed \$1,000 in tax and would be subject to a \$10 penalty (\$1,000 tax due x .5% x 2 months).
• John filed a timely extension and filed his income tax return 2 months after the original filing deadline of April 15th. At that time he paid \$1,000 in tax and would be subject to a \$10 penalty (\$1,000 tax due x .5% x 2 months). Even though he filed a timely extension he would still pay a penalty because the tax was due April 15th.

Failure to pay proper estimated tax – This penalty is hard to calculate because it’s based on the estimated tax due per quarter while factoring in an effective interest rate. Just know that if you plan on owing more than \$1,000 in tax after subtracting withholding and refundable tax credits, then this penalty will kick in.

The key concept tested on the exam is the safe harbor rule. If you pay 90% of the current year’s tax or 100% of the prior year’s tax then you can avoid penalties. If you make more than \$150,000 then you’ll have to pay 110% of the prior year’s tax.

Essentially, if you file your return on time and pay 110% of the prior year’s tax you will avoid penalties (this is the most important thing to remember).

Dishonored check or other form of payment – This one is pretty straightforward

1. For payments of \$1,250 or more, the penalty is 2% of the amount of the payment.
2. For payments less than \$1,250, the penalty is the amount of the payment or \$25, whichever is less.

What We Learned

Here are some of the key takeaways:

1. If you file your return on time and pay 110% of the prior year’s tax then you’ll avoid most penalties
2. If you didn’t file your return on time then the minimum amount of penalty you’ll pay is the lesser of the amount due or \$205.
3. If you didn’t file your return on time then the maximum amount of penalty you’ll pay is 25% of the tax due.
4. If you filed your return on time but didn’t pay the tax on time then the maximum amount of penalty you’ll pay is 25% of the tax due.

To really get into the details you can read more this material that is provided by the IRS.