Hello and welcome to today’s episode of Street$marts with Howe & Rusling. I’m Vince Carson, Certified Public Accountant and Financial Planner at Howe and Rusling. We all know that there’s nothing worse than getting a letter from the IRS… especially when you open it and find out that you did something wrong, and now owe interest and penalties. Today, I am going to be covering some of the most common types of penalties, why they occur, and how to avoid them.

The first type of IRS penalty to avoid is known as the Failure to File Penalty. As the name would suggest, this penalty is imposed on taxpayers who don’t file their tax return on time. This failure to file penalty is calculated at 5% of the unpaid income tax balance, for a maximum of 25%. This penalty is very easily avoidable, by simply filing your income tax return on the due date, April 15^th. Or, by filing an income tax extension, which provides you an additional 6 months to prepare your tax filings.

Speaking of income tax extensions, it’s important to note that filing an extension ONLY gives you additional time to file your tax return. It does NOT give you additional time to pay the amount due.

This leads me to the most common type of penalty, which is the Failure to Pay Penalty, or more commonly known as the underpayment penalty. This is especially important to consider if you own a flowthrough business, such as a partnership or S Corp, or have a sizable amount of taxable investment income in any given year.

The Underpayment Penalty comes about when a person does not have enough income tax withholding during the year, or they don’t pay enough in with their quarterly estimated tax payments. Most of the time, taxpayers find themselves owing an underpayment penalty when they are not aware of their progress, or lack thereof, toward paying in their income taxes throughout the year.

There are two methods to avoiding the underpayment penalty:

1. The first method is known as the Prior-Year Method… If your AGI in the prior year is less than $150,000, then pay in 100% of your prior year income tax liability, either through withholdings or estimated tax payments. Or if your AGI in the prior year was greater than $150,000, then pay in 110% of your prior year income tax liability.
2. The second method to avoiding the underpayment penalty is known as the Current-Year Method… This method is simply to pay in 90% of your current year income tax liability. 

Utilizing either of these methods will help you avoid paying the IRS an underpayment penalty on taxes owed.

For business owners making estimated tax payments, it’s important to note that the IRS expects you to make those 4 payments in 4 equal quarterly installments. Therefore, if you wait until the 4th quarter to make your entire tax payment, you will still get slapped with the underpayment penalty because you didn’t pay evenly throughout the year.

But what if you don’t know what your business income will be until the end of the year? It’s very often difficult for business owners to anticipate what their taxable income is going to be, and then pay their income taxes evenly throughout the year. 

For certain business owners, such as owners of an S Corp, there is one nifty way to avoid this pitfall. That method would be to use W-2 withholdings as your payment method to the IRS. For whatever reason, the IRS views W-2 wage withholdings as always being paid evenly throughout the year, even if the withholdings are done with one big bonus check on December 31^st.

Now, have you ever wondered how the IRS knows what your tax liability should be? This may be a good time to talk about the IRS Matching Program, which is when the IRS receives data that does not match what a taxpayer claims on their tax return.

For example, the IRS receives copies of W-2s from the social security administration, they receive Form 1099s for payments made to contractors, and they also receive Form 1099s for interest, dividends, and security sales from banks and brokerage houses. If a taxpayer fails to include an income item on their tax return, and the IRS received a document stating some type of income should have been reported, the taxpayer will absolutely be receiving a notice from the IRS and will be charged income tax, penalties, and interest on the omitted items.

So, as a recap…

1. The failure to file penalty occurs when you do not file your income tax return by the due date or extended due date. 
2. The underpayment penalty occurs when you fail to pay the required income tax by the due date.
3. The main way the IRS determines a taxpayer has not reported all applicable income on their tax return is through the IRS matching program.
4. And please remember, extensions increase the time to file your income tax return, but not the time to pay the income tax itself.

I hope today’s episode was helpful in understanding some of the more common penalties that taxpayers find themselves paying the IRS for. It’s very important to be aware of the actions you need to take in order to avoid these penalties. As always, if you have any questions on your finances, our team at Howe & Rusling is always available to help.

Thank you so much for tuning into today’s episode of Street$marts with Howe & Rusling.