Good to Know

Alert-As of the date this blog was written (March 16, 2021) pressure was building to extend 2020 tax return due dates in recognition of COVID challenges. However, taxpayers should assume the due date for personal and business income tax returns remains unchanged unless an official IRS pronouncement indicates otherwise.

The IRS recognizes that a taxpayer may not have received all of the tax information needed to file a tax return by the due date, especially if there are complex issues to resolve.

Individual tax returns for 2020 are due by April 15, 2021. By exception, winter storm victims in Louisiana and Texas have extra time to file their 2020 tax returns. Click Tax Relief for Louisiana Storm Victims and Tax Relief for Texas Storm Victims for detailed information.

Truth be told, there are also times when a taxpayer may simply procrastinate. Whatever the reason for late filing, the consequences may include penalties and interest of well over 25% of the unpaid tax due.

We’ll focus on these aspects of the tax return filing and penalty process in this blog:

  • General application of the failure to file penalty,
  • The minimum failure to file penalty,
  • Failure to pay and underpayment penalty,
  • Interest, and
  • Refunds.

Noteworthy—penalties may be waived by the IRS under circumstances such as reasonable cause and first-time penalty abatement.

General Application - Failure to File Penalty

A Failure to File Penalty of 5% per month (not to exceed a total penalty of 25%) of unpaid taxes is assessed for every month an individual income tax return is filed late, i.e., after the due date. The IRS counts a partial month as a full month for penalty purposes.

For example, a taxpayer (Jane Dough) with $5,000 in unpaid tax due would owe a Failure to File Penalty of $1,250 if her 2020 Form 1040 was not filed until August 31, 2021. The penalty is calculated as 5 months x 5% x $5,000. Here is how the IRS counts the five penalty months:

  • April 16 – May 15,
  • May 16 – June 15,
  • June 16 – July 15,
  • July 16 – August 15, and
  • August 16 – August 31 (partial month).

Here is how Jane could have avoided the $1,250 penalty and also serves as answer to  the riddle posed in this blog’s title—she should apply for an Automatic Extension of Time To File U.S. Individual Income Tax Return (IRS Form 4868) to gain a six-month extension of time to file. Jane must then file her 2020 income tax return within the extension period, i.e., no later than October 15, 2021.

The Failure to File Penalty will NOT apply during the extension period. Taxpayers need only prepare the simple, one-page Form 4868, invest 55 cents in a stamp, and mail it to the IRS BEFORE the due date of the tax return. If snail mail is not your client’s style, he or she may apply for the extension online through a tax service such as Turbo Tax, Tax Act or others.

Minimum Failure to File Penalty

How much is the Failure to File Penalty if the taxpayer owes a relatively small amount of unpaid tax? The minimum Failure to File Penalty for returns filed more than 60 days late is the lesser of:

  • $435 (2020 returns), or
  • 100% of the unpaid tax due.

For example, assume a taxpayer owed $500 in unpaid taxes, did not apply for an extension of time to file, and filed 75 days after the due date. The failure to file penalty using the general application would be only $75 (3 months x 5% x $500). However, this is where the minimum penalty kicks in—the taxpayer’s Failure to File Penalty is $435, calculated as the lesser of the unpaid tax due ($500) or $435.

Failure to Pay and Underpayment Penalties

Failure to Pay

  • This penalty applies to the period AFTER the income tax return was due.
  • A penalty of 0.5% of unpaid tax due is generally assessed for every month or fraction of a month the tax remains unpaid after the due date of the tax return.
  • The penalty drops to 0.25% if an installment payment plan is requested from and approved by the IRS.
  • In any month the Failure to File and Failure to Pay penalties run concurrently, the IRS reduces the total of the two penalties to a maximum of 5% per full or partial month.

Underpayment

  • This penalty applies to the 12 months of the current tax year.
  • For example, the underpayment penalty for a 2020 income tax return is based upon underpayments during 2020.
  • In addition to all of the penalties discussed so far, an Underpayment Penalty may also apply whenever taxes paid during the current tax year amount to less than:
    • 90% of the income tax liability for the current tax year, or
    • 100% of the income tax liability for the previous tax year (110% if the taxpayer’s adjusted gross income exceeds certain limits).

So far, we’ve identified three potential penalties that could apply, but there is yet another financial consequence to failing to file and pay timely — interest!

Interest

Every single day that the income tax return filing is late and unpaid tax is owed, the IRS charges interest on the taxpayer’s unpaid account balance. Annual interest rates are adjusted quarterly and are imposed at a 3% annual rate for the first quarter of 2021. The account balance includes unpaid:

  • Income tax,
  • Failure to File Penalty,
  • Failure to Pay Penalty,
  • Underpayment Penalty, and
  • Interest.

Let’s change our focus to a more pleasant topic. What should the taxpayer know about refunds?

Refunds

There is no Failure to File, Failure to Pay, or Underpayment Penalty if no tax is owed!  However, filing the return timely remains a wise choice because:

  • Taxpayers generally have only three years from the original due date of the return to claim a refund by filing the return, and
  • Filing late extends the audit period — the IRS audit period is three years from the later of the original due date of the return or the date the return was filed.

Summary

 Here is the prescription for avoiding or reducing tax penalties and interest:

  • File the return timely and pay the estimated tax due in full with the return if at all possible.
  • If there is insufficient information to file the return when due, apply for an extension of time to file and pay the estimated tax due in full with the application.
  • If the full estimated tax due cannot be paid timely, pay the most tax possible with the return or the application for extension and apply for an installment payment agreement for the remainder of the tax due.

Disclaimer

The information presented herein is provided purely for educational purposes and to raise awareness of these issues; it is not meant to provide and should not be used to provide tax, legal, compliance or financial advice. There are variations, alternatives, and exceptions to this material that could not be covered within the scope of this blog.