Tax Audit Penalties and Consequences
Two of the primary tools the Internal Revenue Service uses to motivate U.S. taxpayers to file honest, accurate returns are tax audits and tax penalties. While the audit process can be an unpleasant experience, what really keeps taxpayers in line is the fact that, in addition to forcing you to pay the tax due with interest, the IRS can impose substantial tax penalties.
The most common penalty imposed on taxpayers following an audit is the 20% accuracy-related penalty, but the IRS can also assess civil fraud penalties and recommend criminal prosecution. In certain limited circumstances, you can avoid the accuracy-related penalty if you can show that you had reasonable cause for underpaying your taxes.
If the IRS conducts an audit of your return and finds it was not accurate, the 20% accuracy-related penalty may be assessed based on the understated amount. For example, let’s say the IRS finds that you should have paid an additional $10,000 in income tax and assesses a 20% accuracy-related penalty. In that case, you would pay a $2,000 penalty in addition to the $10,000 in unpaid taxes and any interest due.
The IRS will impose the accuracy-related penalty if you understated the amount of tax due on your return for one or more of the following reasons:
- Ignoring IRS rules and regulations.
- Underreporting your tax due. The IRS will impose a penalty if you underreport your income by at least $5,000, or 10% of your actual income.
- Misstating the value of your property. Either overvaluing property or undervaluing property will result in tax penalties.
- Not paying your taxes by the deadline. The IRS will charge you with a failure-to-pay penalty, which is usually 0.5% of your unpaid tax. The failure-to-pay penalty will be applied monthly until your taxes are paid in full.
- Understating the value of a gift or estate. If you understate the value of a gift or estate by more than $5,000, you will have to pay civil fraud penalties.
- Understating reportable transactions. The IRS claims these transactions could result in tax avoidance or evasion.
The accuracy-related penalty increases to 40% for any portion of your underpayment that can be attributed to gross valuation misstatements. It may also rise to 40% for failing to disclose some transactions lacking in economic substance or failure to properly disclose foreign assets.
Civil Fraud Penalty
The IRS can also assess a civil fraud penalty equal to 75% of any federal tax that was not paid due to fraud. Any portion of the unpaid tax that cannot be attributed to fraud may still be subject to the accuracy-related penalty.
To assess the civil fraud penalty, the IRS must prove both that you underpaid your taxes and that a portion of the underpayment was the result of fraud. That means the IRS must show by clear and convincing evidence that you knew you owed taxes but took intentional action to prevent them from being collected.
Less than 2% of IRS audits result in criminal charges. Common charges brought by the IRS following audits include filing a false return, tax evasion, failing to file a return, and intentionally failing to pay estimated taxes or keep records.
IRS agents seeking to start a criminal investigation must follow strict procedures and recommend prosecution to the U.S. Department of Justice Tax Division. Several IRS officials must approve the recommendation before it is submitted to the Justice Department and verify that it was based on factual evidence of tax fraud.
Reasonable Cause Exception
If you can show that you had reasonable cause for your tax underpayment, you may avoid the underpayment penalty for the portion of the tax you underpaid. The most important factor used by the IRS to determine reasonable cause is whether the taxpayer made a good-faith effort to pay the correct amount of tax.
The IRS may also take the following factors into account:
- A reasonable misunderstanding of the facts or laws
- The taxpayer’s experience, knowledge, and education
- Isolated errors in computation or transcription
- Reliance on a third-party informational return, such as an employer’s Form W-2
- Reliance on the advice of a professional tax advisor
- Reliance on erroneous information
Appealing the Results of an Audit
If you disagree with the results of an audit, you can ask the IRS to review its findings. If the IRS found that you owe $25,000 or less in taxes, penalties, and interest, you may file an appeal using IRS Form 12203. To contest a debt of more than $25,000, you must file a formal letter of protest with the IRS.
Have More Questions? A Tax Attorney Can Help
If you face an IRS audit and are concerned about the possible penalties you may be facing, a local tax attorney can help. An experienced attorney can guide you through the audit process and represent you if you choose to appeal the results to ensure you do not pay more to the IRS than legally required.