Tax Audit Penalties and Consequences

Tax audits and tax penalties are two of the primary tools the Internal Revenue Service (IRS) uses to motivate U.S. taxpayers to file honest, accurate tax returns. The audit process can be an unpleasant experience. But what really keeps taxpayers in line is that the IRS can impose substantial tax penalties in addition to forcing you to pay the tax due with interest.

The most common penalty imposed on taxpayers following an audit is the 20% accuracy-related penalty. 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 show reasonable cause for underpaying your taxes.

Accuracy-Related Penalty

If the IRS audits your income tax return and finds it is not accurate, the tax code allows an assessment of a 20% accuracy-related penalty based on the understated amount. For example, let's say the IRS finds that you should have paid $10,000 in additional taxes 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 understate 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 liability. The failure-to-pay penalty will apply monthly until you pay your tax bill 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.

If you are unable to pay the full penalty amount, the IRS will often agree to an installment agreement that allows for monthly payments. In some limited cases, the IRS may accept an offer-in-compromise (OIC) where it agrees to accept less than the amount owed. Before the IRS will accept an OIC, it will look at things like your bank account information. Small business owners will need to submit their business records.

Statute of Limitations

The tax code only gives the IRS a limited time to assess additional tax, which is known as the statute of limitations. That generally means the IRS can only look at returns filed in the last three years. But the IRS measures those three years from the later of the return's due date or the date you filed. That means if you filed a return for the 2020 tax year in 2022, the IRS has until 2025 to audit your 2020 return.

It is important to note that the three-year limitations period only applies to filed returns. If you do not file a return for a tax year, the IRS has unlimited time to assess and collect the tax you should have paid.

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 income taxes and that a portion of the underpayment was the result of fraud. That means the IRS must show clear and convincing evidence that you knew you owed taxes but took intentional action to prevent them from collection.

Criminal Charges

Less than 2% of IRS tax audits result in criminal charges that could result in jail time. 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 for violations of tax laws 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 the IRS uses 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 tax professional or CPA

• Reliance on erroneous information

Appealing the Results of a Tax Audit

If you disagree with the audit findings, you can ask the IRS to review them. 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 possible penalties, a local tax attorney can help. An experienced attorney can help resolve your tax problems and protect your rights by guiding you through the audit process. An attorney can also help you if you choose to appeal the results. They can also ensure you do not pay more to the IRS than legally required.