Are IRS Penalties Fair?

The federal government makes a lot of money from IRS tax penalties. Learn more about how they work.

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The federal government makes a lot of money off of IRS tax penalties. In 2012 alone, the IRS assessed 37.9 million penalties for a total of $26.9 billion. If it seems like there are more tax penalties than there used to be, that is because there are. In 1978 the IRS assessed only 15.4 million penalties--less than half of the 2012 amount.

There are a bewildering array of tax penalties, but there are two basic types: civil and criminal. Criminal penalties are reserved for those convicted of tax crimes such as criminal tax fraud. Civil penalties are far more common, and are imposed for noncriminal tax offenses.

There are civil tax penalties for:

  • fraud--the penalty is 75% of the amount owed
  • failure to pay or file taxes (called "delinquency penalties")--usually a 5% penalty
  • failure to deposit estimated taxes--a severe penalty that varies with how late the payments are
  • negligence, substantial understatement, substantial valuation misstatements, substantial overstatement of pension liabilities, substantial estate or gift tax valuation understatement, lack of economic substance, undisclosed foreign financial asset understatements, and understatements with respect to reportable transactions (referred to as "accuracy related penalties")--the penalty is 20% of what you owe,
  • not filing or filing incorrect information returns--the penalty varies based on the type of form and number of nonfiled forms.

The most common civil penalty by far is for failure to pay or file taxes--in 2012, it amounted to 57% of all tax penalties.

The purpose of tax penalties is supposed to be to discourage taxpayers from evading taxes, not simply to make the government money. Many have complained that IRS penalties are confusing and often unfair. You can easily end up owing a penalty due to even the slightest misunderstanding of the tax law, even though you didn't intend to cheat on your taxes.

Some penalties are not in proportion to the taxpayer's degree of noncompliance. For example, the failure to file penalty is 5% per month with a maximum penalty of 25%. Thus, although a taxpayer who files five months late is penalized more severely than a person whose delinquency is cured after 30 days, he is penalized the same as a person who files one year late or a person who never files. This creates some perverse incentives.

In addition, many penalties are automatically assessed against taxpayers by IRS computers through its automated matching system. When penalties are imposed automatically, there is no way for a human at the IRS to first determine whether the taxpayer’s error was the result of conduct that really merits a penalty. Though such penalties may later be abated (reduced or forgiven), in many cases, taxpayers pay penalties even if they are unwarranted because of the difficulty and expense involved in challenging an assessed IRS penalty.

You should never assume that you must pay a penalty just because the IRS says you do (especially if it's a computer that's doing the talking). The IRS can eliminate or reduce any penalty if you request it. The IRS calls this an "abatement." To obtain such an abatement you must establish "reasonable cause"--that is, you have a reasonable excuse for the conduct you've been penalized for. Examples of reasonable excuses include serious illness or death, reliance on tax errant preparers, and natural disasters. About 20% to 25% of all IRS penalties are abated on request.

June 2013

by: , J.D.

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