If your small business fails to comply with tax taws or tax filing requirements, those mistakes can be costly. The number of penalties that the IRS can use to punish small businesses is staggering. This article covers the six most common tax mistakes that small businesses make and the corresponding penalties that the IRS can impose. If you are a small business owner, it pays to learn about these common tax pitfalls and take steps to avoid them.
The IRS can hit your business with a 20% penalty if it finds that you were negligent (unreasonably careless) in reporting your income or that you substantially understated the amount you owed in taxes. Businesses typically incur this "accuracy related" penalty when they can't validate a deduction as part of an audit or when they forget to report all of their income and the IRS discovers the error.
If the IRS finds that you underreported your income with a fraudulent intent (that is, the IRS thinks it was more than just an honest mistake), you can be fined 75% of the amount of the resulting tax deficiency. Don't worry too much about this civil (noncriminal) tax fraud penalty -- it's imposed in less than 2% of all audits. (You may also be charged with the crime of tax fraud, but that occurs in even fewer cases).
Failure to Pay on Time
The IRS usually adds a penalty of 0.5 % to 1% per month to an income tax bill that's not paid on time. This penalty is automatically tacked on by the IRS computer whenever you file a return but don't pay the full amount owed (or when you pay late).
Late payment penalties for failing to make payroll tax deposits on time are much higher.
If you're late in filing certain income tax returns or other forms, the IRS can penalize you an additional 5% per month on any balance due. But this penalty can be applied only for the first five months following the return's due date -- up to a 25% maximum charge.
Filing and Paying Late
A special rule applies if your business both files its taxes late and underpays. The IRS can (and probably will) impose a "combined penalty" of 25% of the amount owed if you don't pay in the first five months after the return and tax are due. After five months, the "failure to pay" penalty continues at 0.5 % per month until the two penalties reach a combined maximum of 47.5 %. This is a slightly (2.5 % less overall) penalty than if the two penalties were applied separately. Those IRS folks sure can be generous.
IRS penalties are "stackable." Late filing and paying penalties can be imposed by the IRS on top of other penalties -- like those imposed for fraud and filing an inaccurate return.
Underpaying Estimated Taxes
Many small business owners get hit with the estimated tax penalty. All self-employed individuals must estimate their income tax for the year and pay it in quarterly installments throughout the year. You must come pretty close to paying everything you will owe, although you don't have to guess the amount precisely. Here are the rules.
- If you earn less than $150,000, your quarterly tax payments must equal at least 90% of your final income tax bill or at least 100% of your tax bill from the previous year.
- If you earn more than $150,000, you must pay at least 110% of your previous year's tax bill in estimated payments or risk the underpayment penalty on whatever amount you come up short.
The IRS may impose a penalty on the amount that was underpaid for each quarter. Quarterly payments should be equal -- you can't play catch-up with larger payments later in the year in order to avoid this penalty.
For comprehensive information on how to avoid IRS penalties, develop the best tax plan for your small business, and understand the ins and outs of the tax code, get Tax Savvy for Small Business, by Frederick W. Daily (Nolo).