Using a frivolous argument to reduce your tax liability can result in a stiff fine from the IRS.
The Internal Revenue Service has instituted a graduated set of penalties applicable to taxpayers who don't pay their taxes on time. These range from penalties calculated based on the amount you owe to criminal penalties that can land you in prison. It is important to understand the risks when calculating your taxes.
Filing or Paying Late
The IRS has instituted two systems of late penalties -- one for filing late, and the other for paying late. They cannot both be imposed at the same time -- only the higher of the two can be imposed. The late filing fee is 5 percent of the amount due for every month or part of a month you file late, while the late payment penalty is 0.5 percent for every month or part of a month that you pay late. The maximum for both of these penalties is 25 percent of the amount due, except that you can be fined the lesser of $100 or the 100 percent of the amount due for filing 60 days or more late. In addition, the IRS will assess an interest penalty at an annual rate of at least 8 percent for any overdue amount.
Substantial Understatement
If you make an error that results in an understatement of your tax liability of at least $5,000 or 20 percent of the amount due, the IRS may declare you negligent and fine you 20 percent of the amount due. This amount is in added to any other penalties assessed against you. You can also be found negligent by blatantly disregarding tax laws or other culpable carelessness -- for example, taking the standard deduction and itemizing deductions at the same time.
Frivolous Returns
The IRS considers a tax return to be frivolous if it does not contain enough information to allow the IRS to calculate the amount you owe, or if you attempt to lower your tax liability by relying on arguments with no basis in fact or law. An example of the first might be estimating your income and failing to include information from W-2 forms your employer provided you. An example of the second might be asserting the tax protester argument that the federal government lacks constitutional authority to tax citizens. If your return is found frivolous, the IRS will fine you $500 in addition to any other applicable penalties.
Tax Evasion
Tax evasion is a criminal offense that can subject you to a fine of up to $100,000 and a prison term of up to five years. You commit tax evasion if you intentionally try to hide assets from the IRS, or if you report false or misleading information in an attempt to lower your tax liability. An example might be failing to report income and depositing it into a bank account overseas.
Under-Withholding and the Safe Harbor Rule
Self-employed taxpayers are required to pay quarterly estimated tax payments, while employees have estimated taxes deducted from their paychecks by their employer . This system carries with it the risk that you will accidentally underpay your taxes, either because you underestimated your own liability or because your employer under-withheld from your paycheck. If you underpay your tax liability, the IRS may penalize you at an annual rate of 4 percent of the unpaid tax, prorated by the number of days the tax is overdue. The IRS "safe harbor" rule protects you from this penalty as long as your total tax liability is less than $1,000, you had no tax liability the previous tax year, you paid at least 90 percent of your total tax liability, or you overpaid your tax liability the previous tax year.
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