Understanding the IRS’s Tax Underpayment Penalty and How to Avoid It

Whether you are a freelance worker or an owner who earns money from your business, if you didn’t pay the estimated tax properly, you could end up paying an Internal Revenue Service (IRS) tax underpayment penalty. 

This article covers what can trigger a penalty and what you can do to avoid penalties in the future. 

What is a tax underpayment penalty and how does it work?

Though you only file one tax return each year, federal income tax is technically a pay-as-you-go system. You’re expected to pay tax on your income as you earn it throughout the year. Ordinarily, your employer does this for you through income tax withholding. However, if you are a freelancer, you must make your own tax payments throughout the year.

A tax underpayment penalty is a fine imposed by the IRS on individual or corporate taxpayers who don’t pay enough of their estimated taxes, don’t have enough withheld from their wages, or who pay late. The purpose of this penalty is to promote on-time and accurate estimated tax payments from taxpayers. 

The IRS may charge the tax underpayment penalty if you owe more than $1,000 in tax when you file your tax return. They may also apply this penalty if the payments you made add up to less than 90% of the tax you owe. For example, suppose that you owe $10,000 worth of tax on your 2020 tax return, but you only made $8,000 in estimated tax payments. In this case, since your tax payments only amounted to 80% of the tax due, the IRS could apply a penalty. 

The tax underpayment penalty isn’t a static percentage or flat dollar amount. Suppose the taxpayer realizes that they have underpaid taxes. In that case, they must then pay the difference plus a penalty calculated based on the remaining balance owed and how long the amount has been overdue. 

The failure-to-pay penalty that applies to tax underpayments is 0.5 percent of the amount owed for each month (or another time frame) the tax is not paid. This underpayment/failure-to-pay penalty won’t exceed 25% of the unpaid amount. 

Along with a penalty, tax underpayments (as well as overpayments) generate interest. The IRS sets the interest rate every quarter for most individual taxpayers, based on the federal short-term rate plus 3%.

The interest payment rates for Q4/2021 (announced on Aug. 25, 2021) are:

  • 3% for individual underpayments
  • 5% for large corporate underpayments (exceeding $100,000)

Exceptions for underpayment penalties

There are certain exceptions when the underpayment penalty doesn’t apply, which are: 

  • A taxpayer’s total tax liability (after withholdings and credits) is less than $1,000
  • The taxpayer paid a minimum of 90% of the total tax from the current year’s return or paid 100% of their tax liability from the previous year. (*See below for a more detailed note)
  • The taxpayer missed a required payment due to an unforeseen, uncommon, or noteworthy event (such as a casualty or disaster)
  • The taxpayer retired at age 62 or older during the prior or current tax year 
  • Estimated payments were unfulfilled because the taxpayer became disabled during the tax year or the preceding tax year
  • Any other situation in which the underpayment was due to a reasonable cause, not willful neglect. 

(*Note: In this case discussed in this second point, the rule changes a bit if your annual income increases. If your adjusted gross income for the current tax year exceeds $150,000 ($75,000 if married filing separately), you must pay 110% of your previous year’s tax liability.

However, those who don’t qualify for the above exceptions may still qualify for a reduced tax underpayment penalty in certain circumstances. For instance, individuals who change their tax filing status from “single” to “married filing jointly” may be eligible for a reduced penalty because of the higher standard deduction.

What you can do if you received a tax underpayment penalty

Generally, if you fail to pay a sufficient amount of your taxes owed throughout the year, the IRS can issue a tax underpayment penalty. However, suppose you have already paid enough and still receive a tax underpayment penalty. In that case, you may request to have it waived by showing a reasonable cause or proving that you were unable to calculate your estimated income. 

In some cases, you may successfully reduce or eliminate your tax underpayment penalty if the IRS provided you with incorrect information. For example, if you called the IRS to address a question and got the wrong advice from an IRS agent, you might succeed in avoiding a tax underpayment penalty. To be eligible for this, make sure you always note down the date and time of your call to the IRS as well as the name of the person you spoke to. If you encounter an agent who is hesitant to give you a firm answer to your question, try to be patient with them. Many agents are cautious to answer anything that could be regarded as tax advice for fear of misspeaking or giving you wrong information.

How to avoid tax underpayment penalties in the future?

No one likes ending up with a tax underpayment penalty, so here are some steps you can take to avoid this penalty in the future. 

1. Be aware of when your payments are due

For starters, adequately paying quarterly taxes by the dates shown below will help save you from incurring the underpayment penalty: 

  • Apr. 15
  • Jun. 15
  • Sept. 15
  • Jan. 15 of the following year

If a due date falls on a weekend or holiday, the payment is due the next business day.

2. Annualize your income

Generally, you don’t need to wait and pay all your tax liability at the end of the year. Especially if your income is unpredictable or seasonal, you may want to annualize your income, which basically means you will pay your tax payments based on a reasonable estimate of your income during each quarterly period. 

If you own a seasonal business and most of your annual earnings come from three consecutive months, annualizing your income can help you better estimate your tax payment. Calculating your estimated payments and making quarterly estimated payments can help you avoid the tax underpayment penalty. To use this method, you need to complete Form 2210 and attach it to your return.

For example, your business makes $30,000 per year, but all of that money comes in from June through September. When determining your estimated payments, take the $30,000 you expect to make and divide it by 12 months. This way, you can spread the amount of your estimated tax payments evenly across the year and make sure you don’t break the IRS’s pay-as-you-go rule.

3. Adjust your W-4 withholding

Generally, employers must withhold taxes from employees’ paychecks based on their earnings and employees’ information on their W-4s. If your employer isn’t withholding enough tax, you can make up the difference by revising your W-4 and requesting that they withhold more.

You can use the IRS withholding calculator to estimate how much your employer should withhold from your paychecks. Then fill out a new Form W-4, indicate how much you want to be withheld, and submit it to your employer. This can reduce or even eliminate the need for making estimated payments on your own.

The bottom line

To pay the right amount of your taxes owed throughout the years, you can ask your employer to withhold more from your paycheck. Otherwise, you can calculate and make your quarterly estimated tax payments if you’re a freelancer.

Submitting tax payments on time and filing paperwork can seem daunting, but it’s all part of developing a disciplined, well-organized documentation process. The Shoeboxed app can help your business stay efficient and organized!

Shoeboxed is a painless receipt-tracking and expense-managing app that helps get you ready for tax seasons. After scanning your receipts with the Shoeboxed app, you can create clear and comprehensive expense reports that include images of your receipts. You can then export, share or print all of the information you need for easy tax preparation or reimbursement, all within a few clicks. Shoeboxed ensures that the digital versions of your receipts are legibly scanned, clearly categorized, and accepted by both the Internal Revenue Service and the Canada Revenue Service in the event of an audit. 
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What Does IRS Stand For? Everything You Need To Know About The Internal Revenue Service.

Many Americans and foreigners working or living in the United States only engage with the IRS once a year when they file a federal income tax return and either wait for a refund or transfer money to pay taxes. However, the IRS does a lot more than just collect money and send out refunds.

So, whether you’re familiar or unfamiliar with this government agency, understanding thoroughly about the IRS will definitely help you in your future career. This article will walk you through the IRS, from its name, history, how it works, and the IRS’s importance in our lives. 

What does IRS stand for?

Most of you probably have heard about the IRS several times before, but what does IRS stand for actually? IRS stands for the Internal Revenue Service. 

Although the Internal Revenue Service didn’t get its name until the 1950s, the origins of the agency date back to the Civil War. President Abraham Lincoln created the IRS through the Revenue Act of 1862 and enacted an income tax to help pay for the Union cost of the Civil War, which lasted for ten years before being repealed. 

In 1894, the Wilson Tariff Act reestablished the income tax, but later, in 1895, the Supreme Court ruled the income tax unconstitutional. This meant no income taxes could be collected until three-quarters of the states ratified the 16th Amendment to allow Congress to enact an income tax. This created and established the legality of the first federal income tax program. The first income tax rate was 1% on income over $3,000 and 6% on income over $500,000. 

Tax rates increased to finance World War I, then decreased in the postwar years before rising again during the Great Depression and World War II. Tax withholding was instituted at this time.

The tax collection agency was reorganized in the 1950s, and the Bureau of Internal Revenue became the Internal Revenue Service. The IRS was reorganized again in 1998 to become more consumer-focused. 

What does the IRS do? 

The Internal Revenue Service’s mission, according to its website, is to help America’s taxpayers understand and meet their tax responsibilities and enforce the law with integrity and fairness, and provide top-quality services to achieve these goals. The IRS divides this mission into three distinct responsibilities: 

  • Administer tax laws:  

One of the first and foremost responsibilities of the IRS is to assess and collect taxes on behalf of the federal government. In 2020, the IRS collected nearly $3.5 trillion in taxes, accounting for income taxes, employment taxes, business income taxes, excise taxes, estate, and gift taxes.

Besides collecting taxes, the IRS is also in charge of issuing tax refunds, which an individual or business can claim if they overpay their taxes. In the fiscal year 2020, the IRS processed more than 240.2 million federal tax returns and supplemental documents. 

  • Enforce tax laws: 

An essential part of the IRS’s enforcement mission is to seek and identify those who have underpaid their taxes, whether due to a math error or criminal activity. These examinations can either take the form of correspondence or field examinations. For the 2019 fiscal year, the IRS audited 771,095 tax returns, accounting for 0.6% of individual income tax returns and 0.97% of corporate tax returns. About 73.8% of IRS audits occurred by mail, while 26.2% happened in the field. 

From 2010 to 2018, the IRS examined about 0.63% of individual tax returns and 1% of corporate tax returns for errors. While most errors are likely unintentional, the IRS completed 2,624 criminal investigations in 2020 alone.

There are various reasons that the IRS will undertake an audit, but certain factors may increase the odds of an examination. The chief among these factors is high income. The audit rate for all individual income tax returns in 2018 was 0.6%, but for those who earned more than $1 million in income, it was 3.2%

Running your own business might bring greater risks, too. Individuals who earn between $200,000 to $1 million in one tax year and file a Schedule C (the form for the self-employed) will have a 0.6% chance of being audited. And for those who do not, the chance ranges from 1.4% to 2.8%. 

Some noticeable red flags which could trigger an audit are failing to declare the correct amount of income, claiming a larger number of deductions than usual (especially business-related ones), making abnormally large charitable donations compared to income, and claiming rental real estate losses. No single element determines whether or not you will face an IRS audit each year.

  • Providing services to assist taxpayers:

Another important responsibility of the IRS is to provide services to taxpayers to help them understand and comply with their obligations. There are numerous reasons for an individual, business, or an exempt organization to call the IRS, but the main reason is the need for help with excise taxes, estate taxes, and gift taxes. You can find these services through the IRS website, its telephone helplines, IRS Taxpayer Assistance Centers, and volunteer tax assistance.

Why is the IRS important?

Income tax revenue, along with other tax revenue, pays for a major part of the activities of the United States Government. Taxes are used to fund Social Security, Medicare, Medicaid, national defense, aid for veterans, foreign affairs, etc. Taxes contribute to community development, pay for law enforcement, and support many government services.

The mission of the IRS is to procure these funds from taxpayers through a variety of passive and more proactive means. The IRS’s secondary purpose is to educate taxpayers on the nature of taxes and their obligations. Therefore, the importance of the IRS can’t be understated.

The bottom line

A successful business starts with great knowledge and experience. Now you know what does IRS stand for, its mission and responsibilities, and how it helps keep the government functioning. You can then prepare how to work with the IRS, from filing taxes to preparing for a business audit

Shoeboxed is a smart receipt and expense tracking app that helps businesses track and manage their business expenses. Whether you are a business owner, independent contractor, or freelancer, you can take advantage of Shoeboxed by using this app to scan your receipts, store them online, create expense reports, and get them ready in the event of an audit. 

After scanning your receipts, Shoeboxed will extract the most important data points and automatically categorize them by vendor, the total spent, date, and payment type. We ensure that the extracted data is fully searchable, editable, and human-verified. From there, you can create clear and comprehensive expense reports that include images of your receipts within just a few clicks. Then, you can export, share or print all of the information you need for easy tax preparation or reimbursement.

Shoeboxed even makes sure that the digital versions of your receipts are legibly scanned, clearly categorized, and fully accepted by both the Internal Revenue Service and the Canada Revenue Service in the event of an audit. 

Try Shoeboxed now to get yourself well prepared for the IRS! 

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IRS To Promote Credits and E-File Options In 2009

WASHINGTON — The Internal Revenue Service today kicked off the 2009 tax filing season by announcing a number of new steps to help financially distressed taxpayers maximize their refunds and speed payments while providing additional help to people struggling to meet their tax obligations.

IRS Commissioner Doug Shulman encouraged taxpayers to take advantage of several new tax credits and deductions this filing season and announced a major enhancement to the Free File program that will allow nearly all taxpayers to e-file for free and accelerate their refunds.

“With so many people facing financial difficulties, we want taxpayers to get all the tax credits they’re entitled to as quickly as they can,” Shulman said. “In addition, we are creating new protections to help people trying to meet their tax obligations. The IRS will do everything it can to help during these tough times.”

Help for People Who Owe Taxes

With many people facing additional financial difficulties, the IRS is taking several additional steps to help people who owe back taxes.

“We need to ensure that we balance our responsibility to enforce the law with the economic realities facing many American citizens today,” Shulman said. “We want to go the extra mile to help taxpayers, especially those who’ve done the right thing in the past and are facing unusual hardships.”

On a wide range of situations, IRS employees have flexibility to work with struggling taxpayers to assist them with their situation. Depending on the circumstances, taxpayers in hardship situations may be able to adjust payments for back taxes, avoid defaulting on payment agreements or possibly defer collection action.

The IRS reminds taxpayers who are behind on tax payments and need assistance to contact the phone numbers listed on their IRS correspondence. There could be additional help available for these taxpayers facing unusual hardship situations.

Among the areas where the IRS can provide assistance:

  • Postponement of Collection Actions: IRS employees will have greater authority to suspend collection actions in certain hardship cases where taxpayers are unable to pay. This includes instances when the taxpayer has recently lost a job, is relying solely on Social Security or welfare income or is facing devastating illness or significant medical bills. If an individual has recently encountered this type of financial problem, IRS assistors may be able to suspend collection without documentation to minimize burden on the taxpayer.
  • Added Flexibility for Missed Payments: The IRS is allowing more flexibility for previously compliant individuals in existing Installment Agreements who have difficulty making payments because of a job loss or other financial hardship. The IRS may allow a skipped payment or a reduced monthly payment amount without automatically suspending the Installment Agreement. Taxpayers in a difficult financial situation should contact the IRS.
  • Additional Review for Offers in Compromise on Home Values: An Offer in Compromise (OIC), an agreement between a taxpayer and the IRS that settles the taxpayer’s tax debt for less than the full amount owed, may be a viable option for taxpayers experiencing economic difficulties. However, the equity taxpayers have in real property can be a barrier to an OIC being accepted. With the uncertainty in the housing market, the IRS recognizes that the real-estate valuations used to assess ability to pay may not be accurate. So in instances where the accuracy of local real-estate valuations is in question or other unusual hardships exist, the IRS is creating a new second review of the information to determine if accepting an offer is appropriate.
  • Prevention of Offer in Compromise Defaults: Taxpayers who are unable to meet the periodic payment terms of an accepted OIC will be able to contact the IRS office handling the offer for available options to help them avoid default.
  • Expedited Levy Releases: The IRS will speed the delivery of levy releases by easing requirements on taxpayers who request expedited levy releases for hardship reasons. Taxpayers seeking expedited releases for levies to an employer or bank should contact the IRS number shown on the notice of levy to discuss available options. When calling, taxpayers requesting a levy release due to hardship should be prepared to provide the IRS with the fax number of the bank or employer processing the levy.

Taxpayers with financial problems who discover they can’t pay when they file their 2008 tax returns also have options available. IRS.gov has a list of What If? scenarios that deal with payment and other financial problems. These scenarios, in question-and-answer format, provide information on specific actions taxpayers can take. Taxpayers unable to pay in full can likewise contact the IRS to discuss additional options to pay.

Maximizing Refunds and Speeding Refund Delivery

This filing season, there are several steps taxpayers can take to maximize their refunds and speed the delivery of money from the IRS.

Taxpayers should look into the numerous tax breaks available and take every credit, deduction and exclusion for which they qualify. People who had less income in 2008 could find they qualify for credits for which they previously did not qualify. And there are several new benefits this year:

  • First-Time Homebuyer Credit: Those who bought a principal residence recently or are considering buying one should take note. This unique credit of up to $7,500 works much like a 15-year interest-free loan. A special page on IRS.gov has more details and answers to common questions.
  • The Recovery Rebate Credit: This credit is figured like last year’s Economic Stimulus Payment except that Recovery Rebate Credit amounts are based on tax year 2008 instead of 2007. Most people already received their full benefit in the form of the Economic Stimulus Payment. However, a taxpayer may qualify for the Recovery Rebate Credit, if, for example, he or she did not get an Economic Stimulus Payment, had a child in 2008 or had a change in income level. If you receive this credit, it will be included in your refund and will not be issued as a separate payment. See the Form 1040 Instructions, Fact Sheet 2009-3 or the information center on IRS.gov for details.
  • Standard Deduction for Real Estate Taxes: Taxpayers can claim an additional standard deduction, based on the state or local real estate taxes paid in 2008. The maximum deduction is $500, or $1,000 for joint filers.
  • Mortgage Workouts and Foreclosures: For most homeowners, these are now tax-free. Eligible homeowners can exclude debt forgiven on their principal residence if the balance of the loan was less than $2 million. The limit is $1 million for a married person filing a separate return. See Form 982 and its instructions for details.

This Web site, IRS.gov, has more information on these and other popular credits, such as the child tax credit, the Earned Income Tax Credit and alternative fuel vehicle credit.

E-File, E-Pay and Direct Deposit

This year, electronic filing options will speed the payment of refunds to millions of taxpayers. Taxpayers who e-file and choose direct deposit for their refunds, for example, will get their refunds in as few as 10 days. That compares to approximately six weeks for people who file a paper return and get a traditional paper check.
This year, taxpayers can begin filing electronically on Jan. 16.

The IRS in 2009 is again offering free tax preparation and filing through the Free File program. Anyone with an adjusted gross income up to $56,000 can use the standard Free File options this year –– that is approximately 98 million Americans. The program also has usability improvements, including a standardized set of electronic forms that are most frequently used by Free File-eligible taxpayers.

This year the IRS and its partners are offering a new option, Free File Fillable Tax Forms, that opens up Free File to virtually everyone, even those whose incomes exceed $56,000.

Free File Fillable Tax Forms allows taxpayers to fill out and file their tax forms electronically, just as they would on paper. This option does not include an “interview” process like the other Free File offerings, but it does allow taxpayers to enter their tax data, perform basic math calculations, sign electronically, print their returns for recordkeeping and e-file their returns. It may be just right for those who are comfortable with the tax law or those who use electronic software to prepare their returns but file using paper forms.

Both the fillable-forms option and the previously available Free File offerings are available only through the IRS.gov Web site. More information will be available in mid-January.

1040 Central and Taxpayer-Friendly Features

When they visit the IRS.gov Web site this filing season, taxpayers may notice the new “rotating spotlight” feature on the homepage. The spotlights, which change every few seconds, give the taxpaying public direct access to more of the IRS Web site’s vast amount of content.

Also on the homepage, taxpayers can click on 1040 Central to find help preparing and filing their tax returns. Like last year, this popular section of IRS.gov has a wide range of offerings that address taxpayer needs.

Finally, the IRS is producing a number of podcasts this filing season that will be available on IRS.gov. In addition to Tax Tips, Fact Sheets and News Releases, these short audio interviews cover a wide range of topics and are a way for the IRS to reach out to a new generation of taxpayers.

Tax Filing Fact Sheets

For more tax season topics, see the following fact sheets: