What Does the IRS Consider to be a Tax Underpayment?
A tax underpayment occurs when a person did not pay enough estimated federal taxes or did not have enough taxes withheld from income.
Tax underpayment situations generally involve self-employed, freelance, or contract workers who receive payments for their services without taxes withheld and they do not pay enough in estimated quarterly taxes during the year.
An example of a tax underpayment is a freelance website developer who charges $1,000 to create a website. Since the developer cannot predict how many customers he or she will have in a year, the developer estimates and pays $20,000 for IRS taxes during the year.
However, when this developer files a federal tax return, they discover they now owe $24,000 in federal taxes. Therefore, the tax underpayment is $4,000.
When Does the IRS Assess a Tax Underpayment Penalty?
If you owe the IRS more than $1,000 for taxes and fail to pay at least 90% of the balance, the IRS will assess a tax underpayment penalty.
In some cases, you can avoid a tax underpayment penalty if you did not owe any taxes for the previous year.
Does the IRS Review Tax Underpayment for Both Individuals and Corporations?
Yes, S corporations, partners, and sole proprietors, just like individuals, are expected to pay the IRS estimated taxes four times per year.
When income is seasonal or varies throughout the year for self-employed individuals and S corporations, they can choose to pay a different amount for estimated taxes each quarter. Note that the IRS provides Form 2210 to help individuals and businesses calculate enough estimated taxes so they can avoid a tax underpayment penalty.
How Does the IRS Calculate a Tax Underpayment Penalty and How Much More Will You Have to Pay?
The exact amount of an IRS underpayment penalty depends on three factors: how much you underpaid for taxes, when your tax payment was due, and the IRS quarterly interest rate.
Late payment penalties, or failure-to-pay penalties, are 0.5% of your past due amount each month.
The tax underpayment penalty caps at 25% of the amount you underpaid.
Keep in mind that an underpayment penalty can be increased to 1% per month once the IRS sends a final notice of intent to levy, or it can be decreased to 0.25% per month when you enter into an installment agreement.
Does the IRS Also Add Interest for a Tax Underpayment Penalty?
Yes, interest will continue to be added to your tax underpayment and monthly penalties until you pay in full. The interest rate charged by the IRS for underpayments is 8% for individuals and businesses.
Compounded IRS daily interest is evaluated according to the previous day’s balance in addition to the interest.
Note that the IRS uses the federal short-term rate to calculate the interest they charge for tax underpayments. For example, the standard interest (the federal short-term rate plus 3%) applies to non-corporate and corporate underpayments only.
The large corporate underpayment interest (federal short-term rate plus 5%) applies to tax underpayments involving C-corporations that exceed $100,000.
Can You Request Tax Relief from the IRS to Waive a Tax Underpayment Penalty?
Yes, the IRS may waive a tax underpayment penalty in certain situations:
- You were a U.S. resident or citizen for the prior tax year and do not owe taxes for that year.
- You missed a payment due to a natural disaster, casualty event, or other catastrophic circumstance.
- You did not willfully cause the underpayment or can show a valid reason the underpayment happened.
- You retired after turning 62 during the preceding or current tax year
- You became disabled during the year you owed estimated tax payments or during the previous tax year
What Happens If I Can’t Pay My Tax Underpayment and Penalties?
Sole proprietors and self-employed individuals who do not qualify for a waiver may be able to get their penalty reduced in certain situations.
For example, if someone changes their filing status from single to head of household, the IRS may reduce the penalty because the standard deduction will be larger than the deduction for a single status filer.
Reduced penalties may also be applied to taxpayers who earn considerable income later in a year. For example, a person who sells investments in November may have to pay a significant capital gains tax. The IRS may take this type of situation into consideration when determining whether to reduce underpayment penalties.
Of course, individuals can always request tax relief from the IRS to pay a tax underpayment in smaller monthly installment amounts, or even ask the IRS to reduce the total tax underpayment amount (Offer in Compromise) because of a severe economic hardship.
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