Taxpayers are charged interest on underpayments of taxes, and in some cases the IRS pays interest to taxpayers who have overpaid taxes. Interest charges or payments usually result from the settlement of tax liability from a tax audit.

Penalties are applied. The tax law contains various penalties to ensure taxpayers accurately report and pay taxes. Penalty payments are considered an additional amount of tax and are not, therefore, deductible. The major types of penalties include failure-to-file, failure–to-pay, and accuracy, and are described in the following paragraphs.

If a taxpayer does not file a tax return on the due date (including extensions), he or she is subject to a penalty of 5% of the tax due with the return for every month or portion of a month that the return is late. The amount of the penalty for failure to file, however, is limited to a maximum of 25% the amount of taxes due with the tax return. If the return was fraudulently filed, the penalty is increased from 5% for each month or portion thereof to 15% and the maximum penalty is increased from 25% to 75%. Also, if the taxpayer fails to file the return within sixty days of its due date, the minimum failure-to-file penalty is the lesser of $100 or the total amount of the taxes due with the tax return. The failure-to-file penalty will not be assessed if the taxpayer can demonstrate that he or she had “reasonable cause” for failing to file the tax return on time.

Taxpayers are also subject to a penalty for failure to pay the amount of the taxes due the due date of their tax return. The penalty for failure to pay is 1/2 of 1% of the amount of taxes due for every month or portion of a month that the payment is late, up to a maximum of 25% of the amount of taxes due. The penalty increases to 1% per month beginning ten days after a notice of levy has been given to the taxpayer. If both the failure-to-file and the failure-to-pay penalties apply, the failure-to-file penalty is reduced by the amount of the failure-to-pay penalty.

The tax law imposes a penalty of 20% of the applicable underpayment due to (1) negligence or disregard of rules or regulations, (2) a substantial understatement of income tax, or (3) a substantial valuation overstatement, as well as other understatements of income tax.

Negligence includes the failure to make a reasonable attempt to comply with the tax law. For example, the penalty could be imposed on a taxpayer who deducts a personal expenditure as a business expense.

A substantial understatement of income tax occurs where the required amount of tax exceeds the tax shown on the taxpayer’s return by the greater of 10% of the amount of tax that should be shown on the return or $5,000 ($10,000 for corporate taxpayers other than S corporations). A substantial valuation overstatement occurs when the value of property is 200% or more of the correct valuation.

For example, a taxpayer who inflates the value of depreciable property to generate additional depreciation deductions may be subject to this penalty. The accuracy-related penalty applies only if the taxpayer has filed a return. In addition, if the taxpayer can demonstrate that he or she has reasonable cause for the understatement of tax and that he or she acted in good faith, the penalty will not be assessed.

The tax law also contains provisions for penalties for filing fraudulent tax returns. The fraud penalty is equal to 75% of the amount of underpayment of taxes attributable to fraud.

For the IRS to impose the fraud penalty, it must be shown by a “preponderance of evidence” that the taxpayer had an intent to evade taxes; however, once the IRS establishes that any portion of an underpayment of taxes is due to fraud, the entire underpayment is assumed to be fraud unless the taxpayer establishes otherwise.

The tax law does not provide clear rules for what constitutes fraud; however, what is clearly just negligence by a taxpayer will not cause this penalty to be imposed. When the fraud penalty is applicable, the accuracy-related penalty cannot be imposed.

The fraud penalty will be applied only when the taxpayer has actually filed a return. Like the accuracy related penalty, the fraud penalty will not be assessed if the taxpayer can demonstrate reasonable cause for the underpayment of tax and the taxpayer acted in good faith.

The tax law contains many other penalties applicable to taxpayers. The following are examples of such penalties:

Statute of limitations. The statute of limitationsstatute of limitationsTime during which the IRS can take action on a tax return. is the time period within which IRS may take an action on a tax return. After the statute of limitations has run out on a given tax return, the government cannot assess additional taxes and the taxpayer cannot amend the return to request a refund. In general, the statute of limitations for a tax return runs for three years from the date the tax return was filed or the return due date, whichever is later.

The tax law contains several exceptions to the general rule of a three-year statute of limitations. Included are the following:

If the IRS assesses a tax deficiency within the period of the statute of limitations, the government has ten years from the date of the assessment to collect the tax due. Go to Publication 17, Chapter 1 and read the sections: Interest on Refunds, Past-Due Refund, and Penalties.