Have you ever filed an extension for your tax return but still received a penalty from the IRS? Well, you’re certainly not the first to assume that filing an extension prevented a penalty. It’s particularly frustrating if you thought you were playing by the administrative rules. Being on top of your admin and your finances is something to be proud of, so we get it.
To best answer this question, it’s good to go over the different types of income tax penalties first. Let’s make sure you don’t fall under any of these categories before you jump on a call with the IRS.
Types of personal income tax penalties
Penalty: Failure to file
As the name implies, this penalty is applicable if you fail to file your tax return by the due date. If you don’t file an extension, that would mean you’re liable if you file your return any day after April 15 on a typical tax year. If you did file an extension, that means you’re liable if you file your return any day after October 15. This penalty is 5% per month up to a maximum of 25% (assessed on your balance due).
As long as you file an extension by April 15 and file your return by October 15, this penalty will not apply.
Penalty: Failure to pay
This penalty applies if you don’t pay the tax you have reported on your return by the due date. Now, the key phrase here is ‘due date’. In this case, that means the original due date of April 15, not the extension to October 15. If you extend your tax return and have a balance due but didn’t pay the balance by April 15, you will be given the failure to pay penalty. This penalty is .5% of the unpaid taxes, each month, and goes up to a maximum of 25%.
So how can you avoid or minimize this penalty? Try to get a solid estimate of how much you will owe by April 15 and send in an extension tax payment with your return extension. Then when you finalize your return by October 15, you can get a refund if you’ve paid any excess (or you can pay the difference for a balance due).
Example: You won’t be ready to file your tax return by April 15, but you know that you will owe something. To minimize the failure to pay penalty, you would give us all of the tax documents you currently have and you would let us know estimates on your business’ income and expenses. With that, we figure a rough estimate on how much you will owe for federal (and potentially state) income taxes. So for federal, it might be $5,000. We would put that $5,000 federal estimate online along with your extension, and it would ultimately go towards your tax return balance due. When you eventually get us the final information a few months later, your tax return might show $4,850 as the tax liability. In which case, having already paid $5,000, you would receive a $150 refund back.
Penalty: Underpayment of estimated tax
You would be given this penalty if you didn’t pay enough in tax estimates throughout the year. The IRS has a pay-as-you-go system which means that they expect you to be paying in taxes as you’re earning (not all at once when you file your tax return). For W-2 employees, this means your employer will be withholding taxes from each paycheck and sending them into the government on your behalf. But, as a creative business owner, you will likely need to send in quarterly estimated tax payments. This means you typically will need to send in payments on April 15, June 15, September 15 and January 15.
There are several variables that determine the amount of this particular penalty, but they are typically around .5% and capped at 25%. To avoid this penalty, you have to pay at least 90% of your current tax bill or 100% of the tax shown on your prior tax return throughout the year. Whatever is less.
Example: Your prior year 2020 tax return showed total federal taxes of $7,500. Your current year 2021 tax return shows a federal tax liability of $9,200. Using these figures, you would need to have paid at least $7,500 on time during 2021 (so this is the prior year amount since it is the lesser of the two) to avoid the underpayment penalty.
Biggest penalty to avoid
The largest penalty is, by far, the failure to file penalty. So, even if you can’t pay your balance due, still make sure to file your tax return on time so that this heftier penalty will be negated. To learn more about what to do if you can’t pay the full balance due, take a look at this blog post.
Key ways to avoid penalties
- File your tax return or extension by April 15
- If you file an extension, make sure to file by the extended due date of October 15
- Pay your balance due (or estimated balance due) by April 15
- Make quarterly estimated tax payments and/or increase your W-2 withholdings during the year to “pay-as-you-go,” and utilize quarterly tax planning sessions to get an even more accurate picture during the year if you can
The Revel difference
Instead of just trying to meet the underpayment penalty criteria set out above, Revel gauges your actual activity during the year. This ensures you aren’t hit with a huge tax bill come April 15 (or due a huge refund on April 15). We offer quarterly tax planning sessions where we look at what has happened so far and estimate what you can expect for the remainder of the tax year. We’ll adjust your tax estimates to reflect the actual year your business is having. This makes your life so much easier, with a much higher chance of never seeing a penalty notice from the IRS!
Contact us here to get going.
Quick note: In all of the above penalty scenarios, interest would also accrue. It is typically based on the penalty itself and is relatively minimal.