It's many people's worst nightmare — you're audited by the IRS and found to owe money. What now? Will you have your wages garnished? Will you lose your house? Will you go to jail?
In most cases, a simple mistake on a tax return won't force you out of your home or land you in jail. You'll most likely just have to pay additional taxes plus penalties and interest. However, if you committed tax fraud or tax evasion, the penalties are more severe.
Common Tax Audit Issues & Penalties
There are several common issues that would lead to an audit subject being found "guilty." There are IRS audit penalties for each of these offenses in addition to the taxes owed. Interest is charged in both the unpaid taxes and the penalty, calculated according to the current IRS interest rate (this changes quarterly).
You Filed Late
Individuals have to file a tax return and pay any taxes owed by April 15 following each tax year. Corporations with their own tax year must file and pay by the 15th day of the fourth month following the end of the company’s tax year.
If you fail to file a tax return by the due date, the penalty is 5% of the unpaid taxes for each month or part of a month that the tax return is late. This penalty is capped at 25% of the value of your unpaid taxes for that tax year.
If your tax return is over 60 days late, you will pay a minimum penalty of $435 or 100% of the tax due, whichever is less. Remember that you can request an extension to file your tax return, but you still need to pay by April 15.
You Paid Late
The penalty for paying your taxes late is 0.5% of the tax owed after the due date, for each month or part of a month the tax remains unpaid, up to a maximum value of 25% of the taxes owed.
If a failure to file and failure to pay penalty are applied to the same month, the failure to pay penalty will be deducted from the failure to file penalty for a maximum penalty of 5% of your unpaid taxes each month or part of a month that you don’t file or pay.
You Failed to Report all of Your Income or Claimed Erroneous Deductions or Credits
The tax penalties for underreporting your income or claiming deductions and credits for which you don't qualify are the same. In both cases, the penalty is 20% of the portion of the underpayment of tax.
Underreporting income includes:
Failing to report all sources of income, including wages, freelance and hobby income, interest, dividends, distributions, income from the sale of a capital asset, alimony, prizes and awards, cryptocurrency income, social security payments, retirement savings distributions, and foreign income.
Reporting less income than you actually received. According to IRS definitions, "substantial underreporting of income" means more than 10% or $5,000 of your actual income—whichever is larger.
Insufficiently reporting transactions that involve tax shelters and tax avoidance shelters.
Claiming erroneous deductions and credits includes:
Overstating the value of donated property
Undervaluing the value of a depreciating property
Claiming a personal expense as a business expense
Claiming a credit for which you don't qualify
Claiming the same dependent who was claimed by someone else for the Earned Income Tax Credit
If you gave a gift or estate and understated its value (to pay less tax) or significantly overstated your pension liabilities, you will also incur penalties.
You Failed to Report Foreign Assets and Bank Accounts
United States citizens are obligated to declare foreign assets with a value of $50,000 or more and foreign bank accounts that held at least $10,000 at any one time during the previous tax year. Accidentally failing to report an eligible foreign bank account has a maximum penalty of $10,000 per violation.
You Didn't Pay Enough in Estimated Taxes
Self-employed people (including freelancers), partnerships, and companies need to pay estimated taxes quarterly. If you didn't pay the right amount of estimated tax or didn't pay in full by the due date, you may also be liable for penalties. If there was a reason that your estimated tax dropped suddenly—for example, you lost your job or your income dropped after a hurricane hit your business in Jacksonville, Florida—you can usually present evidence of the situation to have any underpayment penalties waived.
Civil Penalty vs Civil Fraud Penalty
In IRS audits, a distinction is made between civil penalties and civil fraud penalties. You may have to pay civil penalties for issues like a miscalculation on your tax return or filing your tax return late. You would pay civil fraud penalties for intentionally misstating the value of a property or significantly understating your income. These penalties can be up to 75% of the amount that you underpaid due to fraud.
Paying Civil Penalties and Interest
If you are subjected to a tax audit and found to owe additional taxes (for any of the reasons stated above) and you agree with the IRS agent's assessment, you usually have 21 days to pay taxes you owe to avoid additional penalties.
In the case that you can't afford to pay the total amount of unpaid tax (plus penalties and interest) up-front, you can make a payment plan to pay the outstanding amount.
In some cases, you might also be able to apply for a penalty abatement or offer in compromise to reduce the total amount owed. An enrolled agent can represent you and apply for these kinds of arrangements on your behalf.
If you don’t make arrangements for the payment of any money you owe, the IRS is legally allowed to seize your property, vehicle, and bank accounts, or garnish your wages to ensure that they get the money they’re owed.
Appealing the Result of an Audit
If you receive your audit results and don't agree with the auditor's assessment, you can ask for mediation or appeal the assessment in the IRS Office of Appeals. Some taxpayers have reduced their tax liabilities significantly by appealing the assessment, so it's definitely worth considering if the amount of outstanding tax is high.
Tax Situations that Could Lead to Criminal Prosecution
So far, we've covered the best-case scenario: You are found to owe additional taxes or an IRS audit penalty and make a plan to pay the IRS. However, in some cases, a tax audit may uncover details that result in criminal charges. In this case, the Department of Justice would take you to trial, and you would generally hire a tax attorney to represent you in court.
Criminal Charges as Specified by the Tax Code
According to the tax code (formally the Internal Revenue Code) there is a long list of tax crimes that can land a taxpayer in jail. All of these crimes involve breaking IRS rules intentionally, not simply making a mistake on your tax return.
Failing to file. If you don't file tax returns, keep tax records, or pay taxes and you have criminal charges made against you, you could be incarcerated for up to one year per unfiled tax return and be fined $25,000 for each year that you didn't file.
Tax fraud. If you file a false tax return (one that was completed with made-up or misstated numbers), you could receive up to three years of jail time and fines of up to $100,000.
Tax evasion. If you file a tax return but misstate your income and assets so that you don't pay taxes, you could receive up to five years of jail time and a fine of up to $250,000 or $500,000 for corporations.
Other criminal offenses include (but are not limited to):
Aiding and abetting
Making false statements
Making false, fictitious, or fraudulent claims
Making fraudulent documents
Fictitious obligations
Failing to supply information
Attempting to interfere with the administration of internal revenue laws
Participating in a conspiracy to defraud the United States
Identity theft
The Statute of Limitations on Tax Penalties
The Statute of Limitations for tax fraud and tax evasion is six years, which is why you should keep personal and business tax returns—along with receipts and other supporting documentation—for at least six years. However, there is no statute of limitations on penalties and interest. They continue to add up until you pay any taxes, penalties, and interest owed in full.
Don't Handle an IRS Audit Alone
The best way to avoid being found guilty in an IRS audit is to find out your industry-specific tax obligations, keep accurate bookkeeping records, fill out your tax returns correctly, and submit each return and any taxes owed before the due date. If you need help, a small business accountant can help you calculate your estimated tax payments and assist you to file an accurate tax return.
If you've made a mistake or stretched the truth (and hoped no one would notice), tax professionals are there to help you make a workable arrangement with the IRS and help you get your finances back in order. In most cases, paying for IRS tax audit help leads to a more favorable outcome.
Whatever happens, know that being proactive in catching up on unfiled tax returns, amending incorrect tax returns, or coming to a workable payment arrangement with the IRS for tax owed will always work out far better than ignoring an audit assessment notice (and hoping that your problems will go away). If you ignore an audit notice or an audit assessment notice that says you owe money, you'll have no right to appeal and will always pay the maximum amount.
