Understanding IRS Tax Audit Penalties: Consequences and Solutions

  • Home
  • Audit
  • Understanding IRS Tax Audit Penalties: Consequences and Solutions

Enacted into law in August 2022, the Inflation Reduction Act contains multiple provisions that purport to help working-class Americans. For instance, this law, signed by President Joe Biden, includes many items: deliver lower costs for prescription drugs, make health insurance more affordable, invest in energy production domestically, and help grow the clean energy sector. 

As is usual for many laws passed by Congress and signed into law, the Act also sets aside funds for additional initiatives that may not always seem to go together under one law: it included money to help the IRS do its job better. For instance, within the Act are additional resources for the Service to help in its ongoing efforts to increase tax collections. Of note are monies that dovetail with the agency’s “strategic operating plan” which includes a pledge to significantly increase the number of tax audits conducted for high-income individuals, large partnerships, and large corporations.

Specifically, the IRS intends to increase audits in the following areas:

  • The number of taxpayer audits for individuals who have income over $10 million is expected to rise from 11% in 2019 to 16.5% by the year 2026. 
  • Companies with assets of more than $250 million will see an increase in audits from 8.8% in 2019 to 22.6% in 2026 – nearly triple the amount.
  • Finally, partnerships that have assets over $10 million will see an increase tenfold. (Granted, the percentage rate began at a low base of 0.1% in 2019, rising to 1% in 2026.)
 

So why mention these statistics in regard to audits? What does this mean to our readers? First and foremost, we want to point out that the government does indeed intend to shift resources in its tax collection efforts. Secondly, we want to share information on how to better understand and navigate the IRS tax audit process and any of its potential penalties.  

Intricacies of the U.S. tax system can be challenging enough, let alone having to deal with an IRS audit that will add another layer of complexity. For many, just the idea of a tax audit can evoke stress and feelings of uncertainty. But, by understanding the process and solutions available, approaching an IRS tax audit with confidence is possible.

What is an IRS Tax Audit, and Why Do They Happen?

Let’s first discuss what a tax audit is and why it occurs. An audit is a review of a filed tax return to verify its accuracy and to ensure its compliance with applicable tax laws. While these often sound intimidating, tax audits are actually a routine part of the government’s efforts to enforce and maintain the integrity of the tax system.

As the IRS has limited resources (both in terms of staff and money), it uses sophisticated computer systems to review and flag returns for potential discrepancies. At times, a human auditor may get involved in the return review process and check any anomalies that are detected. That said (and contrary to common belief), the likelihood of individuals being audited is still quite low. Only 0.4% or 4 out of every 1,000 individual tax returns are audited annually. So, while the risk is there, it is minimal.

So why does the Internal Revenue Service audit tax returns? There are several reasons they can be triggered:

  1. Statistical Formulas: The IRS uses a variety of computer algorithms to help flag tax returns that significantly deviate from the norm.
  2. Related Taxpayer Audits: A return may be chosen for audit if it is connected to another audited taxpayer.
  3. Random Selection: And if luck has it, the Service will, at times, randomly select a tax return for review—purely by chance.
 

And what if you receive an IRS tax audit notice? While it can be intimidating, start with these basic steps. First, review the audit notice carefully. It’s important to fully understand what the IRS is questioning and what additional information they are requesting from you. Next, gather the necessary documentation, meaning you must collect all records you have that are related to the audit’s focus. At times, it may be wise to consider contacting a tax professional who can guide you through the entire process. Not only that, but they can also potentially negotiate with the Service on your behalf. (We’ll explore this in a bit more detail later in this article.)

IRS Tax Audit Penalties

As the theme of this blog suggests, penalties applied by the IRS for failing to meet tax requirements or accurately report income, deductions, or credits can result in severe financial consequences. These penalties are not only designed to recover owed taxes but are also used to deter future non-compliance.

 These include:

  1. Accuracy-Related Penalties: 20% Penalty on Underpayments. If a taxpayer significantly underreports their income or claims deductions they aren’t entitled to, they may face a penalty equal to 20% of the unpaid tax. 
  2. Substantial Understatement Penalty: This penalty applies if a taxpayer underreports their tax due that exceeds 10% of the correct amount of their liability, or $5,000—whichever is greater.
  3. Failure-to-File Penalty: 5% Per Month. If a taxpayer fails to file their tax return by the deadline, the IRS imposes a penalty of 5% of the unpaid tax per month, up to a maximum of 25%.
  4. Failure-to-Pay Penalty: 0.5% Per Month. For unpaid taxes, the penalty to a taxpayer is 0.5% per month, with a maximum of up to 25%. Interest will also continue to accrue on the unpaid tax as well as the penalties.
  5. Negligence Penalty: If a taxpayer’s actions are deemed negligent or careless—for example, failing to include all income on their return—they could potentially face additional penalties or fines.
  6. Fraud Penalty: This is the most severe penalty imposed by the IRS. If the IRS determines fraud, they may subject a taxpayer to a 75% penalty on the underpayments. This applies to the portion of underpaid tax attributable to fraud. As fraud is considered so severe, it can even include criminal investigation and, in extreme cases, lead to criminal charges, heavy fines, and even imprisonment.
  7. Late Payment Interest. While such interest might not be considered a “penalty,” if typical penalties do not apply, the IRS will charge interest on unpaid taxes starting from the original filing deadline. The interest rate is determined quarterly and compounds daily. Yes, that can be harsh and add up quickly.
 

Getting Help with an IRS Tax Audit

While facing an IRS tax audit can be daunting, taxpayers do not have to deal with it alone. Seeking the assistance of a tax professional such as a tax attorney or tax accountant with relevant expertise can make a significant difference in how well they can navigate the audit process. Such experts can direct taxpayers at each step of the way to ensure a better understanding of the rights and obligations due to the taxpayer.

When choosing a tax professional or tax advisor, it’s smart to enlist someone with extensive experience in handling IRS audits and/or tax disputes. They should be well-versed in tax laws and regulations (and know all the current updates to the law) as well as the intricacies of the audit process itself. Additionally, it’s vital to look for someone who is responsive and communicative. Being left in the lurch with someone who isn’t available at such a critical moment can be more than unpleasant; it is also avoidable.

Working with a tax professional or tax expert offers benefits worth noting:

  • Expert Knowledge: These experts will possess in-depth knowledge of current tax laws and regulations; these are crucial in understanding the nuances of a particular case.
  • Experience: Their experience in handling IRS audits and tax disputes means they know what to expect and how to address potential issues. They know how to talk to IRS officials to make sure the process is workable.
  • Document Preparation: They assist in gathering and organizing the necessary documents, ensuring the taxpayer is well-prepared for the audit.
  • Representation: They can represent the audited during the process; this can provide a buffer between them and the IRS, not something to be overlooked in such a stressful situation.
  • Negotiation Skills: They can negotiate with the IRS on a taxpayer’s behalf. This means potentially reducing tax liability or penalties.

By enlisting the help of a qualified tax professional or tax attorney, those audited can approach an IRS audit with confidence and can achieve a higher likelihood of a favorable outcome.

Final Thoughts on the IRS Tax Audit

IRS tax audits are indeed intimidating. However, they are not insurmountable. Understanding potential penalties and their financial impact helps taxpayers prepare and avoid mistakes. Whether you’re navigating an audit or disputing penalties, working with a tax professional can help you approach this delicate situation strategically.

"*" indicates required fields

Name*
Email*
Please let us know services you are interested in. Have a question for us? Ask away.
This field is for validation purposes and should be left unchanged.

Request Free Audit Consultation Now

"*" indicates required fields

This field is for validation purposes and should be left unchanged.

"*" indicates required fields

This field is for validation purposes and should be left unchanged.

"*" indicates required fields

This field is for validation purposes and should be left unchanged.

"*" indicates required fields

This field is for validation purposes and should be left unchanged.

"*" indicates required fields

This field is for validation purposes and should be left unchanged.