6 Tax Penalties You Can Easily Avoid

This article is a reprint of Wise Bread's contribution to OPEN Forum from American Express -- where small business owners can get advice from experts and share tips with each other.

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Would you toss a wad of cash into the wind and watch it fly away? Probably not. So why would you incur tax penalties that cost you money and aren’t even tax deductible? You shouldn’t. Avoid these five tax penalties and you won't be caught watching your hard-earned money flutter away.

Late Filing Penalty

There are fixed deadlines for filing various tax returns and penalties for missing these deadlines. For example, if you fail to file your personal income tax return on time (this year it’s April 18, 2011), you are subject to a late filing penalty. The penalty is 5% of the tax due for each month you’re late, up to a maximum of 25%. If the return is more than 60 days late, the minimum penalty is the lesser of $135 or 100% of the tax due. For partnerships and S corporations, the late filing penalty is $195 for each month or part of a month the return is late, multiplied by the total number of owners during any part of the year, up to a maximum of 12 months.

How to avoid the penalty: If, for any reason, you cannot file on time, request a filing extension by the return’s due date. For individuals and partnerships (including most limited liability companies), the filing deadline for the 2010 return is April 18, 2011.

• Individuals (including sole proprietors and one-person limited liability companies) can request a six-month extension (to October 17, 2011) on Form 4868.
• Partnerships can request a five-month extension (to September 15, 2011) on Form 7004.

The filing deadline for corporations (both C and S) is March 15, 2011. Corporations can request a six-month extension (to September 15, 2011) on Form 7004.

Late Payment Penalties

Federal income tax is due on the return’s original due date, regardless of any filing extensions. The late payment penalty is 0.5% of the tax due; the maximum penalty is 25%. In addition, there are interest charges for late payments.

How to avoid the penalty. Pay the tax on time, even if this means requesting an installment payment agreement on Form 9465 or by charging the outstanding amount to a major credit card (find authorized credit card processors).

If you fail to pay on time, you can still avoid the penalty by showing reasonable cause for the lateness. Reasonable cause includes having paid (through withholding, estimated taxes, and additional payments) at least 90% of the taxes due.

Estimated Tax Penalties

If you are self-employed, you probably need to pay estimated taxes to cover your payments for the year. Payments are due four times each year; you cannot wait until you file your return to make a single payment. If you fail to pay minimum amounts, you are subject to underpayment penalties. Essentially, this is an interest charge that is adjusted each quarter. The rate for the second quarter of 2011 is 4%.

How to avoid the penalty. Figure estimated taxes based on one of two safe harbors by paying the following amount over the four installments:

• At least 90% of the taxes due for the current year.
• At least 100% of the taxes shown on the return for the prior year (110% if your adjusted gross income in the prior year was more than $150,000 or more, or more than $75,000 if married filing separately in the current year).

Note: Different percentages apply to farmers and fishermen. Consult a tax professional.

Late Employment Tax Deposits

If you have employees in your business, you have certain payroll tax responsibilities. This includes withholding income taxes and the employee share of FICA (Social Security and Medicare taxes) from their paychecks as well as paying the employer share of FICA and the FUTA (federal unemployment tax). If you fail to deposit these taxes with the government on time, or if you deposit less than the full amount owed, you are subject to a penalty ranging from 2% to 15%; the quicker you make the late deposit, the lower the penalty rate will be.

How to avoid the penalty. Make deposits using EFTPS.gov, which is a free electronic payment system. You can schedule your payments in advance so that they are automatically transferred from your bank to the U.S. Treasury on the due date.

Note: Very small employers – those permitted to file Form 944 because their annual payroll taxes do not exceed $2,500 – can pay the taxes with their annual return.

Late Sales Tax Deposits

If your state levies sales taxes, you must collect them and pay them in a timely manner. Each state has its own rules regarding payments and penalties. Even though you do not actually pay the sales tax – your customers do – you must transfer the funds to your state or face penalties.

How to avoid the penalty. Learn about your sales tax obligations from your state.

Late Information Returns

In the course of your business, you are required to provide various information returns, such as 1099s, to the IRS and to service providers and others. If you fail to do so and do not have reasonable cause for the failure, you are subject to a penalty. The longer you fail to file or submit full information, the greater the penalty (explained in instructions for certain information returns).

How to avoid the penalty. Learn which forms you are required to file. If you discover that you failed to submit a form on time, correct your mistake as quickly as possible to minimize penalties.

Bottom line

Work with a knowledgeable tax professional who can help you meet your filing obligations and avoid penalties. Money spent avoiding these and other tax penalties is definitely not money thrown into the wind.