Penalties and Payment Options When You Fail an IRS Tax Audit
If you get audited by the Internal Revenue Service (IRS), you’ll be asked to back up the information reported on your tax return. If you can’t support the claims and information on your tax return, then the auditor can disregard some of the information on your return, leading to a tax bill and audit penalties.
One of the few things that feel worse than going through an audit is failing an audit and finding out you owe money to the IRS. Not only can this failure be stressful, but it can also be financially devastating.
Additionally, if the auditor believes you filed a false return in a wilful attempt to evade taxes, you could even face criminal charges. That is rare for most people, but if you deliberately understated your income or claimed deductions falsely, you should be aware of the potential.
Read on to learn more about what could happen after failing an audit, as well as what you can do to minimize the financial damage.
Key Takeaways
- Failing an audit – When an auditor makes changes to your tax return, it leads to a tax liability.
- Accuracy penalty – 20% of the unreported tax, applies if you substantially understated your income or the value of an asset on the return.
- Misvaluation penalty – 40% of the tax unreported due to misvaluing an asset by 200% or more.
- Loss of credits – May lose tax credits for several years or permanently if you claim them fraudulently.
- Late filing penalties – Up to 25% of the unreported tax.
- Late payment penalties – Up to 25% of the unreported tax that was paid late.
- Interest – Applied to the unreported tax and backdated to the due date.
- Fraud penalties – 75% of tax not reported due to civil fraud.
- Criminal charges- Tax fraud charges if you filed a fraudulent return.
- Appeal – Request a managerial review or audit appeal if you disagree with the results.
- Paying taxes due to failing audit – You may be able to set up monthly payments or settle for less than owed.
What Happens if You Fail an Audit?
Failing an audit means that the IRS auditor concludes that you were unable to substantiate one or more claims on your tax return. As a result, the auditor makes changes to your tax return. That can include reducing deductions, adding income, or taking away credits. This often leads to bigger tax liability, audit penalties, and interest. In limited cases, an auditor can make changes that decrease your tax liability.
What Are Common Reasons for IRS Audit Penalties and Fees?
The IRS will usually impose a penalty and interest (in addition to any increase in your underlying tax liability) following an audit if they find that you:
- Underreported your income.
- Improperly took one or more deductions.
- Improperly claimed one or more tax credits.
- Made one or more accuracy-related mistakes on your tax return.
- Committed civil tax fraud.
- Made a substantial error in the valuation of assets reported on your tax return.
The content below provides more details on these penalties and what you could be facing if the IRS imposes them on you.
Audit Penalties
Businesses can face a range of penalties, although individuals are most likely to face accuracy-related penalties. Both individual and business taxpayers could face:
- Accuracy-related penalty: 20% of the understated tax if you were negligent about following the tax code or if you substantially understated your income by the greater of $5,000 or 10%.
- Substantial valuation misstatement penalty: 20% of the underreported tax if there’s a substantial misstatement of value by 150% or more. This may apply if you overinflate the value of a personal asset that you convert to a business asset. This penalty can rise to 40% if there’s a gross valuation misstatement, which occurs if the misstatement is by 200% or more.
- Substantial overstatement of pension liabilities penalty: 20% penalty for companies that overstate pension liabilities by 200% or more and a 40% penalty if companies overstate pension liability by 400% or more. There’s no penalty if the misstatement reduces your tax liability by less than $1,000.
Future Loss of Credits
If you claimed a credit you weren’t allowed to claim, the auditor could assess a 20% penalty. Additionally, the IRS might ban you from claiming the credits in the future. If the IRS auditor believes you were negligent when claiming the tax credit, such as the Earned Income Tax Credit (EITC), then you could be banned from claiming it again for two years.
However, if you’re suspected of fraudulently claiming the tax credit, then you could be permanently banned from claiming it for 10 years. This potential ban applies to the EITC and other tax credits, like the American Opportunity Tax Credit, the Child Tax Credit, and the Credit for Other Dependents.
Late Payment or Late Filing Penalties
These penalties can arise during an audit if the auditor realizes you paid your taxes or filed late. The failure-to-file penalty is 5% of the tax due, and it applies monthly from the later of the due date or the filing date. This penalty will continue to increase until you pay the tax (this penalty won’t exceed 25%). The failure-to-pay penalty is 0.5% of the unpaid tax per month, but it can increase to 1%. The failure-to-pay penalty also won’t exceed 25%.
Fraud Penalties
In civil tax fraud cases, the auditor can assess a penalty of 75% of the underreported tax. Imagine the auditor changing your tax return to increase your tax bill by $10,000, and the auditor believes that you committed civil tax fraud while filing your original return. In this case, the penalty would be $7,500.
Interest
If the audit results in you having a bigger tax bill and penalties, it’s likely you’ll have to pay interest. Any interest gets back-dated to the tax return due date. For instance, say that the IRS audits a tax return that was due and filed on April 15, 2024, and then they discovered that you owe an additional $20,000 in taxes. The interest will begin to accrue on April 15, 2024, not the day you fail the audit. This interest will continue to accrue until you pay the tax liability in full.
Interest will also accrue on the penalties that are assessed on your account. Although the IRS rarely removes interest on the underlying tax liability, the interest associated with those penalties will often be removed if you get the penalties removed.
Additional Scrutiny on Past Returns
As if the penalties, interest, and potential ban on claiming future tax credits weren’t bad enough, another consequence of failing an audit could mean the IRS takes another look at your past tax returns. If the auditor only found small mistakes in the recently completed audit, they will likely assess a tax liability and move on. However, if they found significant errors in your returns, they may decide to audit tax returns from past periods.
Generally speaking, the IRS has three years to audit a tax return. However, there’s no time limit for reviewing old returns if the IRS believes fraud was involved.
What to Do if You Fail an Audit
If you fail an audit, there are several things you can do depending on how you failed the audit, whether you agree with the results, and your financial situation. Some of these options include:
- Closely review the audit determination letter to ensure you understand why you failed the audit.
- Paying the tax bill if you agree with the IRS’ conclusions following the audit. You can pay the balance in full immediately or over time.
- Get in touch with a tax attorney if you disagree with the IRS. A tax lawyer can help explain what happens next, such as filing an appeal. Because of the deadlines that apply to appeals, you’ll want to contact an attorney as soon as you can.
- Asking the IRS for penalty abatement. The IRS may waive penalties if it’s your first offense or you had reasonable cause.
What if You Disagree With the Audit Results
As mentioned previously, you have the right to challenge the IRS’ conclusions following an audit. Here are your more likely options.
Managerial Review
Asking for the auditor’s manager to review your case is usually the first step in challenging the auditor’s findings. This is an informal process that gives you the chance to explain your side of the story to the auditor’s supervisor. If the manager wants to uphold the auditor’s original decision, they may be able to explain the IRS’ reasoning better than the auditor can. This explanation can be useful if you plan to challenge the IRS further, as more detailed information about the IRS’ decisions helps you craft better counterarguments.
Alternative Dispute Resolution
Sometimes known as mediation, alternative dispute resolution (ADR) involves meeting with the auditor and an impartial third party. This third party can then facilitate an agreement between you and the auditor. ADRs are confidential and completely voluntary. One thing to keep in mind about ADR, such as mediation, is that you can request it before the audit is completed.
Appeals
Once you receive the official audit determination, you can file an appeal with the IRS. The exact appeals process will be outlined in the notice you receive following your audit. The most important thing to remember is that the appeals process has strict deadlines. You may lose your chance to appeal if you don’t meet the deadlines.
If you miss the appeals deadline, you can contest the liability by filing a petition with the U.S. Tax Court.
How to Pay Taxes Due to Failing an Audit
An unexpected tax bill likely means figuring out how to pay for it. Luckily, the IRS has several different payment options for taxpayers who cannot afford to pay their tax liabilities in full immediately. Here are some of these payment possibilities:
- Offer in compromise: Prove that you can only pay a portion of the tax debt and settle for less than you owe. If you have assets, you may need to sell them.
- Currently not collectible: Establish that you truly can’t afford to pay the tax liability, and the IRS will mark your account as uncollectible and stop collection actions. If your situation improves, you will need to pay.
- Payment plans: Make monthly payments on your tax debt. The minimum payment is $25, and you must pay each month on time and not accrue any new tax liabilities.
There are also options like a partial payment installment agreement (PPIA), which is a hybrid between a settlement and a payment plan. One of the best things about a PPIA is that if the payment period ends and you still haven’t fully paid off what you owe, the IRS will forgive this remaining balance.
What if My Spouse Caused Me to Fail an Audit?
Most likely, you’re on the hook for the tax bill, even if it was your spouse’s mistake or wrongful conduct that led to the audit and additional tax liability, penalties, and interest. This is because when you sign and file a joint tax return with your spouse, you take on joint liabilities for any tax debt. That means that you’re responsible for the full bill, whether it’s related to your income or your spouse’s.
However, you may be able to get around this rule in certain situations. The IRS offers innocent spouse relief for people facing a tax liability due to their spouse’s actions. There are a few different programs under the innocent spouse umbrella, but generally, you must prove that you didn’t know about the understatement of tax and had no reason to know about it. If you know about the tax, innocent spouse relief may still be possible, but only if you can show that you were coerced or forced into signing the tax return.
Tax Preparer Mistakes Uncovered During an Audit
What if the auditor finds mistakes that were due to your tax preparer? This can be especially frustrating as you paid someone to do your taxes to avoid any mistakes with your taxes. That being said, you’re ultimately responsible for the information on your tax return.
When your tax preparer files your return, they should give you a copy to review. Admittedly, this is easier said than done, as if you could easily understand what’s on the return, you would probably have prepared and filed it yourself.
In most cases, you can’t get the penalties removed by arguing that it was your tax preparer’s fault. Tax preparer mistakes are not considered to be reasonable cause, which is one of the main strategies people use to get IRS penalties waived.
This doesn’t mean there’s nothing you can do. One possibility is to sue your tax preparer for malpractice. This isn’t the easiest or most practical option unless there’s a significant amount of money at stake. Luckily, there’s one more thing you can try. It involves going to your tax preparer and telling them what happened. If your tax preparer is reputable, they may be willing to pay any penalties and interest that directly result from their mistake.
Can the IRS Arrest You for Tax Issues Arising from Your Audit?
It’s unlikely. Criminal prosecution following a tax audit is only a possibility if the auditor discovers criminal tax fraud (tax evasion). In this situation, jail time and hefty fines are possible. The IRS’ Criminal Investigation Division has arrest powers. However, if the IRS suspects you of criminal tax violations, they will likely refer your case to the U.S. Department of Justice for prosecution.
In most cases, auditors only assess civil fraud penalties. As stated above, civil penalties are usually 75% of the underpaid tax.
What Happens if the Audit Results in Your Being Found Guilty of Tax Evasion?
Criminal tax fraud or evasion charges can be up to $100,000 for individuals and up to $500,000 for corporations. You can also face up to five years in prison. As bad as this sounds, you can’t be found criminally liable for tax fraud unless you acted intentionally. In other words, you had to know that what you were doing was illegal in order to get charged with tax evasion. So, if you made an honest or careless mistake, you aren’t criminally liable for your tax error. However, you can still face steep civil penalties for those errors.
What Happens if You Ignore the Audit Request?
Nothing good. If you ignore the audit, the IRS will conduct the audit without you. This means they’ll conclude their suspicions about the information on your return subject to the audit are correct and make the necessary adjustments against you. For instance, if they believed you improperly claimed a deduction and asked you for proof to support that deduction, the IRS will assume that ignoring the audit means you can’t provide this required proof, take away this deduction, and adjust your tax liability accordingly.
Not only could this lead to a bigger tax bill, penalties, and interest, but if you later discover that the IRS made a mistake during the audit, you could lose your right to appeal the IRS’ decision. You’ll also have to deal with the IRS’ attempts to collect the tax debt. This means facing tax liens and levies, such as garnished wages. So, as tempting as it might be to tell the IRS to go pound sand when you learn you’re subject to an audit, you shouldn’t ignore the audit. If you’re unsure what the best way to respond is, consult a tax professional who can help you navigate this complicated and uncertain situation.
Get Audit Help Now
Whether your audit has started or you just finished with one, the tax attorneys at Wiggam Law can help. They have extensive experience helping clients navigate audits including IRS and Georgia tax audits, appeal audit results, and apply for penalty relief. We can also help with innocent spouse relief, fraud charges, and any other issues that come up during an audit.
Schedule a consultation with our team or call us at (404) 233-9800.