Common IRS Penalties for Small Businesses and How to Avoid Them
Small business owners know there’s nothing like a letter from the IRS to ruin your day. As tax professionals who work with small business owners every day, we often meet entrepreneurs who could have avoided costly penalties if they'd known what to watch out for. Here's a guide to the most common IRS penalties and, more importantly, how to keep your business penalty-free.
1. Failure to file penalty
What is it: Missing your tax return deadline will cost you. The IRS charges 5% of your unpaid taxes for each month your return is late (up to 25%). If you're more than 60 days late, you'll pay at least $435 or 100% of the unpaid tax, whichever is smaller.
How it happens: This one's simple - the IRS automatically flags your account when they don't receive your return by the deadline.
How to avoid it:
Need more time? File for an extension — but remember, an extensions only gives you more time to file, not to pay.
Even if you can't pay, always file on time.
Work with a tax professional to stay organized and on top of your filing deadlines.
2. Failure to pay penalty
What it is: Filed on time but can't pay the full amount? The IRS charges 0.5% of your unpaid taxes each month (up to 25%) until you pay. Plus, interest keeps accruing until you pay.
How it happens: The IRS will penalize you when you don't pay the full amount due with your return.
How to avoid it:
Set aside money throughout the year for taxes.
If you can't pay the full amount, pay as much as you can and consider an installment agreement.
3. Accuracy-Related Penalty
What it is: Making significant mistakes on your taxes — like underreporting income or claiming deductions you shouldn't — can cost you an extra 20% on top of the underpaid tax.
How it happens: The IRS typically uncovers these mistakes during an audit.
How to avoid it:
Keep detailed records all year long — your future self will thank you.
Use bookkeeping software or work with a professional bookkeeper to stay on top of your taxes.
4. Payroll tax penalties
What it is: If you have employees, you need to regularly deposit their withheld income tax, Social Security, and Medicare taxes. Miss these deposits or pay late, and you're looking at penalties from 2% to 15% of the unpaid amount.
How it happens: The IRS tracks payroll tax deposits closely, so they quickly notice when they're late or missing.
How to avoid it:
Use a reliable payroll system.
Set up automated electronic payments for payroll taxes.
Know your deposit schedule and stick to it.
5. Estimated Tax Penalty
What it is: I Expecting to owe $1,000 or more in taxes? You'll need to make quarterly estimated tax payments. Skip these, and you'll face a penalty based on how much you underpaid and for how long.
How it happens: If you didn’t notice this throughout the year, the IRS will catch it when you file your annual return. Missing deadlines or underpaying can also trigger a penalty
How to avoid it:
Accurately calculate your estimated taxes using IRS Form 1040-ES.
Adjust your withholding if you also have W-2 income.
Pay your quarterly estimated taxes on time.
Adjust payments throughout the year if your income goes up and down.
How the IRS detects penalties
The IRS has a few says to identify when penalties should be applied:
1. Automated systems that flag late or missing returns and payments
2. Cross-checking information returns (like 1099s) against your tax return
3. Audits, both random and targeted
4. Tips from various sources
What to do if you get hit with a penalty
If you receive a penalty notice, don’t panic. There are steps you can take:
1. First-time penalty relief: If this is your first penalty, you might qualify for the IRS’s First-Time Penalty Abatement program. To be eligible, you must have filed and paid all required taxes in the previous three years.
2. Show reasonable cause: Believe it or not, the IRS understands that stuff happens — natural disasters, serious illness, or bad professional advice might get your penalty waived. Just be ready to prove your case.
3. Check their math: Sometimes, the IRS makes mistakes. Double-check IRS calculations against your records.
4. Offer in compromise: If you can demonstrate financial hardship, you may be able to settle your tax debt for less than the full amount.
5. Installment agreement: If you can't pay all at once, you can set up a payment plan with the IRS to avoid more penalties.
The bottom line? Stay organized and deal with problems as soon as they happen. Set reminders for important tax dates, keep good records, and reach out for help when you need it. Understanding these common pitfalls now can save you serious money — and stress — later.
Need help with your tax situation? That's what we're here for at Archer Lewis. We can help you navigate the tax maze and keep your business penalty-free, so you can focus on what really matters — growing your business. Learn more.