IRS Waives 5% Monthly Penalty for Late Returns

Fearing that record numbers of Americans will drop out of the tax system because they can’t pay their taxes, the Internal Revenue Service said Wednesday that it has drastically reduced penalties for those who ask to file returns late and delay sending in tax payments.

The change, which takes effect immediately, will allow roughly 5 million Americans to avoid 5% per month “non-filing” fees, the IRS said. Those fees have traditionally been assessed on taxpayers who did not send payment for estimated taxes due when they asked for more time to file returns.

Even though this new rule is going into effect in the last week of the filing season, tax preparers said Wednesday that it still will have a significant impact. A taxpayer owing $1,000 in tax could save about $250 in penalties, experts said. The penalty reduction also could prompt many taxpayers, who would have borrowed to pay their taxes on time, to opt instead to delay payment--in effect making the IRS their lender.

More people than ever are filing their returns late this year, often because they won’t get a refund and can’t pay taxes due, preparers say. The problem is the result of the sluggish economy, high joblessness--which put millions of individuals on unemployment insurance--and withholding changes put into effect last year, the IRS acknowledged.

Those withholding changes, implemented under the George Bush Administration, caused the government to take out between $172 and $345 less per year from workers’ paychecks. That meant Americans had more money to spend during the year, but more will owe tax payments now.

Additionally, unemployment insurance causes tax problems because the government does not withhold income tax from the benefit payments. The payments are, nonetheless, taxable. So millions of Americans who found themselves reliant on jobless benefits for several months may now find themselves with substantial tax bills.

“The way the economy has been, we’re finding that a lot of our clients owe money and are not in a position to pay,” said Marvin Weisbrod, vice president of technical services at Triple-Check Income Tax Service in Burbank.

In one Triple-Check office, about one out of every three taxpayers had received unemployment payments during the year, Weisbrod added. Several owed hundreds of dollars in taxes. Yet, because unemployment payments often amount to only a fraction of what they earned when working, these individuals have been strapped for cash all year and can’t raise enough money before next week when taxes are due, he said.

The IRS still recommends that taxpayers send in as much as they can, said Wilson Fadely, an IRS spokesman in Washington. Some penalties will still be assessed on late payers, but the biggest penalty--the non-filing fee--will be waived for those who file valid extension requests.

Notably, this change is coming hard on the heels of another new rule change that allows taxpayers filing on time to request “installment agreements” as they file their return. These agreements allow taxpayers to pay over time instead of in one lump sum.

Those who owe less than $10,000, and are willing to pay in less than three years, are likely to get installment arrangements approved with little fuss, says Ruth Lancaster, manager of tax training at H&R; Block in Kansas City.

Both changes are designed to deter cash-strapped Americans from dropping out of the tax system, said Fadely.

“When taxpayers skip the due date because they don’t have the money to pay, they tend to drop out of the system,” Fadely said. “This is part of an integrated approach to the failure-to-file situation.”

This new effort is designed to stop people from failing to file that first return, he added.

The IRS said those who file one-page extension requests on Form 4868, giving them until Aug. 15 to file a return, will still owe some penalties if they did not pay at least 90% of the tax owed through withholding or estimated payments during the year.

In the past, taxpayers would face three penalties if they didn’t pay estimated tax owed at the time of filing for an extension.

One penalty is for interest on the tax due, which currently accrues at 7% annually. The second--a “failure to pay” penalty--amounts to 0.5% of the tax owed for every month the payment is late. And the third--the “failure to file” penalty--amounts to 5% per month. The IRS could assess that penalty because an obscure clause in the tax code says that extension requests are not valid unless they are accompanied by a check for the tax owed.

Under the new rule, those who file extensions and don’t send payment will only face the first two penalties. The savings can be huge for those who owe, says Gregg Ritchie, partner at the Los Angeles office of the accounting firm of KPMG Peat Marwick.

For example, someone who owes $1,000 and can’t pay until September would incur a total penalty of $60--$25 in late-payment fees and $35 in interest. That’s opposed to $305 under previous rules, Ritchie said.

Indeed, the penalties are now so reasonable that many taxpayers may opt to delay payment--in effect letting the IRS finance their tax bill at an interest rate less than those charged for personal loans at banks.

“I have a lot of clients that are using the IRS as their lender for short-term financing,” Ritchie said. “What they’re charging is less than what you would get if you went into the marketplace and looked for personal loan right now.”