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Penalties for Underpayment of Taxes

If you make a mistake on your taxes or willfully provide inaccurate information that causes an underpayment of taxes you owe, the Internal Revenue Service (IRS) will notice. According to Market Watch, the IRS runs each return through a "discriminant function" system which uses data from similar returns and various mathematical formulas to determine if the information you provide is in line with the average return. If not, the IRS may decide you owe more taxes and will send a notice to that effect. The IRS also assigns penalties for underpayment that are determined by the circumstances of the underpayment.


The IRS will levy interest on underpaid taxes. Interest accrues retroactively from the day the IRS determines the taxes were due. As of July 2010, the IRS was charging 4 percent interest. The rate is based on the federal short-term rate and changes every three months, according to the IRS. Interest compounds daily, which means you will have to pay interest on the taxes as well as the previous day's interest. Your balance will continue to accrue interest until you pay the taxes, which can substantially increase the amount you owe if you do not pay quickly. You may be able to avoid paying interest on tax debts under $100,000 if you pay the underpaid portion within 21 days of the IRS notification of underpayment, according to Investopedia.


The IRS imposes a variety of fines depending on the circumstances of the underpayment. For simple miscalculations or accidental omissions---the IRS uses the term "negligence"---there is a fine of 5 percent of the unpaid tax. For more serious cases of underpayment involving extreme negligence, incorrect property values or large understatements of income, assets or gifts, the fine is 20 percent of the unpaid taxes. If the IRS determines that the understatement is gross, or excessive, the fine can increase to 40 percent of the unpaid tax. The cases of underpayment that involve fraud are the most serious and carry the highest fines: 75 percent of the unpaid tax.


If the underpayment was extreme and intentional, you may face time in federal prison. A conviction for filing a false tax return can result in up to three years in prison. Tax evasion can lead to up to five years in prison. Each conviction can also carry up to $100,000 in criminal fines in addition to the fines and interest on the unpaid taxes. The criminal fines can increase to $500,000 for corporations.

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