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We’re interviewing Tax Attorney Jeff Fouts in order to uncover the real deal behind IRS rules, procedures and penalties. Today’s audio edition talks about a little known fact that could save you up to 25% in IRS tax penalties. The interview is approximately 7 minutes long and includes a transcript below.

Originally recorded November 2011

MALE SPEAKER: Great. So we’re talking with Jeff Fouts, tax attorney, and we’re talking about IRS penalty abatement or removing tax penalties. Are you there, Jeff?

JEFF FOUTS: Yes, I am.

MALE SPEAKER: So why don’t you start off by just giving us an overview of what this looks like at the IRS.

JEFF FOUTS: Sure. As time has gone on, the IRS has created more and more penalties. Every time there is a new tax legislation that appears, there is an additional penalty added. The stated reason for the imposition of penalties is to help taxpayers understand that their noncompliant behavior is wrong and to emphasize that their compliant behavior is right.

So of course it’s my opinion that tax payers don’t need a penalty to tell them what’s right or wrong, that they have to pay their tax or file their tax return. And supposedly, according to the IRS, the purpose of the penalties is to deter or stop noncompliance by imposing a cost on that activity.

Well, that sounds good on paper, but their real…very real problem is most people don’t even know that the penalties really exist or how much they are or that they’re tied to compliance. They kind of have some nebulous idea, but they don’t understand it, okay? And so what’s the use of hitting someone if your hitting them doesn’t benefit anybody? As a matter of fact, the penalties increase the likelihood of further noncompliance because the tax liability grows to a point where the taxpayer can’t pay it and the IRS can’t collect it. And actually, that was the whole reason for the creation of the Offer in Compromise Program.

Congress saw that the tax liabilities on the books were increasing exponentially and that the IRS wasn’t able to collect it. And so they agreed to allow the taxpayers to have a potential option to settle their taxes for less than they owed. Well, the – you know, the IRS does its job too well. If you’re wanting to give someone pain, well now you’ve given them so much pain because of their non filing or nonpaying, that they potentially will never be able to pay; and now you’ve created so much fear in them that now they don’t want to file the next year and the next year and the next year. Serial noncompliance.

MALE SPEAKER: Right.

JEFF FOUTS: So there are two penalties that most taxpayers will come in contact with:

One is failure to pay their tax on time in full; the second is failure to file your tax return on time in full. The second, is failure to file your tax return on time.  The good news is that if you don’t have a liability on your tax return, then there’s no penalty because the penalty is on the – calculated on the tax itself. So if you don’t owe anything but you don’t file for three years, you’re not going to have a failure-to-file penalty because there’s no tax liability to calculate it on.

MALE SPEAKER: Okay.

JEFF FOUTS: There’s also not going to be a failure-to-pay penalty either. That’s good news.

MALE SPEAKER: Yeah, that is good news. So does that every happen anyway? Does that happen ever?

JEFF FOUTS: Oh, it happens a lot. It happens – well, I shouldn’t say a lot, but it happens on a very regular basis that taxpayers haven’t filed, but they end up not owing anything.

MALE SPEAKER: Right. But in the meantime, they’ve paid the penalty?

JEFF FOUTS: No, there’s no penalty. They just live in fear. Now, they may – we’re getting a little off topic, but let’s just say, for example, the IRS sees on its records that you did not file a return. And so they create a dummy return for you, but they don’t give you credit for an exemptions, deductions, and they file you as if you were single. They don’t give any mortgage interest deduction, charitable deduction or anything like that. And so it will look like you have a tax liability, and there will be interest and penalties on that. But if you – once you file a correct return, that return, if it shows there’s no liability, the tax goes away, and the interest and penalties go away.

MALE SPEAKER: Okay.

JEFF FOUTS: Now, let’s talk about the failure-to-file penalty. As a general rule, even if you don’t have enough money to pay the tax, you should always file the tax return. Why is that? Because the failure-to-file penalty can be up to a 25 percent penalty on the tax, but the – and another issue with it is it accrues so fast. In a moment, you’ll understand what I mean. It’s a 5 percent penalty per month for each month you’re late.

MALE SPEAKER: Okay.

JEFF FOUTS: Up to 25 percent. So after five months, you’ve accrued the whole 25 percent penalty. That’s fast.

MALE SPEAKER: Um-hmm.

JEFF FOUTS: And then interest accrues on the penalty amount as well.

MALE SPEAKER: Okay. And do they have a set rate for that?

JEFF FOUTS: It varies. They set it periodically based upon – I don’t know what it’s based on. It may be the federal funds rate. I don’t remember what it’s set on. I don’t remember. But they change it…I don’t remember if it’s monthly or quarterly. But now it’s actually pretty low.

Now, contrast that with – contrast that. A failure-to-file penalty is 5 percent penalty per month up to – but over five months, it accrues up to a maximum of 25 percent. So you’re in hurting status, the hurt locker as they say, fast. Contrast that with the failure-to-pay penalty. It’s one half of 1 percent per month up to 25 percent.

MALE SPEAKER: Wow.

JEFF FOUTS: So they really, really want you to file that tax return.

MALE SPEAKER: Um-hmm.

JEFF FOUTS: But people don’t know. I mean, do they know that they’re going to…

MALE SPEAKER: That’s right.

JEFF FOUTS: And the time starts when the tax return was due. So if you’ve asked for a legitimate extension, it counts from the extension time.

MALE SPEAKER: So that’s a way of saving some money if you know to do that.

JEFF FOUTS: Right.

MALE SPEAKER: Is that right?

JEFF FOUTS: Yes. If you file that tax return, you save yourself a lot of money.

MALE SPEAKER: Yeah. So, I mean, if you had a pretty average amount…let’s say you owe $10,000. After five months, you’re talking about $2500 in fees, right?

JEFF FOUTS: Yes.

MALE SPEAKER: So, yeah, big difference. Versus $250 I believe because you said half a percent would be if it was the…failure to pay is half a percent?

JEFF FOUTS: Right.

MALE SPEAKER: We’re good. Anything else?

JEFF FOUTS: Do you have time? Oh, I’ve got tons more, but, I mean, is this enough for today?

MALE SPEAKER: It is enough for today, absolutely. So thanks, and we’ll talk to you next week.

JEFF FOUTS: Thank you. Bye.

Note: Because we ran out of time, we plan to have a future audio interview where we get Jeff’s insight on removing tax penalties (this is called penalty abatement).