The U.S. tax system is complex, and one of the most painful surprises for many taxpayers is an unexpected IRS penalty or interest charge. Whether you're an executive with equity comp, a business owner, or simply someone with side income, even minor missteps in withholding, estimated payments, or filing timing can trigger costly consequences.
At VIP Wealth Advisors, our goal is to help clients not only maximize returns but also avoid unnecessary tax costs. This article walks you through the critical penalties and interest rules imposed by the IRS and how you can strategically plan to avoid them.
It helps to think of penalties as the IRS's "late fees" for noncompliance (late filing, underpaying, misstatements), and interest as the cost of borrowing from the IRS (on unpaid taxes or penalties). Crucially, penalties often accrue interest themselves, creating a compounding effect.
Understanding both parts is essential because a slight delay or underpayment can snowball over time, especially for high-income individuals with volatile cash flows.
If you miss the original tax filing deadline, the IRS imposes a failure-to-file penalty. The penalty is calculated as 5% of the unpaid tax (after subtracting withholding, credits, etc.) for each month, or portion of a month, that the return is late, up to a maximum of 25%.
If both the failure-to-file and failure-to-pay penalties apply in the same month, the combined penalty is capped at 5% (which effectively is 4.5% for filing + 0.5% for payment) for that month.
If your return is more than 60 days late, there is a minimum penalty: the lesser of (i) a flat dollar amount (for 2025, that is $485) or (ii) 100% of the unpaid tax balance.
Also important: the failure-to‐file penalty stops increasing after 5 months (i.e., reaches its 25% maximum) even if the return is still unfiled.
If you expect to owe tax, filing on time, even if you can't pay in full, can significantly reduce your penalty exposure by avoiding this steep 5% monthly hit.
You can file on time and still incur a penalty if you don't pay what you owe by the due date. That's the failure-to-pay penalty. The base rate is 0.5% per month (or part of a month) of the unpaid tax balance, from the day after the return due date, until the tax is paid in full.
This penalty is capped at 25% of the unpaid tax.
If you enter into an installment agreement, the rate is reduced to 0.25% per month while the agreement is in place.
In late collection stages (after the IRS issues a final notice of intent to levy), the rate can increase to 1% per month on the portion subject to levy.
Importantly, whereas the failure-to‐file penalty caps out at 25% after 5 months, the failure-to-pay penalty continues to accumulate (up to its 25% ceiling) until the tax is paid.
If both penalties apply, the combined maximum you can be charged is 47.5% (22.5% from failure-to-file + 25% from failure-to-pay) of the unpaid tax.
For taxpayers who rely heavily on non-wage sources (self-employment, capital gains, dividends, equity compensation), it's insufficient to wait until filing day; you must pay estimated taxes (or withhold sufficiently) during the year. If you underpay in any quarter, the IRS may impose a penalty under IRC Section 6654.
The IRS calculates this penalty based on:
Taxpayers can avoid or reduce the penalty by satisfying safe harbor rules:
Suppose your income is uneven, such as when you receive a large bonus or equity vesting later in the year. In that case, you can use Form 2210, Schedule AI (annualized income installment method), to allocate your payments more precisely and potentially reduce penalties.
You are not always required to file Form 2210; if you prefer, you can let the IRS compute the penalty and issue a notice.
When the IRS detects errors in your return beyond simple miscalculations, more severe penalties may apply:
The IRS may also assess penalties for information return failures (e.g., missing or incorrect Forms 1099 or W-2) and tax preparer penalties. For example, penalties for tax preparers in 2025 include $60 for each failure to sign a return (up to a total cap) and similar amounts for other misconduct.
Unlike penalties, interest is assessed on any unpaid tax (and on penalties once they attach), on a daily compounding basis.
The interest rate is set by the IRS quarterly, based on the federal short-term rate plus a margin (often +3%).
For example, for individual taxpayers, the interest rate on unpaid taxes has been 7% annually in the first two quarters of 2025.
Interest starts accruing the day after the tax due date and continues until full payment is made.
Since penalties accrue compound interest once they are added, postponing any payment, including penalties, can increase the overall cost over time.
The interplay of penalties and interest is what makes unpaid tax so costly. Here's how the sequence typically works:
The IRS does offer relief in certain circumstances. Understanding these routes is key to mitigating damage when unfortunate events intervene.
First-Time Penalty Abatement (FTA):
If you have a clean compliance record (i.e., filed and paid on time for the last three years), you may qualify for a one-time waiver of specific penalties (failure to file, failure to pay, failure to deposit).
Reasonable Cause Relief:
If you can demonstrate that circumstances beyond your control (serious illness, natural disaster, death in the family, reliance on incorrect IRS guidance) prevented compliance, the IRS may waive penalties. You'll need to document and persuasively argue the case.
Statutory Exceptions or IRS Error:
If the IRS itself made an error, or there exists a specific statutory waiver, that may also justify abatement.
To request relief, you typically file a written request (for example, via Form 843) or include an abatement request when responding to a notice, citing the specific penalty code and grounds for relief.
Interest is rarely abated, even when penalties are.
It's often not blatant negligence that leads to penalties but the subtleties that high-income taxpayers and business owners frequently face:
Preventing IRS penalties is all about proactive planning. Some of our top recommendations:
At VIP Wealth Advisors, we integrate tax planning and wealth management so that penalty and interest exposure is part of the ongoing strategy, not an afterthought.
We perform:
By weaving tax risk management into your financial plan, we aim to protect your returns from unseen IRS costs.
The most common IRS penalties include the failure-to-file penalty, the failure-to-pay penalty, and the underpayment of estimated tax penalty. Other penalties can apply for accuracy-related errors, negligence, fraud, or failure to provide information returns (such as 1099s). These penalties can add up quickly, especially when combined with daily compounding interest.
The IRS calculates interest on unpaid taxes daily, starting from the original due date of the return (not the extension date).
This means interest can continue to grow even if you've already been assessed penalties, resulting in a compounding effect that increases your total balance due.
The failure-to-file penalty applies when a taxpayer misses the tax filing deadline, even if no payment is due. It's typically 5% of the unpaid tax per month, up to a maximum of 25%. The failure-to-pay penalty applies when you file your return on time but don't pay the full balance due. This penalty is 0.5% per month (also up to 25%) until the tax is paid in full.
If both penalties apply in the same month, the failure-to-file penalty is reduced by the amount of the failure-to-pay penalty, preventing a "double hit" in that month.
Yes. The IRS may remove or reduce penalties through Penalty Abatement if you can demonstrate reasonable cause, such as illness, natural disaster, or reliance on incorrect professional advice. The IRS also offers First-Time Penalty Abatement (FTA) for taxpayers who have a clean compliance history for the previous three years.
However, interest cannot be abated, even if your penalty is reduced.
The underpayment of estimated tax penalty applies when a taxpayer doesn't pay enough tax during the year through withholding or estimated payments. You can avoid it by meeting one of the following safe harbors:
The IRS calculates this penalty using Form 2210 for individuals or Form 2220 for businesses.
Penalties and interest continue to accrue until the full balance is paid. The IRS generally has 10 years from the date of assessment to collect unpaid taxes, known as the Collection Statute Expiration Date (CSED).
However, if you enter into an installment agreement or file for bankruptcy, this period can be paused or extended.
The only way to stop IRS interest from accruing is to pay your balance in full. Interest continues to compound daily until the tax and any associated penalties are fully paid. Setting up an installment agreement can reduce further penalties, and paying through the IRS Direct Pay system ensures your payment is immediately applied to the correct tax year.
No. If you are due a refund, the IRS does not assess late payment or underpayment penalties, even if you file after the due date. However, filing late may delay your refund, and after three years, you forfeit your right to claim it.
Businesses can face similar penalties as individuals, but there are additional ones, such as:
Because these penalties can be severe, sometimes exceeding 100% of the unpaid trust fund amount, business owners should address IRS notices immediately.
Yes. A qualified tax professional, especially an IRS Enrolled Agent (EA) or CPA, can analyze your IRS transcripts, identify penalty relief options, and negotiate directly with the IRS. Professionals can also help determine whether you qualify for abatement, reasonable cause relief, or a streamlined installment agreement to stop further accruals.
The IRS generally does not waive interest, even if penalties are removed. The only exceptions are if the interest was charged because of an IRS error or unreasonable delay, which must be documented and proven.
To avoid future penalties:
Ignoring IRS penalty notices can lead to escalation in enforcement, including liens, levies, wage garnishments, or asset seizures. The IRS sends multiple notices before taking enforced collection action, but penalties and interest continue to accrue throughout the process. Prompt action, even if only setting up a payment plan, can prevent these consequences and preserve your rights.
Don't wait until penalties start compounding. Meet with a CFP® and Enrolled Agent to review your current tax strategy and identify potential risks before they cost you thousands.