The Four That Can Cost You and How to Avoid Them

Most taxpayers think IRS penalties only apply to those who ignore their taxes.

But the truth is, even diligent, responsible people can get caught in penalty traps often without realizing they did anything wrong.

That’s because IRS penalties are always based on one thing: an unpaid balance. Whether it’s underpaid estimated taxes, a missed payment deadline, or filing late with money still owed, these penalties exist to encourage timely, accurate payment not to punish honesty.

If you don’t owe the IRS, you can relax. Missing the April 15 or October 15 filing deadline won’t trigger penalties if you’re due a refund (with one edge case exception for underpayment penalties).

But if you do owe, those dates matter and understanding how each penalty works can help you avoid unnecessary costs, stress, and interest piling up month after month.

Let’s break down the four main types of IRS penalties that affect individual taxpayers, plus what you can do to reduce or eliminate them.

1. The Underpayment of Estimated Tax Penalty

What It Is

The IRS expects you to “pay as you go” either through paycheck withholding or quarterly estimated payments.
If you don’t pay enough during the year, or pay too late, you may owe an Underpayment of Estimated Tax by Individuals penalty.

When It Applies

You could trigger this penalty if:

• You didn’t have enough tax withheld from your paychecks, retirement income, or Social Security.

• You made quarterly estimated payments late.

• You owed $1,000 or more when filing your return.

For solopreneurs and S-corporation owners, this penalty is especially relevant because your income isn’t always steady, and quarterly estimates can easily fall behind actual earnings.

How It’s Calculated

The IRS looks at three factors:

• How much you underpaid

• How long the payment was late

• The quarterly interest rate in effect during that period

For 2024, the general rule of thumb is to pay at least:

• 90% of this year’s total tax, or

• 100% of last year’s total tax (110% if your prior-year adjusted gross income exceeded $150,000

If you meet either of those tests, you’re usually safe.

A Hidden Advantage for S-Corporation Owners

Here’s a smart insider move:

If you operate through your own S corporation and pay yourself a W-2 salary, the IRS assumes your withholding occurred evenly throughout the year even if you withhold it all in Q4.

That means a properly timed year-end payroll run with adequate withholding can often erase or reduce an underpayment penalty, because the IRS “back-dates” W-2 withholding as if it were paid quarterly.

This technique is fully compliant under Treasury regulations governing withholding treatment and can be a valuable planning lever for business owners who prefer to delay cash flow outlays until year-end.

(Tax Sherpa note: Always coordinate this with your payroll processor and tax professional to ensure the timing and amounts align with your total estimated liability.)

The Business Owner’s Dilemma

Many business owners look at the underpayment penalty as part of the cost of doing business. The IRS is essentially charging you an interest rate for not paying on-time. However, if that capital is of more use in the business then many business owners may decide to take the penalty hit and use that capital throughout the year.

Warning: if you do this, you had better make sure:

1. You don’t lose the money in a bad investment, and

2. Your use of capital outpaces the interest rates

Using Schedule AI for Irregular or “Lumpy” Income

If your income isn’t steady, say you’re in real estate, consulting, or sales where most of your earnings hit late in the year the IRS lets you match your estimated payments to when you actually earned the money.

That’s what Schedule AI (Annualized Income Installment Method) on Form 2210 is for. It lets you calculate each quarter’s liability based on your real cash-flow pattern instead of assuming equal income every quarter.

It takes discipline. You'll need to keep detailed quarterly records and run the math but it’s one of the most powerful ways to avoid penalties without overpaying early in the year.

How to Avoid It

• Use the IRS Tax Withholding Estimator to run a mid-year checkup.
  

• Make quarterly payments by the standard due dates (April 15, June 15, September 15, January 15).

• Note 1: the same dates also apply to state estimated payments.

• Note 2: with the expansion of State and Local Tax (SALT) deductions under the One, Big, Beautiful Bill Act passed July 4, 2025 it can be advantageous to make that 4th quarter state estimated payment in December instead of January.
  

• Adjust your withholding or estimates after any major income change especially if your business takes off mid-year.

Relief Options

You can request a penalty waiver if your shortfall was caused by:

• Retirement or disability within the past two years.
  

• A casualty, disaster, or other unusual circumstance beyond your control, or
  

• Irregular income that qualifies under the annualized income method discussed above.

Automatic disaster relief: If you live or operate in a FEMA-declared disaster area, the IRS typically automatically waives penalties and extends deadlines for affected taxpayers no special application required. Always check current IRS disaster bulletins for your state.

2. The Late Filing Penalty (Failure to File)

What It Is

The IRS cares just as much about when you file as what you file.

If you miss the tax return deadline, even by a few days, and you owe money, the IRS can assess a Failure to File penalty.

This is one of the two “late” penalties that really adds up, and it’s the reason the April 15 and October 15 deadlines matter so much. These dates don’t determine when you owe the money. They determine whether you filed the paperwork on time.

If your return shows a refund, you’re in the clear and no penalty applies.

But if you have a balance due and your return arrives after the filing deadline, the clock starts ticking on this steep penalty.

How It’s Calculated

• 5% of the unpaid tax per month or partial month, up to a 25% maximum.
  

• If you’re more than 60 days late, there’s a minimum penalty: $510 for returns due after December 31, 2024.
  

• If both the Failure to File and Failure to Pay penalties apply, the IRS reduces the filing penalty by the payment penalty (so you’re not being double-charged).
  

It’s the 5% monthly hit that makes this penalty so painful even a short delay can quickly turn a manageable balance into a snowballing liability.

How Extensions Work (Form 4868)

The Form 4868 – Application for Automatic Extension of Time to File buys you an extra six months until October 15 to submit your tax return.

But here’s the critical point:

It only extends the time to file, not the time to pay.

If you file Form 4868 on or before April 15, you’ll avoid the Failure to File penalty as long as your return is filed by October 15.

However, any unpaid balance from April 15 forward will still accrue:

• 0.5% monthly late payment penalties, and
  

• daily interest on the unpaid tax.

So the extension protects you from the paperwork penalty, but not the cash flow penalty.

If you think you’ll owe, always make an estimated payment with your extension. It’s better to slightly overpay and get a refund later than to trigger months of penalties and interest.

Why These Deadlines Matter

Think of April 15 and October 15 as the IRS’s “paperwork checkpoints.”

• April 15: File your return or your extension (Form 4868).
  

• October 15: File the completed return if you extended.

As long as the IRS has your paperwork by those dates, the Failure to File penalty stays off the table even if you still owe tax.

For self-employed business owners juggling deadlines, this distinction is crucial. The April 15 and October 15 dates are filing deadlines, not payment deadlines but missing them can be the costliest mistake you make all year.

Best Prevention

Even if you can’t pay right away, file your return or extension on time.

Doing so immediately stops the 5% monthly penalty from starting and often saves thousands in unnecessary charges.

At Tax Sherpa, we tell our clients: “File first, fix cash flow second.”

You can always set up a payment plan or installment agreement later but you can’t undo a missed filing deadline once it passes.

3. The Late Payment Penalty (Failure to Pay)

What It Is

Filing your tax return is only half the equation. The IRS also expects full payment of any balance due by the filing deadline.

If you don’t, the IRS adds a Failure to Pay penalty, which functions much like an interest charge on unpaid taxes, but it’s a completely separate fee from IRS interest itself.

The penalty accrues at 0.5% of the unpaid balance per month (or part of a month), up to a maximum of 25%.

It’s the government’s way of saying, “We’ll wait, but it’ll cost you.”

How It Differs from IRS Interest

While both the Failure to Pay penalty and IRS interest feel like finance charges, they operate under different rules and stack on top of each other.

The penalty is like a flat monthly late fee, while interest is a daily compounding charge. Together, they can quietly double a balance if left unchecked for too long.

How Extensions Impact the Penalty

This is where many taxpayers get tripped up. Every year I hear people tell me, “But I filed an extension!”

When you file Form 4868 (Application for Automatic Extension of Time to File), you’re getting extra time to submit your paperwork, not extra time to pay.

That means:

• The Failure to File penalty is paused until your extended deadline (usually October 15).
  

• But the Failure to Pay penalty still starts on April 15 and continues each month until the balance is paid or a payment plan is approved.

So even if you’ve filed an extension, the IRS still expects you to estimate and pay your expected balance by April 15. Any unpaid portion continues to accrue:

• 0.5% monthly penalty, and
  

• daily interest on the unpaid amount.

If you pay at least 90% of what you owe by April 15 and cover the rest by your October 15 extension, the IRS generally won’t impose the Failure to Pay penalty.

That’s why strategic taxpayers use Form 4868 with a payment not just as a placeholder. But in this scenario a placeholder is still better than nothing because of the Failure to File penalty discussed above.

Bottom line:

• An extension protects you from the Failure to File penalty.
  

• It does not protect you from the Failure to Pay penalty.
  

• Paying something, even if not the full amount, before April 15 saves you months of unnecessary fees.

Example

If you owe $10,000 and don’t pay for 10 months, the Failure to Pay penalty alone will add $500, plus another $583 in interest at 7% compounded daily — over $1,000 extra just for timing.

And because the penalty is based only on your remaining balance, every dollar you pay early stops a portion of that growth.

How to Stop the Meter

1. Make a payment immediately.
   Even partial payments reduce both penalties and interest.
   

2. Set up an installment agreement.
   Once approved, your penalty rate drops from 0.5% to 0.25% per month.
   If your balance due is under $50,000 any payment plan requests are granted automatically. You can set one up at https://www.irs.gov/payments/online-payment-agreement-application
   

3. Request relief if appropriate.

   • Reasonable Cause Relief for circumstances beyond your control (serious illness, casualty, disaster).
     

   • First-Time Abatement if you’ve been compliant for the prior three years.
     

   • Both can be requested with Form 843.
     

4. Increase late-year withholding if you own an S Corp.
   Since W-2 withholding is treated as paid evenly throughout the year, this can help offset prior underpayments and reduce penalty exposure.

Pro Tip from Tax Sherpa

When you can’t pay in full, don’t freeze. Strategize.

Treat IRS penalties like business interest: something to manage, not fear.

Every payment, adjustment, or plan you set in motion slows the IRS’s clock and brings you one step closer to financial control.

At Tax Sherpa, we remind clients: “Filing late costs you 5%. Paying late costs you 0.5%.”

Knowing the difference and managing it proactively can save you thousands and keep your focus where it belongs: building, not backtracking.

4. Interest on Penalties and Unpaid Balances

The Silent Multiplier

Interest is the quiet multiplier that can turn a small oversight into a serious balance.
Even after penalties are added, the IRS keeps the meter running, compounding interest daily on both your unpaid tax and any assessed penalties until everything is paid in full.

This isn’t a flat “one-time” charge; it’s a moving target that reacts to the economy.

How the IRS Sets the Rate

IRS interest rates are directly tied to the federal short-term rate which, in turn, follows the Federal Reserve’s target for the federal funds rate.

Every quarter, the IRS recalculates the rate as:

Federal short-term rate + 3 percentage points for individuals

For years, when the Fed held rates near zero, IRS interest hovered around 3% or less, barely noticeable.

But as the Fed began raising rates to combat inflation, IRS interest followed suit.

For the first quarter of 2025, the rate for individuals is 7% per year, compounded daily.

That means if you owe a balance in March and still haven’t paid by June, you’ll owe slightly more each day. Not just because of the penalty, but because of the rising cost of money itself.

Why It Matters

The practical impact is this:

• When the Fed lowers rates, IRS interest drops making payment plans slightly cheaper.
  

• When the Fed raises rates, your tax debt instantly becomes more expensive to carry.

If you’re on an installment agreement or planning to pay off a balance over time, it pays (literally) to keep an eye on these quarterly adjustments. A single percentage-point swing in the Fed rate can add hundreds of dollars a year to your IRS balance.

How to Stay Ahead of It

1. Monitor quarterly rate changes.
   The IRS publishes updates every three months in a Revenue Ruling usually announced mid-quarter on IRS.gov/newsroom.
   

2. Pay as soon as possible.
   Because interest compounds daily, even short delays cost money. A payment made today saves interest tomorrow.
   

3. Combine payments strategically.
   If you’re on a plan, round up payments when cash flow allows; reducing the principal cuts both penalties and daily interest accrual.
   

4. Ask your advisor to model scenarios.
   At Tax Sherpa, we regularly run “what-if” projections showing how different payoff dates and interest changes affect total cost helping clients plan instead of react.

The Tax Sherpa Takeaway

Interest isn’t a punishment, it’s economics in motion.

You could make the argument that the IRS is a government organization and the Federal Reserve is a quasi-government organization so the one shouldn't make the other more expensive. But that's getting in to my Defund the Government philosophy.

By understanding how rates shift with the broader economy, you can anticipate costs, make smarter payment decisions, and reclaim a sense of control.

Because while the Fed decides the rate, you decide how long it applies to you.

5. Relief & Abatement: How the IRS Offers a Second Chance

Even the IRS recognizes that life happens.

There are formal ways to ask for penalties to be removed or reduced, and in many cases, they work — if you understand how to present your story clearly and within the rules.

There are three main types of penalty relief:

1. First-Time Abatement (FTA)
   

2. Reasonable Cause Relief
   

3. Disaster Relief

Let’s break them down.

1. First-Time Abatement (FTA): “First Time” Doesn’t Always Mean What You Think

The IRS uses the phrase “first time” loosely.

Just like “first-time homebuyer” exceptions under other parts of the tax code, “first-time abatement” doesn’t literally mean it’s your first penalty ever. It means you meet the IRS’s definition of compliance history:

• You filed all required returns (or valid extensions) for the past three years.
  

• You paid, or arranged to pay, any tax due for those years.
  

• You have no prior penalties during that same three-year period.

If those boxes are checked, the IRS will generally remove a single penalty often without requiring an explanation or long appeal. It’s designed as a “good taxpayer” reward for an otherwise clean track record.

However, FTA can only be used once every three years per taxpayer, and it doesn’t combine with other forms of relief for the same year. Think of it as a one-time “reset button.”

2. Reasonable Cause Relief: When Life Truly Gets in the Way

This type of relief applies when your failure to file or pay was due to circumstances beyond your control — and you acted responsibly once you could.

Common qualifying situations include:

• Serious illness or injury (to you or a close family member)
  

• Death in the family
  

• Fire, flood, or other casualty loss
  

• Reliance on incorrect written advice from the IRS itself
  

• Other “unusual circumstances” where imposing a penalty would be unfair

Real-world example:

We’re currently assisting a client whose wife passed away after a long battle with cancer. He was also ill and fell several years behind on his filings. We’re preparing a request for reasonable-cause relief under these circumstances. Not as an excuse, but as documentation of genuine hardship.

These cases take time because a human being at the IRS reviews them. And right now, with staffing shortages and partial government shutdowns, that process is even slower.

In our experience, the IRS often shows genuine empathy when taxpayers provide honest, well-organized explanations.

How to apply:

• File Form 843 (Claim for Refund and Request for Abatement).
  

• Attach a signed statement, under penalty of perjury, detailing what happened, when it occurred, and why it prevented compliance.
  

• Include supporting documentation (medical records, death certificates, insurance reports, or the IRS letter containing the incorrect advice).

While each case is subjective, strong documentation and a clear timeline make a major difference.

3. Disaster Relief: Automatic and Affirmative Options

Whenever a federally declared disaster occurs like a hurricane, wildfire, earthquake, tornado, the IRS usually issues a press release and Revenue Procedure outlining specific relief for affected taxpayers.

That relief may include:

• Extended filing and payment deadlines
  

• Automatic penalty waivers for late payments
  

• Special rules for claiming casualty losses or accessing retirement funds without penalty

In many cases, the IRS will automatically apply relief based on the address listed on your tax return if it falls within a FEMA-declared disaster area.

However, that matching system isn’t perfect. If you relocated, use a business mailing address outside the affected region, or suffered indirect losses, you may need to affirmatively request relief by referencing the specific disaster declaration number in your correspondence.

Pro tip: Keep an eye on the IRS Newsroom for disaster announcements. Each relief package can vary. Sometimes even including retroactive deductions or special extensions authorized by Congress.

What All Three Have in Common

All three relief paths require:

• Compliance moving forward — the IRS rarely grants abatement if you’re still behind.
  

• Documentation — whether it’s tax transcripts, receipts, or personal statements.
  

• Patience — because these reviews are done by real humans, not algorithms.

But the payoff can be meaningful. Penalties can add up to 25% or more of a balance; having them removed can turn an overwhelming debt into something manageable and give you a clean slate to rebuild.

The Tax Sherpa Perspective

At Tax Sherpa, we’ve seen both sides: the bureaucracy and the humanity.

Yes, the IRS is a massive system but within it are real people who read your story and often apply discernment. When you approach the process with honesty and clarity, relief is absolutely possible.

Our role is to make sure your request is strategic, documented, and persuasive transforming frustration into forward momentum. Because when you’re facing penalties, a second chance isn’t just paperwork, it’s peace of mind.

6. How to Prevent Penalties Before They Start

Avoiding penalties isn’t about “gaming the system.” It’s about staying ahead of it.

The taxpayers who consistently avoid IRS penalties all have one thing in common: they treat tax planning as a process, not a once-a-year event.

At Tax Sherpa, we build that process around each client’s level of complexity and comfort.

Three Levels of Proactive Partnership

1. Monthly Planning & Oversight
For business owners with fast-moving cash flow, payroll changes, or unpredictable income, we meet monthly to review books, update projections, and confirm that withholdings and estimated payments align with real numbers.
This level of attention allows us to:

• Spot issues before they become penalties
  

• Integrate taxes into ongoing cash-flow planning
  

• Model “what-if” scenarios in real time

Monthly clients rarely see penalties at all, and when they do, it’s usually by design as part of a calculated strategy, not an accident.

2. Quarterly Reviews & Adjustments
For most small business owners and self-employed professionals, quarterly tax strategy meetings strike the right balance.

We revisit your numbers before each estimated tax due date: April 15, June 15, September 15, and January 15 to confirm payments, review profitability, and adjust for income fluctuations.

This cadence ensures your quarterly estimates aren’t based on guesswork and keeps your “safe-harbor” coverage intact.

3. Annual Check-Ins & Safe-Harbor Compliance
If your situation is relatively straightforward: predictable income, consistent withholding annual planning may be sufficient.

When we prepare estimated-tax coupons for the year ahead, we base them on the IRS safe-harbor rule:

Paying 100% of last year’s tax (or 110% if your adjusted gross income exceeded $150,000) will generally protect you from underpayment penalties.

This method ensures you’ll avoid the most common timing-based penalty.

However, keep in mind that safe-harbor estimates won’t prevent other penalties like Failure to File or Failure to Pay the two most expensive and preventable types.

Those depend entirely on meeting deadlines and staying current on balances owed, not just calculations.

Practical Habits That Keep You Penalty-Free

✅ Automate your payments.
Use IRS Direct Pay or EFTPS to schedule quarterly payments in advance. Automation removes human forgetfulness from the equation.

✅ Do a mid-year review.
Major life or business changes — a new revenue stream, a property sale, or a move — can shift your tax picture dramatically. A quick review mid-year can save months of interest and stress later.

✅ Keep clean books.
Accurate bookkeeping is the foundation of every smart tax move. It lets you project, adjust, and document for relief requests if ever needed.

✅ Engage proactively with your tax professional.
Whether monthly, quarterly, or annually, the key is consistency. Your advisor can only help you steer if you stay in communication as the year unfolds.

The Tax Sherpa Perspective

Penalties don’t appear overnight, they build quietly when no one’s watching.

The right systems, paired with the right level of professional support, ensure you never wake up to an unexpected notice.

Our philosophy is simple: predict, plan, prevent.

Because when you stay ahead of the IRS calendar, you stay in control of your financial future.

7. The Tax Sherpa Perspective: Clarity = Control

At Tax Sherpa, we know our clients aren’t careless they’re ambitious entrepreneurs juggling a dozen priorities.
Penalties aren’t a reflection of neglect; they’re often a symptom of chaos in an already overloaded system.

Our mission is to bring order to that chaos. We help you understand how the IRS thinks, automate your obligations, and turn tax season from a source of anxiety into a moment of confidence.

Because when you’re in control of your numbers, you’re in control of your freedom financial and mental.

Ready to Stop Worrying About IRS Penalties?

Let’s review your current year’s tax picture together.
We’ll identify where penalties could appear, build a payment strategy to prevent them, and ensure you never overpay again.

👉Schedule your Tax Survey Session →
Get clarity. Gain control. Keep more of what you earn the smart, legal, Tax Sherpa way.

References

• IRS: Underpayment of Estimated Tax by Individuals Penalty
  

• IRS: Failure to File Penalty
  

• IRS: Interest Rates Announcement – Q1 2025
  

• IRS: Publication 505

• IRS: Form 2210 Instructions

• IRS: Publication 1586 – Reasonable Cause Regulations